President Obama, send Charles Evans some help now!

Brad DeLong links to FRB Chicago president Charles Evans calling for more aggressive monetary policy actions to reduce unemployment - including letting inflation rise above the Fed's 2 percent target in the near term. Apparently the FOMC is sharply divided between the "doves" like Charles Evans and the "hawks" like Naryana Kocherlakota who believe that a more expansionary monetary policy would let loose the dogs of inflation. There are two vacant seats on the Board of Governors. President Obama, fill them with economists who think like Charles Evans!

Good reads

This paper by Christiano, Ilut, Motto and Rostagno from last year's Symposium (back when Fed economists seemed to care about whether they could do anything to help pull the world out of recession) is very interesting. Cliffs Notes version: Contrary to conventional wisdom, stock market booms are generally associated with low inflation. This is because anticipated increases in productivity which fuel stock market booms (think the internet bubble) also imply reduction in costs for producers, meaning lower future inflation. Forward-looking price-setters will put off price increases or cut prices today in anticipation of lower future prices. If the Federal Reserve conducts monetary policy using an inflation target (as is its current practice), it will lower interest rates when it sees inflation fall. This causes the economy to accelerate and exacerbates the stock market boom, destabilizing the economy. Instead the Fed should raise interest rates when expected productivity increases spark stock market booms. The optimal policy can be approximated by including a measure of credit in the Federal Reserve's monetary policy reaction function (that is, the Fed raises rates when unemployment falls, inflation rises, or total credit rises). Christiano et al. demonstrate this elegantly in a standard New Keynesian model.



Paul Krugman and others are skeptical that inflation could ever be a problem with the economy in as deep a recession as we currently are, and therefore are very critical of the Federal Reserve's reluctance to get more expansionary in light of recent increases in inflation. The Christiano et al. paper sheds a little light on this argument. Flip the paper's logic around. An anticipated decrease in productivity - could be due to anything, but let's say concerns about excessive government regulation, higher taxes, or deterioration of skills among the long-term unemployed - causes asset prices to fall. It also causes firms to anticipate higher inflation in the future. They therefore start increasing prices now, causing inflation to rise. Boom - standard economic theory (which one should acknowledge Krugman is not wild about) suggests you can have inflation even during a deep recession.



However, standard economic theory, articulated in Christiano et al., also says that the Fed should lower, not raise interest rates in response to this upward pressure on inflation. The Fed should be setting the market interest rate to track the natural rate, which falls when productivity falls. Krugman's wrong that there is no coherent argument that inflation can rise during a severe recession, but correct in his criticism of the Fed's monetary policy.

Bernanke and the Symposium

I didn't think that in his speech at the Jackson Hole Symposium Bernanke would drop any hints about more aggressive monetary policy actions to come, and in that sense he did not disappoint. I am nonetheless awestruck that with the unemployment rate stuck above 9 percent for two years now, GDP at a standstill, financial markets in panic, and evidence of renewed contraction in manufacturing and housing, the Federal Reserve seems content to sit on its hands. People, if you believe that further monetary policy action would be ineffective, tell us so and maybe also tell us what nonmonetary policies might be helpful. If you believe that a more expansionary monetary policy would help spur the economy, and nevertheless do not plan on undertaking such policy, then tell us what freakin' objective function your policy is designed to maximize. What does the weight on the inflation parameter have to be to justify doing nothing when the unemployment rate is 9 percent and inflation is 2.5 percent? Is that weight consistent with the preferences of the typical American?



The program for the Symposium is similarly disheartening. Papers on long-run growth in emerging markets, managing natural resources, and so on. Nothing on the sputtering economy. Didn't someone think to organize the conference around questions like "what's next for monetary policy" or "can we have growth and fiscal contraction at the same time" or "the dangers of excessive sovereign debt" or "can Europe survive"? I get the sense that they're all just too exhausted from their efforts at putting out the fires of the last four years and have decided to pretend that the flames that are consuming the world economy just don't exist.

What's the Fed thinking?

At the August 10 meeting the Fed was confronted with 9.5% unemployment, inflation below the 2% target, and a visibly slowing economy. The proposal on the table was to begin reinvesting proceeds from the Fed's portfolio of bonds. To recap, the Fed had purchased about $2 trillion of government bonds and mortgages in 2009-10 (creating that amount in bank reserves) in order to stimulate the economy. In March the Fed stopped new purchases, which meant that as bonds matured the Fed was turning money back to the Treasury, shrinking its holdings of bonds and reducing bank reserves. Reinvesting the proceeds instead would maintain the size of the Fed's balance sheet and therefore maintain the amount of monetary stimulus being provided.

This seems to me to be an easy call. Any tightening of monetary policy is inappropriate given the weakness in the economy, even if that tightening occurs in a passive way. But as this article by Jon Hilsenrath shows, at least seven of seventeen FOMC members were opposed to the proposal or expressed reservations. Kevin Warsh thought reinvesting the bond proceeds would send a signal to investors that the Fed was paving the way for more aggressive actions in the future, which he would not support. "Some officials" thought they needed more information about the economy before they could support such a move. Richard Fisher thought more bond purchases wouldn't do any good since banks were already flush with reserves. Charles Plosser argued that action wasn't necessary because growth projections for 2011 had not changed. And Narayana Kocherlakota argued that the economy was suffering from a problem of mismatch between available jobs and skills, which monetary policy could not resolve.

Paul Krugman rightly takes Kocherlakota to task for adhering to a primitive form of the "hangover theory" that says that recessions are needed to facilitate the movement of workers from one sector of the economy to the other. This is indeed a nonsensical argument - there's no reason workers can't be pulled into new sectors through higher wages and a booming economy instead of pushed by unemployment, and at any rate all sectors of the economy have seen declines in employment during this recession. But it seems to me that the most important cause of the Fed's reluctance to act is timidity, an excess of caution. For some reason 9.5% unemployment, declining inflation, and a falling GDP growth rate are not sufficient to imbue a significant faction within the Fed with any sort of urgency. That is very odd. The Fed should be doing everything in its power to stimulate the economy and should not stop stimulating until it sees strong growth and a declining unemployment rate.

Negative interest rates?

[I've been out of town and feeling lazy lately, hence the pause in blogging. Time to get back in the swing.]

A number of commentators are suggesting that the Fed reduce the interest it pays on reserves below zero. That is, whereas currently the Fed pays banks an interest rate of 0.25 percent on excess reserves (and banks now hold about a trillion dollars in excess reserves), the Fed could in principal reduce that to zero or negative whatever it wanted. Penalized for holding money idle, banks would have a strong incentive to make loans. There are two problems however:

1. It's not clear whether the Fed has the legal authority to do this. The law says the Fed can pay interest on reserves, but it does not explicitly say the Fed can charge interest. The Fed might be able to get around a prohibition on negative interest by charging banks "fees" that act like interest, but this would have to be cleared through legal, as they say.

2. If the Fed charged an appreciable amount of interest banks would choose to store their reserves as "vault cash" rather than their deposits at the Fed. The Fed might be able to counteract this move by including vault cash in the measure of reserves to be charged interest, but again it's not clear if this is legal. (I'm told that the Fed's mandate to provide an "elastic currency" would get in the way of this action.)

Discussing these options with a friend at the Fed I mentioned that the Fed needs to hire some more bankers. Bankers are very good at finding ways to screw their customers with hidden fees, which is just what the Fed needs to do to banks right now. "That's funny," he said, but I thought I detected a hint of melancholy in his voice as he said it.

Better than nothing

Nothing is what Ben Bernanke is offering in terms of additional stimulus from the Federal Reserve. Joe Gagnon suggests three things the Fed could do:

- Lower the interest rate the Fed pays banks on reserves from 0.25 percent to zero
- Purchase three year Treasury securities in sufficient quantity to achieve a target rate of 0.25 percent (versus 0.90 percent now)
- Establish a facility to allow banks to borrow for terms up to 24 months at an interest rate of 0.25 percent

He claims that

These measures are all within the Federal Reserve's established powers. They pose essentially no risk to the Fed's balance sheet. They would reduce unemployment roughly as much as a 2-year $600 billion fiscal package and yet they would actually reduce the federal budget deficit. And they can be reversed quickly should the balance of risks shift from deflation to inflation.

I'd be interested to know where he got the $600 billion figure - it seems wildly optimistic. Nevertheless, if the Fed did those things it would be better than nothing. I'd add that the Fed could begin charging banks for holding reserves (does anything in the legislation authorizing the Fed to pay interest on reserves require that that interest rate be positive?) as a way of encouraging banks to lend rather than hold idle reserves.

But even so, I think the Fed's ability to influence the economy is very constrained at this point. The Fed's quantitative easing has brought long-term interest rates to historically low levels. Specific intervention in the mortgage and commercial paper markets has brought spreads in those markets down dramatically. Corporate bond spreads are also at normal recession (not normal recovery) levels, but unless the Fed starts buying up corporate bonds in massive quantities there's not much it can do there.

The biggest obstacles to strong recovery now are consumer spending, the housing sector, lack of availability of credit for small businesses, state and local government finances, and employment. This is the job for fiscal policy, not monetary policy.

Ross Levine on the causes of the financial crisis

Ross Levine, "An Autopsy of the U.S. Financial System," NBER Working Paper No. 15956, 2010.

The evidence indicates that senior policymakers repeatedly designed, implemented, and maintained policies that destabilized the global financial system in the decade before the crisis. The policies incentivized financial institutions to engage in activities that generated enormous short-run profits but dramatically increased long-run fragility. Moreover, the evidence suggests that the regulatory agencies were aware of the consequences of their policies and yet chose not to modify those policies. On the whole, these policy decisions reflect neither a lack of information nor an absence of regulatory power. They represent the selection -- and most importantly the maintenance -- of policies that increased financial fragility. The crisis did not just happen to policymakers.

Since technical glitches, regulatory gaps, and insufficient regulatory power played only a partial role in fostering the crisis, reforms that rectify these conditions represent only a partial and thus incomplete step in establishing a stable financial system that promotes growth and expands economic opportunities. The entire system of financial regulation -- the system associated with evaluating, reforming, and implementing financial policies – played a key role in the crisis.

Levine focuses on regulatory failures with regard to the rating agencies, credit default swaps, over-the-counter derivatives trading, capital requirements at investment banks, and Fannie Mae and Freddie Mac. The message is that regulators had the tools they needed to prevent the financial bubble that ultimately collapsed, but chose not to use them. Giving new powers to the regulatory agencies, therefore, is not necessarily a solution to the problem. True enough, but the granting of new powers sends a powerful signal to the regulatory agencies about what is expected of them. They got a very clear signal during the Clinton and Bush years that they were expected to exercise their regulatory powers with a light touch if at all; the financial reform bill working its way toward the president's desk gives them a clear message in the other direction. Also, certain reforms in the bill (e.g. the reform of the rating agencies' relationship with securities issuers) directly correct problems that Levine highlights in his paper.

Greece fire (is that what we're calling it now?)

Europe's attempts to stem the Greek debt crisis haven't calmed interbank lending markets. The TED spread (LIBOR minus Treasury bill rate) has poked up above 30 - well below the crisis levels of 2008-09, but troubling nevertheless.

The NY Times assesses the danger this poses for the European and US banking systems. But the article's focus on the dangers of public debt is misguided:

The European rescue plan, totaling 750 billion euros, is intended to head off the risk of default but would vastly increase borrowing. That could hamstring Europe’s nascent recovery.

Indeed, it was too much debt that caused the problem in the first place: a new report by the International Monetary Fund warns that “high levels of public indebtedness could weigh on economic growth for years.”

The world’s budget deficit as a percentage of gross domestic product now stands at 6 percent, up from just 0.3 percent before the financial crisis. If public debt is not lowered back to precrisis levels, the I.M.F. report said, growth in advanced economies could decline by half a percentage point annually...

After borrowing trillions to stimulate their economies and ease credit concerns during the last wave of fear in late 2008 and early 2009, governments cannot borrow trillions more without risking higher inflation and shoving aside other borrowers like individuals and companies. Short-term interest rates, already near zero in the United States, cannot be lowered any further. And vital steps like raising taxes or cutting spending increases could snuff out the beginnings of a recovery in northern Europe and worsen the pain in recession-battered economies like Spain, where unemployment recently passed 20 percent.

With the exception of wartime, “the public finances in the majority of advanced industrial countries are in a worse state today than at any time since the industrial revolution,” Willem Buiter, Citigroup’s top economist, wrote in a recent report.

“Restoring fiscal balance will be a drag on growth for years to come.”

Though excessive public debt in Greece and possibly Portugal, Spain, and some other countries, is clearly the root cause of the problem, the high levels of debt in the US, Germany, France, UK and other large economies have little to do with it. As Paul Krugman notes, according to the IMF report cited in the article the reason debt has exploded in these countries is a decline in tax revenues due to the recession, not excessive government spending. (The report also makes the specious claim that the financial crisis has caused a permanent reduction in potential GDP.) Attacking deficits now would be the height of insanity: we need continued fiscal stimulus to maintain the recovery and put us in a position where we can begin to restore fiscal balance in a few years.

Near term, the ECB needs to learn a lesson from the Federal Reserve's success in the US and begin a program of quantitative easing focused on purchases of sovereign debt. Fears that this would be wildly inflationary are crazy - at any rate, Europe could use a dose of higher than normal inflation at this point in time to ease the adjustment of countries like Greece.

First press conference

Ben Bernanke's press conference is repeatedly being described as the first press conference by a Federal Reserve Chairman in the 98-year history of the Federal Reserve. Yet I have before me the "Transcript of Press Conference with Paul A. Volcker, Chairman" on October 6, 1979. This was right after the historic meeting where the Fed changed its operating procedures to nonborrowed reserve targeting (I know, you want to know more - look it up). Is there some sense in which Bernanke's press conference is different in kind from Volcker's?

Time to go negative

All right, I'm going to start trying to post regularly again. See if anyone's still reading.

Today's NY Times reports that "Stimulus by Fed is Disappointing, Economists Say." Let me quickly point out two problems with the article. First, the title. It's not really the passive voice, but it's in the classic circumlocutory style of the news media that I find annoying. I'd go with "Fed's Stimulus Disappoints Economists." Saves on newsprint too. Second, the article is very thinly sourced. On the Keynesian end of the spectrum we have Mark Thoma, on the RBC end we have Charles Plosser, and that's pretty much it. Add to that two finance professors from Northwestern and an economist from Bank of America. Not exactly a summary of the profession's opinion. And the article leaves the crucial question unanswered: does the fact that the Fed's efforts have not been tremendously successful mean that it should do more or less in the months to come? One could write a very interesting article surveying economists on their response to that question.

Put me in the "more" camp. Another round of fiscal stimulus, this time focused on aid to states to prevent them from continuing slashing budgets, would be the best policy. That's obviously not going to fly politically in Washington (nor, it has occurred to me these last few months, in the states - it now seems clear that Republican governors have found the fiscal crisis to be a very convenient pretext for pursuing their political objectives, beginning with smashing public employee unions). The Fed should certainly not end its bond purchasing program in June as scheduled, but it will face considerable political pressure to do just that, so I don't see much hope of any further quantitative easing.

That leaves one other policy response: imposing a negative interest rate on bank reserves. A number of economists have proposed this before. The idea is to penalize banks who hold excess reserves, force them to use those reserves to make loans or buy securities (which would have the effect of lowering interest rates, exactly like quantitative easing would do). Banks would also try to pass costs onto their customers by charging interest on checking deposits, so people with money in banks would have the incentive to spend rather than accumulate bank balances. The problem with this proposal is that faced with negative interest rates on checking deposits, customers might instead simply withdraw money from the banking system and hoard it in big piles on their dressers. After all, cash pays a zero percent interest rate which would be better than you could get at the bank.

Greg Mankiw half-seriously proposed imposing a negative interest rate on cash by once a year drawing a number between 0 and 9 by lot, and all currency with a serial number ending in that digit would no longer be useable as legal tender. This would in effect impose an expected rate of return of negative ten percent on all money holdings. (Incidentally: Greg Mankiw is a wonderful guy, a gracious host, a riveting speaker. But I find it highly ironic that this co-founder of the branch of macroeconomics known as New Keynesian economics had to have Silvio Gesell's proposal for stamped money, which Keynes cites approvingly in the General Theory, brought to his attention by Alan Taylor. Apparently Mankiw has not read the General Theory!)

Any scheme of stamped money or money-extinguishing lotteries is likely to be difficult to impose in practice. But there's an alternative. Hoarding money in response to negative interest rates on checking deposits is only possible if the Fed supplies currency perfectly elastically. This happens to be the Fed's current policy: if customers go to their banks in large numbers to withdraw money in cash from their checking accounts, the banks ask the Fed for more currency, and the Fed gives them as much as they want, exchanging the banks' reserves at the Fed for currency at par. But suppose the Fed simply exchanged reserves for currency at a discount (I suppose equal to the negative interest rate charged on reserves)? Banks would pass this charge on to customers: if you wanted to withdraw $100 of cash from your checking account where it was earning -5% interest, you'd have to pay a $5 fee for the privilege. The only way to avoid the charge would be to spend the money in your checking account in some way: buy groceries, a new car, a fine Easter bonnet; or if not that, put your funds into a money market account or retirement account where it ends up being used to purchase stocks, bonds, commercial paper, and other assets, thus driving the prices of those assets up and their yields down.

This proposal has the virtue of not requiring the Fed to purchase any more assets. In essence, the Fed forces the banking system and bank customers to engage in quantitative easing on its behalf. There may of course be practical difficulties. For one thing, the Fed would have to implement this plan (at least the fee for currency purchases) by surprise, because otherwise there would be a massive withdrawal of cash from the banking system in anticipation of the new fees. But the Fed employs thousands of very clever economists, I'm sure they could find their way around these problems.

Monetary policy, bond markets, and the job-rich recovery

Hyman Minsky argued that monetary policy affects the economy in the following way. The Federal Reserve reduces short-term interest rates. There's now no profit to be made sitting on money, so financial managers shift funds out of short-term, risk-free assets into long-term risky assets like corporate bonds. The increased demand for bonds pushes their prices (which were low at the trough of the recession) up and their yields (which were high) down. Credit spreads (the difference between risky rates and risk-free rates) therefore plunge. Businesses can borrow more cheaply, so begin to undertake investment projects that they had delayed due to the recession. Consumers also face lower borrowing costs, so they loosen up, and the recovery is underway.

The story implies that a plunge in credit spreads, say as measured by the difference between the yield on Baa corporate bonds and 10-year Treasuries, should normally precede a recovery in employment. Look at the historical record:

1974-76: Baa-Treasury spread peaks at 3.31 in January 1975, falls to 2.49 by July. Strong growth in employment begins that month.



1981-84: Baa-Treasury spread peaks at 3.82 in October 1982, falls to 1.79 by August 1983. Strong growth in employment begins in April 1983 with spread at 2.89.



1990-94: Baa-Treasury spread peaks falls, rises, falls again in early stages of the "jobless recovery." The last peak, at 2.25, comes in October 1992. From there it falls to 1.29 by December 1994. Strong growth in employment begins December 1992.



2000-2004: Another jobless recovery, with Baa-Treasury spread bouncing around until it peaks at 3.79 in October 2002. From there it plunges to 2.03 by May 2004. Strong growth in employment begins in March 2004.



So what have we seen this time around? A much more severe jump in credit spreads (up to 6.0 in December 2008) and a much more severe recession. But there's been a continuous drop in the spread beginning in March 2009, and the spread is now at 2.65.



Today the WSJ reports on the rally in corporate bond markets, and it sounds like it could have been written by Minsky (or Barbera) himself.

Investors flooded risky companies with money in March even as the government prepares to shut down a key engine driving one of the greatest corporate-bond rallies in history. A total $31.5 billion in new high-yield debt, otherwise known as junk bonds, hit the market through Tuesday, exceeding the previous monthly record in November 2006. Partly propelling the activity: The Federal Reserve's massive mortgage-buying program, which comes to an end Wednesday. By buying $1.25 trillion of mortgage securities, the Fed absorbed a flood of assets that otherwise would have needed buyers. That kept money in the hands of investors, who went searching for something else to buy. The Fed's underpinning encouraged investors to seek riskier, higher-yielding securities. A natural choice: corporate bonds...

The revival of bond fortunes has roots in the Fed's decision, around Thanksgiving 2008, that may have done more than anything else to encourage more investors to take a flyer on bonds. On Nov. 25, the Fed announced it planned to buy debt and mortgage-backed securities issued by housing-related governmentsponsored entities such as Fannie Mae and Freddie Mac. The program pushed mortgage-security prices higher, giving fixed-income managers an incentive to sell to the Fed. In return, they had a flow of cash that had to be put to work. With Treasury debt yields at record lows, the best alternative remaining was corporate debt. "That was the big turning point," says Ashish Shah, head of global credit strategy at Barclays Capital. "That's what drove money into credit."

The Fed expanded this program on March 18, of last year, to buy $1.25 trillion in mortgage securities, along with $200 billion in debt of Fannie and Freddie and up to $300 billion in long-term Treasury debt. The expansion fueled the second leg of the rally, which hasn't stopped.

The behavior of credit spreads in the last year looks very much like it did in 1975-76, 1982-83, and 2003-04. The change in employment has been following a path similar to that in 75-76 and 82-83. It's taken us longer to hit zero this time around because the declines were so enormous during the recession. With monetary policy having delivered a 340 basis point reduction in credit spreads over the last year (compared to 82 in 75-76, 203 in 1982-83 and 176 in 2003-04), is it unrealistic to think we're on the verge of a strong recovery in employment? I don't think so.

Old school, indeed

Apparently the "Shadow Open Market Committee" is pushing for the Fed to start raising interest rates but soon. The WSJ reports:

The guys on the shadow open market committee are old school.

Rutgers University professor Michael Bordo said 0% interest rates, if continued for much longer, are going to cause a “run up in inflation expectations.” Noting history shows the Fed often ends up “exiting too late,” he said the central bank should be raising rates by summer, lest it engineer an unpleasant inflation situation.

Gregory Hess, of Claremont McKenna College, offered the most aggressive prescription.

“At this point it’s time for the Fed to make an announcement that it’s time to get out of the business” of owning mortgages, he said. The central bank needs to offer a timeline, saying the securities would be sold over the course of one to two years, as the Fed moves back to an all-Treasury balance sheet.

Meanwhile, Marvin Goodfriend, of Carnegie Mellon University’s Tepper School of Business, said the risk for the Fed right now was that market perceptions “are in flux” — Treasury yields spiked this week in a worrisome development — and officials should create the impression they will act to keep inflation under control, lest investor confidence be lost.

This is just a wee bit crazy. The spike in the 10-year note rate amounts to less than 20 basis points. Most of that is an increase in expected real interest rates. Expected inflation, as measured by the difference between yields on nominal and inflation-indexed 10-year Treasuries have risen by 5 basis points and is considerably lower than it was at the beginning of the year. The unemployment rate is still 9.7 percent, in case the SOMC has forgotten. So how about we wait a bit until we actually see a net job created before panicking about inflation?

Systemic risk regulator

The Times reports that

The Senate and the Obama administration are nearing agreement on forming a council of regulators, led by the Treasury secretary, to identify systemic risk to the nation’s financial system... The effect would be to diminish the authority of the Federal Reserve, whose regulation of banks has been criticized for failing to head off the problems... Though some in the Fed continue to push for the central bank to be the overseer of systemic risk, the chairman, Ben S. Bernanke, is willing to go along with a Treasury-led council.

It's important that the Fed maintain its regulatory role in the banking system - the authority to regulate banks provides the Fed with timely information about the condition of the banking system that is useful for the conduct of monetary policy. But I also think it's a good idea to put the Treasury rather than the Fed in the lead role of systemic risk regulator. It's a matter of political accountability. In the 2000s monetary and regulatory policy conducted by the Fed, SEC, FDIC, and other regulatory agencies created a dangerous situation in financial markets. Given the political economy of financial policy, these issues were not going to be dealt with by passing off bits and pieces of them to the regulatory agencies where they can be "handled" outside public view. I think there's a slightly greater chance that they'll be taken seriously if they're given a greater public profile. Even if that's not the case, at least centralizing authority at the Treasury Department will make the president directly, publicly accountable.

GDP and unemployment forecasts

The Minutes from the January FOMC meeting include the economic projections from governors and Fed bank presidents. Little change since November. The Fed projects GDP growth in the range of 2.8 to 3.5 percent in 2010 and the unemployment rate to finish the year in the range of 9.5 to 9.7.



Here is the full distribution of estimates. I've penciled in the Council of Economic Advisors' estimates from the Economic Report of the President and the Survey of Professional Forecasters estimates from the Philadelphia Fed. The CEA and SPF forecasts of GDP growth are in the central tendency range of the Fed's while their unemployment forecasts are somewhat more pessimistic.



One often commentators treating these forecasts almost as data - "look at the jobless recovery we're having, unemployment is expected to stay at 10 percent throughout 2010!" As I've noted on many occasions, however, the forecasts are frequently way off the mark. None of these guys thought in 2007 that we were going to have a recession, and all underestimated the severity of the recession in 2008. Given this track record I don't know why one would take the estimates for 2010 at face value.

Free Market Does Not Exist!

Cambridge University economist Ha-Joon Chang offers an institutionalist analysis of the recent injection by Fed as another step in an accelerating currency war, explains the political economy of G-20 summit and argues that there is no such thing as a free market.

Unwinding

During the recession the Fed has bought about $1.5 trillion dollars in assets that include mortgage backed securities, debt issued by the housing agencies Fannie Mae and Freddie Mac, long-term government debt, and a host of other risky assets. In the process it has created the same amount of bank reserves, most of which sit in the banks' deposits at the Fed because banks are reluctant to make loans. In essence, the Fed has become the primary lender to the US housing market and some other financial markets.

Over the coming year banks will, it is to be hoped, become less reluctant to lend. Those idle reserves will be lent out, the money supply will expand, and the Fed will face the problem of how to "unwind" these extraordinary actions to head off inflation. The NY Times is misleading, however, when it says "Ben S. Bernanke ... now faces the delicate task of beginning to pull the central bank out of its extraordinary effort to prop up the economy." Now is certainly the time to plan, but it is far too early to do.

One thing the Fed certainly should be in no hurry to do is to reduce its holdings of securities (in central bank jargon, to reduce the size of its balance sheet). I think there is a certain level of discomfort, if not at the Fed than among commenators in the press, with the idea that the Fed would be the owner of so many different types of privately issued securities. But the fact that the Fed holds, say, $970 billion of mortgage-backed securities, is not in itself inflationary. Inflation will be a danger when idle reserves are turned into loans and therefore bank deposits (money). The Fed can control the pace of new lending by adjusting the interest it pays on reserves. It does not have to adjust its holdings of securities.

It would be a terrible mistake for the Fed to sell off its security holdings prematurely. Doing so would cause interest rates on these types of lending to rise and cause the recovery to stall. The Fed knows this, and so will not make this mistake. Securities should be sold off only as quickly as private sector demand for them increases. This could be a long process.

Circular firing squad department

So now Russ Feingold and Barbara Boxer have announced that they will not support Ben Bernanke's reappointment as chair of the Federal Reserve, putting his reappointment in jeopardy. No good can come out of this, none at all.

Bernanke screwed up during the bubble years but has since then performed heroically. He has ticked people off by being coy about the Fed's future stimulus efforts - maybe the Fed will keep rates low as the economy recovers, maybe it'll start raising rates this year when the economy heats up. The possibility that the Fed would tighten significantly before we get a meaningful recovery is a real concern. And maybe Bernanke has been too cozy with banks.

But Bernanke is not the problem here, it's the Fed as an institution and the hypersensitivity of financial markets to every utterance that comes from the Fed. Any plausible candidate for the job will be equally reticent about keeping the spigots open while the economy recovers. You simply cannot be taken seriously at the Fed or in the financial markets if you take a relaxed attitude toward inflation.

What are the upsides and downsides of appointment someone else to take Bernanke's place? On the upside, you might get a guy who is marginally more willing to keep interest rates low than Bernanke. Maybe he (more likely she - Sheila Bair at FDIC is probably on Democrats' short list) may take a slightly tougher line as bank regulator. But the upside seems pretty modest to me.

The downside, on the other hand -- hoo boy! I do not want to see the Dow fall 500 points on concerns about leadership at the Fed or the Fed's independence from Congress. I do not want to see bond yields jump a hundred basis points. I do not want to see the dollar plunge in foreign currency markets. I do not want everyone in the world wondering why the hell they put Democrats in charge of running the country.

Just confirm Bernanke, for God's sake.

Happy (belated) non-borrowed reserves targeting day

How come none of the economics blogs I follow regularly noted that yesterday was the 30th anniversary of Paul Volcker's announcement that the Fed would begin targeting non-borrowed reserves rather than the federal funds rate? This decision was the beginning of the end of the Great Inflation that wracked the economy in the 1970s. It was such a historical milestone that today no respectable macroeconomist will run a regression on post-war US data without acknowledging the likelihood of a structural break in 1979:Q4.

The pessimists seem to be backing off a bit

It wasn't so long ago that forecasters and analysts were warning about sluggish growth and rising unemployment well into 2010. The consensus was that the economy wouldn't begin to add jobs until May or June. Now even the pessimists acknowledge that strong growth is likely for the fourth quarter of 2009 and that the December jobs report could show an increase in employment for the first time in two years, but concern has shifted to the second half of 2010.

Here's Paul Krugman:

The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.

As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is, in fact, mired in a prolonged slump...

Such blips are often, in part, statistical illusions. But even more important, they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with large stocks of unsold goods. To work off their excess inventories, they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up...

Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief.

It's nice to see that Krugman is acknowledging that one shouldn't overreact to temporary blips in the data - his tendency to do that for pessimistic economic reports is one reason he was so slow to see the strength of the recovery in recent months. I think he exaggerates the temporary nature of the inventory bounce: inventory investment requires production, which creates employment and income, which increases sales, which requires further inventory adjustment, etc. But he's right on the larger point: it is too soon for the government to start reversing the stimulus it has been providing the economy. Even under optimistic scenarios, the unemployment rate will be close to 9 percent in the summer - that's no time to start reducing the budget deficit and raising interest rates.