Tag Archives: Federal Reserve

Bizarre Anecdotes at the Fed

At its May meeting, the Fed prepared markets for a rate hike that it never intended to result in an inevitable move when it announced the bias toward tightening. But the FOMC did end up raising the FFR in June, despite the fact that April’s jump in the core CPI appeared to be a one-off event rather than an indication that inflation had begun to accelerate. So why did the Fed act?

As the transcripts reveal, the Fed’s new instrument failed to affect markets in the way the Fed anticipated:

I was startled by the extraordinary market talk after we announced an asymmetrical directive following the May meeting. . . We might as well have raised rates at that point as far as I am concerned. . . . Indeed, what we are looking at is a long-term interest rate that is moving up because market participants think the Fed is going to move (Greenspan, Transcript, June, p. 88).

Thus, because markets were anticipating a rate hike, some saw the increase as preordained, arguing that raising the federal funds rate was “largely a foregone conclusion” (Boehne, Transcript, June, p. 44). Others, such as President McTeeter and Vice Chairman McDonough believed that conditions did not merit an increase and that the Fed should show restraint until such time as inflation appeared to resurface:

[T]he public and markets everywhere are waiting for us to pounce on growth and job creation and stifle them. Since I do not believe we should do that, I believe that our challenge is to clarify out strategy – first to ourselves, then to the public and the markets. . . . we should not be in a tactical position of being constantly poised to attack an enemy that does not appear visible to me. We need to find a way to tactical symmetry – to a position where we, the public, and the markets think we are watchfully waiting but not looking for windmills to knock down (McDonough, Transcript, June, p. 48).

Thus, while some felt compelled to validate the market’s expectations in order to maintain credibility, others believed that a rate hike was unwarranted in the absence of troublesome news on the inflation front. After much deliberation, the FOMC felt compelled to move, voting to raise the FFR 25 basis points at the close of its June meeting.

To justify the June increase, members argued that despite a drop in the core CPI, there were reasons to believe that inflationary pressures were mounting. Some truly strange anecdotes were offered as “evidence” of these pressures. For example, President Broaddus relayed the following story:

One of our economists [from the First District] has a close friend who has a house in the Boston area. The friend got an estimate last year for an addition to his house but didn’t have the work done. He got an estimate again just recently, a year later, and it’s up about 30 percent. That’s really extraordinary!” (Transcript, June 1999, p. 40).

And President Minehan shared the following:

The job market for summer teenage employment is strikingly good if my 17-year old and his friends are any indication of that market” (Transcript, June 1999, p. 37).

No one offered any tangible evidence of pipeline inflation. Yet the majority – many of whom felt ‘boxed in’ by the May directive – clearly wanted to raise the FFR. Ultimately, they justified their move for the record by offering anecdotal evidence and impassioned commentary about the importance of credibility and the need to fulfill market expectations.

References:

  1. Bell-Kelton, Stephanie. “Behind Closed Doors. The Political Economy of Central Banking in the United States.” International Journal of Political Economy 35.1 (2006): 5-23.

 

Advertisements

Leave a comment

Filed under Economics, Notes on Economics, Politics

The Fed and the Wealth Effect

jim-rickards

I’m currently reading The Death of Money: The Coming Collapse of the International Monetary System, by James Rickards and the book is pretty bad. My current impression is that Rickards is a stereotypical “heterodox” economist/analyst that doesn’t actually understand basic economic theory. He constantly makes sweeping assertions about economists he hasn’t read. His scenarios on financial warfare seem really far fetched. His pretentious writing doesn’t help either.

Instead of complaining, I thought I would do something a little more constructive. As I continue to read the book, I’ll critique the parts that bug me. I probably won’t cover the stuff about financial warfare, as I don’t know if his concerns are real or not. I will cover the sections on economic theory, an area that I’m a little more comfortable with.


James Rickards, like many critics of QE and Federal Reserve Policy, thinks that Fed officials are obsessed with the “wealth effect”:

Policy makers respond to economic distress by pursuing policies designed to improve the data. After a while that data themselves may come to reflect not fundamental economic reality but a cosmetically induced policy result. If these data then guide the next dose of policy, the central banker has entered a wilderness of mirrors in which false signals induce policy, which induces more false signals and more policy manipulation and so on, in a feedback loop that diverges further from reality until it crashes against a steel wall of data that cannot easily be manipulated, such as real income and output. A case in point is the so-called wealth effect. (Rickards 2014: 72)

For those unfamiliar, the wealth effect says that an increase in the value of household financial and non-financial assets will bring about an increase in aggregate expenditure. So for every dollar in asset appreciation, the owner of that asset will spend a part of that dollar. Advocates of the wealth effect say that as stock prices and housing prices go up, consumers will feel more confident about their financial position and start to spend more.

I haven’t read much literature on the wealth effect, so I have no idea if Rickards’ critique addresses the most recent empirical research (I will say that the little research I have read is more tentative than Rickards and other critics would have you believe). But let’s ignore that and assume he is correct. It turns out that the connection between assets and consumption is tenuous. And to be fair to Rickards, a lot of respectable analysts take issue with the wealth effect. It’s also true that several Federal Reserve officials have talked about wealth effect. Everybody loves to cite this Greenspan quote:

A substantial part of the excess growth of demand over potential supply owes to a wealth effect, induced by the rising asset prices that have accompanied the run-up in potential rates of return on new and existing capital. The rise in stock prices, as well as in the capital gains on homes, has created a marked increase in purchasing power without providing an equivalent and immediate expansion in the supply of goods and services. That expansion in supply will occur only over time.

Ben Bernanke has talked about the wealth effect, albeit very briefly in an op-ed piece:

Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

So Rickards and the critics may have a point. However, one thing I noticed when I read all these pieces is that they reference the same three or four quotes. In my search for Bernanke quotes on the wealth effect, I could literally only find one. It’s the one I’ve quoted above, a brief off-hand sentence in an op-ed piece. If he talks about it anywhere else, a Fed speech or a paper, I’d love to see it. But citing this op-ed as if it’s representative of Bernanke’s thoughts on monetary policy is just silly. The thing about monetary policy is that it works through lots of channels. Ben Bernanke, being a central banker and knowledgeable economist, knows this (he’s even written about it before). Most economists know this. Heck, even I know this. Just look at this picture from Frederick Mishkin’s extremely popular undergraduate textbook on money and banking:

monetary policy channels

As you can see, there’s a lot of channels that monetary policy can work through. In fact, the most commonly cited channel that QE is supposed to work through is interest rates which in turn affects investments. Here’s a newsletter from the St. Louis Fed explaining the process:

QE affects the economy through changes in interest rates on long-term Treasury securities and other financial instruments (e.g., corporate bonds). To have an appreciable impact on interest rates, QE requires large-scale asset purchases. When the Fed makes such purchases of, for example, Treasury securities, the result is an increased demand for those securities, which in turn raises their prices. Treasury prices and yields (interest rates) are inversely related: As prices increase, interest rates fall. As interest rates fall, the cost to businesses for financing capital investments, such as new equipment, decreases. Over time, new business investments should bolster economic activity, create new jobs, and reduce the unemployment rate. QE is not a new approach; it was used by the Fed in the 1930s, the Bank of Japan in 2001, and more recently by the Bank of England.

This is especially funny when you consider that Rickards writes an entire paragraph on the importance of investment in GDP:

Investment is one of the four fundamentals components of GDP, along with consumption, government spending, and net exports. Of these components, investment may be the most important because it drives GDP not only when the investment is made, but in future years through a payoff of improved productivity. Investment in new enterprise can also be a catalyst for hiring, which can then boost consumption through wage payments from investment profits. Any impediments to investment will have a deleterious effect on the growth of the overall economy. (Rickards 2014: 84)

Now I’m not defending QE and other Fed policies, but these criticisms by Rickards and others are unconvincing. Rickards does talk about how the Federal Reserve is distorting incentives through other channels* but he puts a lot of focus on the wealth effect (he has a whole section titled “The Wealth Effect”). In doing this, he commits a common mistake that critics of the Fed and Federal Reserve policy commit, i.e. only looking at one channel of monetary policy, declaring it useless, and pronouncing that the Fed is impotent. This is nonsense. You need to take a detailed look at all monetary policy channels and go from there. Some critics** do this, most don’t. Rickards definitely falls in the later category.

*He does it in an confusing and incoherent fashion, but I’ll get to that in another post

**One exceptional critic of QE and FED policy is Frances Coppola

Links:

The Inherent Fragility of the “Wealth Effect”

Lumping Everything into the Wealth Effect

Fed is Too Focused on Wealth Effect, Equity Markets

Hoisington: On the Fed and the Wealth Effect

The Fed’s Flawed Model

Debunking the “Wealth Effect”

What the Fed did and why: supporting the recovery and sustaining price stability

Technology and the economy

A Wealth Effect

References:

1. Bernanke, Ben S., and Mark Gertler. “Inside the Black Box: The Credit Channel of Monetary Policy Transmission.” Journal of Economic Perspectives 9.4 (1995): 27-48. Web.

2. Matteo Iacoviello, 2011. “Housing wealth and consumption,” International Finance Discussion Papers 1027, Board of Governors of the Federal Reserve System (U.S.)

3. Sydney Ludvigson & Charles Steindel, 1999. “How important is the stock market effect on consumption?,” Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 29-51.

1 Comment

Filed under Economics, Home

Why Currency Sovereignty Matters

I often hear on the airwaves that the United States government is broke. You might get some reference to Greece and the Eurozone or maybe even the classic comparison of the government to a household. On face value, these comparisons seem rather valid. If no household can continually spend more than its income, why can the federal government? Unfortunately, the economic reality couldn’t be further from the truth.

Most of my readers (or anyone that casually reads the economic blogosphere) have probably heard many arguments against the government-household analogy from various economists, most notably Paul Krugman. So I thought I would approach this issue from a different angle, specifically a Monetary Realist/Modern Monetary Theory framework. The fact is, understanding that the US government is a currency issuer and the institutional structure of the US monetary system is vital if you want to understand monetary and fiscal policy.

When thinking about this issue, we must consider two institutions, the US Treasury and the Federal Reserve. The US treasury is responsible to enacting fiscal policy, i.e managing the tax system and selling bongs to obtain funds for spending. The Federal Reserve is responsible for monetary policy, using a variety of methods that ultimately serve the needs of private banks (think “lender of last resort”).

The US government, specifically the US Treasury, uses operational accounts at the Federal Reserve. So in a sense, the Federal Reserve is the banker to the US government. It’s through these accounts that the US Treasury settles all of its transaction (in terms of taxing and spending) using bank reserves, a form of outside money i.e money created outside the private sector. However, the US Treasury must first obtain funds from the private sector in the form of inside money, i.e money created inside the private sector, before it can settle the funds in its reserve account. It does this by crediting the bank accounts of recipients. As L. Randall Wray puts it, “A sovereign government spends by crediting bank accounts of recipients; it taxes by debiting them. A budget deficit means that credits exceed debits.”  

So fiscal policy, in this case Government taxation, is best though of as a simple redistribution of inside money. When the US Treasury taxes and procures funds, it simply redistributes pre-existing inside money from the private sector. Cullen Roche provides a useful illustration:

When the US government taxes Paul, Paul pays with bank deposits or inside money. This inside money provides a credit to the Treasury’s Treasury Tax & Loan account at a commercial bank. The Treasury will settle this payment by having the Fed credit its account in what is called the Treasury General Account (the Treasury’s account at the Fed). This flow of funds from Paul allows the Treasury to then spend a bank deposit into Peter’s account. From start to finish, this process results in inside money in (taxation) and inside money out (government spending).

The important thing to think about here is that, although the US Treasury must collect fiscal receipts in order to spend (legally speaking), it isn’t constrained in its ability to obtain funds. In theory, the US government could utilize the Federal Reserve to create more money and finance the spending. The US government can’t actually “run out of money” as many politicians and journalists would have you believe. This is the key difference between the government and a household. A household or business are always limited in their ability to obtain funds. There is an actual solvency constraint. The same can be said of Greece and other countries in the Eurozone. Because of the structure of the Eurosystem, Greece isn’t a currency issuer and the ECB is essentially a foreign central bank. Again, there is a solvency constraint.

This process questions the very purpose of taxation. Taxes are often assumed to fund spending. But as it can be seen, the government doesn’t need taxes, it can just use the Federal Reserve (or any central bank) as a source for funds. Instead, the role of taxation is to control aggregate demand and inflation. When the government spends money, that spending will jump around the economy through a large number of transaction and when you have a lot of money chasing too few goods, you get inflation. But when the government taxes, that takes inside money out of the private sector, controlling aggregate demand and lowering inflation. Warren Mosler explains further:

The government taxes us and takes away our money for one reason – so we have that much less to spend which makes the currency that much more scarce and valuable. Taking away our money can also be thought of as leaving room for the government to spend without causing inflation. Think of the economy as one big department store full of all the goods and services we all produce and offer for sale every year. We all get paid enough in wages and profits to buy everything in that store, assuming we would spend all the money we earn and all the profits we make. (And if we borrow to spend, we can buy even more than there is in that store.) But when some of our money goes to pay taxes, we are left short of the spending power we need to buy all of what’s for sale in the store. This gives government the “room” to buy what it wants so that when it spends what it wants, the combined spending of government and the rest of us isn’t too much for what’s for sale in the store

As it can be seen, currency sovereignty really does matter when we analyze the US economy or any economy that has a central bank. So when David Stockman says that the “we’re broke” he doesn’t know what he is talking about and he is engaging in political rhetoric. Unfortunately, the same can be said of almost every politician on the right (and many on the left as well).

References:

Seven Deadly Innocent Frauds of Economic Policy

Understanding Modern Money: How a Sovereign Currency Works

Understanding the Modern Monetary System(To get a more detailed picture of Monetary Realism, read this very detailed paper by Cullen Roche. It’s where I got most of my information when writing this post)

Links:

Holding Ourselves Hostage Again

Why the USA Isn’t Going Bankrupt

What is a Sovereign Currency?

Dean Baker Says Taxes Don’t Fund Spending

More Musings on Modern Monetary Theory

The Reason for Taxation, and What a Deficit Really is

Fiat Money and its Social Significance

4 Comments

Filed under Economics, Home