Archive for the 'Ben Bernanke' Category



What’s a Central Banker To Do?

The FOMC is meeting tomorrow and Wednesday, and it seems as if everyone is weighing in with advice for Ben Bernanke and company. But you can always count on the Wall Street Journal editorial page to dish up something especially fatuous when the topic turns to monetary policy and the Fed. This time the Journal turns to George Melloan, a former editor and columnist at the Journal, to explain why the market has recently turned “skittish” in anticipation that the Fed may be about to taper off from its latest venture into monetary easing.

Some of us have been arguing that recent Fed signals that it will taper off from quantitative easing have scared the markets, which are now anticipating rising real interest rates and declining inflation. Inflation expectations have been declining since March, but, until the latter part of May, that was probably a positive development, reflecting expectations of increased real output under the steady, if less than adequate, policy announced last fall. But the expectation that quantitative easing may soon be tapered off seems to have caused a further decline in inflation expectations and a further increase in real interest rates.

But Melloan sees it differently

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy. . . .

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors.

Oh dear, where to begin? Who cares how many males and females are on the FOMC? Was the all-male Federal Reserve Board that determined monetary during the Great Depression more to Mr. Melloan’s liking? I discovered about three years ago that since early in 2008 there has been a clear correlation between inflation expectations and stock prices. (See my paper “The Fisher Effect Under Deflationary Expectations.“) That correlation was not created, as Melloan and his colleagues at the Journal seem to think, by the Fed’s various half-hearted attempts at quantitative-easing; it is caused by a dangerous conjuncture between low real rates of interest and low or negative rates of expected inflation. Real rates of interest are largely, but not exclusively, determined by entrepreneurial expectations of future economic conditions, and inflation expectations are largely, but not exclusively, determined by the Fed policy.

So the cure for a recession will generally require inflation expectations to increase relative to real interest rates. Either real rates must fall or inflation expectations (again largely under the control of the Fed) must rise. Thus, an increase in inflation expectations, when real interest rates are too high, can cause stock prices to rise without causing bond prices to fall. It is certainly true that it is not good for investors when the economy happens to be in a situation such that an increase in expected inflation raises stock prices. But that’s no reason not to reduce real interest rates. Using monetary policy to raise real interest rates, as Mr. Melloan would like the Fed to do, in a recession is a prescription for perpetuating joblessness.

Melloan accuses the Fed of abandoning free markets and rigging interest rates. But he can’t have it both ways. The Fed did not suddenly lose the power to rig markets last month when interest rates on long-term bonds rose sharply. Bernanke only hinted at the possibility of a tapering off from quantitative easing. The Fed’s control over the market is supported by nothing but the expectations of millions of market participants. If the expectations of traders are inconsistent with the Fed’s policy, the Fed has no power to prevent market prices from adjusting to the expectations of traders.

Melloan closes with the further accusation that Bernanke et al. hold “the grandiose belief . . . that the Fed is capable of superhuman feats, like running the global economy.” That’s nonsense. The Fed is not running the global economy. In its own muddled fashion, the Fed is trying to create market expectations about the future value of the dollar that will support an economic expansion. Unfortunately, the Fed seems not to have figured out that a rapid recovery is highly unlikely to occur unless something is done to sharply raise the near term expected rate of inflation relative to the real rate of interest.

What’s with Japan?

In my previous post, I pointed out that Ben Bernanke’s incoherent testimony on the US economy and Fed policy last Wednesday was followed, perhaps not coincidentally, by a 2% intraday drop in the S&P 500 and by a 7% drop in the Nikkei average. The drop in the Nikkei was also accompanied by a big drop in long-term bond prices, and by a big jump in the yen against all major currencies (almost 2% against the dollar).

For the past six months or so, ever since it became clear that Shinzo Abe and his Liberal Democratic party would, after two decades of deflation, win the December elections on a platform of monetary expansion and a 2% inflation target, the Nikkei average has risen by over 50% while the yen has depreciated by 25% against the dollar. The Japanese stock-market boom also seems to have been accompanied by tangible evidence of increased output, as real Japanese GDP increased at a 3.5% annual rate in the first quarter.

The aggressive program of monetary expansion combined with an increased inflation target has made Japan the poster child for Market Monetarists, so it is not surprising that the tumble in the Nikkei average and in the Japanese long-term bonds were pointed to as warning signs that the incipient boom in the Japanese economy might turn out to be a flop. Scott Sumner and Lars Christensen, among others, effectively demolished some of the nonsensical claims made about the simultaneous drop in the Japanese stock and bond markets, the main point being that rising interest rates in Japan are a sign not of the failure of monetary policy, but its success. By looking at changes in interest rates as if they occurred in vacuum, without any consideration of the underlying forces accounting for those changes – either increased expected inflation or an increased rate of return on investment – critics of monetary expansion stumble into all sorts of fallacies and absurdities.

Nevertheless, neither Scott nor Lars addresses a basic problem: what exactly was happening on Black Thursday in Japan when stock prices fell by 7% while bond prices also fell? If bond prices fell, it could be either because expectations of inflation rose or because real interest rates rose. But why would either of those be associated with falling stock prices? Increased expected inflation would not tend to reduce the value of assets, because the future nominal value of cash flows would increase along with discount rates corresponding to the expected loss in the purchasing power of yen. Now there might be some second-order losses associated with increased expected inflation, but it is hard to imagine that they could come anywhere close to accounting for a 7% drop in stock prices. On the other hand, if the increase in interest rates reflects an increased real rate of return on investment, one would normally assume that the increased rate of return on investment would correspond to increased real future cash flows, so it is also hard to understand why a steep fall in asset values would coincide with a sharp fall in bond prices.

Moreover, the puzzle is made even more perplexing if one considers that the yen was appreciating sharply against the dollar on Black Thursday, reversing the steady depreciation of the previous six months. Now what does it mean for the yen to be appreciating against the dollar? Well, basically it means that expectations of Japanese inflation relative to US inflation were going down not up, so it is hard to see how the drop in bond prices could be attributed to inflation expectations in any event.

But let’s just suppose that the Japanese, having experienced the positive effects of monetary expansion and an increased inflation target over the past six months, woke up on Black Thursday to news of Bernanke’s incoherent testimony to Congress suggesting that the Fed is looking for an excuse to withdraw from its own half-hearted attempts at monetary expansion. And perhaps — just perhaps — the Japanese were afraid that a reduced rate of monetary expansion in the US would make it more difficult for the Japan to continue its own program of monetary expansion, because a reduced rate of US monetary expansion, with no change in the rate of Japanese monetary expansion, would lead to US pressure on Japan to prevent further depreciation of the yen against the dollar, or even pressure to reverse the yen depreciation of the last six months. Well, if that’s the case, I would guess that the Japanese would view their ability to engage in monetary expansion as being constrained by the willingness of the US to tolerate yen depreciation, a willingness that in turn would depend on the stance of US monetary policy.

In short, from the Japanese perspective, the easier US monetary policy is, the more space is available to the Japanese to loosen their monetary policy. Now if you think that this may be a bit far-fetched, you obviously haven’t been reading the Wall Street Journal editorial page, which periodically runs screeds about how easy US monetary policy is forcing other countries to adopt easy monetary policies.

That’s why Bernanke’s incoherent policy statement last Wednesday may have led to an expectation of a yen appreciation against the dollar, and why it also led to an expectation of reduced future Japanese cash flows. Reduced expectations of US monetary expansion and US economic growth imply a reduced demand for Japanese exports. In addition, the expectation of US pressure on Japan to reverse yen depreciation would imply a further contraction of Japanese domestic demand, further reducing expected cash flows and, consequently, Japanese asset prices. But how does this account for the drop in Japanese bond prices? Simple. To force an increase in the value of the yen against the dollar, the Bank of Japan would have to tighten money by raising Japanese interest rates.

PS Lars Christensen kindly informs me that he has a further discussion of Japanese monetary policy and the Nikkei sell-off here.

How Did Bernanke Scare the Markets?

On Wednesday Ben Bernanke appeared before the Joint Economic Committee of the US Congress to give his semi-annual report to Congress on the Economic Outlook. The S&P 500 opened the day about 1% higher than at Tuesday’s close, but by early afternoon had already given back all their gains, before closing 1% lower than the day before, an interday swing of 2%, pretty clearly caused by Bernanke’s testimony. The Nikkei average fell by 7%. Bernanke announced no major change in monetary policy, but he did hint that the FOMC was considering scaling back its asset purchases “in light of incoming information.” So what was it that Bernanke said that was so scary?

Let’s have a look.

Bernanke began with a summary of economic conditions, giving himself two cheers for recent improvements in the job market. He continued by explaining how, despite some minimal and painfully slow improvements, the job market remains in bad shape:

Despite this improvement, the job market remains weak overall: The unemployment rate is still well above its longer-run normal level, rates of long-term unemployment are historically high, and the labor force participation rate has continued to move down. Moreover, nearly 8 million people are working part time even though they would prefer full-time work. High rates of unemployment and underemployment are extraordinarily costly: Not only do they impose hardships on the affected individuals and their families, they also damage the productive potential of the economy as a whole by eroding workers’ skills and–particularly relevant during this commencement season–by preventing many young people from gaining workplace skills and experience in the first place. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending on income-support programs, thereby leading to larger budget deficits and higher levels of public debt than would otherwise occur.

Bernanke then shifted to the inflation situation:

Consumer price inflation has been low. The price index for personal consumption expenditures rose only 1 percent over the 12 months ending in March, down from about 2-1/4 percent during the previous 12 months. This slow rate of inflation partly reflects recent declines in consumer energy prices, but price inflation for other consumer goods and services has also been subdued. Nevertheless, measures of longer-term inflation expectations have remained stable and continue to run in the narrow ranges seen over the past several years. Over the next few years, inflation appears likely to run at or below the 2 percent rate that the Federal Open Market Committee (FOMC) judges to be most consistent with the Federal Reserve’s statutory mandate to foster maximum employment and stable prices.

In other words, the job market, despite minimal improvements, is a disaster, and inflation is below target, and inflation expectations “continue to in the narrow ranges seen over the past several years.” What does that mean? It means that since the financial crisis of 2008, inflation expectations have consistently remained at their lowest levels in a half century. Why is any increase in inflation expectations above today’s abnormally low levels unacceptable? Bernanke then says that inflation appears likely to run at or below the 2% rate that FOMC believes is most consistent with the Fed’s mandate to foster maximum employment and stable prices. Actually it appears likely that inflation is likely to run below the 2% rate, perhaps by 50 to 100 basis points. For Bernanke to disguise the likelihood that inflation will persistently fail to reach the Fed’s own nominal 2% target, by artfully saying that inflation is likely to run “at or below” the 2% target, is a deliberate deception. Thus, although he is unwilling to say so explicitly, Bernanke makes it clear that he and the FOMC are expecting, whether happily or not is irrelevant, inflation to continue indefinitely at less than the 2% annual target, and will do nothing to increase it.

You get the picture? The job market, five and a half years after the economy started its downturn, is in a shambles. Inflation is running well below the nominal 2% target, and is expected to remain there for as far as the eye can see. And what is the FOMC preoccupied with? Winding down its asset purchases “in light of incoming information.” The incoming information is clearly saying – no it’s shouting – that the asset purchases ought to be stepped up, not wound down. Does Bernanke believe that, under the current circumstances, an increased rate of inflation would not promote a faster recovery in the job market? If so, on the basis of what economic theory has he arrived at that belief? With inflation persistently below the Fed’s own target, he owes Congress and the American people an explanation of why he believes that faster inflation would not hasten the recovery in employment, and why he and the FOMC are not manifestly in violation of their mandate to promote maximum employment consistent with price stability. But he is obviously unwilling or unable to provide one.

Why did Bernanke scare the markets? Well, maybe, just maybe, it was because his testimony was so obviously incoherent.

The Vampire Theory of Inflation

The FOMC issued an opaque statement yesterday observing that the economy is continuing to expand at “a moderate pace,” though unemployment remains too high while inflation is falling. The statement attributes the weakness of the recovery, at least in part, to fiscal tightening, perhaps suggesting that the Fed would not, under these circumstances, tighten monetary policy if fiscal policy were eased.

Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Notice despite the neutral, matter-of-fact tone of the statement, there are two factually inaccurate, or at least misleading, assertions about inflation. First, while the assertion “inflation has been running somewhat below the Committee’s longer-run objective,” is not objectively false, the assertion ignores the steady downward trend in inflation for the past year, while sewing confusion with a gratuitous diversionary reference to “temporary variations that largely reflect fluctuations in energy prices.” By almost any measure, inflation is now running closer to 1% than to the Fed’s own 2% target.

Second, the statement asserts that longer-term inflation expectations have remained stable. Oh really? If we take the 10-year TIPS spread as a proxy for long-term inflation expectations, inflation expectations have been falling steadily since the mid-January to mid-March time frame, when the breakeven rate fluctuated in a narrow range between 2.5% and 2.6%, to a spread of 2.3% yesterday, the lowest since early September of last year.

The FOMC continues:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee continues to see downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2% objective.

Well, here is my question.  If the FOMC “seeks to foster maximum employment and price stability,” and the FOMC itself anticipates that inflation over the medium term will likely be less than 2%, why, under the FOMC’s own definition of price stability as 2% inflation, is the FOMC proposing to do nothing — not a single wretched thing — to hit its own inflation target?

Under both elements of its dual mandate, the FOMC is unambiguously obligated to increase the rate of monetary accommodation now being provided. The FOMC asserts that unemployment is elevated; it also asserts, notwithstanding a pathetic attempt to disguise  that obvious fact, that inflation is below its target. Both conditions require increased monetary expansion. There is now no trade-off between inflation and unemployment, and no conflict between the Fed’s two mandates. So why can’t the Fed do what it is plainly obligated to do by current legislation? Pointing a finger at the President and Congress cannot absolve the Fed of its own legal obligation not to tolerate an inflation rate below that consistent with price stability when unemployment is elevated. Is there no one capable of extracting from the Chairman of the Federal Reserve Board an explanation of this dereliction of duty?

Interestingly enough, I happened to catch a piece (“Should we bring inflation back from the dead?”) on American Public Radio’s “Marketplace” last evening. After asking David Blanchflower of Dartmouth College and Kevin Jacques of Baldwin Wallace University about the potential benefits of moderate inflation in the current environment, reporter David Gura turned to Marvin Goodfriend, formerly of the Richmond Fed, and now at Carnegie-Mellon, for a contrary view. Here is how Goodfriend explained why more inflation would not be a good thing.

Of course, resurrecting inflation is not risk-free. Economist Marvin Goodfriend says this kind of thinking could lead the economy to overheat: “If a little inflation is good, maybe a little more inflation is better.” It is something that is hard to control.

Goodfriend tells his students at Carnegie Mellon University to remember something.

“Inflation doesn’t die,” he says. “It’s like a vampire.”

You can vanquish it with “determined policy,” Goodfriend explains. Inflation will creep back into its coffin. And then, when you least expect it, it can come back with a vengeance.

Whew! Talk about sophisticated economic analysis. But then again, Goodfriend’s students at Carnegie-Mellon are super bright, aren’t they? Could this be what Bernanke and his colleagues are thinking? The vampire theory of inflation? Say it ain’t so, Ben.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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