What more could the Fed do? (cont’d)

The New York Times joins the chorus of complaints that the Fed has not done enough to jump-start this stalling economy. In yesterday’s lead editorial the gray lady ruefully notes that Ben Bernanke basically ruled out further quantitative easing when he said at the Fed’s June meeting that it would not happen unless there was a heightened risk of deflation. Then the editorial offers a paragraph’s worth of additional measures the Fed could take. One by one:

‘For starters, the Fed could take modest steps, like shifting its portfolio toward bonds with longer maturities, which would help to keep long-term rates low and nudge investors into riskier investments.’

In other words, QE3, or QE2 on steroids. Normally the Fed targets the shortest of short-term rates (the fed funds rate) and does so through its open market purchases and sales of short-term T-bills. And T-bills are the security of choice because the Fed does not want to make too big a splash (at least not directly) in the markets for particular bonds. The logic here is the reverse: of course the Fed wants to make a splash in the bond market by lowering long-term interest rates — that’s the penultimate goal of monetary policy, behind stimulating business investment and consumer spending. In today’s extraordinary circumstances, ending the Little Depression seems more important than not disrupting the bond market. So it’s hard to argue against this one, other than to note that the Fed would probably be monetizing a lot more of the federal debt than otherwise, which could raise inflation fears. (Of note: In the early 1930s Keynes thought the central banks should buy up long-term debt so as to lower long-term interest rates, too. So this isn’t exactly a new idea.)

‘It could reduce the interest it pays on the banks’ huge reserves or even tax the reserves to try to encourage more lending.’

Absolutely. Reduce it to 0%, which was the rate on reserves prior to 2008. Bernanke’s main rationale paying interest on reserves, as I understand it, was to reassure the markets that the huge pools of bank reserves, which the Fed created in response to the crisis, would not lead to a runaway inflation when the economy began to recover and banks loaned those reserves out. The idea was that as the economy recovered the Fed would “soak up” those reserves by raising the interest rate on them so that banks would be less inclined to loan them out. At this point, however, hardly anyone seem to be worried about the inflation threat posed by those reserves. They’re more worried about how they continue to just sit there. Lowering the rate to zero can only help, though maybe not by much.

‘It could also resume buying Treasuries or other securities to provide additional monetary stimulus.’

This is a lot like the first suggestion. It could get more radical if the “other securities” are things like mortgage-backed securities, in which case it’s more like QE1 (when the Fed effectively bought up many of the toxic subprime securities, thereby taking them off the market). This brings to mind the dramatic proposal by Joseph E. Gagnon of the Peterson Institute for International Economics, which has gotten a lot of attention lately. Gagnon: “First and foremost, the Federal Reserve should announce an additional $2 trillion of asset purchases, including longer-term Treasury bonds, agency mortgage-backed securities (MBS), and foreign exchange. This is more than three times the size of the woefully underpowered quantitative easing of late last year (dubbed QE2) and it should be accompanied by a clear statement that more is forthcoming if the economy continues to underperform.” I haven’t digested Gagnon’s proposal yet, but this is what a radical proposal looks like. Krugman and Brad DeLong seem to like it.

‘A more aggressive strategy would be letting inflation rise above the Fed’s comfort level of 2 percent or so to, say, 4 percent. That could help the economy by easing the repayment of debt.’

This would have promise if the Fed could actually control the rate of inflation like that. As I’ve written before, I don’t think it can, not when the economy is in a depression and seems to be tending on its own more toward deflation than to 4% inflation. The Fed has already flooded the banking system with reserves; when they don’t get loaned out (as so many of them haven’t), they don’t raise aggregate demand, the money supply, or the price level.

In sum: The first two steps seem worth taking, but are probably too modest to have much impact. The third step can be about as big as the Fed wants it to be; it has the most potential, though as with QE1 just moving a lot of assets from the private sector onto the Fed’s balance sheet doesn’t necessarily generate a surge of private investment. The fourth step looks impossible at present, even without the inevitable political resistance to the Fed backing down on inflation.

Is inflation on target? (corrected)

The new BLS unemployment numbers (9.1% unemployment rate, 16.1% comprehensive unemployment rate, 117,000 new jobs created) are the talk of the morning. I don’t have much to add to it, but I’ll echo the oft-made point that job growth needs to be twice as fast for the next several years for unemployment to fall to normal levels. I’ll also note that the numbers are a bit better than those of a year ago, but a bit worse than those of March, when unemployment was 8.8%. So although the numbers are better than expected, they’re still underwhelming and we still might be in a double-dip recession.

Instead I want to focus on the other big economic variable. Inflation has been so low over the past few years — in the range of 1-2% — that Ben Bernanke and others have seemed more worried about deflation than inflation. At the same time, some Fed critics have charged that the Fed’s actions to backstop dodgy financial asset markets and flood the banks with new reserves will lead to a massive inflation after the slump is over or a stagflation (stagnant economy with high inflation) even sooner. Some numbers to remember: Inflation has averaged 3% a year over the past century, and close to that over the past few decades. The Fed’s unofficial target for inflation is 2%. What do the markets expect for the years to come?

A good way to answer that question is to compare the well-reported interest rates on regular Treasury bonds with the interest rates on “TIPS” — Treasury Inflation-Protected Securities. The payments on a TIPS bond are adjusted for whatever inflation occurs over the bond’s lifespan.  The inflation adjustment is trickier than I’d originally thought — instead of simply adding the inflation rate to the interest rate that arose from the bond’s auction, the interest rate stays the same but the bond’s principal rises, and the interest payments are based on the original interest rate times the new principal. (Ex.: Imagine a 1-year, $1000-face-value TIPS bond that sells at par, i.e., for $1000 and therefore has an interest rate of 0%. If inflation is 3% over the next year, then the principal rises 3% to $1030. The interest is still $0, but the overall yield on the bond is 3% ($30/$1000). That’s a simplified example. It’s more complicated if the interest rate isn’t 0%.) Because the arithmetic can get complicated, it’s easier to look up the “breakeven” rate, which is the inflation rate implied by the different on TIPS and ordinary T-bonds.

(Add to that a conceptual complication: Because the TIPS bond is less risky, since it’s indexed for inflation, it should be in somewhat greater demand than the regular T-bond. So, other things equal, it should command a higher price and pay a lower interest rate. With that in mind, the difference between the interest rates on regular T-bonds and TIPS bonds is roughly the expected inflation rate plus an inflation-risk premium, which reflects people’s uncertainty about future inflation.)

Comparing the interest rates for 5-year bonds last week (when this was originally posted), the  T-bonds paid 1.12% and the TIPS paid -0.67%. The implied inflation rate (1.80%, if my spreadsheet math is correct) is actually very close to the difference in the interest rates on the two bonds (1.79%). Apparently the market is expecting the Fed to be just shy of its 2% target over the next 5 years.

Looking at the 10-year bonds, the T-bonds paid 2.47% and the TIPS paid 0.24%. The 2.03-percentage-point difference is again a close approximation of the breakeven rate; my spreadsheet math yields an expected inflation rate of 2.22%, or slightly over the Fed’s target. Together the two breakeven rates imply that the market is expecting inflation to average about 2.6% in years 6 through 10. These numbers provide no guide to where they think that inflation is going to come from (recovery? shortages of gas or food? QE5?), but the weakness in the stock market suggests they’re not expecting a recovery anytime soon. It may just be that their flight to safety has gone into overdrive, and TIPS are in exceptionally heavy demand because they are even less risky than regular T-bonds. So possibly they’re expecting inflation rates of about 1% through 2016 and 2% in 2016-2021, with the remainder being a risk premium.

In sum, the Fed does seem to be hitting its inflation target, more or less, but that’s about all. Bondholders appear willing to lock in near-zero or negative real returns over the next five or ten years, just so they can hold a safe asset. Which suggests they’re scared shitless.

‘The market is rational and the government is dumb’

The above quote is a favorite of former House Speaker Dick Armey (R-TX). He even used to write it on the blackboard on the first day of class when he was an economics professor. Armey has been out of government for years, but as a founding member of a Tea Party group, he’s been a big influence on that wing of the Republican Party. Not surprisingly, he seems pleased with the pounds of flesh they’ve extracted in the new Budget Control Act of 2011.

Armey and I have different ideas of “dumb.” He favors slashing government spending during our Little Depression and also favors a balanced budget amendment that would supposedly compel further slashing. I think those things are time-tested recipes (the times being 1932 and 1937) for worsening a depression. What do the markets think?

The stock market is on track for its eighth straight day of decline (as of 11:55 a.m., the S&P 500 is down 0.5%, and its biggest drop, 2.6%, was yesterday, when the Budget Control Act finally passed). 10-year Treasury bond prices have been rising, and T-bond interest rates falling, over the same span, now down to 2.57%. How to interpret those numbers?

Hard to do, because nobody (as far as I know) takes scientific polls of market participants to ask them why they did what they did. Armey would probably say, as some commentators have, that stocks have tanked because the $2.1 – 2.5 trillion in cuts over a decade aren’t enough. I would say, as have others, that the market is reacting to the dismal state of the economy and to the likelihood that, as basic macroeconomic theory tells us, the spending cuts will make it even more dismal.

What about bonds? The rosy view would be that T-bond prices have improved because the debt-ceiling vote means no default through 2012 and the spending cuts reduce the overall burden of debt. Armey and I might actually agree that the unrosy view is correct: T-bonds are in higher demand because of a worldwide “flight to safety,” as grim economic news causes people to move away from risky, cyclical assets like stocks and toward safe assets like T-bonds. Again, is the grimmer news the “failure” to slash spending more or the weakening economy?

I’m thinking Armey’s quote fits right now, except it’s the budget bloodletters who are dumb and the markets are rationally reacting by anticipating that they will cause further hemorrhaging of the economy.

P.S. At least one market participant agrees. From the Aug. 2 Financial Times:

‘Jim Reid, strategist at Deutsche Bank, . . . has warned the US could be approaching a “1937 moment” – when authorities removed post-Depression stimuli from still-fragile markets and triggered another recession. This risk, he says, has in fact only been magnified in the markets’ eyes by agreement on raising the US debt ceiling.’

(Hat tip: Brad DeLong)

No reason to get excited

President Obama and Congressional leaders have apparently reached a deal on reducing the deficit, which might end the debt-ceiling crisis for now, assuming Congress passes it. Cause for celebration? More like cause for heavy sighs. I’ve been saying over and over that cutting government spending in an economic slump makes the slump worse. The best that can be said about it is that the (real-world political) alternative is worse, i.e., not raising the debt ceiling.

In a front-page article in today’s NYT a chorus of economists make the same point. In a time of slack demand, don’t weaken demand further by cutting government spending. The headline (from MSNBC.com’s republished version):

“Economists warn cuts to federal spending ill-timed:
Debt deal to spend less on US economy puts recovery at risk, experts say.”

The Times could have put this story on its front page months ago. Too late — by now, slashing social spending has gone from Republican fantasy to Washington Wisdom.

Fed up with Bernanke?

Greg Mankiw has a good column in today’s NYT in defense of embattled Fed Chair Ben Bernanke. How embattled is Bernanke? Mankiw notes an (admittedly unscientific) online CNBC poll from June, in which the question was “Do you have confidence in the way Ben Bernanke is handling the economy?” 95% of respondents answered no.

Mankiw says the Fed has done basically all it can to combat the Little Depression (unfortunately “all it can” is not enough), while steering clear of high inflation. The core inflation rate in recent years has been just 2%, widely believed to the Fed’s unofficial target inflation rate. Mankiw suggests making that 2% target official, but otherwise sees no obvious room for improvement in Bernanke’s performance.

I tend to agree that Bernanke’s Fed has done about all that monetary policy can do here, but Scott Sumner, one of the more interesting monetary thinkers I’ve come across lately, says the Fed actually has a lot more ammunition in its arsenal and compares the situation to the early 1930s, when the Fed increased the monetary base but needed to do a lot more to stem the massive tide of bank failures and monetary collapse. Unfortunately, I’ve yet to find the specifics of his argument, but I’ll share them with you when I do.

Sumner, by the way, loves the idea of a 2% inflation target and even suggests that Mankiw be appointed to the Fed’s Board of Governors. Maybe Mitt Romney (to whom Mankiw is an adviser) can do that next year.

Feeling 1932 (updated, Aug. 1)

I’ve written already that the best deal on the debt ceiling would simply be to raise it (or better still, abolish it), without attaching it to a bill that punishes the economy further by slashing spending and/or raising taxes. The last thing this ailing economy needs is a Grand Bargain to reduce the current deficit. It was disastrous policy during the Great Depression — first by Congress and President Hoover in 1932, then by Congress and President Roosevelt in 1937. I would have thought those historic blunders would not be repeated, but I guess it’s always a mistake to assume that politicians know economics or history. But I’ve said all that before.

What I want to point out here is that we’re due for some ill-timed spending cuts (and maybe tax increases), regardless of what Congress does in the next week. Remember that $787 billion stimulus package that Congress passed in early 2009? It was spread out over two years, so roughly $400 billion a year, about $250 billion of which was spending and $150 billion tax cuts, almost all in 2009-2011. So that stimulus is just about “spent.” The main tax cuts, like extending the patch for the alternative minimum tax, will probably be maintained because they’re politically popular, but the spending almost surely will not. So that’s an abrupt drop of about $250 billion in government spending, or about 2% of GDP, over the next year. This chart from James Fallows’ blog for The Atlantic shows the projected big drop in fiscal stimulus from “Relief measures.” That’s the trouble with stimulus — it’s finite. Congress passes these things reluctantly, and if the economy still needs stimulating when it’s over, people are more likely to conclude that it failed rather than that it was too small (which it was) or that it spared us even worse devastation (which it did).

Now it is possible, perhaps even probable, that Congress will fail to pass any deficit-reduction deal and will end up raising the debt ceiling anyway — after all, that’s what’s happened virtually every previous time that a debt-ceiling vote has come up. But even if Congress ends up not inflicting any new wounds on the economy, we’re looking at big-time deficit reduction that will do plenty of damage on its own.

UPDATE, 1 Aug. 2011: Actually, it looks like it’s already happened. In the dismal GDP figures released last week, the government’s contribution to real GDP growth was negative 1.2 percentage points in the first quarter of 2011, with about two-thirds of the decline coming from the federal government. Government purchases account for about 20% of GDP, so cuts in government purchases reduce GDP. “Fiscal drag,” the economists call it. Federal government purchases fell 9.4% in the first quarter (the unwinding of the stimulus surely had much to do with this), and state and local government purchases fell 3.4%. (In the second quarter federal purchases rose 2.2% and state and local purchases again fell 3.4%.)

P.S. The title’s musical inspiration is forty years off and I’ve used it before, but hey, it’s a good song.

Pouring water on a drowning man

Today’s New York Times editorial, “The Worst Time to Slow the Economy,” says it all. Voting against raising the debt ceiling is foolish even in the best of times, and it’s insanity right now. Congress already voted to raise the debt ceiling, or to do the equivalent, when it passed a budget with a deficit. It makes no sense for Congress to vote on the budget again.

Is the economy already in a double-dip recession? The rising unemployment rate (up to 9.2% for June, as announced on Friday, or 16.2% using the more inclusive U-6 unemployment rate) suggests it might be. See John Nichols’s column in The Nation for a good account of the unemployment crisis. Nichols says this is President Obama’s biggest problem, pointing out that no president since FDR has won reelection when unemployment was over 8%. (Nichols said over 7%, but he may have meant “over 7% and change,” as Reagan won reelection in 1984 when unemployment was about 7.5%. But at least it was falling, as it was for FDR in 1936 and 1940.)

While Nichols is correct that high unemployment is Obama’s biggest problem, it’s still true that the debt-ceiling impasse is Obama’s biggest worry. An act of supreme self-sabotage like not raising the debt ceiling could put the economy into free fall. As far as I can tell, Republicans who say it’s no big deal, like most of their presidential candidates, either (1) cynically are hoping it brings about an economic avalanche that sweeps Obama out of power or (2) cluelessly believe the Tea Party rhetoric about how “spending” has caused our current woes and think any shock that compels spending cuts will actually be good for the economy. It’s as if they were taught government purchases were a negative entry into GDP instead of a positive, i.e., GDP = Consumption + Investment + Net eXports – Government purchases, instead of GDP = C + I + G + NX.

If we’re lucky, the Constitution — in particular, the line in the 14th Amendment that says “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned” — will save the day. The whole concept of a debt ceiling as something that Congress can refuse to raise, even to pay off previously issued debt, looks unconstitutional to me. (Former Reagan adviser Bruce Bartlett has forcefully raised this option.) But then again, it’s up to the Supreme Court to make that determination, and, as far as I know, nobody has asked them to yet. Harvard Law School Professor Laurence Tribe, in a New York Times op-ed that I otherwise tended to find unconvincing, points out that someone with standing would have to sue the government and that “increased interest rates would have already inflicted terrible damage by the time the Supreme Court ruled on the matter.”

So maybe the Constitution won’t ride to the rescue. Is there hope for a long-term bipartisan budget deal that could convince Congressional Republicans to raise the debt ceiling? And could such a deal be amenable to those of us who don’t want to shred the social safety net? I guess we’ll find out in a couple weeks.

Gambling Is Going On in Here! (576 pp.)

Granted, nobody reads 576-page commission reports, but this newly released, two-year-in-the-making report by the Financial Crisis Inquiry Commission looks pretty good, based on the article about it in today’s NYT.  The article states:

‘The commission that investigated the crisis casts a wide net of blame, faulting two administrations, the Federal Reserve and other regulators for permitting a calamitous concoction: shoddy mortgage lending, the excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.

‘“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done,” the panel wrote in the report’s conclusions, which were read by The New York Times. “If we accept this notion, it will happen again.”’

Right on. And with testimony from more than 700 witnesses to inform those conclusions, there ought to be some good detail within the report.

The above conclusions might seem obvious, but acknowledging the obvious is something that politicians are not good at. And predictably, the commission was split among party lines.  The above excerpt is from the majority report. From the article:

‘Of the 10 commission members, the six appointed by Democrats endorsed the final report. Three Republican members have prepared a dissent focusing on a narrower set of causes; a fourth Republican, Peter J. Wallison, has his own dissent, calling policies to promote homeownership the major culprit. The panel was hobbled repeatedly by internal divisions and staff turnover.’

So much for feasible solutions. Even with a Democratic Congress, the financial reform bill we got last year was extremely watered down. Get ready for the next conflagration.

Hope and jobs

Optimism is breaking out among economic forecasters. I admit, I share their optimism, as should be clear from my recent posts. My optimism is bolstered by the latest Index of Leading Economic Indicators, which rose in November for the fifth straight month and by the most (1.1%) in eight months.

Two of the big banks cited in today’s New York Times article (first link) predict 4% real GDP growth for 2011, i.e., fast enough to actually reduce the unemployment rate. Unfortunately, as Princeton’s Alan Krueger suggests in the article, that would only be enough to make a modest dent in the unemployment rate. Does the Times still run those “Remember the neediest” taglines, I wonder?

Much as I think recovery is already underway and will pick up steam in 2011, I can’t stop thinking that this recovery, like most recoveries in the past several decades, is likely to leave millions of Americans behind. Will the new Congress care? My main hope is that Republicans’ love of all things voucher will extend to relocation vouchers for the unemployed, to encourage them to move from places like Detroit and Upstate New York to where the jobs are.

P.S. The second link, from 24/7WallSt.com, includes a helpful discussion of the Conference Board’s index of ten Leading Economic Indicators, namely what they are and how some of them might be more like coincident or lagging indicators. The index is still useful, but there’s a reason why nobody is able to extract airtight forecasts from it.

The Other 2%

One of the big issues before Congress right now is whether and how to extend the Bush tax cuts, enacted in 2001 and scheduled to expire at the end of this year.  Congressional Republicans want to make them permanent.  President Obama and many Democrats want to extend the Bush tax cuts for everyone except the very wealthy, i.e., those in the top tax bracket (which would go from 35% back to 39.6%, where it was in 2001).

Throughout this debate I had agreed with the Democratic position, for reasons of both equity and economics.  Over the past thirty years, incomes and wealth in this country have become much more skewed in favor of the rich, so as long as we have a progressive tax system why not use it to push back against that trend?  (I’m not saying let’s equalize incomes, just that trying to check the increase in inequality is a reasonable thing to do.) Only about 2-3% of households — those earning over $373,651 —  are in the top tax bracket, and even then their first $373,651 of income would be taxed at the same rate as before, so the pain associated with raising the top tax rate seems small.  On the economic side, cutting taxes for the wealthy provides a smaller boost to consumer spending than just about any other tax cut or benefit increase you can think of.  See, for example, the “stimulus bang for the buck” table on page 5 of this testimony by Mark Zandi, Chief Economist of Moody’s Analytics back in April.  In the case of making the Bush tax cuts permanent, a dollar of tax cuts would raise GDP by 32 cents, compared with, say $1.41 from an increase in aid to state and local governments or $1.61 for an extension of unemployment benefits.  (The logic is that wealthy taxpayers save much of their income, so small differences in their after-tax income won’t affect their spending much, at least not compared with other taxpayers.  And increases in government spending increase GDP directly and can, if the government starts jobs programs, employ people directly.) And then there are the tax revenues to consider — those top 2-3% of taxpayers have a huge amount of taxable income, so a 4.6% difference in that top tax rate makes a big difference in the government’s deficit and debt.

But equity and economics are unlikely to carry the day in Washington, D.C.  Today’s New York Times has a remarkable op-ed by the same Mark Zandi, titled “A Tax Cut We Can Afford,” in which he argues for extending the Bush tax cuts, sort of.  He says they should be extended for the wealthy, too. His reasoning is political:  Yes, it would be ideal to let the top rate go back to 39.6% and use the new revenue to pay for jobs programs or bigger jobs tax credits, but that option is not on the table.  Republicans and conservative Democrats would undoubtedly block it.  Another truly sizable spending stimulus is not on the table either.  What is feasible, besides minor measures like the jobs bill passed this month, is . . . extending the Bush tax cuts.

Although extending tax cuts on those making $374,000+ a year is not a great option, Zandi says, raising their taxes and (with effective stimuli off the table) doing nothing with it is a worse option.  Most of U.S. GDP is people’s consumption, and even though the rich consume less of their income than other people do, they still consume a lot, so much that their consumption may determine the fate of GDP over the next few years.  The Times recently reported that rich Americans have cut back on their spending.  The article quotes Zandi yet again: “One of the reasons that the recovery has lost momentum is that high-end consumers have become more jittery and more cautious.”  The top 5% of Americans account for one-third of consumer expenditures, according to the piece.

Generally speaking, you don’t raise taxes in a recession.  That’s one of the endlessly repeated lessons of the Great Depression (Hoover and Congress raised taxes in 1932, Roosevelt and Congress did so in 1936), and it still applies.  Again, if you could raise upper-income taxes and use them to pay for well-targeted stimulus programs, that would be fine, but to quote Zandi again, “it is asking too much of our political system now to get it just right. I’m skeptical that a politicized Congress would be able to pull it off, and failure to do so would leave us next year with higher taxes and a hobbled recovery.”

Zandi says the tax-cut extension for wealthy households should be temporary, to be removed when “the economy is off and running,” with the increase phased in perhaps over a three-year period.

I am pretty well convinced.  I’ve been arguing in this space that the severe slump we’re in makes this a terrible time for drastic spending cuts.  By the same token, this is not a good time to raise taxes on anyone.