Cleveland Fed: It's Not Looking Good

The Cleveland Fed has launched a new website that will provide on a monthly basis estimates of expected inflation over various horizons. These estimates are supposed to be cleaner than those coming from Treasury inflation-protected securities (TIPS) which are contaminated by risk premia. The model that is the basis for these estimates can also be used to derive real interest rates and an inflation risk premium. This is a great addition to the universe of online economic data and the Cleveland Fed should be commended for providing it to the public.

The numbers for June 2010 are not pretty. Here is the lead paragraph:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.84 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

It gets worse. This 1.84% is down from the previous month as is all yearly horizons of inflation expectations. This can be seen in the following Cleveland Fed figure. This figure shows the expected inflation over maturities ranging from 1 to 30 years:

The first of these data points says that the market expects inflation to be 1.34% over the next year. A closer look at the data for the whole year indicates this broad decline in inflationary expectations is not a one-time drop. Inflation expectations are down for the first half of this year. These findings confirm the point I have been making with TIPS data: the market expects aggregate demand to slow down over the next year. And the Fed's failure to stabilize these expectations means that monetary policy is effectively tightening.

Speaking of tightening, below is the Cleveland Fed's estimates of the 1-month real interest rate that comes from the same model generating the expected inflation series. (The red highlight and related commentary are mine):

So real interest rates spiked in November 2008 and stayed elevated through March 2009. This bit of evidence lends support to Scott Sumner's claim that monetary policy effectively tightened here and helped usher in the Great Recession.

Go check out the website.

Ambrose Evans-Pritchard Unloads Both Barrels at the Fed

Ambrose Evans-Pritchard always has something interesting to say about economic policy. Some observers have called him sensational, but he often is spot on in his analysis of U.S. monetary policy. His latest piece doesn't disappoint. It is a reply to Kartik Athreya's now infamous essay that tells readers to ignore economic commentators on matters of monetary policy and only listen to the high priests of the Federal Reserve System. What is really great about this reply is that it summarizes many of my own views on the evolution of U.S. monetary policy over the last 10 years: monetary policy was too loose in the first half of the decade and has been effectively too tight in the latter half. It also does a good job highlighting how the Fed's inordinate focus on stabilizing credit markets has come out the expense of stabilizing aggregate demand. Here is Evans-Pritchard:

Dr Athreya’s assertions cannot be allowed to pass...

Central banks were the ultimate authors of the credit crisis since it is they who set the price of credit too low, throwing the whole incentive structure of the capitalist system out of kilter, and more or less forcing banks to chase yield and engage in destructive behaviour.

They ran ever-lower real interests with each cycle, allowed asset bubbles to run unchecked (Ben Bernanke was the cheerleader of that particular folly), blamed Anglo-Saxon over-consumption on excess Asian savings (half true, but still the silliest cop-out of all time), and believed in the neanderthal doctrine of “inflation targeting”. Have they all forgotten Keynes’s cautionary words on the “tyranny of the general price level” in the early 1930s? Yes they have.

They allowed the M3 money supply to surge at double-digit rates (16pc in the US and 11pc in euroland), and are now allowing it to collapse (minus 5.5pc in the US over the last year). Have they all forgotten the Friedman-Schwartz lessons on the quantity theory of money? Yes, they have. Have they forgotten Irving Fisher’s “Debt Deflation causes of Great Depressions”? Yes, most of them have. And of course, they completely failed to see the 2007-2009 crisis coming, or to respond to it fast enough when it occurred.

The Fed has since made a hash of quantitative easing, largely due to Bernanke’s ideological infatuation with “creditism”. QE has been large enough to horrify everybody (especially the Chinese) by its sheer size – lifting the balance sheet to $2.4 trillion – but it has been carried out in such a way that it does not gain full traction. This is the worst of both worlds. So much geo-political capital wasted to such modest and distorting effect.

The error was for the Fed to buy the bonds from the banking system (and we all hate the banks, don’t we) rather than going straight to the non-bank private sector. How about purchasing a herd of Texas Longhorn cattle? That would do it. The inevitable result of this is a collapse of money velocity as banks allow their useless reserves to swell.

And now the Fed tells us all to shut up. Fie to you sir.

Read the entire piece here.

Two Ends of the Spectrum

Via Brad DeLong I found this piece by James Morely. In it Morely provides a thoughtful but thorough smackdown on some of the claims made by proponents of "modern" macro. It was an interesting read throughout and just the fix I needed after reading this Fed economist's pejorative and arrogant take on economic bloggers. This Fed economist recieved his just due from Scott Sumner.

Update: Matthew Yglesias responds to this Fed economist.

Update II: Mark Thoma, Ryan Avent, Nick Rowe, Brad DeLong, Arnold Kling, Will Wilkinson and Richard Green respond.

My Response to Martin Wolf

Martin Wolf has an article where he considers whether monetary policy is currently too tight or too expansionary. He asks his readers what they think. Here is the reply I left at his site:

Dear Martin:

Two points. First, one of the better ways to currently measure the stance of U.S. monetary policy is to look at the market's expectation of future inflation. This can be seen by looking at the spread between the nominal Treasury yield and the real yield on TIPS. Given that productivity is not changing rapidly and affecting the price level, this forward-looking measure of inflation will be implicitly reflecting the market's expectation of aggregate demand in the future. The central bank, if it has the will, can shape total nominal spending and stabilize it. A failure to do so, whether from it being passive (e.g. not responding to declines in velocity) or active in the wrong direction (e.g. tightening when the recovery is still fragile), is a failure of monetary policy.

As shown here, expected inflation in the U.S. has been heading down for the past six months. This implies an effective tightening of monetary policy in the United States. For example, some of this (particularly in May) decline in inflationary expectations may be coming from the uncertainty in the Eurozone and all the austerity talk. This heightened uncertainty has created an increased demand for liquidity and, in particular, an increased demand for money. The Fed has passively sat by and failed to offset this increased money demand and thus is effectively tightening.

Second, I think it is useful to think about what monetary policy should do and how it can do it by taking the equation of exchange, MV=PY, and expanding the money supply or M term in it. (V = velocity, PY = nominal GDP.) Since M = Bm, where B = monetary base and m = money multiplier, the expanded version of the equation of exchange can be stated as follows:

BmV = PY

In this form, the equation says (1) the monetary base times (2) the money multiplier times (3) velocity equals (4) nominal GDP or total nominal spending (i.e. aggregate demand). The Fed has complete control over the monetary base, B. It has less control over the money multiplier,m, but still can shape it to some degree as it is currently doing by paying banks interest payments to sit on excess reserves. (What would happen to m if the Fed started charging a penalty for holding excess reserves?) The Fed could also influence V by setting an explicit inflation, price level or nominal GDP target. In short, the Fed has enough influence that if it really wanted to it could stabilize BmV (or MV). But it isn't and is therefore effectively tightening. (For more on the expanded equation of exchange see here.)

I personally favor the Fed targeting nominal GDP--and if there were a nominal GDP futures market then I would opt for it targeting expected nominal GDP--but I would settle for an inflation or price level target at this time. Anything to stabilize MV.

Update: In an earlier post I explained how this equation of exchange could be used to show that the dramatic increase in the monetary base, B, in late 2008 was largely offset by the collapse in the monetary multiplier, m. Consequently, the decline in velocity at this time was the deciding factor that lead to dramatic collapse in aggregate demand in late 2008 and early 2009. My take on these developments was that the Fed was so narrowly focused on B and m that it lost sight of V.

Why Isn't the Fed Doing More?

Houston, we have a a problem. It appears that that total spending in the U.S. economy is slowing, if not outright contracting. Retail sales fell in May while in April personal consumption expenditures stalled. In addition, housing starts and homes sales plummeted in May. Meanwhile, the MZM measure of the money supply has been declining since late 2009. Since these developments indicate that both money (M) and velocity (V) are declining, it is safe to conclude that aggregate demand (PY) is falling too (i.e. MV = PY). Given these developments why isn't the Fed doing more to help the U.S. economy? Surely, it can stabilize MV. Here is what three observers had to say in response to this question:

1. David Leonhardt. Financial markets are fragile and the Fed does not want to upset the market's confidence in the U.S. government by further easing of monetary policy. More monetary stimulus might just be the trigger to spook markets into dumping the dollar and U.S. debt.

2. Daniel Gross: The Fed is exhausted from its grand experiments in central banking--it has already drop interest rates to 0%, created new lender-of-last-resort facilities, and blew up its balance sheet--and is puttering out from sheer exhaustion.

3. Ryan Avent: There is division within the Fed on whether further monetary stimulus is really necessary. Moreover, even if there were no internal divisions, the Fed leadership may still be reluctant to act because it fears doing so may cause long-run inflation expectations to become unanchored.

There may be some truth in these responses, but let me add two more potential reasons for the Fed's inaction. First, the Fed may believe that some of the problems in the economy may be real in nature rather nominal and if so there is little monetary policy could do to improve matters. For example, if the Fed believes the high level of unemployment is mostly of the structural kind rather than cyclical then there is only a downside to further easing. This probably isn't a big factor--see the Atlanta Fed and the Ryan Avent on this issue--in the Fed officials' thinking but on the margin it may give them another reason to be reluctant to ease.

A second reason may be the Fed is looking at the wrong indicators in determining the stance of monetary policy and thus mistakenly thinks it is being highly accommodative when in fact it is not. In particular, the Fed may believe it is already doing enough by holding its target interest rate, the federal funds rate, close to 0%. That is the impression one gets when reading statements like this one from the FOMC press release for the June 23, 2010 meeting:

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

Observers, however, like Michael Belongia, Scott Sumner, and Nick Rowe have been arguing for some time that a low federal funds rate can be a misleading indicator of the stance of monetary policy. Even if one sticks with the federal funds rate as an indicator, then folks like Glenn Rudebush would point out that it would need to be about -3% (which it can't because it can't below zero) to be adding the right amount of stimulus. The bottom line is that the Fed may be inadvertently tightening by sitting on a 0% interest rate target and doing nothing.

This unintended tightening of monetary policy seems to be the message coming from the difference between the nominal interest rate on the 5-year Treasury and the real interest rate on the 5-year Treasury inflation protected security (TIPS). This difference or spread amounts to the markets expectation of future inflation. Below, this spread is graphed for the first half of this year up through June 24, 2010.



There is a clear downward trend in inflation expectations. Given the developments mentioned above and the other looming economic problems (Eurozone uncertainty, austerity talk, weak household balance sheets, etc.) the most obvious way to interpret this decline is that the markets expect aggregate demand to weaken going forward. Now it is possible that an increase in the liquidity premium is driving some of this decline, but I am not convinced it undermines my interpretation for several reasons. First, such a change in the liquidity premium would itself be driven by the recent uptick in perceived market risk, but that development has only happened in the last month or so as seen in the figure below. The decline in expected inflation has been going on for six months.

Second, even if spreads are driving the some of the more recent declines in expected inflation one must ask whether the spreads would be going up in the first place had the Fed been stabilizing inflation expectations (and thus aggregate demand) all along. Any way you slice the data it ain't a pretty picture.

So what do you think? Why isn't the Fed doing more?

Update I: Scott Sumner says Ben Bernanke is trying to do more, but is constrained by internal divisions at the Fed. Chalk one up for Ryan Avent.

Update II: The expected inflation chart was updated one day to June 24.

Martin Wolf Calls for a NGDP Target

Okay, maybe not quite but he comes close in his most recent article where makes the following statement (emphasis added):

The argument for aggressive monetary expansion remains strong, though not equally everywhere, since the growth of broad money and nominal GDP is weak (see chart). So Friedman’s policy of “quantitative easing”, as it is called, still makes good sense. Am I recommending the economics of Robert Mugabe? No. As in everything else, it is the context that matters. At present, we have “too little money chasing too many goods”. In this environment, monetary policy must be aggressive.

Note that Martin Wolf did not say the argument for aggressive monetary expansion is the looming deflationary pressures. Rather he focused on the anemic aggregate demand growth as indicated by his "nominal GDP is weak" statement. He seems to be making the point that monetary authorities should be targeting the cause, not the symptom in their conduct of monetary policy. If so, then Martin Wolf should have a chat with his fellow FT columnist Samuel Brittan who has explicitly called for monetary policy to stabilize total cash spending. He should also take time to read Scott Sumner's article on targeting expected aggregate demand, a forward-looking approach to NGDP targeting. I hope he takes these steps and follows up with a column in the FT.

Dollarization in Zimbabwe

Having lived in Southern African for a number of years when I was younger, I have more than a passing interest in the economic crisis that is Zimbabwe. As I noted early last year, there were two policy moves there last year that were very promising: (1) Zimbabwe was abandoning the production of its own currency and (2) it was allowing foreign currencies to be used as legal tender. The hope at the time was that these developments would make life more bearable there, as it would bring an end to the hyperinflation and start allowing a functioning medium of exchange to emerge. Here is a video clip that shows how life has improved since these changes took place:



Here is a link to another video clip that shows how hard life was right about the time these changes took place. In case you missed it, here is my post on the extent of the Zimbabwe hyperinflation and here is my post on the $100 trillion bill in Zimbabwe.

Recommended Readings

• Is Spain Next?--Mark Copelovitch
• Policy Responses to Long-Term Unemployment --Annie Lowrey
• The Great Deviation--John B. Taylor
• No Fed Tightening Unitl 2012--Glenn D. Rudebush
• The Hourless Recovery--Rebecca Wilder
• Fed to Touch Extension Chord--Randall W. Forsyth
• Types of "General Gluts"--Brad DeLong

This Does Not Look Good

Take a look at the figure below. This figure shows the difference between the nominal interest rate on the 5-year Treasury and the real interest rate on the 5-year Treasury inflation protected security (TIPS). This difference amounts to the markets expectation of future inflation. This figure, which goes through June 15, 2010, reveals a clear downward trend in inflation expectations over the first half of this year.

Source: Fred Database

I would like to attribute this decline to productivity growth, but it too appears to be coming down. That leaves us with one troubling possibility: the market is expecting aggregate demand to decline going forward. And unless the Fed acts to stabilize this expected fall in total spending it will effectively amount to a tightening of monetary policy. Obviously, the last thing the U.S. economy needs is a tightening of policy during an anemic recovery. I hope Ben Bernanke and the Fed are taking notice.

P.S. This is another instance where a NGDP futures market would be immensely helpful. More generally, they would make monetary policy a whole lot easier and effective as explained here. I really wish our leaders would push NGDP futures as part of the package of economic reforms.

A Double Dip Recession?

The topic du jour in many parts of the economics blogosphere is whether there will be a double-dip recession in the second half of 2010. Some folks like MacroAdvisors see absolutely no chance of a recession while others like David Rosenberg see a 80% probability of another recession. Other observers like Yves Smith, meanwhile, question whether there has even been a real recovery at all. One bit of information that is stoking the coals of this debate is the ECRI's weekly leading economic indicator series. Supposedly this is one of the better leading indicator series and as a result some folks have taken notice of the recent 5-week decline in the series as evidence there is a real chance of a double-dip recession. This series is graphed below (click on figure to enlarge):


I thought it would be interesting to use this series to help forecast real GDP over the second half of this year. To make this forecast I first converted the weekly series into a monthly one and plugged it into a vector autoregression (VAR) model that also had the monthly real GDP series from MacroAdvisors (yes, the same ones who see no recession later this year). Using 6 lags of data, I estimated this simple two-variable VAR and forecasted monthly real GDP for the months of May, 2010 through December, 2010. The forecast starts in May since the current real GDP data only goes through the month of April.

So what does this precipitous decline in the ECRI leading indicator mean for real GDP going forward? Here is how the VAR answers the question:


Real GDP will slow down to about 0% growth according to this simple model. This forecast is consistent with many observers--including ECRI as seen this video--who see a growth slowdown the second half, but not an outright contraction of the economy. I would note, though, that this type of analysis should only serve as a baseline forecast. Other developments such as a worsening of the Eurozone crisis or premature tightening of economic policy could further undermine U.S. economic growth.

Night and Day Difference

When I first moved to Texas I was surprised at the intensity of Texan pride. I now think some of it is justified given how well the Texan economy has handled the recession. Texas was one of the last states to start shedding jobs--employment peaked in August 2008--and started adding jobs way back in October 2009 as illustrated in the figure below:

Now compare these developments in Texas to the employment carnage in my previous home state, Michigan:

What a night and day difference. Michigan has had a decade of job destruction. Micheal D. Lafaive argues these developments are due to differences in economic freedom between the two states. Maybe so, but I suspect the lack of industry diversification in Michigan compared to that in Texas plays an important role. One point Lafaive does get right is that Michigan's gift to Texas is people. I am evidence of that. I left Michigan in 2007 and have never looked back.* Apparently a net total of 68,000 Michiganders did the same thing as me between 2000 and 2008. If only the Eurozone had such labor mobility.**

*To be clear, though, I am not a true Michigander like fellow economics blogger Josh Hendrickson. Therefore, leaving Michigan was not hard for me.
**If the Eurozone did have such labor mobility, which country would be Michigan (Greece?) and which one would be Texas (???)?

Update: The Dallas Fed takes thinks it sees a recovery under way in Texas.

Update II: I inadvertently put up financial sector employment in the original post for Michigan. It is now corrected to reflect total non-farm payroll employment.