At the end of its two-day policy meeting on January 25th, the Federal Reserve revealed its new communication strategy. It will now share with us all the forecasts made by all of the voting members of the Federal Open Market Committee (FOMC) and more on interest rates. It has a formal medium-term inflation target of 2% based on the price index for personal consumption expenditure (PCE). It does not have an employment target or unemployment rate. It has concluded, for better or worse, that it has more influence over inflation outcomes than over employment outcomes. It thinks that the natural rate of unemployment in the US is between 5.2% and 6.0%.
FOMC in December 2011
In addition to all of the above, what else did the FOMC decide on January 24-25? It decided that interest rates would stay low up to late 2014. The last time the FOMC met was on December 13th. The FOMC decided the following at that time:
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
What was the economy doing then? This is what they said:
Information received since the Federal Open Market Committee met in November suggests that the economy has been expanding moderately, notwithstanding some apparent slowing in global growth.
Now, what did the FOMC decide on Jan. 25th?
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 per cent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
That is a 15-18 month extension of the zero interest rate policy, pre-committed. What does the Federal Reserve need monetary policy autonomy and independence for, if they are going to chain themselves more and more? At least, is there any incremental logic in what they did between December 2011 and now? They repeated the same assessment of the economy:
Information received since the Federal Open Market Committee met in December suggests that the economy has been expanding moderately, notwithstanding some slowing in global growth.
There was no incremental deterioration in their assessment. It was identical to the December statement, in fact.
In terms of actual economic data, the housing market index has improved beyond what they could have imagined. The unemployment rate has declined and so have did the initial jobless claims. Purchasing Managers’ indices in various Federal Reserve regions have shown first order or second order improvement. As usual, the US stock market is defying gravity.
Now, let us make one thing clear. We do not think these are lasting signs of economic recovery. We may even venture to add that some of the improvements do not pass the test of rigour. However, from a rational decision-making angle, what matters is the change; what happens at the margin. At the margin, things have certainly not deteriorated but got better.
Lastly, if we examined the forecasts developed by the Federal Reserve Board members and Federal Reserve Bank Presidents, it is hard to discern a case for extending the zero rate (or, low rate) pledge until late 2014. If anything, their unemployment rate projections are more optimistic now than the ones they made in November 2011!
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Medium-term inflation target – case for tightening
If the natural rate of unemployment is now estimated at between 5.2% and 6.0%, then it is logical that the output gap is not as negative as is deemed. When the excess capacity is not as large as thought of earlier, then it further weakens the case for extending the period of exceptional policy setting.
The Federal Reserve has now announced a medium-term inflation target of 2% measured by the annual change in the price index for PCE. The average annual inflation rate measured by the PCE Price Index is 3.2%. If we are somewhat more charitable to the Federal Reserve, omit the early years of the 1980s when the inflation rate was in double-digits and calculate the average inflation rate from the 1990s, the rate is 2.2% – still above the Federal Reserve target of 2.0%. The annual inflation rate in the last two quarters (June and September 2011) has been 2.5% and 2.9% respectively.
(Click on the image for a clearer view)
In other words, there is nothing in the data to warrant the Federal Reserve extending its zero interest rate policy by another 18 months.
Lastly, empirical evidence over the last three decades has shown that inflation targeting is useless in helping central banks avoid or contain systemic crises. If anything, inflation at or below target lulls central banks into policy complacency. Central banks need to look at a wide variety of indicators to identify and eliminate risks before they become too big to handle. In a well-functioning market economy, prices of goods and services would automatically adjust as both demand and supply respond to price signals. There is really nothing for central banks to do except to oversee prudent money supply and credit growth.
Forsaking policy independence is irrational
What did the last episode of pre-commitment under Greenspan achieve? He kept the Federal Funds rate at 1.0% from 2003 until 2004 (he need not have brought it down to 1.0% in the first place) and then increased them gradually at a pre-announced pace of 25 basis points per meeting? Did it cause market participants to taper off their risk-exposure gradually? No. It made them take on more risk because he had removed monetary policy unpredictability and uncertainty, which are legitimate weapons in the policy arsenal.
So, what was the logic in extending the zero per cent interest rate commitment by another 15 to 18 months when mid-2013 is already some 18 months away? Is there something that they know that we do not know about the underlying economy? Are all the recent improvements in the data fabricated? If they do expect the economy to remain as sluggish as to warrant zero per cent interest rate for almost another three years, then why are they not simultaneously warning of irrational exuberance in the stock market?
With his excessively loose monetary policy in 2001-2004 and with his gradual tightening from 2004 to 2006, Greenspan played a major role in precipitating the global financial crisis of 2008. His successor has exceeded him in many ways. It should not surprise us if the consequences too are far worse.
So, why is the Federal Reserve doing this?
There are many reasons. First, they suffer from intellectual paralysis. All policymakers (and economists) work with dogmas and not with open minds. If they are lucky, the dogmas do not lead to disasters. Otherwise, it does. That is what happened in 2008. They do not learn from errors. They are human beings, after all.
Second, to be charitable to them, American policymakers see deflation and depression in every corner. Every other risk is worth taking to avoid that one risk. To be uncharitable and honest, their true goal is monetary debasement and inflation. That is how one takes care of the mountain of present, future and contingent debt. Savers, pensioners and creditors – domestic or foreign – be damned.
Third, given that they are worried about deflation, they could have considered another round of money printing as they did in 2009 and in 2010. Republican Presidential hopefuls have set their face against it. Hence, Bernanke has to resort to this subterfuge.
Fourth, the Federal Reserve was smug with confidence that they were the only one in the race to debase money. Now, they have a rival who has either already closed the gap or raced ahead of the Federal Reserve. The expansion of the European Central Bank (ECB) balance-sheet in recent months has been astounding. It does not even require high-school mathematics to estimate that the growth rate of the ECB balance-sheet has been just under 50% in the last seven months.
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Economists would argue that this would not cause inflation immediately because either (a) the money multiplier is weak or that (b) these are temporary expansions of the balance-sheet or (c) that the market believes them to be temporary and hence, they would not influence expectations. May be, all of it is true although we are sceptical of all the claims made above.
Even if they were true, the distortions it causes to human behaviour (encouraging speculation in contrast to investment), to asset prices (bubble-creation), to competitiveness of developing countries (their currencies appreciate too much too soon for them to adjust) and to social equality (asset price gains do not accrue to the majority of the population) are too serious to be intellectualised or dismissed with a wave of hand.
The actions of the Federal Reserve are irresponsible and hence, indefensible. Their putative gains, if any, outweigh both local and global costs.
Investors react like flies drawn to fire
In response to this decision, stock markets went up in the US and in Asia. May be, that pleases the FOMC. After all, they measure their success in terms of the reaction in stock markets. Previous episodes of excessive and prolonged loose monetary policy have shown that such gains are not sustainable. This one will be no different.
Commodity and carry-trade currencies have also surged ahead (Australian dollar, South African rand and Brazilian real, to name a few). Such gains are neither economically desirable for their countries nor are they sustainable.
Gains in precious metals and commodities are the only things that matter, as the race to make paper currencies worthless is now well under way. The number of participants is increasing by the day. We only have to wait for the Bank of Japan to join. They have resisted wisely so far. Will politicians and exporters let them stick to their sensible approach? When they too succumb, expect gold to soar. Of course, gold does not need further impetus than what the Federal Reserve and the ECB have provided already.
Brilliant post and apt title.
Beginning with the reckless Spanish monetary expansion that was the result of influx of Latin American gold and silver, each episode of excessive money creation through the centuries has resulted in complete economic disaster. This time will be no different.
You are right in concluding that the purpose of this money printing is to inflate away debt. This induces moral hazard all through the economy and promotes irresponsible risk-taking by economic actors.
But, the most important outcome of this monetary expansion is that it short-circuits the self-correcting mechanism – the process of creative destruction – of the economy, setting the stage for an even bigger correction when it does come around.
In the long run we are all dead, but it is no reason to screw things up for people who will be alive then.
What would be the likely effect of monetary expansion in Europe and the US on inflation in India? Would inflation increase, or would the exchange rates adjust enough so that there will be no effect?
You have identified correctly the two competing influences. On balance – and I admit I have no way of proving or demonstrating it – I suspect that inflation effects would not be fully offset by the currency appreciation, given India’s own domestic issues, among other things.
The recent appreciation in domestic currency has completely offset the devaluation of foreign currency. Since December 21, the day ECB announced its LTRO, gold has risen by 6.8% in dollar terms, while the rupee by 7.67%.
It’ll be interesting to see how this evolves.
I think you raise some existential angst here, Anant. The world operates on the basis of fiat currencies which major currencies widely floating in nature. When these adjustments aren’t sufficient to compensate for the loss of internal demand, governments’ and/or monetary authorities’ balance sheets will have to expand. Period. We can argue back and forth about the inflation risks, asset bubble risks, developmental externalities, yada, yada. However, at the end of the day central banks and finance ministries are national institutions and safeguard key policy objectives which are formulated with core national goals in mind. So with that BOJ has followed ZIRP for years, and still no inflations, zip, nada. Do you see risk taking behavior by Japanese firms, residents?? Sure JPY has become a funding currency for all manner of carry trades, but the moot question is has the quantum of risk taking increased to the extent of heightening financial instability in Japan? By any stretch of household and corporate balance sheet measures, the answer would be NO.
Now the US Fed has embarked on a far more aggressive course of QE than the BOJ’s incremental moves over a long period of nearly a decade, and you seriously believe core inflation is about to explode? The momentum’s flat (3m/3m, saar), output gaps are huge, wage price-pressures are nearly non-existent!
This brings us finally to global commodity price pressures… well this simply won;t be as hurtful, if EM currencies (starting with the RMB) appreciated much more. No one on this blog seems to be critical of 3.2 tln of FXR accumulation by the PBOC with the niggardliest pace of FX appreciation! Same holds true of other mercantilist east Asian hard currency hoarders but this simply can;t go on much longer.
If you notice the composition of FXreserve growth in East Asia, you will notice that current account surpluses have historically acctd for most of the reserve increase. Since 2010 however things are changing. E.Asia is still accumulating reserves (barring China’s recent mthly reversal in reserve growth by $50 bln or so), but the capital account surpluses now are driving most of the currency hoarding, whilst current surpluses (and the contribution of net exports to growth) have actually begun falling.
So in a sense you are right, Anant, the drivers of shifts in global flows are being catalyzed by policy institutions in the west. And this has inflation and ultimately REER implications. But lets at least acknowledge these institutions have as muhc right to act in their national interest as much as east asian currency hoarders played a role in creating the global savings glut which, arguably, also contributed to low interst rates, and excessive risk taking in the west.
Cheers,
Andy
I think you raise some existential angst here, Anant. The world operates on the basis of fiat currencies in which major currencies are widely floating in nature. However, when these adjustments aren’t sufficient to compensate for the loss of internal demand, governments’ and/or monetary authorities’ balance sheets will have to expand. Period.
We can argue back and forth about the inflation risks, asset bubble risks, developmental externalities, yada, yada. However, at the end of the day, central banks and finance ministries are national institutions and safeguard key policy objectives which are formulated with core national goals in mind. So with that in mind, BOJ has followed ZIRP for years, and still no inflation, zip, nada. Sure JPY has become a funding currency for all manner of carry trades, but the moot question is has the quantum of risk taking increased to the extent of heightening financial instability in Japan? By any stretch of household and corporate balance sheet measures, the answer would be NO.
Now the US Fed has embarked on a far more aggressive course of QE than the BOJ’s incremental moves over a long period of nearly a decade, and you seriously believe core inflation is about to explode? The momentum’s (3m/3m, saar) flat, output gaps are huge, wage price-pressures are nearly non-existent!
This brings us finally to global commodity price pressures… well this simply won’t be as hurtful, if EM currencies –starting with the RMB– appreciated much more. No one on this blog seems to be critical of 3.2 tln of FXR accumulation by the PBOC with the niggardliest pace of FX appreciation! Same holds true of other mercantilist east Asian hard currency hoarders.
Asides from the absence of malignant price pressures in the US, another interesting development pertains to the composition of FX reserve growth in East Asia. You may recall that current account surpluses have historically accounted for most of the reserve accumulation. Since 2010 however things have begun changing. E.Asia is still accumulating reserves to be sure (barring China’s recent mthly reversal in reserve growth by $50 bln or so, or the occasional drop in MAS’ fwd book), but it is the capital account surpluses that are now are driving most of the currency hoarding, whilst current surpluses (and the contribution of net exports to growth) have actually begun falling.
So in a sense you are right, Anant, the drivers of shifts in global flows are being catalysed by policy institutions in the west. And this has inflation and ultimately REER implications. But let’s at least acknowledge these institutions have as much right to act in their national interest as much as east asian currency hoarders have sought to act in their own best interest. And, which has undoubtedly played a role in creating the global savings glut which, undoubtedly, also contributed to low interest rates, and excessive risk taking in the west. It is true that Greenspan was slow to raise rates. But raise rate he did! When the transmission to long-term rates did not materialize, that –in hindsight- should have been signal enough to do two things. First crack down on the US shadow banking system; and, second, take a much harder line on REER apprc by China.
Cheers,
Andy
Hear, hear Andy! I’ve been saying this (in some shape or form) for quite some time here, nice to see some support.
The implications for India, though, of this shift are going to be not very good…not directly related to the post, but this “mercantilist, export-led growth, current account-surplus” (though we never had the latter) way of developing one’s economy is fast closing, & India seems to have missed the bus. I think the biggest 2 reforms we could now do are speed up development of a deep & wide LT debt market & strengthen governance (I know, easier said than done), if need be, by coercive measures.
Countries have a right to act in their national interests. Every country will do that, then. You have a problem with Asian reserve accumulation. I have a problem with Fed ZIRP. The world is not on a yen standard. De facto, if not de jure, the world is on a dollar standard. That is why American actions will have a disproportionate influence on the world prices than Japan’s actions did. More importantly, these actions are unlikely to help America either. De-leveraging and raising the savings rate are not helped by the pledge of zero interest rates until the end of the world.
The economists and investment community can debate until the cows come home as to which was the original trigger for reserve accumulation. The following sequence is equally plausible and relevant: the hasty liberalisation of capital accounts by Asia in the late 1980s and early 1990s under US and IMF pressure that led to overvalued currencies (relative overvaluation accentuated by China’s outsized currency devaluation in end-1993), current account deficits, exchange rate and banking crisis, IMF humiliation, US banks’ chutzpah (and with US Treasury brazenly using the opportunity to open up their economies for US banks and insurance companies prompting even the conservative Martin Feldstein to assert sovereign rights to choose the path and timing of economic reforms) in demanding full restitution by sovereigns for their commercial lending decisions. This sequence of events made Asian governments decide in favour of ‘never again to the IMF’ and the decision to accumulate reserves.
That it has had a role in the US banking and housing crisis is a legitimate claim. To lay the blame on the excessive risk-taking and all other non-sense that went with it in the US on the so-called savings glut in Asia boggles the mind, to say the least.
If, as you say in the end, the US should have taken a harder line on China’s REER (I think they should have taken a harder line on a lot of things happening back home first before cracking the whip on China but that does not matter), then ask yourself why they did not.
That would bring a lot of skeletons out of the US policy-making (and political) cupboards.
If I may continue arguing:
A few things you said…
“I have a problem with Fed ZIRP. The world is not on a yen standard. De facto, if not de jure, the world is on a dollar standard. That is why American actions will have a disproportionate influence on the world prices than Japan’s actions did.”
So you think the United States’ Federal Reserve should take into account the “disproportionate” effects of QE on world prices, than BOJ? Ummmm… are you kidding me? Or do you think a weak US$ alone explains shifts in commodity prices?
“The following sequence is equally plausible and relevant: the hasty liberalisation of capital accounts by Asia in the late 1980s and early 1990s under US and IMF pressure that led to overvalued currencies (relative overvaluation accentuated by China’s outsized currency devaluation in end-1993), current account deficits, exchange rate and banking crisis, IMF humiliation, US banks’ chutzpah (and with US Treasury brazenly using the opportunity to open up their economies for US banks and insurance companies”
This seems like 1/ backward looking if not outdated/irrelevant analysis of the savings-glut causation and 2/ donesn’t address the principal cause of the savings glut: China. If your backward looking analysis was to be relevant/correct, then Indonesia and Thailand and Korea (the worst affected in the AFC) should be accumulating the most amount of fx reserves. On the contrary it is China which has absolved unto itself the exactor of “revenge” for developments in 1997-98. And, as we all know, China was one of the least adversely impacted countries from the Asian crisis. So the “never again” thesis is either mis-placed or naive. You take your pick, Anant.
Then you go on to say…
“If, as you say in the end, the US should have taken a harder line on China’s REER (I think they should have taken a harder line on a lot of things happening back home first before cracking the whip on China but that does not matter), then ask yourself why they did not.”
Sure they should have smelt the coffee and woken up to the dangers of the shadow banking system, and the misplaced faith in structured finance and CDO ratings. That they did not, can be attributed to ideological pig headedness (that markets are self restraining). And that’s not an unreasonable characterization. However, I would prefer to see it as allowing the markets to take its course within a system where market forces have usually taken its course, and which had until 2007 paid reasonably sound dividends. And which is quite unlike several (or most?) Asian countries, where mkts rarely take their course. You can call this “hidden corruption” or “state capture” or what you will (a-la Simon Johnson, etc., etc.) but then do you seriously believe paternalistic systems like China or Singapore or Taiwan (all three of which are the world’s most voracious hard currency hoarders) are more benign, or have far better Gini coefficients, or whose growth models are inherently more stable?
Rgds,
Aninda
(sorry for the double post in the earlier round)
Andy,
While China’s reserve accumulation dwarf’s everyone else’s, every major emerging market country has seen a massive increase in reserves since 1998–Russia, India, Brazil, Korea, all have reserves in excess of $300 billion from low double digit levels prior to 1998. Why do you think there was no emerging market currency crisis in 2008 and why do you think that EMs were able to ease policy for the first time in a global crisis? I agree that the Fed is concerned about its domestic priorities and they should be.
Andy, are you sure that “market forces” have been allowed to run their course in the US until 2007? Regulatory nonfeasance in the presence of deposit guarantee and unlimited Fed backstop is is Greenspan’s definition of free markets, not mine. In my jargon that is not far from crony capitalism about which the Asian were lectured in 1998. Also, given the extensive erosion of accounting, the almost complete abdication of duty by the SEC, I cannot see where you are getting your optimism about state of free markets in the West?
Very well put Srini. Regulatory non-feasance in the amidst deposit gtees and unlimited Fed backstop is indeed the Greenspan put, and privatization of losses and socializatiosn of costs. But my point is not that I’m optimisitc about free markets, it is 1/ first and foremost, I’m less pessimistic about inflation in the US; and 2/ secondarily, I do not believe the currency hoarder in chief, China, is structurally or ideologically well positioned to demonstrate conclusively the short-comings of the type of free-market capitalist system as practiced in the US. In other words we’ve hardly seen the end of history – to paraphrase Fukukyama and notwithstanding what Arvind Subramanian thinks (though, I’ve yet to readeclipse).
As for reserve accumulation by other EMs. You are right in pointing out the buildup. But, reserve adequacy indicators by any stretch (greenspan-guidotti rule, or other risk based measures of reserve cover) aren’t improving exponentially or continuously at other EMs.
Regards,
Andy
It is a good discussion. Thank you, Andy and Srini. But, I must confess that I am at a loss to understand why there is a comparison with China. I have, never in my posts, held up China as a model. In the post titled, ‘mind-boggling non-sense’, I had not held China up as a model. Whenever this blog has commented on China’s data, for example, it has only been with a tone of bewilderment at all the optimism on China based on the headline numbers that report. There is no way of verifying and crosschecking these numbers.
For the record, I am not optimistic on inflation in the US, notwithstanding their ability to fudge these numbers as well as any body does with all their hedonic adjustments, etc.
You are setting up straw-men to knock them down. Did I do a comparison with East Asian countries and held them up as better than the US? That is a completely different argument and I am not engaged in that discussion now. Period.
As for your rhetorical question, “So you think the United States’ Federal Reserve should take into account the “disproportionate” effects of QE on world prices, than BOJ? Ummmm… are you kidding me? Or do you think a weak US$ alone explains shifts in commodity prices?”
The answers are: (1) I am not kidding. I maintain that statement. (2) Again, you are putting words into my mouth. Weak dollar alone does not explain shifts in commodity prices. They do have a significant role.
Dear Srini,
I would not be concerned about the Federal Reserve minding its domestic priorities were it not for the fact that America enjoys seigniorage benefits of the world being on a dollar standard and for the fact that America worked hard at bringing about that dollar standard in the world and is working hard to preserve it. America does not want to pay the price for that or, put differently, shoulder the responsibilities that go with it. Of course, this is not new. America has been at it from the 1970s if not earlier. Here are some important verbatim statements from ‘The Rules of the Game: International Money in Historical Perspective’, Ronald I. McKinnon, Journal of Economic Literature, Vol. 31, No. 1 (March 1993):
(1) Concern for the “overvalued” American exchange rate from about 1968 onward reflected the slipping American resolve to continue anchoring the common price level (Rule X Box 3 – from the paper). By caving into domestic political pressure to be more ‘expansionary’, the U.S. Federal Reserve allowed the American producer price index to begin increasing at about 3.5% per year from 1968 to 1972 whereas from 1951 to 1967 inflation had averaged closer to 1% per year. Other countries, notably Germany, were thereby induced to violate Rule IV by attempting a sufficiently tight money policy to reduce their inflation rates below that prevailing in the United States.
(2) … If the US Federal Reserve System had continued to anchor the common price level, and if the Americans had not asserted their legal right to adjust the dollar exchange rate as promised by Bretton Woods Articles, the fixed dollar exchange parities could have continued indefinitely once the residual commitment to gold convertibility was terminated. Clearly, the discrepancy between the unwritten rules in Box 3 and the legal obligations in Box 2 eventually proved lethal for the par value system.
(3) In 1970-71, facing the clamor for dollar devaluation and greater exchange rate flexibility, the schizophrenic American government would not disinflate the American economy in order to defend the most successful international monetary regime the world has ever seen.
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Whether we agree with its contentions not, this paper is a great read for a bird’s eye-view tour of international monetary arrangements since the Gold Standard.