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Posts from the ‘Federal Reserve’ Category

Marketplace of Ideas

Before you head out for the holiday weekend, catch up on some of the week’s economic news:

 

UncleSam
  • Congratulations, America—most of you survived tax day! If you’re getting a refund, you essentially made an interest-free loan to the government last year. According to the Brookings Institution, tax overpayments in 2013 totaled $192 billion. Washington Post’s Wonkblog has some maps illustrating how over- and underpayments are distributed across the country. Overpayments are centered in Appalachia and the deep South, while underpayments are concentrated in the Plains states. Wonkblog also looks at H&R Block’s claim that taxpayers are leaving $1 billion in potential refunds on the table by doing their own taxes. While Americans’ tax returns are rife with errors, those errors can lead to both under- and overpayments—even when a tax professional does the return. Worried about getting audited? Wonkblog says the likelihood is decreasing, in part because the IRS has fewer auditors now than in the 1980s. Last year fewer than 1 percent of returns were audited. Meanwhile, the New York TimesEconomix blog looks at debates over whether the tax code is “fair”—a tough task, since there are many, often conflicting, ways to evaluate fairness. Wherever you stand on the issue, you can likely agree that the chances Congress will get its act together and reform the tax code are pretty low.

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What’s on Janet Yellen’s Dashboard?

The Federal Reserve’s Federal Open Market Committee (FOMC) this week changed its “forward guidance” on monetary policy, dropping its 6.5 percent unemployment rate “threshold” for considering an increase in the federal funds target rate. Previously, the Fed had said that it would keep its key interest rate target near zero “at least as long as” the unemployment rate remained above 6.5 percent, then “well past the time” it declined below 6.5 percent. The unemployment rate is currently 6.7 percent.

Explaining the move, Chair Janet Yellen said that as the economy comes closer to achieving full employment, the FOMC will have a more finely balanced decision about when and by how much to raise the target for short-term interest rates. So what will the Fed, and Ms. Yellen, be looking at to assess labor market conditions? In her press conference, Ms. Yellen listed a “dashboard” of indicators that she watches to gauge the progress the labor market has made in its recovery from the Great Recession. We have represented those indicators in a series of six charts, so you can get a sense of the trends and lingering troubles Ms. Yellen has her eye on.

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The New Normal in Our Economy

Federal ReserveIn the aftermath of the financial crisis of 2007-08, the Federal Reserve has implemented so-called “quantitative easing programs” to inject liquidity into the financial system to support economic growth. However, weak economic conditions and tight financial restrictions have discouraged lending and borrowing. As a result, unprecedented amounts of potential liquidity created through the QE programs have been sitting in the banking system as excess reserves. As the Fed started tapering its large asset purchases in January 2014, the critical question has become how to further normalize unconventional monetary policy. Before we try to find an answer to “where from here,” we should first answer “where are we now?” Given the untraditional monetary policy implemented since 2008 and the special nature of the recent recession, there are now several important new elements in our economy. There are reasons to believe that a new operating framework is needed for the Fed to conduct policy if such new elements are going to be workable for the long term. The new elements are listed as follows.

  • The Federal Reserve created various emergency liquidity facilities to ease the liquidity problem during the crisis by lending to banks as well as non-banks.

These facilities, such as Term Auction Facility (TAF), the Term Asset-Backed Securities Loan Facility (TALF), and central bank liquidity swap lines etc., have helped bank and non-bank lending. The enormous demand for loans from the emergency facilities shows the importance of those facilities to improving financial conditions.  Going forward, the Fed should consider retaining this new framework to be able to respond to any future financial stresses without having to change its target for the overnight interest rate.

  • Unprecedented levels of free reserves were created and likely to persist for an extended period of time.

The Fed has increased its assets holdings to over $4 trillion. If the Fed continues tapering at the current pace, the asset purchase will end in the fourth quarter of this year. Therefore, the total amount of assets held by the Fed is expected to reach a peak of $4.5 trillion. How to shrink the Fed’s balance sheet is an important question to be answered. Based on the previous Federal Open Market Committee (FOMC) meetings, the Fed is more likely to hold the assets as they are redeemed than sell them off quickly. Since most of the assets held by the Fed have maturities of more than 10 years, it will take a long period of time to shrink its balance sheet to a size similar to that prior to the crisis. The normalizing monetary policy will have to take place in the presence of high potential liquidity.

  • The Fed has paid interest on excess reserves since 2008 in an effort to keep liquidity from flooding to the financial system and causing price level to rise.

Another important contributor to the unprecedented amount of excess reserves is the fact that the Fed started paying interest at the rate of 25 basis points on excess reserves since 2008. This undoubtedly helped prevent liquidity from flooding into the financial system and causing a big rise in price level. Paying interest on reserves has other effects, like limiting the Fed’s ability to control the federal funds rate and causing arbitrage opportunities. Still, it is widely expected that the Fed will continue it in an effort to avoid pouring too much liquidity into financial markets and maintain price stability.

  • Short-term interest rates have been kept at a record-low level for years. How to regain the Fed’s control over short-term interest rates is still puzzling.

Near-zero short-term interest rates have been a key element of the financial system for several years now. There has been a lot of debate about when the Fed should raise short-term interest rates. In order to make its policy transparent, the Fed has reaffirmed its anticipation that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal. As the unemployment rate recently fell to near 6.5 percent, the Fed might soon need to revise this guidance and implement more measures. There are reasons to expect short-term interest rates to be raised in 2015 after the QE ends.

  • Closer scrutiny by regulators since the financial panic in 2008 has been viewed as a new element of the financial system. How increased stringency in regulation will affect the ongoing economic recovery has important implications for monetary policy normalization objectives.

Well-functioning bank lending is a major driver of economic growth. Even though making or adjusting financial regulation is not the central bank’s policy objective, it is important for the Fed to take into account the lending environment when conducting monetary policy. Going forward, tougher financial regulations will affect other objectives around normalizing monetary policy.

[Photo: Wikipedia/Dan Smith]

Fed to the Rescue?

Ben Bernanke at FOMCBen Bernanke was center-stage at his last FOMC meeting as chairman this week. The Fed was widely expected to continue to taper its large-scale asset purchase program, and it did—reducing its monthly purchases by another $10 billion to $65 billion, following a $10 billion reduction at its previous meeting. However, there was some speculation among analysts that in the wake of the emerging markets sell-off that has plagued global financial markets since last week, the Fed might postpone any further tapering in an effort to alleviate some of the panic. Why might the Fed be considered responsible for this market correction? In a recent report, the World Bank warned that changes in Fed policy could have negative implications for emerging market economies this year—if the adjustment to the policy changes is disorderly.

In the end, the Fed continued with its tapering, heedless of the plight of emerging markets. It received some flack for this in the press, but it also faced a “credibility crisis” if it deviated from its presumed intention to continue a steady $10-billion-per-month tapering program. The Fed was in a lose-lose situation: To postpone tapering would be to neglect the U.S. economy. To taper would be to neglect global markets.

Here are some other issues the Fed failed to address this week: It did not propose a solution to the stubbornly high long-term unemployment rate in the United States. It also did not take a stand on various proposals to raise the minimum wage, or to address income inequality. It made no effort to help resolve the impasse on immigration reform in Congress. The Fed did not draft a contingency plan for the bailout of European banks at risk of failing because of new regulatory standards about to be imposed by the European Central Bank. Furthermore, Ben Bernanke did not give Canadian Mark Carney advice on how to be a more effective Governor of the Bank of England.

The Fed did not draft a treaty to achieve peace in the Middle East. It did not fix the polar vortex, nor did it predict a winner for the Super Bowl. It did not even disclose which team the majority of FOMC members are rooting for. What is the Fed hiding? Does it not even care about football? How could the Fed be so un-American? Worst of all, Ben Bernanke did not personally call my mother to wish her a happy birthday.

In responding to the 2007-08 financial crisis, the Fed may have overstepped the bounds of its mandate. Bernanke himself has seemingly justified this as a valid response to the tight fiscal policy imposed by Congress. Unfortunately, the Fed’s attempt to single-handedly resolve the financial crisis and foster an economic recovery from the Great Recession has encouraged the markets, media, and punditry to expect the Fed to solve all the problems plaguing the U.S. economy—and the world. But that is not its job.

[Photo: REUTERS/Business Insider]

On the Fed’s 100th Birthday—Many Happy Returns?

Andrew Jackson slays Monster Bank

Amidst all the fuss over the Fed’s decision to slow the pace of its long-term asset purchases—the much-anticipated but largely symbolic “taper”—a more significant milestone passed relatively unnoticed: December 23 marked the 100th anniversary of the Federal Reserve Act, the legislation that paved the way for the creation of the Federal Reserve System and its current policymaking body, the Federal Open Market Committee.

That’s right—the United States lacked a central bank for much of the first 125 years of its existence. The nation’s first two attempts at central banking fell victim to partisan rancor, regional animosity, and fears that the centralization of monetary authority would lead to an unruly “Monster Bank,” all too susceptible to the whims of corrupt politicians and financial elites. While these matters were still hotly contested in the early years of the twentieth century, the Panic of 1907—which was widely seen as the result of a preventable liquidity crunch—fomented consensus over the need for a central bank to mitigate such crises in the future.

Most of the Fed’s century-long history of monetary policymaking has been marked by trial and error rather than scientific precision—but by necessity, not caprice: Congress did not bestow the Fed with a monetary policy playbook. The Federal Reserve Act of 1913 lacked a clear policy mandate for the new central bank, beyond fostering financial stability. In fact, a specific set of monetary policy objectives was not legislated until 1977, when Congress gave the Fed its “dual mandate”—to foster maximum employment and stable prices “commensurate with the economy’s long run potential.”

Just as the financial system has evolved over time, the Fed’s policy scope and authority have shifted and expanded. In fact, its ability to “innovate” in this regard might be considered one of the institution’s merits. But in the context of the Fed’s 100-year history, the monetary policy innovations implemented in the wake of the 2007-08 financial crisis are unprecedented and contentious. After driving its key interest rate down to zero in 2008, the Fed effectively exhausted its conventional, time-tested policy tools. In an effort to mitigate the effects of the still-raging financial crisis, the Fed undertook the extraordinary measure of making large-scale asset purchases, also known as quantitative easing, or QE. Successive waves of QE, aimed at restoring the economy to its long-run potential growth rate, have expanded the Fed’s balance sheet from roughly $800 billion to over $4 trillion. The “tapering” approved by the Fed last month will only slow the rate at which its balance sheet continues to grow, to $75 billion per month instead of $85 billion. This is by no means a policy reversal.

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Was the Fed a Good Idea?

31st Cato Monetary Conference
By Steven R. Cunningham, PhD, Chief Economist and Jia Liu, PhD, Research Fellow

112213 Was the Fed a Good IdeaThis year marks the 100th anniversary of the founding of the Fed with the Federal Reserve Act of 1913. With a hundred years of experience behind us, it seems like a good time to evaluate the performance of the nation’s system of central banks. To this end, on November 14, the Cato Institute held its 31st annual Monetary Conference, entitled “Was the Fed a Good Idea?

A pretty heady group of economists, policymakers, business/economics writers, and bloggers converged on Washington to participate. The attendees were too many to list, but a few examples may serve to give the reader a sense of the proceedings.

As former chairman and CEO of BB&T, John Allison was certainly well-qualified to talk about the Fed’s performance through the recent financial crisis. Current and past Federal Reserve Bank Presidents Charles Plosser (Philadelphia) and Jerry Jordan (Cleveland) offered perspective from the lectern, while former Fed Governor Wayne Angell commented from the floor. (I remember Wayne well from my time at the Board of Governors, and he doesn’t seem to have slowed down a bit.)

We got a European perspective from Leszek Balcerowicz, chairman of the National Bank of Poland, and Athanasios Orphanides, formerly a governor of the Central Bank of Cyprus and an advisor to the Federal Reserve Board. Orphanides also served on the Governing Council of the European Central Bank.

Rep. Kevin P. Brady, chairman of the Joint Economic Committee, and Rep. Jeb Hensarling, chairman of the House Financial Services Committee, offered Congressional representation. Lawrence H. White (George Mason University) and George Selgin (University of Georgia), known in particular for their writings on free banking, are past participants in AIER programs. Lewis E. Lehrman, of the Lehrman Institute, gave the closing address.

The issues addressed at the conference include lessons from a century of U.S. central banking, alternatives to discretionary government fiat money, comparisons between the Fed and the market as bank regulators, and the case for a National Monetary Commission and fundamental reform.

Charles Plosser gave the keynote address to discuss the Fed’s essential role and to propose how this institution might be improved. Plosser offered four suggestions for the central bank to limit discretion and improve outcomes and accountability.

First, the Fed should abandon its mandate of maximum employment and solely focus on price stability. Second, the Fed should only hold Treasury securities on its balance sheet. Third, the Fed should use a systematic and rule-like approach to conduct its monetary policy. Fourth, the Fed should limit the boundaries of its lender-of-last-resort credit extension.

Plosser also argued that the Fed’s mandate should have its emphasis on the longer run. He said “…focusing on short-run control of employment weakens the credibility and effectiveness of the Fed in achieving its price stability objective.” In order for the public to hold the Fed accountable for its monetary policy, he offered three solutions: “Simplify the goals, constrain the tools and make decisions more systematically.”

When asked about the Fed’s current 2 percent inflation target in the Q&A session, Plosser argued that 2 percent is just a number the Fed used to show the public its commitment and ability to achieve policy goals.

But if 2 percent is just a random number picked by the Fed to only serve that purpose, why didn’t the Fed pick 3 percent or 4 percent? Higher numbers would make it easier for the Fed to claim inflation is under control.

It is true that the central bank cannot control real economic variables, at least not in the long run, and the public has come to expect too much from its central bank. But since price stability is the Fed’s primary objective, isn’t it reasonable for the public to expect central bankers to rigorously and analytically determine its inflation target? If “simplifying the goals” means randomly selecting a number for inflation target without considering its impact on the economy, maybe this is not the right approach.

Scott B. Sumner, a professor of economics at the Bentley University, gave a controversial presentation on nominal GDP (NGDP) targeting that brought on a wide-ranging audience discussion. Sumner argued that the optimal monetary rule is for the Fed to target NGDP instead of targeting a certain level of inflation or attempting to achieve maximum employment. He started out by showing the co-movement between NGDP and total losses to the U.S. banking system during 2008-2009 to argue that the decline in NGDP, not failure of the financial markets, caused the Great Recession.

We would argue that NGDP is the market value in current dollars of final production, namely a measure of the economy unadjusted for inflation. Hence, changes in NGDP capture upward and downward growth of the economy.

When the housing bubble burst in 2007-2008, sharply declining housing prices caused quickly spreading financial distress, which resulted in a financial crisis. Disposable personal income started to drop, and consumption and investment went down sharply until 2009, when, as Sumner pointed out, NGDP reached the largest decline since the 1930s. The decline in NGDP only measured the downturn of the economy that was caused by the financial crisis; not the other way around.

There are problems with Sumner’s advocacy of the Fed targeting NGDP rather than inflation. A central bank with authority to control the money supply can only achieve its goal for price stability in the long run and cannot control real economic activity, at least not over time. The only long-term role for the central bank and monetary policy in ensuring economic growth or NGDP growth is in providing price and financial stability to provide a healthy environment for growth to occur.

Lawrence H. White, a professor of economics at George Mason University, made the case for two alternative monies, the Liberty Dollar and E-gold.

White believes that there is a single monetary standard in the economy that requires alternative monies to be transformed from the existing money. But he told stories about the Liberty Dollar and E-gold to discuss alternative monetary standards that might arise in parallel with the fiat dollar. He concluded that the legal barriers to open currency competition in the U.S. include anti-money-laundering laws, money transmitting licensing requirements, capital gains taxes, state sales taxes on precious metals, and banning private coinage.

Larry Summers’s Turkey Hangover

Thanksgiving Turkey Dinner HangoverA colleague lamented at the lunch table yesterday that he hates Thanksgiving because he tends to overeat. Who doesn’t? The overindulgence of Thanksgiving dinner is followed by the turkey hangover—listlessness, bloating and a sizable portion of guilt.

In addition to our turkey and pumpkin pie this Thanksgiving, we have this morsel from Larry Summers—President Obama’s first choice for the Federal Reserve chair—to digest: in a speech at the International Monetary Fund last week, he suggested, “Suppose that the short-term real interest rate that was consistent with full employment had fallen to -2 percent or -3 percent sometime in the middle of the last decade.” This somewhat opaque notion has won a lot of attention from economists and pundits, much of it positive. But what does it mean?

Let’s indulge in a little Thanksgiving metaphor: in the years leading up to the 2008 crisis, every day was Thanksgiving. Americans were eating a lot of turkey—in fact, more turkey than was good for us. Why did we do this? Because turkey was relatively cheap, because we were told that turkey was good for us, and because with the price of turkey so low, turkey producers and vendors had to sell more and more of the stuff to make a profit.

In other words, leading up to the 2008 crisis, Americans consumed a lot of credit. Why? Because credit was relatively cheap (interest rates were low), because we were told that credit was good for us (owning a home is the American dream! Get a mortgage!), and because with the price of credit (interest rates) so low, lenders had to push more and more of it to make a profit. We all know that recovering from an extended bout of overeating requires a diet of discipline and moderation—and much, much less turkey. Diets are never fun, they are never easy, and it usually takes longer to work off the pounds than it did to put them on in the first place.

In his IMF speech, Larry Summers essentially argued that the recovery of the U.S. economy from the Great Recession is sluggish not because the nation collectively overate in the years leading up to the crisis, and the diet necessary to correct that overeating will be long and difficult, but rather that turkey prices (interest rates) are still too high. What Summers thinks we need is even cheaper turkey, incentivizing us to give up our diets and go back to overeating.

This might make sense if you tend to see the world from the perspective of people who benefit from selling a lot of turkey, but is it the right answer for the longer-term health of the economy?

photo courtesy Mom Prepares/Flickr

The Fed’s Zero Interest Rate Policy in Perspective

110713 Fed ReserveMany people are increasingly frustrated by the Federal Reserve’s zero interest rate policy because of its harmful effects on middle-class savers. It’s not clear how much it’s helping the economy and it is reducing returns to people trying to save for their future.

For example, since January 2009, the return to investors holding the Vanguard Prime Money Market Fund, with over $100 billion, was a total of less than 1%. For the 20 years prior to 2009 a number closer to 4-5% per year was the norm. Older savers were counting on this fund for liquidity and safety. Someone with $100,000 in the fund should have earned a minimum of $20,000, instead they earned $1,000. The complaint is that their income was confiscated by the US Government so that the government could continue to deficit spend. Who got that $19,000? Why should savers be forced into risky equities to save for their futures?

I would like to share some of my thoughts on the zero interest rate policy to answer some of these questions.

The interest rate targeting policy has been the primary tool for the Fed to stimulate the economy. If we take a look at recent past efforts to forestall recessions we will see that it had usually dropped more than 5%. For instance, during the recession of the 1980s and the dot.com bubble in early 2000s rates fell by 10% and 5%.

In order to put the brakes on an overheating economy before the housing bubble burst, the fed funds rate was raised to a little bit above 5%. After the crisis, all the Fed did was to implement its conventional policy by lowering the fed funds rate. The Fed didn’t arbitrarily decide the short term interest should be near zero this time. By lowering the rate by 5%, it happened to be around 0%. Read more

An Unreliable Unemployment Rate?

An economics report from the Wall Street Journal suggests that the Fed might not take action on its bond-buying programs this October because of some unusual statistics tied to the country’s unemployment rate.

The piece explains that the Fed has often used the unemployment rate as a barometer of what to do with bond-buying programs and interest rates, but slow growth and a decline in people in the workforce are causing the organization to hold off on its bond decision.

From the Wall Street Journal:

“The unemployment rate is behaving in peculiar ways. It is coming down as people leave the labor force and exit the tallies of those seeking employment. In normal times, the labor force grows as the population grows, and employment must grow in excess of that labor force growth in order to reduce the unemployment rate. Now, because the labor force isn’t growing much, even small employment gains are bringing down the unemployment rate, even though millions of Americans remain parked on the sidelines.”

In other words, the unemployment numbers might not be as a strong an indicator of what the Fed should do about bonds as it has been in the past. This “disconnect makes it very hard to for them to send clear signals or make decisions with conviction.”

Read the full story here.

Three Central Banking Takeaways from Amar Bhidé

Quantitative easing hasn’t done much to improve wealth or confidence in the U.S., according to an op-ed in the Wall Street Journal this week. Amar Bhidé, a professor at Tufts University’s Fletcher School, and Columbia University’s Edmund Phelps argue that if the Federal Reserve wants to improve the economy, it should wind down the stimulus program and concentrate on bank regulation.

I talked to Bhidé about three big ideas that led him to come down against quantitative easing and for vigilant bank supervision, and what he thinks central banking can and can’t accomplish.


1. The economy is so complex that even the best statistical models can’t accurately predict the effects of monetary and fiscal policy.

“I’m completely agnostic about what monetary policy or fiscal policy does,” Bhidé says. “I don’t think there is good evidence that it does what it’s supposed to do, but then again, the absence of evidence is not evidence of absence.”

“What we do know is that the world is way more complex and diverse than a statistical process can predict. People respond to different economic conditions in unpredictable ways–just because consumption went up by a certain percent last time doesn’t mean the same thing will happen again.”

2. In the absence of solid scientific evidence, we should rely on other criteria when determining monetary policy.

“One criterion can be, for example, has this action been done repeatedly in the past without causing great harm?” Bhidé says. “If it has, you can give the measure a pass.”

“Other criteria are particularly important in matters of public interest. If one group of people may be hurt in the short run by adopting a measure, was there a process by which their voices and the voices of their representatives were heard?

For example, with quantitative easing, the Fed may say that if they hadn’t adopted the stimulus program things could have been much worse. That may be true; it can’t be proven or unproven. But, on the face of the issue, the Fed has engaged in a perverse form of redistribution. It’s driven up stock prices, which largely benefits the wealthiest 1 percent who own almost half the country’s stocks. Meanwhile, they deprived Grandma and Grandpa of interest on their CDs. So they have impoverished one large group of people who are already living on the edge to begin with, and enriched another group of people who were already quite wealthy.”

3. Tougher bank examinations would help prevent another financial crisis. But in order for regulators to do their jobs, we need sweeping reform of the banking industry.

“Banks have become unexaminable, because they’re too complicated. So we rely on top-down measures like capital requirements, which turn out to be pretty useless. We need to break up banks to restructure them and make them more examinable. That means not just separating investment and commercial banking, but making sure that banks engage in a relatively simple set of activities.”