Once again, the FOMC ignores its statutory mandates

The FOMC released its statement today (excerpted below; emphasis added). The statement may as well have been written by the Bank of Japan.

It is what I had feared: the dollar amount is 10% of what economists have estimated may be needed, and, more disturbingly, there is no mention of inflation-targeting.

QE without inflation targeting is like driving slowly without a destination, hoping to arrive somewhere. It’s like “take two aspirin and call me in the morning”.

Clearly, Bernanke and the doves could not get a consensus in favor of targeting. All they could muster was a very weak compromise on some more QE.

Maddeningly, the statement references the Fed’s full employment mandate and then shrugs its shoulders and says “Oh well”. A central bank that does not fulfill its statutory mandates is negligent or incompetent.

Today’s decision means that the US will continue to have a weak, jobless recovery and that millions of people will remain without employment “for an extended period”. There is nothing that the American people, the White House or Congress can do about that. (Aside from amending the Federal Reserve Act.)

Here it is. Read it and weep for the millions of people with no jobs and no prospects:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure [why not just delete the word help?] that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities.

The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

GOP gains: Good for hawks, bad for doves

The GOP midterm gains should be positive for equities because they increase the probability that taxes on dividends and capital gains won’t be raised in January. However, this silver lining also comes with a cloud: Tea Party antipathy to the Fed and “inflation”.

To the extent that Congress decides to award itself a seat on the FOMC, there will be even greater pressures against unconventional anti-deflationary policies. This is not good for equities.

To understand the way that central bankers think about public opinion, this is what Governor Kevin Warsh said recently:
“The Fed's institutional credibility is its most valuable asset, far more consequential to macroeconomic performance than its holdings of long-term Treasury securities or agency securities. That credibility could be meaningfully undermined if we were to take actions that were unlikely to yield clear and significant benefits.”

In other words, millions of unemployed parents is unfortunate, but “institutional credibility” more important. Just ask the BoJ.

Tomorrow's FOMC meeting

The markets expect the FOMC to announce another round of asset purchases (QE2). The number that has been mooted is $500B, which would bring the balance sheet up from $2.2T to $2.7T or so. The market also expects the committee to say that it will go further if necessary.

What isn’t known is whether the FOMC will make a definite statement about inflation-targeting. To the extent that it is weak or vague, the market will react negatively (despite the midterms). If the language is more definitive and muscular, I’d expect the stock market to react very positively. The market would prefer no dissenters, and certainly no more than Hoenig.

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.

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.

Greenspan

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.