Wednesday, October 27, 2010

Once again, the FOMC drops the ball

Bernanke is no Greenspan. The Maestro was able to herd the FOMC where he wanted it to go. Bernanke, who is a monetary radical, is unable to do so. He faces not only FOMC voters who disagree with him, but who also will do so publicly! I think this is unprecedented.  He therefore faces a very unpalatable choice: go with consensus and face a no-growth future, or go with massive QE and face huge controversy.

It is clear from recent statemments that he is trying to split the difference. Goldman says that in order for the Fed to meet its policy objectives, it needs to triple its balance sheet from $2T to $6T. There was a moment in time when the stock market thought that this was going to hapen, and the Dow rose by 1000 points. Now it appears that the best Bernanke can do is maybe $500B (we’ll know next week). That is 25% of what needs to be done, and it sends a strong signal that he does not have control of the FOMC.

This means that the Fed will continue to miss its inflation and employment targets, and that growth will remain weak. Investors who are speculating on inflation (gold, yen, TIPS) will be disappointed. We will have subnormal inflation, and the entire economy and all asset classes will suffer.

The only hope is that Obama’s governors get confirmed quickly (hold your breath) so that BB will have a commanding majority. Frankly, I have no idea how the confirmation process is going, although it is good news that Janet Yellen is now the vice chairman.

Tuesday, October 19, 2010

The Weekly Standard weighs in on monetary policy

This is where we’ve come to on the Right with respect to monetary policy thinking. Bill Kristol’s neoconservative Weekly Standard:

Conservatives should take this opportunity to swear off the paper dollar standard and monetary micromanagement for good. This needed catharsis will allow the founding republican principles of limited government and human fallibility to inform our monetary policy. As always, the world is looking to the United States for leadership. If we do not begin to return to the simple, transparent workings of the international gold standard, where the world’s final money once again is something of independent value, the future not just of money but of global capitalism itself is likely to be cast into even greater doubt than we’ve seen so far.

In order to return to the gold standard, the Fed would have to buy enough gold to make the peg credible. Right now M2 is about $2 trillion, and our gold reserves are about 15% of that. So to be credible we would have to get to around a 40-50% backing, or about $1 trillion of gold purchases. As the Fed seeks to buy $1 trillion of gold, its price will shoot up in dollar terms. So instead we would have to buy maybe $2 trillion, or $3 trillion. We would suck up gold from all over the world. The Fed would raise interest rates to maintain the dollar’s value against gold.  We would experience a massive deflation (see the UK in the twenties), resulting in depression, revolution and communism. And, in the end, we would fail at the objective of buying enough gold to have a credible peg. But we would not care, because we would be communist and destitute.

But who cares? It’s only monetary policy.

Die neue deutschemark? (or is it das neue deutchehmark?)

ECB board member Axel Weber has publicly criticized the ECB’s policy of buying the bonds of weak governments without strict conditionality. The reason he gives is that having the central bank finance governments “risks blurring the different responsibilities between fiscal and monetary policy”.

Fair enough. He want the EU to bailout Greece, not the ECB. But I’ll bet you that he doesn’t want the EU to bail out Greece either. My guess is that he wants his deutschemark back, and I think he isn’t alone in that desire.

So far only the German media has called for restoring the DM, but I’m confident that we will start hearing from politicians as well.

Paul Krugman solves the foreclosure crisis

That thoughtful Paul Krugman has a plan to fix the mortgage market. He endorses the idea of “giving mortgage counselors and other public entities the power to modify troubled loans directly”.

That might be a good idea if you had a mortgage you didn’t want to pay back. But, inconveniently, a mortgage is actually a legally-binding contract between two parties, and there is nothing in that contract about modifications without the consent of the lender. This speaks to such abstract and old-fashioned concepts as private property, rule of law, the sanctity of contracts and a thousand years of Anglo-Saxon jurisprudence (which if you go way back, is all about mortgages and conveyances).

But even if we wanted to chuck out all of those inconvenient and old-fashioned concepts, would it still be a good idea to give  “public entities” the power to modify “troubled loans”? Yes, if you wanted to wreck the mortgage market. If mortgages are converted by law from loans backed by the power of foreclosure into semi-secured consumer loans underwritten primarily on the basis of the borrower’s credit rating, then you can kiss home-ownership for most Americans goodbye. And the Freddie and Fannie bailouts will not cost us a few hundred billion. They’ll cost a trillion.

Bernanke makes Europe unhappy

The FT (10/15):
The dollar tumbled against most major currencies on Thursday, prompting warnings that the weakness of the world’s reserve currency could destabilise the global economy and push other countries into retaliatory devaluations to underwrite their exports.

Increasing expectations the Federal Reserve will pump more money into the US economy next month under a policy known as quantitative easing sent the dollar to new lows against the Chinese renminbi, Swiss franc and Australian dollar. It dropped to a 15-year low against the yen and an eight-month low against the euro. The dollar index, which tracks a basket of currencies, reached its lowest level this year.

A senior European policy-maker, who asked not to be named, said a further aggressive round of monetary easing by the US Federal Reserve would be “irresponsible” as it made US exports more competitive at the expense of its rivals.

What is going on? In simple terms: there are two competing philosophies in money policy today:

1. Orthodoxy
Orthodox money policy says that the role of the central bank is to provide a currency with a stable value. The central bank is not responsible for economic growth.
Poor economic performance is due to structural factors such as labor immobility, sticky wages, unions, etc. Seeking to create growth “artificially” by stoking inflation is self-defeating and dodges the need for permanent structural reform.
Orthodoxy is the religion of the Bundesbank, the ECB, the BoJ (until lately), the FOMC hawks, and most of the Republican party. [It is not the religion of the French government, which is a vocal dissenter.] Orthodoxy is the preferred religion of “conservatives” who are against soft money and in favor of free-market structural reforms.

2. The Depression School
There is a long line of American academic economists (all students of US monetary policy during the Great Depression) stretching from Milton Friedman to Ben Bernanke who believe that the role of the central bank is to provide a currency with a stable value as well as economic growth. This school has an advantage in the US because the Fed has a growth mandate, and because the US (outside of the South) has never gone through the hyperinflations suffered by Germany and Japan.
The core belief of this school is that the catastrophic deflation of 1930-33 was avoidable, and that deflation is always and everywhere a monetary phenomenon. This school believes that monetary malpractice causes recessions, not structural factors. (Structural factors retard growth, they do not cause the business cycle.) The Depression School believes that the conduct of successful monetary policy requires a stable financial system such that banks do not default upon their debts.
Unlike the Orthodox, the Depression School is a mixed-bag ideologically, including libertarians such as Milton Friedman and liberals such as Paul Krugman.

Historically, both of the above schools have had representatives on the FOMC, and Greenspan was a master of herding them all toward his desired (middle-of-the road) consensus. But now, facing the failure of the Fed to achieve its twin policy goals, the conflict between the hawks and th doves has never been more consequential. And it would appear that the doves are winning, thus resulting in the plan to adopt price-level targeting at the next meeting.

This is creating (as desired) inflationary expectations and a weak dollar. The goal is to achieve stronger nominal growth and to reduce unemployment. As the US is the engine of global demand, this should be welcome news to our trading partners.

But the Germans are having none of this. They and their instrument, the ECB, are firmly in the Orthodox seat, and they oppose QE, unconventional policy, and currency devaluation. Hence statements such as that above that FOMC easing is “irresponsible”. Of course, to those of us in the Bernanke school, it is the ECB’s deflationary policies that are irresponsible, and which will ultimately lead to the breakup of the euro.

Coming soon: price-level targeting

FOMC minutes 10/21:
Many members considered the recent and anticipated progress toward meeting the Committee's mandate of maximum employment and price stability to be unsatisfactory...

Several members noted that unless the pace of economic recovery strengthened or underlying inflation moved back toward a level consistent with the Committee's mandate, they would consider it appropriate to take action soon.

With respect to the statement to be released following the meeting, members agreed that it was appropriate to adjust the statement to make it clear that underlying inflation had been running below levels that the Committee judged to be consistent with its mandate for maximum employment and price stability, in part to help anchor inflation expectations. Members generally thought that the statement should note that the Committee was prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

It’s not about QE.

The media is abuzz with discussion of QE2. The Fed is going to buy more bonds in the hope that deflation will be avoided.  

The FOMC is not discussing buying more bonds. They’ve already done that. They are discussing the fact that they have failed to meet their informal inflation target by 50% (1% vs 2%) and their full employment target by 50% (10% vs 5%). They are beginning to confront the fact that, by any objective measure, they have failed (just as the BoJ has failed and as the ECB will fail).

So instead of talking about how much more bonds to buy, they are finally talking about targeting outcomes instead of policy inputs. Their intended outcomes (more or less enshrined in law), are moderate inflation and full employment.

Once the discussion shifts from policy inputs (“Should we buy another $500 billion?”) to outcomes (“What are we targeting?”), everything changes, and quite dramatically.

The FOMC has four possible targets, listed in increasing degrees of radicalism:
1. Inflation (change in the CPI)
2. Price level (the CPI itself)
3. NGDP growth (change in NGDP)
4. NGDP level (NGDP itself)

Bernanke advocated #4 in Japan in 2002. But, tragically, it’s way too radical for the country club regional bankers on the FOMC. But the Chairman seems to be on the verge of building a consensus in favor of #2, targeting not change in the CPI, but the CPI level itself.

What does this mean? It means (assuming that Bernanke prevails) that the Fed will do whatever it takes to achieve its targeted price level. So if the CPI is 123 today and the target is 126, the Fed will expand the money supply until the target is achieved, even if this means a massive expansion of its balance sheet. It also means that if they undershoot, they must catch up with above-normal inflation.

There is no limit to the tools used, only to the goal meant to be achieved. This is what is so scary for the members. What if it takes $7 trillion?  $17 trillion? What if they overshoot and inflation breaks out? Isn’t it easier to just buy another trillion of treasuries and see what happens?

The problem with QE (as the Japanese have learned) is that it doesn’t create inflationary expectations, and thus productive-sector behavior doesn’t change.

Sunday, October 10, 2010


In the FT, Alan Greenspan assembles the data (which sure sounds bullish to me):

For non-financial corporations (half of gross domestic product)... the share of liquid cash flow allocated to illiquid long-term fixed asset investment...fell to 79 per cent [1H '10], its lowest reading in the 58 years for which data are available.

The corresponding surge in the proportion of liquid assets following the Lehman bankruptcy was the most rapid in postwar history, amounting to a rise of nearly $400bn. By mid-2010 total liquid assets had risen to $1,800bn, the highest share of total assets in nearly a half century.

In such an environment, the equity premium (the excess return that equity produces over the risk-free rate) has become exceptionally elevated. As estimated by JPMorgan, it is currently “at a 50-year high”.

American households have shifted their cash flows from illiquid real estate and consumer durables to paying down mortgages and consumer debt. Commercial banks are exhibiting a similar reduced tolerance towards risk on partially illiquid lending. A trillion dollars of excess reserves remains parked, largely immobile, at Federal Reserve banks yielding only 25 basis points with little evidence of banks seeking higher returns through increased lending.

Saturday, October 9, 2010

Stop foreclosures now!

Washington Post:
Senate Majority Leader Harry Reid (D-Nev.) called on major lenders to halt foreclosures in all 50 states Friday following Bank of America's announcement it was stopping proceedings until it finishes reviewing possible paperwork problems.

Here’s a great way to restart the housing market:  find legal loopholes to invalidate mortgages.

Let's say I’m a rational community banker. I want to make mortgages. I am willing to make mortgages at a low interest rate because, if the borrower defaults, I can take away his house.

But now I learn that (1) even if a delinquent borrower lied about everything on his application and is indeed a serial deadbeat, I must “modify” his mortgage in the interest of “fairness”; and (2) if I made the slightest paperwork mistake (such as a photocoped signature), I can’t foreclose on my collateral, even though the borrower is 24 months delinquent on his payments.

Should I start making mortgages? Yes, as unsecured personal loans. The the next time a school teacher applies for a mortgage, I will happily lend him as much as $20,000. That’s the “new normal”.

The Dow votes for QE2

It has been said that the conduct of monetary policy can be analogized to piloting a supertanker, due to the substantial lag between actions and outcomes. But, as Scott Sumner argues, this isn’t true. There is, in fact, a real-time feedback loop for monetary policy, which is the price of equities.

DJIA on August 9th: 10, 700
August 10 FOMC statement:
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

Translation: We are going to sit on our hands until things get worse.

Market reaction: DJIA on August 26th: 9,900 (minus 800 points).

September 21st FOMC statement:
Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract...
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

Translation: Things have gotten worse, and we are going to do something. (Subtext: The doves are winning.)

Market reaction: DJIA on October 8th: 11,000 (up 1,100 points)

Hmm. FOMC says in August “monitoring”, stocks tank. FOMC says in September “action”. Stocks up.

What is driving bullish sentiment is that the balance of power on the FOMC is gradually shifting toward the doves (or, as Larry Kudlow calls them, the “inflationistas”). Bernanke is slowly but surely pushing the consensus on the FOMC toward QE2 (helped by the recent addition of two doves to the Board).

Now, it’s time for the Fed to put its money where its mouth is; time to start buying things (Treasuries, agencies, gold, Buicks, houses, Frisbees, Slim Jims, bubble gum, whatever).

The BoJ (yes, the BoJ) is now buying ETFs. Never in a million years would I have believed that the BoJ, the bastion of central banking “respectability”, would be buying stocks. How ironic is it that the BoJ can take Bernanke’s advice* while the Fed remains mired in "eat your spinach" hard money dogma.

Here’s the PhD question for all of you armchair Fed governors:
“How much stuff does the Fed have to buy?”

Scott Sumner’s answer: “Whatever it takes to meet its policy objective.”

How much is that? It could be  lot more than you might think. One number that has been tossed out is $7 trillion. Personally, I don’t know and I don’t care. This country and its citizens will go broke unless the Fed is able to meet its formal inflation targets and its informal NGDP targets.

The Chairman told the BoJ in 2003: Don’t target NGDP growth, target NGDP levels. Meaning: When you fail to meet your targets, catch up.

My prediction: Ben will win. The FOMC will start QE2 and the Dow will cross 12,000.

*I would bet dollars to donuts that the BoJ adopted QE because the DPJ told them that the alternative was an “amendment” to the Bank of Japan Law. 

Precis of the Sumner thesis

Scott Sumner, author of the blog TheMoneyIllusion:

Premise 1: The only coherent way of characterizing monetary policy as being either too“easy” or “tight” is relative to the policy stance expected to achieve the central bank’s goals.

Premise 2: “Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.”

Premise 3: After mid-2008, and especially in early October, the expected growth in the price level and nominal GDP fell increasingly far below the Fed’s implicit target.

In plain English, the first premise means the Fed should adopt the policy stance most likely to achieve its goals. It is a point forcefully advocated by Lars Svensson, who Paul Krugman recently cited as an expert on the role of expectations in monetary policy.

The second is a quotation from Mishkin’s best selling monetary economics text (p. 607), i.e. it’s what we have been teaching our students. And I have encountered few if any economists who disagree with my third assumption.

The logical implication of these three premises is that the Fed has the ability to boost nominal growth expectations, and if they let those expectations fall far below target (as they did last fall) the subsequent recession (depression?) is their fault.

Wednesday, October 6, 2010

Regional Feds push for QE

I think these guys are carrying water for Bernanke. They are setting the FOMC up for asset purchases. This is a very bullish signal. Bad for bonds, good for stocks.

Charles Evans, president of the Federal Reserve Bank of Chicago, called for the Fed to do more to charge up the economy, including a new program of U.S. Treasury bond purchases and possibly a declaration that it wants inflation to rise for a time beyond its informal 2% target. "In the last several months I've stared at our unemployment forecast and come to the conclusion that it's just not coming down nearly as quickly as it should," Mr. Evans said in an interview with The Wall Street Journal. “This is a far grimmer forecast than we ought to have,” he added. As result, he said, he favors “much more [monetary] accommodation than we’ve put in place."

Bill Dudley (NY Fed):
Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.
We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.

Don't mix monetary policy and politics

Scott Sumner (the world’s leading monetary dove) on the subject of trying to understand the intellectual confusion of liberal economists who are fiscal doves and monetary hawks:  

I have no idea where these guys are coming from.  A currency war causes everyone to lose?  Why is that Mr. Reich?  Because it leads to high inflation?  And what causes the high inflation?  Rising aggregate demand?  And what is the point of the fiscal stimulus you favor?  Higher aggregate demand?
The name of my blog [The Money Illusion] never seemed more appropriate.  We’re hardwired to think disputes must be over who gets what—who’s favoring the capitalists and who favors the workers.  It’s much more than that.  It’s mass confusion about the nature of monetary policy.  Krugman and Stiglitz are distinguished economists with impeccable progressive credentials, and they both can’t be right.  The AFL-CIO opposed FDR’s dollar depreciation of 1933, even though it led to a rapid increase in production.  Every day that goes by I’m reminded more and more of the intellectual climate during the 1930s.  We’ve learned nothing.

Tuesday, October 5, 2010

"I buy gold; you should too!"

I think by now we have learned that low interest rates create asset price bubbles, while high interest rates create bargains.

What’s a bubble? An asset class that is overvalued relative to its discounted future cashflow. Right now, the leading candidates for price bubbles are gold, treasuries and JGBs.

It is paradoxical  that the price of gold, treasuries and JGBs have been so closely correlated since the crisis. Gold is a hedge against inflation, treasuries are a hedge against deflation, and JGBs are a hedge against common sense. 
What’s good for gold should be bad for treasuries. Remember 1980, when gold was at an all-time high and bond prices were at an all-time low?

So what’s going on? I think the reason is that “safety” is highly overpriced, while risk is highly underpriced. This is due to the volatility of risk asset prices since 2006.

Also, as in the case of all bubbles, the assets in question have “momentum”: bonds and gold have been the best (and steadiest) investments during this period, while stocks and real estate have been volatile and ugly. Momentum, of course, is meaningless as an investment criterion unless you believe in astrology or technical analysis.

The real return on treasuries is extremely low (unless you expect deflation). If treasury yields returned to ~5%, you would be looking at massive MTM losses.

The real return on gold is nothing because it pays neither interest nor dividends. But isn’t gold a hedge against inflation or the dollar or bad news or something?

Why? How can an overvalued asset that has no intrinsic value be a hedge against anything besides evil spirits? Gold at $35/oz in 1971 was, in retrospect, a good hedge against inflation and a weak dollar. But is gold at $1,300 a good hedge against inflation? It wasn’t in 1981, when its value collapsed in spite of unprecedented inflation.

There is simply no logic to the price of gold. It is a talisman, a fetish, a religious article, not an investment.

Will gold and treasuries remain correlated when things turn around? I don't know, because there is no logic behind the price of gold. If the Fed can revive inflationary expectations, treasury prices will fall; that is axiomatic. Inflationary expectations will revive nominal activity and the stock market. Flows into bonds should reverse, resulting in a bond crash. That I know.

And gold? Well, it could go down due to flows into equities, or up due to inflationary expectations. But, because it has no intrinsic value, it has no economic “support level” to prevent a repeat of the 1980 crash.

My view would be that, as confidence in equity valuation returns, and the ERP goes down, gold will stall, then dip, and then crater (to below $1000).

That would be the rational prediction. But I reiterate: there is no logic to movement in the price of gold. It is a random walk.

Sunday, October 3, 2010

Bill Dudley signals more quantitative easing

NY Fed president William C. Dudley:

Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.

We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.