Tag Archives: Kohn

Re: Letter from Kohn to you, 1994

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(an email exchange PLUS pdf of Kohn letter)

consider it public information,
as you can see, he’s one of the few who understand monetary operations

thanks!

>   
>   On Mon, Aug 25, 2008 at 7:58 PM, Steve wrote:
>   
>   Hi Warren,
>   
>   Hope all is well with you.
>   
>   A year or two ago, William Hummel was kind enough to give me a copy of the
>   response you received from Donald Kohn regarding Fed/Treasury money
>   mechanics, confirming what you had laid out in S.C.E.; copy of letter is
>   attached.
>   
>   I might want to use that sometime in the future, if the occasion arises, to help
>   bolster an argument or two — but wanted to ask you permission beforehand.
>   If you’d like to keep it private, I’ll just paraphrase it as necessary.
>   
>   Thanks, and take care,
>   Steve
>   
>   ps- If you still have a copy of your letter to Greenspan, I wouldn’t mind seeing
>   how you worded your questions to him.
>   

Letter from Kohn to Warren, 1994


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Re: Kohn to ROW- You hike, not us (today’s speech)

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(an interoffice email)

On Thu, Jun 26, 2008 at 7:48 AM, Karim wrote:
>   
>   
>   

Global Economic Integration and Decoupling


Vice Chairman Donald L. Kohn
At the International Research Forum on Monetary Policy, Frankfurt, Germany
June 26, 2008

For the moment, higher headline rates of inflation have shown only a few tentative signs of embedding themselves in core inflation or in longer-term inflation expectations.

>   -talking about u.s. here
>   
>   
>   

However, policymakers around the world must monitor the situation carefully for signs that the increases in relative prices globally do not generate persistently higher inflation. Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

>   -not describing/talking about u.s. here;
>   focusing on EM primarily.
>   
>   

right, gets back to bernankes testimony a while back that the falling dollar has been a good thing as it works to lower the trade gap via increasing US exports that sustain US demand. the old ‘beggar they neighbor’ policy from the 30’s.

unfortunately for us it’s actually a ‘beggar thyself’ policy on closer examination as most mainstream economists will attest. they all say you don’t ‘inflate your way to prosperity’ by weakening your currency. otherwise latin america and africa for example would be the most prosperous places in the world

seems they are still in the mercantalist mode where exports are good and imports bad, and this policy is making us look like a bananna republic at an increasing rate.

recall from previous emails the dollar decline has been triggered by paulson succeeding in keeping cb’s from buying $US, Bush keeping oil producing monetary authorities from accumulating $US, and Bernanke discouraging foreign portfolio managers from accumulating same.

(more later on how it’s actually not happening due to fed rate policy, but they think it is)

as suspected, the $US is most likely to take another major leg down as it adjusts to a level where the trade gap is in line with foreign desire to accumulate $US financial assets which is probably a lot lower than the current 55-60 billion per month.

the ‘cost push inflation’ is pouring in through the trade channel, and the fed is increasingly taking the heat from the mainstream (not me- i’m the only one who thinks inflation isn’t a function of rates the way they do) for its apparent weak $US/inflate your way out of debt approach.

furthermore, the mainstream (and the stock market) sees the low interest rate/weak dollar policy as taking away US domestic demand as higher price for food/fuel leave less domestic income for everything else, including debt service.

that is, they see the falling dollar hurting us domestic demand more than the low interest rates are helping it.

the reality is there’s foreign monopolist- the saudis (and maybe russians)- that’s milking us for all they can with price hikes, and keeping us alive buying our goods and service and thereby keeping US gdp muddling through.

the real standard of living for most working americans has dropped by perhaps 10% as they work, get paid enough to eat and drive to work, and the rest of their real output is exported.

and our policy makers, including bernanke and paulson who’ve ‘engineered it’ think this is all a good thing- they think imports are bad and exports good and we are paying the price in declining real terms of trade.

while in my book interest rates are not a factor, the mainstream thinks they are, and the response when the inflation gets bad enough will be higher interest rates. The ‘correct’ anti-inflation rate last August was 5.25 when the fed didn’t cut.

by Jan 08 it was probably at least 7% with headline moving through 3% to get a sufficient ‘real rate.’

today it’s probably moved up to 8%+ as cpi is forecast to go through 5% over the next few months and gdp muddles through around 1%.

the mainstream (not me) will say that by having a real rate that’s too low now the fed will need a rate that much higher down the road as inflation accelerates due to over accommodative fed policy.

by the time the cost push inflation works its way to core- probably over the two quarters- the fed will ‘suddenly’ feel itself way behind the inflation curve and recognize they made a horrible mistake and now the cost of bringing down inflation is far higher than it would have been early on- just like they’ve always said.

the mainstream knows this, and now sees a fed with its head in the sand regarding inflation. they also see this weak dollar policy as subversive as it undermines the currency and inflation accelerates.

i expect there will be a groundswell of mainstream economists calling for the replacement of bernanke, kohn and the entire fomc very soon.

ironically, in my book low rates have helped moderate inflation via cost channels and have helped moderate domestic demand via interest income channels.

rate hike will add to domestic demand as net interest income of the private sectors from higher government interest payments add to personal income and demand.

and rate hikes will add to the cost push inflation via higher interest costs for firms.

it’ all going down hill fast, with policy makers both going the wrong way on key issues as they have the fundamentals backwards.

the only near term ‘solutions’ are near term crude oil supply responses like 30 mph speed limits which isn’t even under consideration in any form, nor are any other crude supply responses. most other alternative energy sources don’t replace crude.

medium term supply responses include pluggable hybrids that only start being produced in late 2010.

longer term supply responses include nuclear which might come on line 15 years down the road.

a collapse in world demand is possible if china/india let up on their deficit spending and growth, but so far that doesn’t seem in the cards. all their ‘tightebning’ seems to be on the ‘monetary’ side which does nothing of consequence apart from further increase inflation.

so with no supply responses on the horizon expect the saudis to keep hiking prices, and keep spending the new revenues to keep world gdp muddling through, cb’s hiking interest rates that will bring results that will cause them to hike further, and continuously declining real terms of trade for oil importers.

what to do?

cds on germany- it’s one go all go over there, and germany is the least expensive insurance.

forward muni bmas over 80 with no interest rate hedge as markets should discount the obama lead and long move up with inflation.


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Another look at Kohn’s June 11th speech

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This still reads hawkish to me:

The results of such exercises imply that, over recent history, a sharp jump in oil prices appears to have had only modest effects on the future rate of inflation. This result likely reflects two factors. First, commodities like oil represent only a small share of the overall costs of production, implying that the magnitude of the direct pass-through from changes in such prices to other prices should be modest, all else equal. Second, inflation expectations have been well anchored in recent years, contributing to a muted response of inflation to oil price shocks. But the anchoring of expectations cannot be taken as given; indeed, the type of empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to the last two decades, a period in which inflation expectations were not as well anchored as they are today.

Nonetheless, repeated increases in energy prices and their effect on overall inflation have contributed to a rise in the year-ahead inflation expectations of households, especially this year. Of greater concern is that some measures of longer-term inflation expectations appear to have edged up since last year. Any tendency for these longer-term inflation expectations to drift higher or even to fail to reverse over time would have troublesome implications for the outlook for inflation.

The central role of inflation expectations implies that policymakers must look beyond this type of reduced-form exercise for guidance. After all, the lags of inflation in reduced-form regressions are a very imperfect proxy for inflation expectations. As emphasized in Robert Lucas’s critique of reduced-form Phillips curves more than 30 years ago, structural models are needed to have confidence in the effect of any shock on the outlook for inflation and economic activity.

This was considered the dovish part:

In particular, an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation. By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago.

So the question is whether that point was realized by a 2% Fed funds rate currently?

Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.

But it was then qualified by this return to hawkishness regarding the inflation expectations that he previously said showed signs of elevating:

I should emphasize that the course of policy I have just described has taken inflation expectations as given. In practice, it is very important to ensure that policy actions anchor inflation expectations. This anchoring is critical: As demonstrated by historical experiences around the world and in the United States during the 1970s and 1980s, efforts to bring inflation and inflation expectations back to desirable levels after they have risen appreciably involve costly and undesirable changes in resource utilization.11 As a result, the degree to which any deviations of inflation from long-run objectives are tolerated to allow the efficient relative price adjustments that I have described needs to be tempered so as to ensure that longer-term inflation expectations are not affected to a significant extent.

And the FOMC all agree that long term inflation expectations have been affected to some extent already.

Summary
To reiterate, the Phillips curve framework is one important input to my outlook for inflation and provides a framework in which I can analyze the nature of efficient policy choices. In the case of a shock to the relative price of oil or other commodities, this framework suggests that policymakers should ensure that their actions balance the deleterious economic effects of such a shock in the short run on both unemployment and inflation.

Of course, the framework helps to define the short-run goals for policy, but it doesn’t tell you what path for interest rates will accomplish these objectives. That’s what we wrestle with at the FOMC and is perhaps a subject for a future Federal Reserve Bank of Boston conference.

This all could mean a Fed funds rate that causes unemployment to grow and dampen inflation expectations down, but not grow so much as to bring inflation down quickly is in order.

The question then is whether the appropriate Fed funds rate for this ‘balance’ between growth, employment, and inflation expectations is 2% or something higher than that.

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June 9 Bernanke speech

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Outstanding Issues in the Analysis of Inflation

Nonetheless, much remains to be learned about both inflation forecasting and inflation control. In the spirit of this conference, my remarks this evening will highlight some key areas where additional research could help to provide a still-firmer foundation for monetary policymaking.

Good start!

Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.

Downside risks diminished, but still remain.

One of the most effective means by which the Federal Reserve can help to restore moderate growth over time and to reduce the associated downside risks is by supporting the return of financial markets to more-normal functioning. We have taken a number of actions to promote financial stability and remain strongly committed to that objective.

Technical market functioning action vs. interest rate cuts.

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities. Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand. However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention. Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.

Upside risks to inflation and inflation expectations have increased as the downside risks to growth have diminished.

Turning now to the principal topic of my remarks, I will briefly touch on four topics of particular interest for policymakers: commodity prices and inflation, the role of labor costs in the price-setting process, issues arising from the necessity of making policy in real time, and the determinants and effects of changes in inflation expectations.

Commodity Prices and Inflation

Rapidly rising prices for globally traded commodities have been the major source of the relatively high rates of inflation we have experienced in recent years, underscoring the importance for policy of both forecasting commodity price changes and understanding the factors that drive those changes.

Policymakers and other analysts have often relied on quotes from commodity futures markets to derive forecasts of the prices of key commodities. However, as you know, futures markets quotes have underpredicted commodity price increases in recent years, leading to corresponding underpredictions of overall inflation. The poor recent record of commodity futures markets in forecasting the course of prices raises the question of whether policymakers should continue to use this source of information and, if so, how.

It’s worse – they have been reading the market information incorrectly, confusing the difference between perishable from non-perishable commodities in regards to the term structures of futures contracts.

Despite this recent record, I do not think it is reasonable, when forecasting commodity prices, to ignore the substantial amounts of information about supply and demand conditions that are aggregated by futures markets. Indeed, the use of some simple alternatives–such as extrapolating recent commodity price trends–would require us to assume that investors in commodity futures can expect to earn supernormal risk-adjusted returns, inconsistent with principles of financial arbitrage. However, it does seem reasonable–and consistent with the wide distributions of commodity price expectations implied by options prices–to treat the forecasts of commodity prices obtained from futures markets, and consequently the forecasts of aggregate price inflation, as highly uncertain.

Futures markets for non-perishables express inventory conditions, not price expectations per se.

These considerations raise several questions for researchers: First, is it possible to improve our forecasts of commodity prices, using information from futures markets but possibly other information as well? For example, the markets for longer-dated futures contracts are often quite illiquid, suggesting that the associated futures prices may not effectively aggregate all available information. Second, what are the implications for the conduct of monetary policy of the high degree of uncertainty that attends forecasts of commodity prices? Although theoretical analyses often focus on the case in which policymakers care only about expected economic outcomes and not the uncertainty surrounding those outcomes, in practice policymakers are concerned about the risks to their projections as well as the projections themselves. How should those concerns affect the setting of policy in this context?

They need to understand what futures markets for non-perishables express.

Empirical work on inflation, including much of the classic work on Phillips curves, has generally treated changes in commodity prices as an exogenous influence on the inflation process, driven by market-specific factors such as weather conditions or geopolitical developments.

Or imperfect competition? Like the Saudis and/or Russians and/or Iranians setting price?

By contrast, some analysts emphasize the endogeneity of commodity prices to broad macroeconomic and monetary developments such as expected growth, expected inflation, interest rates, and currency movements. Of course, in reality, commodity prices are influenced by both market-specific and aggregate factors. Market-specific influences are evident in the significant differences in price behavior across individual commodities, which often can be traced to idiosyncratic supply and demand factors. Aggregate influences are suggested by the fact that the prices of several major classes of commodities, including energy, metals, and grains, have all shown broad-based gains in recent years. In particular, it seems clear that commodity prices have been importantly influenced by secular global trends affecting the conditions of demand and supply for raw materials.

And at least some influence from pension funds engaging in passive commodity strategies?

We have seen rapid growth in the worldwide demand for raw materials, which in turn is largely the result of sustained global growth–particularly resources-intensive growth in emerging market economies. And factors including inadequate investment, long lags in the development of new capacity, and underlying resource constraints have caused the supplies of a number of important commodity classes, including energy and metals, to lag global demand. These problems have been exacerbated to some extent by a systematic underprediction of demand and overprediction of productive capacity for a number of key commodities, notably oil. Further analysis of the range of aggregate and idiosyncratic determinants of commodity prices would be fruitful.

And biofuels converting our food supply to energy, thus linking the price of the two?

I have only mentioned a few of the issues raised by commodity price behavior for inflation and monetary policy. Here are a few other questions that researchers could usefully address: First, how should monetary policy deal with increases in commodity prices that are not only large but potentially persistent?

Attempt to add to demand with aggressive rate cuts like the FOMC has done?

Second, does the link between global growth and commodity prices imply a role for global slack, along with domestic slack, in the Phillips curve? Finally, what information about the broader economy is contained in commodity prices? For example, what signal should we take from recent changes in commodity prices about the strength of global demand or about expectations of future growth and inflation?

Or the emergence of imperfect competition and price setters as excess capacity dwindles?

The Role of Labor Costs in Price Setting

Basic microeconomics tells us that marginal cost should play a central role in firms’ pricing decisions.

More precisely, they have been assuming pricing where marginal cost and marginal revenue curves cross, not cost plus pricing.

And, notwithstanding the effects of changes in commodity prices on the cost of production, for the economy as a whole, by far the most important cost is the cost of labor.

Yes, and the cost of labor is also closely tied to the share of the output that goes to labor.

Over the past decade, formal work in the modeling of inflation has treated marginal cost, particularly the marginal cost of labor, as central to the determination of inflation.2 However, the empirical evidence for this linkage is less definitive than we would like.

‘Like’??? Yes, they blamed labor unions for the 1970s inflation, and now they would ‘like’ support for that presumption?

This mixed evidence is one reason that much Phillips curve analysis has centered on price-price equations with no explicit role for wages.

Problems in the measurement of labor costs may help explain the absence of a clearer empirical relationship between labor costs and prices. Compensation per hour in the nonfarm business sector, a commonly used measure of labor cost, displays substantial volatility from quarter to quarter and year to year, is often revised significantly, and includes compensation that is largely unrelated to marginal costs–for example, exercises (as opposed to grants) of stock options. These and other problems carry through to the published estimates of labor’s share in the nonfarm business sector–the proxy for real marginal cost that is typically used in empirical work. A second commonly used measure of aggregate hourly labor compensation, the employment cost index, has its own set of drawbacks as a measure of marginal cost. Indeed, these two compensation measures not infrequently generate conflicting signals of trends in labor costs and thus differing implications for inflation.

The interpretation of changes in labor productivity also affects the measurement of marginal cost. As economists have recognized for half a century, labor productivity tends to be procyclical, in contrast to the theoretical prediction that movements along a stable, conventional production function should generate countercyclical productivity behavior. Many explanations for procyclical productivity have been advanced, ranging from labor hoarding in downturns to procyclical technological progress. A better understanding of the observed procyclicality of productivity would help us to interpret cyclical movements in unit labor costs and to better measure marginal cost.

The relationship between marginal cost, properly measured, and prices also depends on the markups that firms can impose.

Right, this assumes they attempt to price where marginal cost curves cross with marginal revenue curves.

One important open question is the degree to which variation over time in average markups may be obscuring the empirical link between prices and labor costs. Considerable work has also been done on the role of time-varying markups in the inflation process, but a consensus on the role of changing markups on the inflation process remains elusive. More research in this area, particularly with an empirical orientation, would be welcome.

Real-Time Policymaking

The measurement issues I just raised point to another important concern of policymakers, namely, the necessity of making decisions in “real time,” under conditions of great uncertainty–including uncertainty about the underlying state of the economy–and without the benefit of hindsight.

In the context of Phillips curve analysis, a number of researchers have highlighted the difficulty of assessing the output gap–the difference between actual and potential output–in real time. An inability to measure the output gap in real time obviously limits the usefulness of the concept in practical policymaking. On the other hand, to argue that output gaps are very difficult to measure in real time is not the same as arguing that economic slack does not influence inflation; indeed, the bulk of the evidence suggests that there is a relationship, albeit one that may be less pronounced than in the past.

That’s a big issue. They suspect the Phillips Curve is very flat, which means large changes in the output gap are needed to change the price level.

These observations suggest two useful directions for research: First, more obviously, there is scope to continue the search for measures or indicators of output gaps that provide useful information in real time. Second, we need to continue to think through the decision procedures that policymakers should use under conditions of substantial uncertainty about the state of the economy and underlying economic relationships. For example, even if the output gap is poorly measured, by taking appropriate account of measurement uncertainties and combining information about the output gap with information from other sources, we may be able to achieve better policy outcomes than would be possible if we simply ignored noisy output gap measures. Of course, similar considerations apply to other types of real-time economic information.

This is particularly problematic as ultimately they see their role as altering the output gap to control inflation expectations.

Inflation itself can pose real-time measurement challenges. We have multiple measures of inflation, each of which reflects different coverage, methods of construction, and seasonality, and each of which is subject to statistical noise arising from sampling, imputation of certain prices, and temporary or special factors affecting certain markets. From these measures and other information, policymakers attempt to infer the “true” underlying rate of inflation. In other words, policymakers must read the incoming data in real time to judge which changes in inflation are likely to be transitory and which may prove more persistent.

Seems more important for the FOMC should be to determine what measure of inflation, if held stable, optimizes long-term growth and employment? Without that, what do they have under mainstream theory?

Getting this distinction right has first-order implications for monetary policy: Because monetary policy works with a lag, policy should be calibrated based on forecasts of medium-term inflation, which may differ from the current inflation rate. The need to distinguish changes in the inflation trend from temporary movements around that trend has motivated attention to various measures of “core,” or underlying, inflation, including measures that exclude certain prices (such as those of food and energy), “trimmed mean” measures, and others, but other approaches are certainly worth consideration.8 Further work on the problem of filtering the incoming data so as to obtain better measures of the underlying inflation trend could be of great value to policymakers.

I’m sure they are troubled about cutting rates into a triple negative supply shock based on forecasts of lower inflation that didn’t materialize.

The necessity of making policy in real time highlights the importance of maintaining and improving the economic data infrastructure and, in particular, working to make economic data timelier and more accurate. I noted earlier the problems in interpreting existing measures of labor compensation. Significant scope exists to improve the quality of price data as well–for example, by using the wealth of information available from checkout scanners or finding better ways to adjust for quality change. I encourage researchers to become more familiar with the strengths and shortcomings of the data that they routinely use. Besides leading to better analysis, attention to data quality issues by researchers often leads to better data in the longer term, both because of the insights generated by research and because researchers are important and influential clients of data collection agencies.

Implying that ‘if only they had better data they might not have made the same decisions’.

Inflation Expectations

Finally, I will say a few words on inflation expectations, which most economists see as central to inflation dynamics.

All mainstream economists. As Vice Chairman Kohn stated a few years ago, ‘the entire success of the US economy over the last twenty years can be attributed to successfully controlling inflation expectations’.

But there is much we do not understand about inflation expectations, their determination, and their implications. I will divide my list of questions into three categories.

First, we need to understand better the factors that determine the public’s inflation expectations. As I discussed in some detail in a talk at the National Bureau of Economic Research last summer, much evidence suggests that expectations have become better anchored than they were a few decades ago, but that they nonetheless remain imperfectly anchored. It would be quite useful for policymakers to know more about how inflation expectations are influenced by monetary policy actions, monetary policy communication, and other economic developments such as oil price shocks.

The growing literature on learning in macroeconomic models appears to be a useful vehicle to address many of these issues.10 In a traditional model with rational expectations, a fixed economic structure, and stable policy objectives, there is no role for learning by the public. In such a model, there is generally a unique long-run equilibrium inflation rate which is fully anticipated; in particular, the public makes no inferences based on central bankers’ words or deeds. But in fact, the public has only incomplete information about both the economy and policymakers’ objectives, which themselves may change over time. Allowing for the possibility of learning by the public is more realistic and tends to generate more reasonable conclusions about how inflation expectations change and, in particular, about how they can be influenced by monetary policy actions and communications.

Yes, the mainstream does consider that a serious topic of discussion!

The second category of questions involves the channels through which inflation expectations affect actual inflation. Is the primary linkage from inflation expectations to wage bargains, or are other channels important? One somewhat puzzling finding comes from a survey of business pricing decisions conducted by Blinder, Canetti, Lebow, and Rudd, in which only a small share of respondents claimed that expected aggregate inflation affected their pricing at all. How do we reconcile this result with our strong presumption that expectations are of central importance for explaining inflation?

Easy – they don’t matter at all. But then they are left with no theory of the price level, apart from the relative prices; so, they MUST matter.

Perhaps expectations affect actual inflation through some channel that is relatively indirect. The growing literature on disaggregated price setting may be able to shed some light on this question.

Good luck.

Finally, a large set of questions revolve around how the central bank can best monitor the public’s inflation expectations. Many measures of expected inflation exist, including expectations taken from surveys of households, forecasts by professional economists, and information extracted from markets for inflation-indexed securities. Unfortunately, only very limited information is available on expectations of price-setters themselves, namely businesses. Which of these agents’ expectations are most important for inflation dynamics, and how can central bankers best extract the relevant information from the various available measures?

Someday they will realize the currency itself is a simple public monopoly, and the price level is necessarily a function of prices paid by government. But that someday is nowhere in site; so, keep your eye on what they consider inflation expectations for clues to their next move.

Conclusion

This evening I have touched on only a few of the questions that confront policymakers as we deal with the challenges we face. The contributions of economic researchers in helping us to address these and other important questions have been and will continue to be invaluable. I will conclude by offering my best wishes for an interesting and productive conference.


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5 year tips 5 years forward and recent Fed speeches

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2008-05-22 5yr Tips 5yr Forward

5yr Tips 5yr Forward

The Fed watches this carefully in regard to inflation expectations, along with surveys and professional forecasts which have gone up considerably.

The 5 year tips 5 years forward dipped a couple of months ago on the generally commodity sell off, then fell again for short term technical reasons- the first five years went up with crude and the 10 year stayed about the same, so the forwards went down as a matter of arithmetic and little volume – and now this is all sorting itself out along the curve, with the forwards moving up as shown.

Just saw Fed Gov Warsh on TV saying the same thing Vice Chair Kohn said (and was also in the Fed minutes) they have to be careful about perceptions that the Fed’s inflation tolerance have gone up feeding into inflation expectations.

And concern has been further supported by pronouncements that even if the economy weakens some there’s no room for rate cuts.


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Vice Chair Kohn comment and today’s opening

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Recent comment by Fed Vice Chair Donald Kohn:

If longer-term inflation expectations were to become unmoored–whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought–then I believe that we would be facing a more serious situation.

This could be telling. It hasn’t been said before by any FOMC member, and it was voluntary, in that no one asked the question.

It is something he is trying to communicate.

The FOMC sees inflation expectations showing signs of elevating, and is wondering whether it is at least partially responsible.

Their ‘theory’ had told them there was an inflation price to pay for cutting into a triple negative supply shock if it went so far as to allow inflation expectations to accelerate.

Credit spreads are in substantially from the wides, GDP isn’t collapsing and forecasts are for modest improvements.

Fiscal rebates are kicking in, being spent, and supporting prices.

Inflation is ripping, and now has the full attention of the FOMC.

Oil 130+

Dollar down

Stocks down a touch

Interest rates up a touch

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Excerpt from Kohn’s speech

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My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations.

The FOMC has never wavered on this all important aspect of monetary policy – they firmly believe inflation expectations are what causes a relative value story to turn into an inflation story.

In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored–whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought–then I believe that we would be facing a more serious situation.

If inflation expectations come unmoored for any reason, inflation is thought to follow.

And here he expresses concern that inflation expectations may be rising due to a public perception that the Fed easings mean the Fed has a greater inflation tolerance.

Governor Kohn is clearly concerned that the Fed’s actions since August may be causing inflation expectations to elevate, and his statement further implies that it will take actual ‘action’ on the part of the Fed to dispel the notion that they are more tolerant of inflation.

Markets will not believe the Fed will take action on inflation until after they actually do it, but that the Fed will respond to weakness regardless of inflation. This was expressed by today’s price action. With crude hitting $129 EDs a year out are 8 bps lower in yield.

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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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Re: update

Posted on by

Dear Philip,

Seems there’s a break between Mishkin and Kohn that previously wasn’t there.
Markets are thinking Kohn supports a 50 cut and that he and Bernanke are alligned.

Today Bernanke may show whether he leans towards Mishkin, the co academic, or Kohn, more the practitioner.

Meanwhile, another ‘inflation day’ with oil and commodities up, $ down, and headlines like ‘Honda says no recession in US.’

All the best,
Warren

On 27 Feb 2008 09:09:43 +0000, Prof. P. Arestis wrote:
>
> Dear Warren,
>
> Many thanks.
>
> > Do you think Kohn’s speech indicates he’s ready to cut another half point
> > on Mar 18?
>
> I think the simple answer to the question is probably no with a question
> mark. I say this in the sense that before March 18 we will probably hear
> more about Kohn’s views, which may be clearer in terms of whether he is
> ready for another half point reduction. However, in terms of the analysis
> he offered in the piece you kindly sent me I did not see anything that
> suggested half point cut, although there is plenty in the piece to suggest
> that he is in favour of more cuts. I say this in that although he sees
> problems with the real economy he is also mindful of inflation, but he is
> not an ‘inflation nutter’ as some others are. So at this stage I believe he
> will go for a cut but not as much as half point.
>
> What do you think?
>
> Best wishes, Philip

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Kohn speech

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After the speech, crude up $1.61 and back over $100.
Yields down on fixed income as markets anticipate Fed won’t respond to inflation anytime soon:

February 26, 2008

The U.S. Economy and Monetary Policy

(SNIP)

Several major developments are shaping current economic performance, the outlook, and the conduct of monetary policy. The most prominent of these developments is the contraction in the housing market that began in early 2006. Both the prices and pace of construction of new homes rose to unsustainable levels in the preceding few years. For a time, the resulting correction was largely confined to the housing market, but the consequences of that correction have spread to other sectors of the economy.

The financial markets are playing a key role in the transmission of the housing downturn to the rest of the economy.

(SNIP)

The result has been a substantial tightening in credit availability for many firms and households.

At the same time, continued sizable increases in the prices of food, energy, and other commodities have raised inflation. To some extent, those increases have resulted from strong demand in rapidly growing emerging-market economies, like China and India. But the increases likely also reflect conditions such as adverse weather in some parts of the world, the use of agricultural commodities to produce energy, and geopolitical developments that threaten supplies in some petroleum-producing centers. The higher prices have eroded the purchasing power of household income, adding to restraint on spending.

(SNIP)

Recent Economic and Financial Developments

The pace of real economic activity stepped down sharply toward the end of last year and has remained sluggish in recent months. Real gross domestic product (GDP) is estimated to have risen only slightly in the fourth quarter. The contraction in the housing market continues to drag down economic growth. Declines in real residential investment subtracted nearly 1 percentage point from the overall increase in real GDP in 2007. Even so, the inventory of unsold new homes remains unusually high, because the demand for housing has fallen about as rapidly as the supply. Problems in the subprime market have virtually cut off financing in this sector. Prime jumbo mortgages are being made, but the lack of a secondary market has caused the spread between rates on these mortgages and on those that have been eligible for purchase by Fannie Mae and Freddie Mac to widen substantially. Even the standards for conforming mortgages have been tightened of late. Weak demand, in turn, is leading to widespread declines in the actual and expected prices of houses, further discouraging buyers. Starts of new single-family homes continued to fall in January, dropping to fewer than 750,000 units–a level of activity more than 1 million units below the peak in early 2006. Judging from the further decline in permits last month, additional cutbacks in construction are likely. It appears that the correction in the housing market has further to go.

For the better part of the past two years, the trouble in the housing market was contained; however, over the past several months, the weakness appears to have spread to other sectors of the economy. Tighter credit, reductions in housing and equity wealth, higher energy prices, and uncertainty about economic prospects seem to be weighing on business and household spending. Labor demand has softened in recent months. Private nonfarm payrolls were little changed in January, and the unemployment rate moved up to 4.9 percent, on average, during December and January, after remaining around 4-1/2 percent from late 2006 through most of 2007. The higher level of weekly claims for unemployment insurance suggests continued softness in employment this month.

Agreed, the economy has hit the ‘soft spot’ previously forecast by the Fed and private economists.

Apart from the labor market, the hard data on economic activity in the first quarter are limited, but, on the whole, the data suggest economic activity has remained very sluggish. Retail sales were up moderately in nominal terms in January, but after adjusting for the rise in prices of consumer goods, real spending on non-auto goods appears to have been little changed last month. In addition, unit sales of new motor vehicles weakened. Total industrial production rose just 0.1 percent in January for a second consecutive month, and manufacturing output was unchanged. Much of the other information about the current quarter has come in the form of surveys of business and consumers–and most all of it has been downbeat. That said, I can still see a few bright spots. One is that the level of business inventories does not appear worrisome at present. Another is that international trade continued to be a solid source of support for the economy through the end of last year. The worsening financial conditions and slower growth in the United States have had some effect on the rest of the world, but the prospects for foreign growth remain favorable.

Agreed, weak domestic demand supported by rising exports.

The most recent news on inflation–the January report on the consumer price index (CPI)–was disappointing. Once again, total or headline CPI was boosted by a jump in energy prices and relatively large increases in food prices; last month’s rise left the twelve-month change in the overall CPI at 4.3 percent–twice the pace a year ago. In addition, the January increase of 0.3 percent in the CPI excluding food and energy was slightly higher than the average monthly rate in 2007. Nonetheless, the twelve-month change in this measure of core inflation, at 2-1/2 percent, was still slightly below the rate one year earlier. The recent readings on core inflation suggest that the higher costs of energy, a pickup in prices of imported goods, and, perhaps, the persistent upward price pressures in commodity markets may be passing through a bit to core consumer prices.

Headline passing through to core – not good.

The Implications of Financial Stress for the Economic Outlook

(SNIP)

The pressures from the financial turmoil have been most intense for those financial intermediaries that have been exposed to losses on mortgages and other credits that are repricing, as well as for those institutions now required to bring onto their balance sheets loans that previously would have been sold into securities markets. As those intermediaries take steps to protect themselves from further losses and conserve capital, and as investors more broadly have responded to the evolving risks, spreads on household and business debt in securities markets have widened, the availability of bank credit has decreased, and equity prices have weakened.

In addition to the drying up of large portions of mortgage finance that I referred to previously, conditions have firmed on loans for a variety of other purposes. Responses to our Senior Loan Officer Opinion Survey in January showed that banks have tightened terms and standards for household and commercial mortgages, commercial and industrial loans, and consumer loans.

The Fed puts a lot of weight on this and reads it differently than I do. Yes, they have tightened standards, but that doesn’t mean those who had previously qualified no longer qualified under the new standards. For example, requiring a larger down payment is considered tightening, and there’s no evidence yet that would be borrowers don’t simply put more money down. Same with other ‘tightening standards’ issues.

In corporate bond markets, spreads have been widening on both investment- and speculative-grade issues. Lenders are demanding much higher risk premiums for commercial real estate loans. And equity prices have fallen substantially over the past seven months, reducing household wealth and increasing the cost of raising equity capital for businesses.

All true, but part of the great repricing of risk. Arguably spreads were unsustainably narrow a year ago.

To be sure, the easing of monetary policy that I will be discussing in a minute has, quite deliberately, been intended to offset the effect of this tightening, resulting in some borrowers seeing lower interest rates. But financing costs have risen, on balance, for riskier credits, and almost all borrowers are dealing with more cautious lenders who have adopted more stringent standards. Those financial market developments are, in many respects, a healthy correction to previous excesses.

Yes, agreed with that.

But, in some cases, they may represent an overreaction, or at least positioning for the small probability of very adverse economic conditions. In any case, they have the potential to adversely affect household and business spending.

Yes, they have that potential. And regulatory over reach is also a problem he doesn’t address, as the OCC is unnecessarily making things more difficult for small banks to function ‘normally’.

The recovery in financial markets is likely to be a prolonged process. The length of the recuperation will depend importantly on the course of the economy, particularly on developments in the housing market. If the deterioration in the housing market were greater than expected in coming months, the losses borne by financial institutions would be even greater, and lenders might further reduce credit availability. More widespread macroeconomic weakness could make lenders more cautious and could cause the financial problems to spread further. The recent problems of financial guarantors, with possible implications for municipal bond markets as well as for bank balance sheets, are an indication that the financial sector remains vulnerable.

Agreed that parts of the financial sector remains vulnerable, while others are doing exceptionally well.

Even in a more favorable economic environment, some time is likely to be required to restore the functioning and liquidity of a number of markets.

(SNIP)

The Monetary Policy Response

(SNIP)

As the deterioration in financial markets increasingly has threatened to hold down spending and employment, the FOMC has eased monetary policy, reducing the federal funds rate target by 2-1/4 percentage points since the turmoil erupted in August. Those actions have been intended to counteract the effects on the overall economy of tighter terms and conditions in credit markets, the drop in equity and housing wealth, and the steep decline in housing activity. Our objective has been to promote sustainable growth and maximum employment over time.

(SNIPS BELOW)

What policy can do is attempt to limit the fallout on the economy from this adjustment.

Lower interest rates should support aggregate demand over time, even in the face of widespread contraction in the supply of credit.


Among other things, lower rates should facilitate the refinancing of mortgage loans, and they will hold down the cost of capital to business.

Easier policy should also support asset prices–or at least cushion declines that otherwise would have occurred.

And expected policy easing likely contributed to the drop in the foreign exchange value of the dollar, which is bolstering our exports.

Yes, the ‘inflate your way out of debt’ approach. Highly unusual for a central bank to aggressively do this. Harks back to the ‘beggar thy neighbor’ policies of the 1930s.

The extent of the financial adjustment, as I mentioned previously, is itself highly dependent on how housing and the economy evolve. Part of the rise in risk spreads, reduction in credit availability, and the declines in stock prices in the past few months reflect investor efforts to protect themselves against the potential for very adverse economic outcomes–that is, the exposures and losses that would accompany a persistent steep decline in house prices and a significant recession. Of course, these actions–reducing exposures, tightening credit standards, demanding extra compensation for taking risk–themselves make these “tail risk” scenarios even more likely. In circumstances like these, the decisions of policymakers must take account of not only the most likely course of the economy, but also the possibility of very unfavorable developments.

Not including inflation?

Doing so should reduce the odds on an especially adverse outcome not only by having policy a little easier than otherwise, but also by reassuring lenders and spenders that the central bank recognizes such a possibility in its policy deliberations. Whether the Federal Reserve has done enough in this regard is a question this policymaker will be weighing carefully over coming months.

Even as we respond to forces currently weighing on real activity, we must also set policy to resist any tendency for inflation to increase on a sustained basis. Allowing elevated rates of inflation to become entrenched in inflation expectations would be costly to reverse, constrain our ability to cushion further downward shocks to spending, and result over time in lower and less stable economic expansion. Inflation expectations generally have appeared reasonably well anchored, giving the FOMC room to focus on supporting economic growth. Moreover, as I will explain below, for a variety of reasons, I do not expect the recent elevated inflation rates to persist. In my view, the adverse dynamics of the financial markets and the economy have presented the greater threat to economic welfare in the United States. But the recent information on prices underlines the need to continue to monitor the inflation situation very carefully.

The Outlook for Economic Activity and Inflation

How long the adjustment in financial markets will take and the consequences of that adjustment for economic activity are subject to considerable uncertainty. In my view, the most likely scenario is one in which the economy experiences a period of sluggish growth in demand and production in the near term that is accompanied by some further increase in joblessness.

New building activity will continue to decline until the overhang of inventories of unsold homes has been substantially reduced, and the demand side of the market is not likely to revive appreciably until buyers sense that price declines are abating and financing conditions for mortgages are improving. Consumer spending will be damped by the effects on real incomes of a weak labor market and rising energy prices and by the effects of declines in the stock market and home prices on household wealth. Business spending on capital equipment should be held down by slower sales and production and by caution in a very uncertain economic environment. Nonresidential construction is likely to lose some momentum in the wake of both weak growth in overall economic activity and tighter credit. Some modest offset to these areas of weakness should come from export demand, which should be boosted by the lagged effects of recent declines in the dollar and supported by still-solid growth abroad.

Seems he doesn’t realize export demand is part of the cause of higher prices, as non-residents compete with residents to buy the US output of goods and services. That’s what an export economy looks like, and this will continue for as long as non-resident desires to accumulate $US financial assets continues to fall.

By midyear, economic activity should begin to benefit from several factors. One is the fiscal stimulus package that the Congress recently enacted. The rebates that households are scheduled to begin to receive in May should provide a temporary boost to consumption. Although the timing and the magnitude of the spending response is uncertain, economic studies of the previous experience suggest that a noticeable proportion of households are quite sensitive to temporary cash flow. The potential effects of the business incentives are perhaps more uncertain. Although economic theory suggests that they should bring forward some capital spending, past experience has been mixed.

Second, the decline in residential investment should begin to abate later this year as the overhang of unsold homes is worked off, reducing what has been a significant drag on economic growth over the past two years. Finally, the declines in interest rates that began last summer should be supporting activity over coming quarters, and their effects should show through more clearly to improvements in economic activity as the stress in financial markets dissipates.

Although a firming in the growth of economic activity after midyear now appears the most likely scenario, the outlook is subject to a number of important risks. Further substantial declines in house prices could cut more deeply into household wealth and intensify the problems in mortgage markets and for those intermediaries holding mortgage loans. Financial markets could remain quite fragile, delaying the restoration of more normal credit flows. As observed in the minutes of its most recent meeting, the FOMC has expressed a broad concern about the possibility of adverse interactions among weaker economic activity, stress in financial markets, and credit constraints.

I expect the run-up in headline inflation to be reversed and core inflation to edge lower over the next few years. This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets.

No other reasons? Not much to bet the ranch on? And futures prices for non perishables are not about expectations, but about inventory conditions. Contango indicates a surplus of desired spot inventories and backwardation a shortage of desired spot inventories.

The current backwardated term structure of oil and other futures is indicating shortages, which, if anything, tell me the risk is more to the upside than the downside, as well as support my position that the Saudis/Russians are acting as swing producers and setting price.

Moreover, greater slack in the economy should reduce pressure on prices and wages.

Maybe, but also a risky stance.

Rising import prices are in fact rising real wages for US, as many imports have high labor contents.

And given rising import prices of labor intensive goods and services due to the weak $, lower US domestic real wages shift production back to domestic firms, who support US nominal wages and keep employment firmer than otherwise.

Despite high resource utilization over the past couple of years and periods of elevated headline inflation, labor cost increases have remained quite moderate, and inflation expectations remain reasonably well anchored.

As above, rising import prices represent rising labor costs, and inflation expectations have dropped to only ‘reasonably’ well anchored.

Nonetheless, policymakers must remain very attentive to the outlook for inflation. As I mentioned earlier, the recent uptick in core inflation may reflect some spillover of the higher costs of food, energy, and imports into core prices.

To the mainstream economists, this is a serious development.

And the prices of crude oil and other commodities have moved up further in recent weeks. A related concern is that inflation expectations might drift higher if the current rapid rates of headline inflation persist for longer than anticipated or if the recent easing in monetary policy is misinterpreted as reflecting less resolve among Committee members to maintain low and stable inflation over the medium run. Persistent elevated inflation would undermine the performance of the economy over time.

Worse, to a mainstream economist, including Governor Kohn, it’s a necessary condition for optimal growth and employment.

Conclusion

These have been difficult times for the U.S. economy. The correction of excesses in sectors of the economy and financial markets has spilled over more broadly. Growth has slowed, and unemployment has increased; both borrowers and lenders are facing problems, and the functioning of the financial markets has been disrupted. At the same time, inflation has risen.

Yes, weakness and higher prices.

I believe we will see a return to stronger growth, lower unemployment, lower inflation and improved flows in financial markets, but it probably will take a little while.

This ‘belief’ is at best scantily supported in this speech. Lower inflation because futures are lower? Lower employment/output gap and bringing inflation down to comfort zone at the same time?

And adverse risks to this most likely scenario abound: Uncertainty could trigger an even greater withdrawal from risk-taking by households, businesses, and investors, resulting in more pronounced and prolonged economic weakness; events beyond our borders could continue to put upward pressure on inflation rates.

Yes.

But we should not lose sight of some fundamental strengths of our economy. Our markets have proven to be flexible and resilient, able to absorb shocks, and quick to adapt to changing circumstances. Those markets reward entrepreneurship and risk-taking, and many people are looking for opportunities to buy distressed assets and restructure and strengthen businesses to take advantage of the economic rebound that will occur. Monetary policy has proven itself, under a wide variety of circumstances, very effective in recent decades in damping inflation when needed

Yes, but only by hiking rates. There is no other policy option for bringing down inflation.

and in stimulating demand and activity when that has been appropriate. Our job at the Federal Reserve is to put in place those policies that will promote both price stability and growth over time. We have the tools.

They have one tool – setting the interbank interest rates and other rates as desired.

They have no way of directly increasing or decreasing aggregate demand. That requires direct buying or selling of actual goods and services, not just financial assets.

Treasury spending/taxing directly add/removes demand.

As Chairman Bernanke often emphasizes: We will do what is needed.

Yes, to the best of their knowledge and ability.

This is a relatively neutral speech with more inflation talk than in previous, dovish speeches.

Conclusion:
High February CPI numbers before the next meeting will make it very difficult for the FOMC to vote on a cut without a more than anticipated decline of economic activity.

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