Author Archives: meethoon

Revisiting Minimum Wage Debate

Not long ago, I wrote about minimum rate debate in my blog post, Expensive tool: Minimum Wage to Meet the Targeted U.S. Inflation, I recognized that the title of the blog was misleading readers. What I intended to deliver was increasing minimum wage is not a good solution or rather insignificant solution for helping U.S. inflation rate to rise in the long term. However, I believe that raising minimum raise will have a definite impact on raising inflation on a longer term. In my previous blog post, I have illustrated why increase in minimum wage will push up the price level, thus Consumer Price Index (CPI) will also doubtlessly go up. Today, I would like to reiterate an important point made by Michael Saltsman, who was an undergraduate student in our school. Michael wrote, Why Subway Doesn’t Serve a $14 Reuben Sandwich inside of WSJ and made a distinct point that is worth mentioning for the last class blog post.

According to the article, Costco, Michigan-based deli Zingerman’s , and East Coast burger chain Shake Shack  were recognized during the White House’s minimum-wage promotional tour. Michael then, argues these stores should be used as the well representative cases why the president’s plan to raise the minimum is not a good idea or promptly meets the wall of reality. For example, Costco can “afford” to pay a higher minimum wage to their employers because

“Costco charges its customers as much as $110 a year for the privilege of shopping at the store. That’s a $2 billion-per-year luxury no grocer or restaurant enjoys. As a result, the warehouse retailer rakes in what amounts to a more than $10,000 profit per employee, according to data from business research company Hoovers. A casual dining restaurant, on the other hand, earns a roughly $2,000 profit per employee, which explains why most businesses aren’t following the president’s “just be more like Costco” advice

For small business, not like a Michigan-based deli Zingerman’s where president stopped during his visit to our campus last month, it is also very hard to afford higher minimum wage without losing their customers. I will present the same examples which Michael used in his opinion page. Imagine you have to pay $14 for the subway foot-long sandwich, of course the assuming that quality of sandwich is directly related with the cost, or pay $14 for a Double Quarter Pounder at the McDonald. I cannot count how many meals I have to skip in order to meet my budget constrain during my academic year. The point is that in order for the owner of subway to pay their employees the higher minimum wages of $11.50 like Costco or Zingerman’s, the food price have to be as least twice expensive than the current price, otherwise business has loses customers and its competiveness against other business. When government forces higher minimum wage law, either the quality of food has to go down in order to compensate the higher wage, or person like me, have to skip a few meals because it is just too expensive. Thus, personally I prefer that minimum wage stays the same or just gets raised within the range of 5% to 10%. Otherwise, we are going to see more negative side effects.

P.S. This is the last blog post for the course. I would like to thank our classmates for the comments on my blogs, and our GSI, Ryoko Sato for reading all of the blog posts.

(Revised) Specific Forward Guidance to persuade the U.S. market participants

WSJ reporter Ben Leubsdorf summarized a recent speech given by the president of Federal Reserve Bank of Boston, Eric Rosengren. The original text of speech can be found here. In his speech, President Eric Rosengren claimed that Fed’s Forward Guidance should be more specific. If then, let’s compare two of most recent statements of Fed’s Forward Guidance.

During the Great Recession, FOMC had a fairly specific guidance such as “that short-term rates would remain low until we had seen significant improvement in labor market- improvement that could be proxied by seeing the unemployment rate fall to the 6.5 percent threshold” (Rosengren, p3). On the other hand, in March of 2014, FOMC adjusted their Forward Guidance as U.S. economy has picked up its pace and seen the report of which unemployment rate dropping down to 6.7% from 7.5%. Witnessing optimistic incoming data, Fed responded this with by cutting their bond purchase. At the March FOMC meeting, Fed suggested that “ for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent-run goal, and provided that longer-term inflation expectations remain well anchored” (Rosengren, p3).

Rosengren admits that recent announcement of Forward Guidance is bit less specific given that it is missing specific targeted goal, such as 6.5% unemployment rate in the previous example. In conjunction with pointing out the lack of specification in Fed’s Forward Guidance, WSJ reported Ben Leubsdorf named his article, Rosengren: Fed’s Forward Guidance Should be Linked to Employment, Inflation Data. However, the article is still somewhat missing the core message of what Rosengren had said in his speech. For example, Rosengren has emphasized that in order to achieve both sustainable employment and price level, “Forward Guidance should be increasingly focused on how quickly we expect to make progress on inflation “(Rosengren, p4). So it is not just about linking Forward Guidance to employment and inflation data.

In order to draw more positive attentions from the markets, Fed’s Forward Guidance should be specific but not overly specific to a level which Fed must not misguide the market by overlooking market uncertainties. Here is a good example of what is specific but not overly specific forward guidance. Rosengren suggests FOMC to “keep short-term interest rates at very low levels until the economy is within one year of reaching full employment and 2 percent inflation, based on the trends in incoming data and an assumption about how they will continue” (Rosengren, p5). By specifically hinting to market that Fed will follow the incoming data like summary of the economic projections (SEP) which has been routinely published by Federal Reserve Board members, Market watchers will become more prudent in analyzing the data which corresponds to the Fed’s Forward Guidance. I believe this will make the market more data oriented object rather than a rugby ball bouncing up and down with variety of unsorted uncertainties. In addition, benefit of having data orientated market that accords with Fed’s monetary policy can reduce the volatility of market risks compare to the absence of data oriented market. When Fed reduces the volatility of market sways, this will hugely benefit U.S. economy. One of the reasons, I think that Great Recession has not healed as quickly as Fed anticipated is that market’s own expectations were not necessary aligned with Fed’s expectations of market. For example, investors have their own expectations and have been playing their own expectation game.

In other words, there are too many boats searching for the same treasure, yet they bumped into each other and crashed, because they all have different beliefs even though the same map has been distributed to them. One possible reason that those boats are sailing their own ways and creating havoc during the course of the journey can be found in the lack of confidence of map that was given. In this analogy, map distributor is the Fed and sailors of boat are market participants.

Absence of complete information, how can we sail in a similar direction knowing that we may not find the treasure? Answer is: We have to make people to believe. How can Fed make them believe? How about borrowing a concept from the Ellsberg paradox? “The basic idea is that people overwhelmingly prefer taking on risk in situation where they know specific odds rather than an alternative risk scenario in which odds are completely ambiguous” What I am suggesting to Fed is that Fed should favor releasing more information that can help market participants to determine the risks of following what Fed announces. Then, markets will cautiously analyze the data, and will likely choose known risks rather than the odds that are unknown. Here, I am not encouraging the manipulation of data, but recommending a strategy which perhaps can align market expectations with Fed’s expectations of economy. Thus, it can stir more boats to sail in the same direction.

Building A Stronger Forward Guidance

WSJ reporter Ben Leubsdorf summarized a recent speech given by the president of Federal Reserve Bank of Boston, Eric Rosengren. The original text of speech can be found here. In his speech, President Eric Rosengren claimed that Forward Guidance should be more specific. Here is two different statements of Fed’s Forward Guidance.

During the Great Recession, FOMC had fairly specific guidance such as “that short-term rates would remain low until we had seen significant improvement in labor market- improvement that could be proxied by seeing the unemployment rate fall to the 6.5 percent threshold” (Rosengren, p3). On the other hand, in March of 2014, FOMC adjusted their Forward Guidance as U.S. economy picks up its pace and especially seeing unemployment rate dropping down to 6.7% form 7.5%. Witnessing optimistic incoming data, Fed responded this with by cutting their bond purchase. At the March FOMC meeting, Fed suggested that “ for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent-run goal, and provided that longer-term inflation expectations remain well anchored” (Rosengren, p3).

Rosengren admits that recent announcement of Forward Guidance is bit less specific given that it is missing specific targeted goal, such as 6.5% unemployment rate in the previous example. WSJ reported Ben Leubsdorf named his article, Rosengren: Fed’s Forward Guidance Should be Linked to Employment, Inflation Data, is somewhat missing the core message of what Rosengren had said in his speech. For example, Rosengren emphasizes that in order to achieve both sustainable employment and price level, “Forward Guidance should be increasingly focused on how quickly we expect to make progress on inflation “(Rosengren, p4). So it is not just about linking Forward Guidance to employment and inflation data.

In order to create a positive attention, Fed’s Forward Guidance should be specific but not overly specific to a level which Fed must be able to manage market’s uncertainties. For example, Rosengren suggests FOMC to “keep short-term interest rates at very low levels until the economy is within one year of reaching full employment and 2 percent inflation, based on the trends in incoming data and an assumption about how they will continue” (Rosengren, p5). By specifically hinting to market that Fed will follow the incoming data like summary of the economic projections (SEP) which has been routinely published by Federal Reserve Board members, Market watchers will become more prudent in analyzing the data which corresponds to the Fed’s Forward Guidance. I believe this will make the market more data oriented object rather than a rugby ball bouncing up and down with variety of unsorted uncertainties. In addition, benefit of having data orientated market that accords with Fed’s monetary policy can reduce the volatility of market risks compare to the absence of data oriented market. When Fed reduces the volatility of market sways, this will hugely benefit U.S. economy. One of the reasons, I think that Great Recession does not healed as quickly as Fed anticipated is that market’s own expectations were not necessary aligned with Fed’s expectations of market. For example, investors have their own expectations and have been playing their own expectation game.

In other words, there are too many boats searching for the same treasure, yet they bumped into each other and crashed, because they all have different beliefs even though the same map has been distributed to them. One possible reason that those boats are sailing their own ways and creating havoc during the course of the journey can be found in the lack of confidence of map that was given. In this analogy, map distributor is the Fed and sailors of boat are market participants.

Absence of complete information, how can we sail in a similar direction knowing that we may not find the treasure? Answer is: We have to make them believe. On way, I like to propose is by using the concept from the Ellsberg paradox. “The basic idea is that people overwhelmingly prefer taking on risk in situation where they know specific odds rather than an alternative risk scenario in which odds are completely ambiguous” What I am suggesting to Fed is that Fed should release more information that can help market participants to determine the risks of following Fed’s direction. Markets will cautiously analyze the data, and will likely choose known risks rather than the odds that are unknown. Here, I am not encouraging the manipulation of data, but recommending a strategy which perhaps can align market expectations with Fed’s expectations of economy. Thus, it stirs more boats to sail in the same direction.

Quota for H1B-Visa is too low

Mr. Slaughter who is a professor and associate dean at the Tuck School of Business at Dartmouth wrote a heart touching post inside WSJ on March 25th of 2014. This article named, How America Loses a Job Every 43 Seconds, especially shocked me even though, his arguments favor for allowing more highly-skilled workers to work in the United States. As an international student who has completed dual concentration majors at the University of Michigan, I have always disliked being asked questions such as “Do you now or later need a sponsorship from the company?” or “Are you a legal resident of the United States of America?” by employers. Questions like those always came up in my job interviews and during every position I applied. From my previous experience I thought I have understood the company’s position and its difficulty of hiring foreign workers, yet data shown in the article made me more desperate.

The H-1B program, which accounts for nearly all of America’s skilled immigration, imposes an annual cap of 85,000 new visas: 65,000 with at least a bachelor’s degree and 20,000 with at least a master’s degree. In many recent years, demand for H-1B visas has far exceeded supply. In 2013, the government received roughly 124,000 applications in just four days—and then stopped accepting petitions on April 5.

Above fact is unpleasant for me as well as it can be the same for domestic students; however the reasons can be very different. For me, this fact is overwhelmingly displeasing because I think that the U.S. skilled immigration policy quota is too small and supply of skilled foreign labor is overwhelmingly overflows the demand and policy quota. At the same time, others may think that 85,000 jobs are stolen from the U.S. workers, however I would like to borrow Mr. Slaughter’s work to show that is not true. First, Mr. Slaughter shows that how skilled immigrants have been a great and important contribution to U.S. economy.

One quarter of U.S. high-technology firms established since 1995 have had at least one foreign-born founder. These new companies today employ 450,000 people and generate more than $50 billion in sales. Immigrants or their children founded 40% of today’s Fortune FT.T +5.41% 500 companies, including firms behind seven of the 10 most valuable global brands.

Second, highly skilled foreigners are not really stealing the domestic workers job, according to Mr. Slaughter.

Talented immigrant STEM workers do not crowd out American-born STEM talent. Companies that cannot hire talented immigrants in America often don’t hire anyone at all. Or these companies may hire—but overseas.

Instead, the real cost for restricting fewer skilled-workers are “forgone jobs created in the companies and beyond. More broadly, the cost is forgone ideas, innovation and connections to the world” In a conjunction, Bill Gates testified that “for every immigrant hired at technology companies, an average of five additional employees are added as well” Considering all of the above, I hope that U.S. Congress passes a law that extends quota for skilled workers who have obtained a bachelor degree or more from the accredited university like University of Michigan. Students here are all hard-workers regardless of their race, origin, and sex. They possess necessary skills and mind sets to contribute their potential to do some good for U.S. economy, not to harm it. So, Congress needs to raise quota for allowing highly skilled foreign students who have attained their degree in the U.S.

Brilliant Move by Fed: Higher Capital Requirement

On April 8th, WSJ wrote “Big Banks to Get Higher Capital Requirement” which led eight major banks in U.S to add $68 billion dollar to their balance sheet. What is “Capital Requirement?” The term ‘Capital Requirement’ is defined as follows: According to Wikipedia,

“It is the amount of capital a bank of other financial institution has to hold as required by its financial regulator” Important point to notice is that capital requirement is different from reserve requirement rule, because capital requirement is a ratio of equity to debt while reserve requirement enforces banks to set aside their extra money. Thus, traditionally reserve requirement plays a critical role in the U.S. money supply side. A low reserve requirement means more money being circulating in the market while a low capital requirement means less protection for financial institutions. Now, Fed plans to fully implement the new regulation by 2015 when banks must report their new equity of debt ratio. In addition, by 2018, Fed expects this new rule to be effectively running, raising capital requirement to 5% of their total asset.

Fed Chairwoman, Janet Tell said “The final rule is an important part of the board’s package of enhanced prudential standards for the most systemic U.S. banking firms—a package that is designed to materially reduce the probability of failure of these firms and to materially reduce the damage that would be done to our financial system if one of these firms were to fail”

I think she is absolutely right that U.S. cannot afford another failure like Lehman Brothers. Increasing capital requirement to 5% from the 3%, which is the global standard, this may not be enough to prevent future disasters and corruptions of U.S banks. As Comptroller of the Currency Thomas Curry said in this article “”While we can’t entirely prevent future disruptions, we can preserve confidence in the financial system by ensuring that our large banks are well-capitalized” I think what him saying is right not because banks made foolish investments and lends money extravagantly but more because no one knows about the risks which major banks carry. In other words, lack of transparency is the biggest issue in the U.S. financial industry. So, raising the capital requirement above the international standards is a good move which Fed has done brilliantly. From this, I have expanded my thoughts to seek for other positive externality caused by raising capital requirement. The article said “Increase in leverage ratio will require the eight largest lenders to add $ 68 billion to level” I think this may have some similar effects as done by increasing reserve ratio. Even though, I said from the very beginning that reverse ratio and capital requirement is different. I want to emphasize why raising capital requirement can help Fed’s monetary policy in ways which not only build more buffer for financial risks of bank’s failure but also for Fed’s tapering. My reasons are that now banks must to either raise extra money or reduce the size of balance sheet in order to raise their equity to debt ratio. So either equity is going up, or debts have to decrease. In case of debts going down scenarios happens when they borrow less, on the other hands, equity increase when banks collect their debts from the market. Either way, money is circulating back to their banks thus, less money be left off in the market. This is what Fed wants to do now from the tapering. So, once again, I think that Fed has made a brilliant move against financial banks’ lack of transparency.

Expensive tool: Minimum Wage to Meet the Targeted U.S. Inflation

On April 8th, WSJ posted a nice article, As Wage Debate Rages, Some Have Made the Shift, about recent debate about minimum wage debates.  According to the Merriam-Webster’s online dictionary, minimum wage is defined as following:

An amount of money that is the least amount of money per hour that workers must be paid according to the law

And the law says “the federal minimum wage provisions are contained in the Fair Labor Standards Acts (FLSA). The federal minimum wage is $ 7.25 per hour effective July 24, 2009. Many states also have minimum wage laws. Some state laws provide greater employee protections; employers must comply with both”

I assume that most of people who read this blog post are aware of the common argument in support of the minimum as well as the other side of arguments. However, I would like to reiterate one main point from each sides of argument. For the supporter’s side, they want to make sure the people who sit at the lower level of socio-economic standing to have some purchasing power to live healthier life. On the other hand, the other side argues that minimum wage law hurts those same people, because the market adjusts to the increases fairly quickly and it returns back to us as the increase in the real price tags. Today, I am not trying to pick a side but to mention the fact that it is expensive tool, (not recommended), which Fed can use when it needs of meeting their inflation target. In U.S., inflation has been hovered bellowed 2% mark. Fed wants to meet their goal of 2% inflation target while holding Federal fund rates close to zero. Because, this way, Fed can achieve their goal of stimulating economy more effectively than 1% inflation rate considering the Zero Lower Bound problem. However, I do not recommend that use minimum wage increase to meet their goal. I am not saying Fed wants to do so, yet you never know why things are happening in real life. Thus first, here are some of examples from the article, why raise in minimum wage pushes up the inflation rate.

Here is some of testimony which WSJ interviewed:

“Our business is a penny business,” he said. Overcoming higher labor costs “ultimately comes down to pricing.”Last year he raised prices 5% across all his restaurants, which span Fresno to the Bay Area, and said consumers haven’t flinched. Due to those price increases, he said, profits haven’t been hit by San Francisco’s escalating minimum wage.

Another saying that

Patrick Renna, CEO of boloco, a 22-unit burrito chain based in Boston, pays starting workers $9 an hour. State lawmakers are considering raising the minimum wage to as much as $11 an hour from $8 an hour. To offset labor costs, he has raised prices three times since 2010.

I presented cases in which price level gets increased to point out the cost of products often adjust to upward in order to offset the increase in wage cost. In addition, it seems from the article that rises in minimum wage made many workers happier, because of increase in wage. Trade off to gain higher inflation rate and save thousands of people out of poverty seems bit expensive to me, Congressional Budget Office estimated that raising the minimum wage to $10.10 an hour would reduce U.S. employment by 500,000 but lift 900,000 Americans out of poverty” Now we can hope that government use this force of inflation push wisely and create better jobs for 500,000 people whom lost their job due to the minimum wage increase.

Economic Development VS Keeping Environment Clean

On Jan 29th, Bloomberg reported that the State of New York will delay their decision on fracking regulation for natural gas until at least April 2015. For the people who are not familiar with the word ‘fracking’ I would like to give a brief introduction about the word, and why this is a hot potato in the state of New York. I guess, at the end, this is all comes down what human have faced since the beginning of the industrialization era. It is always really hard to make decision when one side gains, therefore another loses. With current fracking issue in New York, this seems the exactly the case. Fracking is somewhat different than conventional gas drilling method, because it uses mixture of water, sand and other chemical mixtures which can easily pollute drinking water. This is the biggest threat to the State of New York, because it can endanger people’s life. Environmentalists as well as many people in New York raise their voice and create the movement to protect their state from the pollution, in the contrast there are many people whose roots lie in pro-economic development side which favors drilling all the resources in the Marcellus Shale. Historically, data shows oil boom is very enticing deal because it can boost of economic health of that region. On April 4th, WSJ reported the positive economic benefit of fracking, The U.S. Energy Boom Lifts Low-Income Workers Too. This article summarized how oil boom can also bring positive externality to the region. For example, article mentions that oil boom can create more jobs as well as increasing wage of low income workers. Here is one of historical data analysis reported:

Before the Bakken boom in 2003, BLS data showed that average wages in all jobs in Richland County and Williams County were roughly equal to their respective statewide averages. In Richland County, wages averaged $30,000, or 91% of the Montana average. In Williams County, wages averaged $32,700, or 97% of the North Dakota average.

The data show that these counties now have average wages that have risen to 133% (Montana) and 170% (North Dakota) of their state averages. And wages in lower-paying jobs have also increased in inflation-adjusted terms and relative to the region. In Richland County, food-service wages have risen to 109% (from 80%) of the Montana average. In Williams County, wage growth has been even more dramatic—to 146% from 97% before.

People should not totally rely on statistical data since many times it can be misleading, however above data looks simple and shows straight forward wage increase. Still this does not mean economic benefit can weigh more than keeping environment safe. From my stand point of view, I would like to see more economic boom in New York and hope more people gets benefit from this potential oil boom, yet I am still unsure about how much I can trust the media saying, How to Make Fracking Safer, written in WSJ on April 4th, 2014. Forgive me for throwing out more questions to you. What should the governor of New York do? Should he wait for his next election and use this issue to favor where more voters sit, or favors pro-environmentalists over pro-economists or vice versa. Either way, I guess, it is not a decision to make but I would like to hear if more people will favor economic boom over the cost of ruining some of “our” nature.

Wild Guess on Global Inflation Eases.

On April 1st, WSJ article “OECD, G-20: Global Inflation Eases” had nicely summarized ongoing concerns of deflation risk which has been spread out globally. In Europe, ECB is willing to take further monetary policy easing in order to defend deflation risks. Deflation hurts economy in a serious way because value of all of debts increase. No one like to see their debts increase and this also hurts job markets as investors and companies are unwilling to finance their new projects knowing debt will increase. Historically, even only with these two components playing, Japan has struggled almost 15 years to escape from unwelcomed deflation spiral. Thus, marketing is spotting the danger and announcing it as early as possible. According to the WSJ, recent figures released “showed consumer prices rose in the euro zone by 0.5%, in Europe, In the U.S., the annual rate of inflation fell to 1.1% in February form 1.6%, while in Canada it dropped to 1.1% from 1.5%.; the annual rate of inflation fell to 2.0% from 2.5 in China, and 6.7% from 7.2% in India.”

Reading those figures in the article, I had to ponder why this trend of decreasing inflation is happening all around the world, especially many countries are lowering their short term interest rates by printing more money, thus pushing inflation rate upward. I know it is wrong to make direct comparison with decreasing inflation rate to actual deflation status, this is just not right. Yet, I have considered them to be somewhat similar in order to find possible cause of current global phenomena of inflation easing. However, I still have failed to find the vaild cause because it was too complex to determine.

Low inflation rate in each OECD countries probably have different stories which caused downward pressure in their inflation rate figure, yet I originally suspect that there would be a common problem which is linked with every global inflation easing. I thought this might be connected with the fact that countries’ exchange rate not being fully reflecting its true economic health. However, I have no proof for this. I do not blame you stop reading this after this, yet if you care to hear my wild guess, here is my unproven logic.

For example, U.S. is often reluctant to decrease the value of dollar even though decreasing the value of dollar will boost up their exports due to lowing price. Instead, U.S. wants to gain their comparative advantage in export by improving the quality of exports, such as having advanced technology. This is what other European countries as well as other G-20 countries would like to do, because the cost of devaluing its own currency is not cheap. The problem kicks in when those countries fail to attain comparative advantage over others who have been playing same strategies as your country, the costs loser have to pay are like, rise in unemployment rate and slow growth rate. The world may be playing no winner economic games, because it seems like everyone chips into the game but only end up losing something. What I am really try to say is that when countries try to artificially shift their AD curve and AS curve in order to gain more benefits from other countries, AD/AS curve does not behave what they had expected to behave because other countries mess up your AD/AS curve before you see your expected change in your AD/AS curve.

An Advice from Professor Martin Feldstein to Fed

On March 31, 2014 Martin Feldstein wrote an amazing article that is concise, well developed and most convincing article that I have ever encounter inside the Wall Street Journal. Title of this article is “The Fed’s Missing Guidance”. Martin Feldstein is an economics professor at Harvard University, and it seems that he is deeply involved in many economic research institutions as well as a writer for WSJ. I really recommend all of my classmates to read this article if you are looking for legitimate answers why potential inflation hike is such a hot topic and controversial issues in U.S. economy. In this sense, Professor Feldstein emphasizes that Fed should give more clear guidance to both public and market to understand how Fed is prepared to prevent the sudden inflation jump if it inevitable.

There are many people who merely believe that such a jump in inflation rate is very unlike, however, I think that is not quite true. Following Professor’s example should explain more of this straight forward:

Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later. That surge was not due to oil prices, which remained under $3 per barrel until 1973.

Still do not believe that there is only a fractional chance of seeing real inflation hike? Here is more. I hope you are familiar with the quantitative easing policy which Fed injected over 4 trillion dollars since the great recession. However, U.S inflation rate kept below 2%. Are you perhaps thinking about the Liquidity Trap? That is not the reason why price level has been stable. Extra money has been piling up inside the Federal Reserve Banks because commercial banks parked their money for the return of great interests and safety. In order to prove this point, professor said “the broad money supply (M2) increased only about 6% in the past year” and below is the graph from the Federal Reserve Bank of St. Louis Data.

fredgraph

 

I have created the graph showing percent change of M2 from Year ago, and it mostly hovers around 6 to 7 percent range. As Professor suggested, what this means is that Fed has been well paying commercial banks to keep them under control. Then, the real trouble comes next, according to Professor Feldstein:

The real source of the inflation risk is that the commercial banks can use their enormous deposits at the Fed to start lending when corporate borrowers with good credit ratings are prepared to borrow. That increase in lending to businesses will be welcomed until the economy is back at full employment.

Basically, when the commercial banks no longer needs the benefit of keeping their excessive reserve in the Fed’s vault and reaches the point where they do not need interchange bank loans, troubles turn into a disaster. Many banks will lend their excessive money to companies in order to collect higher interests than what Fed can offer. Professor talks about the reverse repo and how Fed has been testing the repurchase agreement to manage short-term interest rate, I also wrote a blog post on Monday about the effect of reverse repo. In fact, what I had not considered from my earlier post turn out to be problem for using reverse repo. Professor Feldstein said:

Repos may obscure the implied interest rate, but the repo strategy will not stop the Fed from losing money when it pays more than it earns on its bond portfolio. To be effective in preventing inflation, the Fed will have to push short-term market rates to a high enough level to deter excessive commercial borrowing.

Jumping into conclusion somewhat rapidly, Professor Feldstein suggests two potential solutions which itself brings another problem, yet enough to re-emphasize his original point that Fed should give more clear answers and guidance to market. One is increasing required reserve ratio and increase capital requirement on commercial banks. Both restrictions will allow more room for piling cash, thus allowing more stimulus while keeping price level steady. However, imposing those restrictions seem politically impassable. Regardless of its difficulty of their job, Fed still needs to provide clear explanations how they would deal with potential risks of inflation hike.

Rising of Reverse Repo

On WSJ article, Fed Officials Moving Slowly on Managing Rate-Increase Mechanics, has touched topic that is directly linked with keeping forward momentum or economic growth in the forthcoming of higher federal fund rate. Now is not the good time for raising federal fund rate, I am assuming that you agree economy still needs monetary stimulus; however it is true that Fed must deal with absorbing excessive reserve that continues to pile up in the U.S. economy. I cannot predict when Fed must take strong action to deflate some of bubbles that had been created due to their unprecedented monetary policy since October of 2008. However, sooner or later the time will come.

When the time comes, as always, Fed will face very difficult situation which they must decide the level of interest rate which can both keep economic boosts and reduce some risks of “bubble bursting”. Fed has ability to decide the short term interest rates but the difficulty is not coming from changing the interest rate, but dealing with the consequences afterwards. In order to minimize the risks of adjusting federal fund rate, Fed is diligently searching for the mechanics that will create the least hassles when interest rate increases. One of arising methods is using reverse repo.

I believe that combination of reducing bond purchasing with reverse repo will allow Fed to have more controlling power dealing with some of consequence of rising interest rate and with money supply control. Thus, let me briefly, introduce the term reverse repo. According to the investopedia’s definition of reverse repo or reverse repurchase agreement is that “the purchase of securities with the higher price at a specific future date. Repos are classified as a money-market instrument. They are usually used to raise short-term capital” In other words, a company gains advantage in financing their short term liquidity buy selling asset that can be repurchased in the short term. How Fed can use this money market tool to control the money supply, thus setting floor for a short term interest rate? Here is the advantage of using repo according the Federal Reserve Bank of New York:

How can an ON RRP facility help provide the Federal Reserve with greater control over short-term interest rates?  
In many ways, an ON RRP facility would operate similar to the way the Federal Reserve’s payment of interest on excess reserves works for depository institutions.  Absent other constraints, any counterparty that is eligible to participate in the ON RRP facility should generally be unwilling to invest funds overnight with another counterparty at a rate below the facility rate.  The effectiveness of the facility will depend on a range of factors, including whether a sufficiently broad set of counterparties has access to the facility, the costs associated with regulatory and balance sheet constraints, and the level of competition in the money markets. 

Adding my interpretation to this is that Fed can decrease the money supply by providing their counterparties or commercial banks and institutions more incentives to save their funds at Federal Banks, thereby decreasing the supply of money in the market. Of course, Fed has never used reverse repo in such a large scale which is required to deliver the “real” impact in the market. I agree with Charles Plosser, president of the Philadelphia Fed, during his interview with WSJ about using reverse repos. He said “There are a whole bunch of issues we haven’t explored”. He is absolutely right, however the benefits of having large scale of reverse repo is tempting to both financial markets and Fed. More precisely, fo0r example, companies and financial institutions can hedge their risk by not financing a long term binding deal with unsecure market, and at the same time, Fed can control its interest rate to borrow and payback, thus able to set a new bench mark for short term interest rate. It seems that both parties can gain what they want to stimulate economy. From now, just need enough small scale exercises to test the pitfall Fed handles a large scale of reverse repo, I believe NY fed is running many exercise and increasing the list of their counter parties. So be aware of the rising of reverse repo!