Thursday, November 21, 2013
The Fed’s October Minutes: Embracing Defeat
[Note to readers: I have been a bit preoccupied with healthcare policy lately, such that I took my eye off of the economy for the past two months. I may write something about the ACA, although there has already been a tidal wave of ink on the subject. And having said that, I return to my regular beat.]
“Although the incoming data suggested that growth in the second half might prove somewhat weaker than many of them had previously anticipated, participants broadly continued to project the pace of economic activity to pick up.
“Participants generally expected that the data would prove consistent with the Committee's outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months.
--FOMC minutes from 10/29-30/13 meeting
The Fed has concluded that, despite the fact that it has failed to achieve either of its dual mandates, conditions will nonetheless improve and it can begin to reduce monetary stimulus. Although none of the Fed’s prior forecasts with respect to unemployment and inflation have proved remotely accurate, its current optimistic forecast is sufficient reason to take away the punch bowl with 7.2% unemployment, a low labor-force participation rate, and inflation running at 50% below target.
The Fed has congratulated itself on the success of its policies, despite the fact that the zero funds rate and massive growth in the Fed’s balance sheet have had no impact on money growth, inflation or unemployment.
In my view slowing QE is an economically meaningless event, since QE itself proved economically meaningless. Instead of using the proceeds of the Fed’s purchases to make loans, banks have instead left it on deposit at the Fed as an interest-bearing, zero-risk asset, doing nobody any good. Money growth has remained sluggish despite “massive monetary stimulus”.
The economy’s #1 problem today is not the sequester, the deficit or Obamacare. It is the abysmal nominal growth rate, now hovering just above 3%. Historically, 3% nominal growth has been recessionary; luckily for us it is only near-recessionary. If the Holy Grail is 4% real growth, we will never achieve it with 3% nominal growth: there isn’t room. We will need 6-7% nominal growth if we ever hope to see pre-crash unemployment levels.
It has not entirely escaped the Fed’s notice that the rate of inflation has been steadily falling since 2011, and is now at 1%, 50% below a target that was already too low. The failure of QE to influence money growth has resulted in disinflation that threatens to become deflation.
Monetary policy can be challenging in the context of “stagflation”, when inflation is high and real growth is low. That challenge, however, is completely absent today. Today, both inflation and growth are very low. If some version of the Phillip’s Curve still operates, the Fed has plenty of room for both higher inflation and higher growth. Expressed differently, money growth today is below NAIRU, the lowest achievable rate of unemployment that does not cause inflation to accelerate. Instead, we have high unemployment and falling inflation, also known as a pre-recessionary condition.
It is ironic that the hawks (on and off the FOMC) criticize the Fed when it experiments with new ways to achieve its mandates. They say that by changing policy instruments or guideposts, the Fed will “lose credibility” because any change is inconsistent with prior guidance. They desire a foolish consistency, and fail to understand that the best way for the Fed to lose credibility is to consistently miss its mandates, as it has been doing for the past five years.
The Fed’s employment and inflation targets have no credibility because they seem to have no influence on policy. When inflation expectations are “firmly anchored” at a rate below your target, you should know that your policy has no credibility. Instead of committing to “do what it takes” to achieve its mandates, the Fed instead commits to continue doing what it has been doing: policy continuity for the sake of policy continuity. And now, to further reinforce its credibility, it will do a bit less of what it has been doing.
The key question going forward is whether the FOMC’s dynamics will be affected by the change in leadership. Will Yellen’s dovish views be given greater deference than Bernanke’s were, or will the War of the Angry Birds continue unabated? Let us pray that, once Janet is seated in the driver’s seat, things will change. The mention in the minutes of possibly reducing interest on reserves provides a glimmer of hope.