Tag Archives: FOMC

Re: WSJ: Greg Ip’s Article

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right, it’s a way to keep the ff rate from falling below target, but does nothing for ‘liquidity’ that’s not already being done.

seems fomc maybe still struggling with ‘monetary operations’

From: Adam
Sent: Tuesday, April 29, 2008 3:59 AM
To: a
Subject: CS: DEF WORTH A READ – GREG IP ARTICLE THAT PROPOSES ANOTHER FED INNOVATION – ALL EXPLAINED BELOW

 

Greg Ip’s piece in the WSJ received some attention today. The piece is titled “ Fed to Consider Paying Interest To Commercial Banks on Reserves” and states that the Fed will discuss this proposal at todays meeting. There is no suggestion that the Fed are about to immediately change the current standard policy of paying zero per-cent for reserve balances, but given that the press had a very good lead on the introduction of the TSLF and PDCF it’s prudent to pay attention. (http://online.wsj.com/article/SB120941973079950909.html?mod=economy_lead_story_lsc)

The reason for changing policy and paying interest on reserve balances is not at first obvious, but is in fact a simple way for the Fed to solve the problem of increasing cash liquidity in the banking system without driving down the Fed effective rate. As the Fed take illiquid asset-backed securities from banks they hand over cash in return. As banks get zero interest on reserve balances that are left with the Fed they quickly seek to place their newly raised cash out into the market, earning a coupon on their investment instead of earning nothing on a reserve balance. As the Fed pay nothing it is in every banks interest to lend any excess balances at rates greater than zero, and what typically happens is that the cash market rate falls dramatically as cash rich banks try and find bids, offering at lower and lower rates until we get close to zero. This is an unwelcome development from the Fed’s perspective as the effective Fed Funds rate that results is often significantly lower than the official Fed target rate. By injecting large amounts of cash liquidity into the system the Fed may actually undermine their own target rate.

Paying a coupon on reserve balances would allow the Fed to inject as much cash via asset-backed repo as they like without needing to worry about driving down the Fed effective cash rate. The Fed would effectively sterilize their own cash injection by placing a guaranteed fixed rate floor on reserve funds, and ensuring that something close to the Fed Funds target rate was achieved. This would mean that the Fed could continue to increase the amount of repo’s that they are willing to undertake and to upsize the auctions without concerns about the effects of huge amounts of excess cash

sloshing around in the system.

Some thoughts to go along with this:

  • Great care needs to be taken in setting guaranteed cash levels. Sometimes unexpected consequences result. Central banks like the RBA and RBNZ  have long operated a cash system which guarantees a floor on overnight rates at a margin below the target rate. This ensures that cash generally trades close to the target rate, or slightly rich to it. Generally local market participants prefer to hold an excess of long balances in the knowledge that cash shortages often occur, but they have a defined downside guarantee. In New Zealand’s case the RBNZ found that banks were hoarding cash to such an extent that the short dated market traded significantly above the OCR target because the banks had a 25bp downside guarantee. It wasn’t until the RBNZ reduced the guaranteed floor substantially that rates traded much closer to target.

 

Banks that get cash from the Fed via the PDCF currently seek to off-load that cash to the street, effectively spreading liquidity to all elements of the banking system, and discouraging the holding of very short term balances which will end of earning 0% if they are not on-lent. If the Fed’s guaranteed rate is not far enough below the FF target rate Banks will simply recycle any excess back to the Fed rather than taking unsecured interbank credit risk. This may leave the smaller regional Banks without direct Fed access short of cash, forcing them to pay a premium instead of getting funds at a discount. The challenge of course is that if the rate is set too far below the Fed Fund’s Target rate the Fed will have the same problem of the effective daily rate printing substantially beneath target. An appropriate margin that the Fed should pay on reserves is likely to be around 50bp below the target rate. This will prevent the Fed effective rate from collapsing, but the 50bp penalty will also incentivise banks to find alternative borrowers wherever possible

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Changing Tides

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I’ve been thinking that when the Fed turns its attention to inflation it will find itself way behind that curve, which it is by any mainstream standard, and that the curve then gets negative from a year or two out as markets anticipate rate hikes followed by falling inflation and rate cuts.

Didn’t know exactly how it would get from here to there, how long it would take or exactly when it would happen.

I never thought the Fed would let it go this far. Especially Governor Kohn, who has been through this before in the 1970s with Burns, Miller, and Volcker. This FOMCs inflation tolerance lasted a lot longer than I expected, even with a weak economy and perceived systemic risk.

Won’t be long before the mainstream comes down hard on this FOMC for letting the inflation cat out of the bag with a high risk, untested, counter theory strategy of aggressively cutting into a triple negative supply shock. The mainstream will see it as a ‘hail Mary’ move. If it works, fine, if not it was a foolish error with a major price to pay to fix it.

Maybe they just got what will turn out to be overconfident in their inflation fighting ability. Kind of a ‘we know how to do that and can do it anytime’ attitude.

Wrong. They will soon find out it is not so easy.

Maybe they got confused and saw the tail risk as that of the gold standard era when there were real supply side constraints to money to deal with.

Also, they probably blamed the whole 1970’s thing on labor unions; so, maybe they got blind sided this time because they thought without unions wages would be ‘well contained’ and therefore there would be no inflation.

Wrong on that score as well. It was about oil before, and it is about oil now.

And the fact is, they have no tools for fighting inflation. They think they do (hiking rates), but higher rates just make it worse by raising costs and jacking up rentier incomes. (Incomes of savers who do not work or produce = more demand and no supply)

The inflation broke in the early 80’s only because of a supply response of about 15 million barrels of crude per day that buried OPEC and caused prices to collapse for almost 20 years. (And even during the 20 years of low oil prices and falling imported prices inflation still averaged around 3%.)

That kind of supply response is not going to happen in the near future. I expect the Saudis to keep hiking and inflation to keep getting worse no matter what the Fed does. It is payback time for them from being humiliated in the 1980s, and they are also at ideological war with us whether we know it or not.

Markets might have a false start or two with the interest rate response and flattening curve, just to not make it too easy.

Also, as before, there could be an equity pullback when it is sensed the Fed is going to seriously fight inflation with hikes designed to keep a sufficient output gap to bring inflation increases down.

And along the way everything goes up, including housing prices, during a major cost push inflation. Even with low demand. Just look at all the weak emerging market nations that have had major inflations with weak demand, high rates, etc. etc.

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WSJ: Taul Paul chimes in

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The FOMC take this very seriously:


Volcker’s Demarche

On the dollar, Mr. Volcker’s blunt talk of crisis is a welcome tonic to the devaluationist consensus that now dominates Washington. The world has been staging a run on the greenback, with damaging results if it continues. Mr. Volcker noted that when “concerns about recession are rife,” the central bank will be tempted to “subordinate the fundamental need to maintain a reliable currency” to the impulse to shore up a flagging economy. The danger is that you lose both battles, as the U.S. did in the 1970s, and wind up with stagflation.

The present climate, Mr. Volcker told his audience, reminded him of nothing so much as the early 1970s. Then as now, certain commodity prices were rising fast – he cited oil and soybeans as two examples. Then as now too, these were explained away as speculative price run-ups and not as a harbinger of a broader inflationary trend.

We all know how that ended, and Mr. Volcker knows better than anyone. He was the one who, at the end of that decade, had to step in and raise interest rates to punitive levels to break the back of that bout of inflation. With commodity prices spiking again – soybeans are $12 a bushel today compared to $7 a year ago – Mr. Volcker is warning the Fed not to let inflationary expectations become embedded once again.

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FOMC

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Karim Basta:

  1. Further cut to gwth outlook
  2. Financial conditions tighter and housing getting worse
  3. Inflation receives greater concern than prior statement
  4. Conclusion: downside risks predominant and ‘timely’ means another intermeeting cut on the table.

Agreed, further comments below:

Release Date: March 18, 2008

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Could have been 100 as anticipated by the markets. Fed shaded its cut to the low side of the priced in expectations.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed

Implies there is still some growth, not negative yet.

and labor markets have softened.

Looking unrevised February payroll number, not the lower unemployment rate. In January they looked at the higher unemployment rate. Unemployment has subsequently gone from 5.0% to 4.9% to 4.8% (rounded).

Financial markets remain under considerable stress,

They went a long way to relieve stress over the weekend.

and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Housing starts were revised up, and other indicators indicate it may have bottomed.

Inflation has been elevated, and some indicators of inflation expectations have risen.

This was noted in several Fed intermeeting speeches.

The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization.

They continue to make this projection even after being completely wrong for many meetings.

Still, uncertainty about the inflation outlook has increased.

That’s why – their forecasts have proven unreliable, and crude/food continues to rise as the USD continues to fall.

It will be necessary to continue to monitor inflation developments carefully.

Only ‘monitor’? No action planned.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Intermeeting action is on the table, for both growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.

Wonder how much less aggressive?

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, and San Francisco.

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CNNMoney.com: Dallas Fed President: Inflation, not recession, is No. 1 woe – Mar. 4, 2008

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Yes, Fisher is on record as the lead inflation hawk.

If he’s right and it turns out Bernanke cut rates into a 70’s style inflation Fisher has to be a leading candidate for Fed Chairman. Much like when Volcker replace Miller in 1979. And Kohn gets passed over a second time, this time for missing the inflation surge, if it happens.

Too early to tell which way it will go. I give the odds to inflation, whether the economy strengthens or weakens.

Bernanke is betting his career that the economy will weaken and bring inflation down. And, as he stated last week, ‘and the futures markets agree.’

Fed officials debate recession risk

Dallas Fed President Fisher argues inflation greatest threat to economy, while Fed Governor Mishkin says recession risks are greater than central bank’s forecast.

by Chris Isidore

Fed's aggressive cut fans fear
The central bank’s decision to slash rates are raising inflation fears as the economy shows signs of slowing. Play video



NEW YORK (CNNMoney.com) — Two members of the Federal Reserve’s rate-setting body gave conflicting speeches Tuesday as to whether rising inflation or a recession is the greater risk for the economy.

Inflation risk greater Dallas Federal Reserve President Richard Fisher said Tuesday he believes inflation is a greater threat, saying he would accept a slowdown of the U.S. economy in order to keep price pressures in check. The remarks suggest that Fisher, a so-called inflation hawk, will keep pushing his Fed colleagues to stop cutting rates.

But Frederic Mishkin, a Fed governor and a close ally of Fed Chairman Ben Bernanke, argued in a speech to the National Association for Business Economics that the risks are so great that the economy will not be able to meet even the Fed’s modest forecast, which essentially calls for little or no growth in the first half of the year. He argued price pressures remain in check and that the threat from inflation should wane in upcoming years.

The Fed made a 0.75 percentage point rate cut at an emergency meeting Jan. 21, and another half-point cut at the conclusion of the Jan. 29-30 meeting. Fisher, who joined the Federal Open Market Committee for the two-day meeting, was the sole vote against that cut.

The FOMC is next set to meet March 18, and investors are widely expecting another half-point cut at that meeting.

In remarks prepared for a speech in London, Fisher said that he’s upset by talk that recent Fed rate cuts represent an “easy money” policy by the U.S. central bank.

“Talk of ‘cheap money’ makes my skin crawl,” he said in his prepared remarks. “The words imply a debased currency and inflation and the harsh medicine that inevitably must be administered to purge it.”

“So you should not be surprised that I consider the perception that the Fed is pursuing a cheap-money strategy, should it take root, to be a paramount risk to the long-term welfare of the U.S. economy,” he added.

Fisher points out that yields on long-term bonds have risen, not declined, in the wake of the Fed rate cuts, a sign of growing concern about inflation – although he conceded that traders could be mistaken about the effect of the cuts on prices.

“Twitches in markets that have occasionally led me to wonder if they were afflicted with the financial equivalent of Tourette’s syndrome,” he said.

But Fisher said inflation readings have not been encouraging and that he believes price pressures can continue to build even in the face of an economic slowdown, an economic condition popularly known as “stagflation.”

Fisher argues it’s better to have the economy go into an economic downturn than to risk a pickup in inflationary pressure through low rates due to global forces.

“We cannot, in my opinion, confidently assume that slower U.S. economic growth will quell U.S. inflation and, more important, keep inflationary expectations anchored,” he said. “Containing inflation is the purpose of the ship I crew for, and if a temporary economic slowdown is what we must endure while we achieve that purpose, then it is, in my opinion, a burden we must bear, however politically inconvenient.”

Recession risk greater But Mishkin said he believes the economy is at greater risk than seen in the Fed forecast released last month which called for modest growth between 1.3% to 2% between the fourth quarter of 2007 and the end of this year.

“I see significant downside risks to this outlook,” he said. “These risks have been brought into particularly sharp relief by recent readings from a number of household and business surveys that have had a distinctly downbeat cast.”

The Fed governor argues that the housing prices are at risk of falling more than forecasts, and that if that happens, he believes it will put a crimp in both consumer confidence and their access to credit. He said that the declines also could create greater upheaval in the financial markets, which he argues “causes economic activity to contract further in a perverse cycle.”

Mishkin also said he expects the problems in the economy to cause a rise in unemployment. And while he believes the Fed needs to keep an eye on inflation pressures, he doesn’t believe they pose a significant threat anytime soon.

“By a range of measures, longer-run inflation expectations appear to have remained reasonably well contained even as recent readings on headline inflation have been elevated,” he said.

“I expect inflation pressures to wane over the next few years, as product and labor markets soften and the rise in food and energy prices abates,” he added. He also said he believes that inflation measures that strip out volatile food and energy prices should be close to 2% a year going forward, which is the upper end of what is generally believed to be the Fed’s comfort zone that leaves the door open for further rate cuts.

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Here’s how Congress sees it…

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Congress sees their voters facing prices that are rising faster than incomes due to Fed rate cuts driving the $ down.

Bernanke testifies that price hikes for food and energy are not a problem for the Fed until wages go up.

So, he’s going to keep cutting rates and driving the cost of living higher until wages go up or Wall Street recovers.

Then, he hikes rates if inflation isn’t behaving.

Hardly a comforting response to those working for a living and getting squeezed by the high prices.

With elections coming, I anticipate the Congressional opposition to escalate.

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FT.com The Economists’ Forum (cont.)

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On 3/1/08, Wray, Randall wrote:

agreed supervisors/regulators need to do their job. however there is also something to be said for economic growth restoring balance sheets. i think his proposal to clamp down hard on banks now to get capital ratios up would make things worse.

Yes, seems it could hurt current demand. The government of Japan wound up buying preferred stock from the banks at the expense of shareholders, much like the sovereign wealth funds are doing today in the US.

No one seems to understand the US doesn’t ‘need money’ from any source, and instead feels the nation owes a debt of gratitude to those who invest $ here.

For a long time no one understood the fundamentals: exports are costs, imports benefits, no govt solvency issues, nominal vs real issues, what is and isn’t a function of interest rates, financial equity for one sector must come from another, savings is the accounting record of investment, loans create deposits, CBs are about price not quantity, etc.- but it didn’t matter that much they all had it wrong on the way up.

On the way down it is turning what was potentially a non-event for the US real economy into a massive real loss for the US standard of living.

The ‘answer’ to restoring domestic demand and enhancing price stability and real wealth remains:

Offer a public service job to anyone willing and able to work:

  1. better price anchor than unemployment
  2. can produce useful output
  3. reduces social costs of current system
  4. provides a channel to ‘distribute’ productivity gains from the bottom up
  5. let’s the market set the budget deficit

Eliminate using the liability side of banking for ‘market discipline’ by lowering the discount rate to the target interest rate and opening it to any bank with any ‘bank legal’ collateral for any gross $amount. The net will be very small in any case.

Use capital requirements for market discipline and also regulate assets as currently is the case.

Get the treasury out of the capital markets by eliminating government securities and leave the excess balances from government deficit spending in bank reserve accounts.

Leave interest rates at zero, and let the Fed concentrate on regulation.

Unilaterally eliminate restrictions on exports to the US apart from quality and env. concerns.

To keep domestic industries deemed essential for national security have government buy from them, but let the private sector source anywhere.

Restore the notion of real terms of trade to national politics.
etc.

But since none of that is going to happen, I see continued weakness and a lower standard of living via ever higher prices and deteriorating terms of trade.

And a Cervantesesque Fed pursuing a merchantalist ideal.

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Plosser Speech

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Plosser is perhaps the most hawkish Fed president.

Look for a dove to speak soon to soften this stance?

(intro remarks deleted)

The FOMC and Monetary Policy Objectives

In conducting monetary policy, the FOMC seeks to foster financial conditions, including growth of money and credit and a level of
short-term interest rates, consistent with achieving two goals: price stability and maximum sustainable economic growth.

Note this general policy statement:

I believe that the most important contribution the Fed can make to sustained economic growth and employment rests on credibly committing to and achieving long-run price stability. In fact, without a credible commitment to maintaining price stability, the Fed’s ability to promote sustainable growth would be seriously undermined. Moreover, price stability is not only an important element in achieving sustained economic growth, it is also critical in promoting financial stability.

That is the mainstream view, and the view the Fed has presented to Congress over the years regarding how it complies with its dual mandate: get price stability right and markets function to promote optimum long-term growth and employment.

The primary tool for implementing monetary policy is the federal funds rate,

(SNIP)

It is important to recognize that the influence of changes in the FOMC’s targeted funds rate on inflation and economic growth occurs with a lag, so by necessity the FOMC must be forward-looking in setting an appropriate funds rate target. It must forecast future economic growth and inflation based on available economic data and financial conditions, including a particular path for the fed funds rate.

(SNIP)

A change in the economic outlook is what was at work in the last two weeks when the FOMC decided to reduce its target fed funds rate in two steps to its current level of 3 percent.

Let me elaborate on recent economic and financial conditions and my current outlook for the economy and inflation.

The Outlook
Since last August, financial and economic conditions have deteriorated. As that occurred, policymakers revised downward their forecasts for 2008 economic growth. This took place in several steps as new data were released and, in turn, led the FOMC to lower the federal funds rate in a series of steps.

By last September, we had already seen a cumulative deterioration in the housing sector during the earlier part of 2007. In addition, the disruptions in financial markets in August caused by the problems in the subprime mortgage market raised the risk of potential adverse effects on the broader economy from a further tightening of credit conditions. As a result, I lowered my projection of economic growth for the fourth quarter of 2007 and the first half of 2008. In particular, the adjustment to my forecast involved pushing back the turnaround in residential construction, as low demand for homes meant it would take longer than expected for the economy to work off the inventories of new and existing homes for sale. The continuing high prices of oil and other commodities also suggested the potential for some slowing in the pace of economic activity, as well as hinting at increasing inflationary pressures — a point I will return to later. As the outlook changed, the FOMC lowered the fed funds rate target by 50 basis points in September, and then by another 25 basis points in both October and early December.

Since the Committee’s meeting in early December, the economic data have indicated that the deterioration in the housing market has continued unabated. Although that by itself was discouraging, other economic indicators also showed signs of an economy that was weakening. The renewed widening of some credit spreads in financial markets, along with weaker figures for retail sales, manufacturing activity, and job growth in December, led many forecasters in early January to further mark down their forecasts for 2008. The sharp rise in December’s unemployment rate, which was released in early January, also heightened many economists’ concerns about the economy’s health. What’s more, the Philadelphia Reserve Bank’s closely watched manufacturing survey recorded a surprisingly steep decline in industrial activity in January, to a level not seen since the last recession.

Although the economy’s resilience to past shocks makes me cautious about making changes to my outlook based on just one or two pieces of economic news, the string of weaker than anticipated numbers released in late December and in January had a cumulative effect on my own assessment of the 2008 outlook. While I would not be very surprised if the economy bounces back more quickly than many forecasters are now projecting, I am now, nevertheless, anticipating a weaker first half of 2008 than I did in October. This downward revision to the economic outlook is what led me to conclude that a substantially lower level of interest rates was needed to support the process of returning the economy to its trend rate of growth. Consequently, I believe the recent reductions in the federal funds rate were a necessary and appropriate recognition of this changed outlook.

The ongoing housing correction and the volatility and uncertainty in the credit markets are significant near-term drags on the economy and I expect growth in the first half of the year to be quite weak, around 1 percent. As conditions in the housing and financial markets begin to stabilize, I expect growth to improve in the second half of the year and to move back to trend, which I estimate is around 2.7 percent, in 2009. Overall, I am now anticipating economic growth in 2008 of near 2 percent.

Confirming ‘trend’ GDP at 2.7%.

Given the slowdown in economic growth this year, payroll employment will rise more slowly than last year and will remain below trend for much of the year before picking up in 2009. Slower job growth will also lead to an unemployment rate near 5-1/4 percent in 2008, after fluctuating between 4‑1/2 and 5 percent in 2007.

Two adjustments will continue to be needed to help work down the large number of unsold homes: further cuts in construction and declines in housing prices. I expect the decline in housing starts will bottom out in the middle of this year, but starts are likely to then be quite flat through the end of 2009 as the inventory of unsold homes is reduced gradually.

Interesting how long he thinks starts will stay around one million.

Of course, as was the case in 2007, how quickly housing bottoms out remains one of the main uncertainties surrounding any forecast in today’s environment. It seems that ever since last spring, the turnaround in housing was always six months away. Well, nine months later, it is still six months away. Simply having housing stop contracting will help economic growth. In 2007 the decline in residential construction took 1 percentage point off real GDP growth, which turned out to be 2.5 percent for the year (4th quarter to 4th quarter). Once residential construction stops declining, it will cease subtracting from overall growth. But housing is unlikely to make a positive contribution to economic growth until 2009.

Business investment should continue to increase this year, but at a slower pace than in 2007. Outside of autos and housing, there isn’t a large inventory overhang in the economy to be worked off. This is actually good news. Recessions are often preceded by periods of large inventory accumulation and much of the decline in production during recessions reflects a working off of an inventory imbalance. The absence of such an inventory overhang is encouraging.

The biggest component of GDP is consumer spending. With slower growth of employment and personal income in the first half of 2008, and as the decline in the value of homes and equities diminishes households’ net worth, consumer spending is likely to grow more slowly before picking up again in 2009.

One piece of good news has been the growth in exports. The trade sector supported economic growth last year as domestic demand weakened in the U.S. while foreign growth remained strong. The declining dollar also helped fuel a rebound in our exports. The net export component of GDP should continue to improve this year, although more slowly than it did in 2007 because we are likely to see somewhat slower growth among our major trading partners this year.

Inflation
Let me now turn to the outlook for inflation. Unfortunately, I expect little progress to be made in reducing core inflation this year or next, and I am skeptical that slower economic growth will help.

My understanding is the Fed was forecasting weakness that would bring down inflation.

All you have to do is recall the 1970s when we experienced both high unemployment and high inflation to appreciate that slow economic growth and lower inflation do not necessarily go hand in hand. I anticipate that core inflation (which excludes the prices of food and energy) is likely to remain in the 2 to 2‑1/2 percent range in 2008, which is above the range I consider to be consistent with price stability. If oil prices stabilize near their current levels, I expect headline, or total, inflation to decrease to around the 2 to 2‑1/2 percent range in 2008.

That is not a welcome forecast for the FOMC. They don’t want to conduct policy that lets core get that high.

(SNIP)

As the FOMC’s January 30 statement said, it will be necessary to continue to monitor inflation developments carefully. Most measures of inflation, including the core CPI and core PCE price measures, accelerated in the second half of 2007 compared to the first half. With inflation creeping up, we have to be particularly alert for rising inflation expectations. It is important that inflation expectations remain stable. If those expectations become unhinged, they could rapidly fuel inflation.

Again, that is the mainstream view. The expectations operator is key to a relative value story turning into an inflation story, as they say.

Moreover, as we learned from the experience of the 1970s, once the public loses confidence in the Fed’s commitment to price stability, it is very costly to the economy for the Fed to regain that confidence. The painful period of the early 1980s was the price the economy paid to restore the credibility of the Fed’s commitment — we certainly do not wish to go through that process again.

The mainstream often states it this way: ‘The real cost of bringing down inflation once expectations elevate is far higher than the cost of a near term recession.’

Fortunately, so far inflation expectations have not changed very much. But they bear watching because there are some signs that they, too, are edging higher. These may be early warning signs of a weakening of our credibility, and we must be very careful to avoid that.

The Fed is divided here. Most say that if expectations begin to elevate, it could be too late -the inflation cat is out of the bag- so, that much be avoided at all costs. Others say you can let them elevate a little bit, but must then act quickly to bring inflation down.

Monetary Policy Going Forward

(SNIP)

Over the course of the last five months, as forecasts for economic growth have been revised downward, the FOMC has lowered the fed funds rate by 225 basis points — from 5.25 percent to 3 percent. Taking expected inflation into account, the level of the federal funds rate in real terms — what economists call the real rate of interest — is now approaching zero. That is clearly an accommodative level of real interest rates. The last time the level of real interest rates was this low was in 2003-2004. But that was a different time with a different concern — deflation — and we were intentionally seeking to prevent prices from falling. Recently we have had reason to be worried about rising inflation, not declining prices.

This is a very strong statement – real interest rates are near zero, which was maybe appropriate given deflation fears in 2004, but he says not that is not the issue.

The FOMC’s reductions in the federal funds rate have been proactive in responding to evolving economic conditions that led to the deterioration in the outlook for economic growth. My inclination to alter monetary policy depends on whether the accumulation of evidence based on the data between now and our next meeting causes me to revise my forecast further. Weaker than expected data might lead to a downward revision, while stronger than expected data may lead to an upward revision to the forecast.

To make this point concrete, last Friday the Bureau of Labor Statistics reported that the economy lost 17,000 jobs in January. This was not an encouraging number. However, it was consistent with my forecast of weak employment growth in the first quarter of this year. Thus, by itself, it does not lead to a substantive revision to my forecast. We must look at the accumulation of data from a variety of sources to assess how the outlook may have changed relative to what was expected.

The payroll number did not change his forecast.

I also want to note that in early January there was much concern when the BLS reported only 18,000 jobs were created in December. Yet in the employment report last Friday that preliminary number was revised up to 82,000. Thus, we have to realize that economic data are subject to revision, and we have to be very careful not to rely on any one statistic or data series in assessing current economic conditions or our outlook.

Looks like he recognized January may be also revised up as December and August were.

There are those who have expressed the view that in times of economic weakness, the Fed must not worry about inflation and should focus its entire effort on restoring economic growth by dramatically driving interest rates down as far and as rapidly as possible. To borrow a line attributed to that famous, or perhaps infamous, Union Admiral David Farragut at the Battle of Mobile Bay, it is sort of a “damn the torpedoes, full speed ahead” approach to policy. But the Fed has a dual mandate for a reason. Price stability is a necessary component for achieving sustained economic growth. Ignoring price stability during times of economic weakness risks undermining our ability to achieve economic growth over the long run. It fuels higher inflation down the road and risks inappropriate risk taking and recurring boom/bust cycles. This would be counterproductive.

Again, this is the mainstream view.

Although it might be tempting to think that monetary policy is the solution to most, if not all, economic ills, this is not the case. I think it is particularly important, for example, to recognize that monetary policy cannot solve all the problems the economy and financial system now face. It cannot solve the bad debt problems in the mortgage market. It cannot re-price the risks of securities backed by subprime loans. It cannot solve the problems faced by those financial firms at risk of being given lower ratings by rating agencies because some of their assets are now worth much less than previously thought. The markets will have to solve these problems, as indeed they will. But it will take some time. However, the Fed can and should help by offsetting some of the restraint created by tightening credit conditions and the sharp reduction in housing investment. The Fed can and should also promote the orderly functioning of financial markets.

Going forward, then, my approach to making monetary policy decisions will be to look at incoming information and ask whether it is consistent with my outlook and the achievement of the Fed’s dual mandate. My outlook for 2008 already incorporates the fact that we will be receiving quite a few weak economic numbers in the first half of the year. However, to the extent that economic conditions evolve differently than expected, we will need to be prepared to incorporate those changing conditions into our policy decisions in a manner that is consistent with our dual mandate.

He uses the term ‘dual mandate’ to stress the importance of price stability.

Conclusion
In conclusion, my own forecast for economic activity has been revised downward since last October as economic conditions have evolved. I believe the recent reductions in the level of the federal funds rate target will be supportive of the economic adjustment process and a return to trend growth near the end of this year and on into 2009. The Fed has been aggressive in making this adjustment in rates, which will mitigate some, but not all, of the problems the economy and financial markets are facing. Some problems will simply take time for the financial markets to work out.

Seems his opinion is that unless the economy weakens more than currently forecast, the Fed is done.

In taking aggressive action in supporting the economy’s eventual return to its trend growth rate, I continue to believe we must not lose sight of the other part of the Fed’s dual mandate – which is price stability. We cannot be confident that a slow-growing economy in early 2008 will by itself reduce inflation.

The FOMC has been banking on this happening, Plosser is not so sure.

I am also convinced that we need to keep our eye on both headline as well as core inflation in assessing how well we are doing in achieving our goal of price stability.

Going forward, monetary policy decisions will depend on how the economy unfolds and whether further changes in the economic outlook are necessary.

Again, let me thank Philip Jackson and the Rotary Club for inviting me to return to speak here in Birmingham.

♥

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