Tag: FOMC

The FOMC meets and, among other things, we discover Jerome Powell has been vaccinated

The FOMC met for the first time in 2021 yesterday. The committee has maintained its accommodating policy stance as the economic recovery slows in the US.

Chair Powell hanging on for dear life like the rest of us

As at the last meeting, the Fed expects to keep this in place for some time:

With regard to interest rates, we continue to expect it will be appropriate to maintain the current 0 to ¼ percent target range for the federal funds rate until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.

The Q&A session with Chair Powell had a few interesting nuggets:

  • He addressed the ‘burst of inflation’ hypothesis (discussed by me here), arguing that any inflation this year is likely to transient and minor – “we think its very unlikely that anything we see now results in troubling inflation.” And, even if it did appear, “we’re going to be patient. Expect us to wait and see, and not react.”
  • With the ongoing Gamestop frenzy (expect a write up soon…), there were lots of questions about markets, macro-prudential regulation, and ultra low-interest rates. He reminded everyone that with 9%-10% unemployment, the Fed will continue to prioritise jobs over hedge fund tears.
  • One of the striking parts of the Fed’s language in recent years has been the recurring emphasis on employment, jobs, and minorities. Inflation increasingly feels like a side-show. This conference was no different, Chair Powell discussed joblessness in almost emotive terms.

We’re not just going to look at the headline numbers. We’re going to look at different demographic groups, including women, minorities, and others. We’re not going to say we’ve reached full employment, which is our statutory goal, until we have reached maximum employment. Which you haven’t if there are lots of pockets of people not participating or not employed in the labour market.

We want an economy where everyone can take part, can put their labour in, and share in the prosperity of our great economy.

I’m much more worried about falling short of a complete recovery and losing people’s careers and lives that they’ve built because they don’t get back to work in time. I’m more concerned about that, not just to their lives, but to the US economy. I’m more concerned about that than about the possibility – which exists – of higher inflation. Frankly we’d welcome slightly higher, somewhat higher, inflation. The kind of inflation that people like me grew up with seems far away, unlikely, in the domestic and international context we’ve been in for some time.

This shift in emphasis was partly forced on the Fed. Persistently low inflation despite falling unemployment shone a spotlight on the full employment side of the Fed’s mandate. Its similar elsewhere; as central banks took on on ever larger roles in economic management following the GFC, they needed to maintain legitimacy with a public concerned about joblessness and inequality, not inflation.

From my own analysis of language in all central banking speeches between 01/2007-01/2020

This language creates precedent which could constrain, or influence future Fed decisions, or at the very least, how they are presented and framed. This could have long-term consequences. It is said that the experience of inflation in the 1970s/80s shaped the minds of a generation of economists and policy makers. The Fed’s new attitude and language may have a similar effect on its institutional culture. Might there be a dovish, employment bias, for years to come?

Are we crying wolf over inflation?

The FT has just published an op-ed from one Professor Jeremy Siegel of Wharton. In it, he predicts that the US is going to experience “an extremely inflationary economy in 2021,” where “inflation will run well above the Fed’s 2 per cent target, and will do so for several years.”

This is a contrarian position. The Federal Open Market Committee – the body at the Fed which sets monetary policy – does not project inflation reaching 2% until 2022. Professor Siegel joins the vocal minority warning about inflation.

December 2020 FOMC projections

Professor Siegel bases his argument on an old proposition: the Quantity Theory of Money (QTM). Simplified, it argues that the price level is a function of the quantity of money in an economy. If the quantity of money increases faster than output, all other things being equal, prices will rise.

The QTM has motivated previous inflation warnings. After the Global Financial Crisis, some warned that Quantitative Easing (QE), with its massive expansion of the money supply, would cause runaway inflation. The opposite happened, and the major macroeconomic puzzle of the last decade has been falling, not rising, prices.

Professor Siegel argues this time is different (always a red flag). QE created trillions in reserves, but it turned out banks were happy to sit on them, and not make loans, in part because the Fed began paying interest on excess reserves. Today, thanks to the stimulus checks, grants to local government, and the Paycheck Protection Program, money is “going directly into the bank accounts of individuals and firms.” Where before money wound up in bank vaults, this time it will get into the hands of private sector individuals and be spent.

As part of QE, banks exchanged their bond holdings for reserves, and then sat on them

Is that really the case though?

Siegel’s argument rests upon a distinction between the money held by banks as excess reserves, and the money now in consumer bank accounts; growth of the former had little or no effect on inflation, but growth in the latter will.

This raises the question of why money in a consumer bank account is more likely to be spent than bank reserves? Siegel suggests that liquidity requirements, and the interest the Fed pays on excess reserves, explains the tendency of reserves to accumulate. But if so, why should it be any different with consumers, who, as we all know, also receive interest.

The Fed started paying interest on reserves, and regulators imposed liquidity requirements that could be satisfied with these reserves. The banks easily absorbed the extra reserves created by the Fed and quantitative easing led to only a modest increase in lending.

But, why is money sometimes stashed under the proverbial mattress, and other times not? It seems unlikely the answer is directly related to how many notes are under the pillow. It is not enough to simply increase the money supply, you need people to want to spend it.

In fairness, the QTM does acknowledge this. In addition to the price level, the quantity of money, and a measure of real output, it includes a variable called the “velocity of money,” a measure of how often it changes hands.

M = quantity of money, V = velocity, P = price level, T = a measure of real output

High velocity looks like this. I pay you $100 for a bicycle, you use it to (under)pay your neighbor’s son to paint your house, and he spends it taking his girlfriend to a gauche mini-golf bar. In a low velocity world, I buy your bicycle, and you stash the money between the pages of your untouched copy of War and Peace. A healthy economy looks more like the former than the latter.

The problem is, if velocity is subject to unpredictable changes, then there can be no fixed relationship between quantity and the price level. Instead we must look to a third (or fourth or fifth) variable to explain why velocity changes. But, if one wants to posit a stable relationship between quantity and price level, as Professor Siegel does, then velocity must be relatively static in the short to medium term. Otherwise, price is conditional on the quantity of money, which is conditional on velocity, which is conditional on some other unknown. At best we could say the quantity of money is a necessary condition of inflation.

The point is to be skeptical of mechanistic explanations, especially ones first developed in the 18th century. The money supply is broadly correlated with inflation, but that does not mean they are causally related. Even if they were, it would not necessarily tell us the direction or magnitude of the effect.

Correlation or causation?

Let us also look skeptically on theories which avoid falsification tests and rely on verification. QTM theorists can always find historical episodes to verify their arguments. In fact, the allure of the “more money = more inflation” argument is that it is right eventually; at some point there will be inflation, and it is more than likely it will follow an increase in the money supply, if only because the money supply is usually increasing.

To paraphrase Paul Samuelson, inflation hawks have predicted 9 of the last 5 inflationary episodes. Despite this, the opinion pages of major newspapers always seem to find room for them.

It is unclear what would constitute a falsification of their hypothesis. Inflation failed to rise after the GFC, and a series of ad hoc explanations were provided. If inflation fails to increase in 2021, is that a definitive rejection of the QTM, or will more ad hoc explanations be appended to explain it away?

For the second time this week, I am reminded of the Marxists, who, when confronted by the failure of history to match their deterministic predictions (when is the revolution?), could always respond “not yet.”

We remain waiting.

Merry Christmas at the Federal Reserve

The US Federal Reserve held their December FOMC meeting yesterday. They voted unanimously to continue the current accommmodative stance, keeping interest rates at zero and asset purchases at $120 billion a month.

The decision is unsurprising given the impact of Covid in the US, and the ongoing fight in Congress over more fiscal stimulus.

The FOMC meets eight times a year, but every second meeting they release a Summary of Economic Projections. Each member of the committee forecasts the path of GDP, unemployment, and inflation and they are aggregated. The public gets to see the median, central tendency, and range, but not the projections of individual members.

The figures reveal the diversity of opinion on the FOMC, especially when it comes to the path of unemployment. Since September, forecasts have improved, but there is still quite a gap between the optimists and pessimists. Of particular interest is the longer run estimate, which likely reflects participant’s views on the “natural rate of unemployment.”

Source

Where the FOMC thinks the “natural rate” is matters because, up until this year, the Fed would tighten policy preemptively when unemployment neared the “natural rate.” If the estimate was wrong, and there was still slack, the effect would be to unnecessarily throw people out of work.

The experience after 2015, where unemployment dropped below estimates of the natural rate (at that time, ~5%), down to the unprecedented level of 3%, without stoking any inflation, led the Fed to change tact. Under the Fed’s new strategy, policy will not be tightened preemptively, it will instead wait for inflation to pick up sustainably.

Still, estimates of the “natural rate” continue to be an important guide for central bankers around the world. They have real consequences for the stance of monetary and fiscal policy, and are important to keep track of.

A busy week of central bank announcements

Fair warning, this is going to be a wonky post. (If you’re unsure what asset purchases or quantitative easing is and you’re wondering why in the world i keep talking about it, see this explainer.)

This week was a big one for acronyms. The Fed’s Federal Open Market Committee (FOMC) and the Bank of England’s Monetary Policy Committee (MPC) met on November 5th. The Reserve Bank’s Board (surprisingly no one calls it the RBB) met two days earlier on November 3rd. These are the respective committees at each central bank that make decisions on policy like interest rates or quantitative easing.

Bank of England

The BoE kept interest rates at 0.1% and added an additional £150 billion in government bond purchases, taking the total stock to £875 billion. In their words:

The Committee does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably.

The BoE predicts inflation will be back at 2% in two years time. Given the potted history of central bank inflation predictions, this should be taken with a grain of salt. Still, policy looks set to stay incredibly accommodative for at least two years.

Reserve Bank of Australia

The cash rate was lowered to 0.1% and $100 billion in new government bond purchases was announced. The RBA is also one of the few central banks in the world to do Yield Curve Control (YCC), where they commit to keeping the yield on a certain category of bond (in this case a 3-year Australian Government) at a certain rate. It is an open-ended commitment to buy any quantity of bonds required to achieve the target rate, which is 0.1%. In simple terms, the Australian Government can take out three year loans at 0.1% as long as the RBA keeps this policy in place. How long will policy stay like this?

For its part, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. Given the outlook, the Board is not expecting to increase the cash rate for at least three years. The Board will keep the size of the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation. The Board is prepared to do more if necessary.

Its important to note that while the cash rate is staying where it is for at least three years, the RBA might wind back its bond purchases or YCC. Either way its an incredible commitment, especially given inflation has been so subdued globally for the last decade.

Federal Reserve

The Fed switched to average inflation targeting this year. Instead of just apologizing for missing their inflation target, the Fed will now attempt to average out past inflation performance. Put simply, if the target is 2% and inflation averaged 1% between 2010-2020, then inflation needs to average 3% between 2020-2030. It is a little more complicated because the Fed has not been explicit about what periods they will use, how they will calculate the average, or how high they will let it go, but that’s the basic premise. Here’s the relevant part of the statement:

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.

The Fed kept interest rates where they were, 0-0.25%, and will continue to purchase bonds at the current pace of $120 billion a month.

Chairman Powell continues to emphasise minorities and low-income groups:

The economic downturn has not fallen equally on all Americans, and those
least able to shoulder the burden have been hardest hit. In particular, the high level of joblessness has been especially severe for lower-wage workers in the services sector, for women, and for African Americans and Hispanics

Powell’s appeals for more fiscal stimulus come at a time when the prospect of a Republican Senate and Democrat President make new stimulus increasingly fraught:

As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid. Many borrowers are benefiting from these programs, as is the overall economy. But for many others, getting a loan that may be difficult to repay may not be the answer. In these cases, direct fiscal support may be needed. Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources

So what?

Monetary policy looks set to be incredibly accommodative for at least two more years, possibly longer should inflation continue to be stubborn. What are the implications?

  • Financial stability risks: The longer monetary policy is accommodative, the greater the financial stability risks. This is no secret and banks have macroprudential policy (MPP) tools at their disposal. Still, MPP is a newish field and there are still questions about the best approach.
  • Will monetary policy continue to crowd out fiscal policy? Over the last five years or so, central banks have become increasingly vocal about the need for fiscal stimulus. Covid-19 finally forced open the purse strings, but its an open question how long it will last. Before the second wave, the UK Chancellor was already talking about debt, and the austerity hawks are never far from the opinion pages of the Australian or the Washington Post. Will the commitment of three years of super expansionary monetary policy make it easier for governments to take their foot off the gas?

    There is no easy solution to this problem, in part because its the result of the system working as intended. Independent central banks were partly set up as a check on fiscal policy, and to take as much discretionary macroeconomic policy out of the hands of elected politicians as possible. We are now in the awkward position where the politicians have learnt the lesson too well, and are happy to hand off macroeconomic management to central banks.
  • No one knows what monetary policy normalization will look like: The Fed’s asset portfolio is north of $5 trillion, the ECB’s €3 trillion, the BoE almost £1 trillion. Japan is another universe; the Bank of Japan’s portfolio is bigger than Japan’s GDP. (The chart below is pre-Covid, so the numbers are actually significantly higher – the Fed has added almost a trillion in asset purchases this year.)

    The point is that these numbers are so large they are probably impossible to eliminate, especially because central banks have been clear that QE is now a standard part of counter-cyclical policy. To date it looks as if central banks holding nearly 50% of their government’s outstanding debt is fine? In fact central banks regularly insist these holdings are “market neutral.” The point is, we’re in a Wild West where the only thing we know is that the limits of the past were figments of our collective imagination or a world that now lives only in history books. This is good news for progressives.
From the WSJ

September FOMC meeting

The Federal Reserve had its September Board meeting yesterday (Australian time). Apart from the time difference, the most frustrating thing is the Fed appears to host the press conference video themselves, and there is no button to adjust playback speed.

The press conference and statement offered some useful clarifications on the big announcements made last month at Jackson Hole (see forthcoming piece – hopefully this week!)

There were a lot of questions about how the Fed’s new average inflation targeting approach would work, how far above 2% would inflation be allowed to go and for how long?

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent

So what will policy be like in the meantime?

The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time

Low for loooooooong baby! Remember inflation has barely touched 2% over the last decade. The projections of Board members show no one thinks inflation will reach 2% before 2022/3. The median projection for unemployment is 4% in 2023, but the range goes all the way up to 7.5%. The Fed has already issued a mea culpa for raising rates in 2018 when unemployment dropped below 4%, so it is unlikely they will do so again. All this adds up to low rates for the next few years, barring something extraordinary.

Source

Preemptive tightening in the face of unemployment is officially dead and buried.

We view maximum employment as a broad-based and inclusive goal and do not see a high level of employment as posing a policy concern unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals

Powell acknowledged the new normal; low interest rates are now part of the furniture.

In turn, well-anchored inflation expectations enhance our ability to meet both our employment and inflation objectives, particularly in the new normal in which interest rates are closer to their effective lower bound even in good times

Aside from all the technical announcements, two short sections caught my eye:

As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid

Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. (is monetary policy not?)

Firstly, it is simply not true that the Fed cannot grant money to particular beneficiaries. Legality aside, it is certainly possible operationally. It would be politically momentous, sure, but lets not kid ourselves about what Central Banks can and cannot do.

Secondly, the second paragraph implies that monetary policy, unlike fiscal policy, is not one of society’s collective resources. Again, I disagree. The money supply is a collective resource, and even if its creation and control currently sits outside day-to-day political control, that is a choice. It is neither inevitable nor eternal and we do ourselves a disservice when we blithely reify the specific institutional arrangements we happen to have today.