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(Revised) Should We Print Money For Aid?

I recently sat down to watch an interesting TED talk by Michael Metcalfe, a senior managing director at State Street Global Markets, who brought up a few interesting ideas about the way we fund our foreign aid programs. Metcalfe begins the talk by introducing a few interesting observations about the global economy. He first addressing the contradiction in foreign aid policy in developed countries. Metcalfe points out that, although the United Nations has put forth the incredibly ambitious Millennium Development Goals, which include halving extreme poverty rates and halting the spread of HIV/AIDS by 2015, the ratio of foreign aid to national GDP of developed countries has stagnated around 0.35%, even though aid targets remain at 0.7% of GDP. He asserts that foreign aid payments have also dropped since the financial crisis, and that progress towards our ambitious development goals will remain slow if this problem is not properly addressed. His solution? Simply print money for foreign aid.

At the basis of Metcalfe’s idea is the suggestion that the money supply doesn’t affect inflation as drastically as many believe. He explains that despite the U.S. Federal Reserve’s multi-trilion dollar asset purchasing program, the inflation rate in the U.S. has remained relatively unaffected 6 years later. Indeed, if we use the Consumer Price Index as a strong proxy for annual inflation in the U.S., then it does appear that the price level, apart from a small and temporary increase during the recession, hasn’t dramatically risen since the financial crisis. Screen Shot 2014-04-05 at 9.19.05 PMBuilding the foundation of his argument upon this information, Metcalfe asserts that we should take a fraction of the money that was printed to stimulate the economy and send it to countries who rely on U.S. foreign aid. Like a firm that matches the charitable donations of its employees, the U.S. central government could encourage the Federal Reserve to match its contributions to its annual foreign aid payments. Furthermore, since these payments would be going overseas, he explains that it’s not obvious how this form of funding would directly contribute to inflation in the central bank’s home country. According to Metcalfe, this could dramatically increase the amount of foreign aid payments to developing countries with limited risk to creating inflation and smaller requirements from the central government’s coffers.

At first glance this looks like a very interesting idea, and one that seems certain to garner praise. I mean, who wouldn’t want to eliminate eliminate global poverty with a few keystrokes from the FED? On the other hand, there do appear to be a few inconsistencies with his logic and methods that could prove problematic. First, I would be careful not to make the assumption that just because inflation didn’t appear to increase much after QE, that printing money doesn’t cause high levels of inflation. While it is true that the central banks of the U.S., UK, and Japan created around $3.7 trillion to help push the global economy out of a recession, that doesn’t mean that all of this money made it out into the economy. As we’ve all learned in Econ 102, the Federal Reserve adjusts the money supply though Open Market Operations, in which it buys securities from national banks. These banks are then supposed to take this newfound money and loan it out to individuals, whereupon it the money will have a multiplicative effect after individuals deposit their loans in other banks, who lend out a share of this money to other individuals, who deposit it in other banks, so on and so forth. A problem occurs, however, when banks decide not to lend money to individuals. This was an apparent phenomenon during the financial crisis when banks decided to hold on to the Fed’s newly invented money in in fears of the risk of financial collapse. We actually see there is a steep decline in the number of loans make by commercial banks after the financial crisis, so not all the money created by the fed actually entered the U.S. economy. Therefore, it’s not fair to use the Fed’s dramatic monetary policy and subsequent small blip in price levels during the recession as evidence that we could simply print money for aid without affecting inflation. Screen Shot 2014-04-05 at 10.25.44 PM

 

It seems surprising that a senior managing director and supposed global macroeconomic expert would make such a statement based on shaky evidence, so perhaps he is more privy to the more quantitative effects of QE on inflation than he lets on in his talk (he only has 15 minutes after all). Regardless, I would also contend that his strategy may also fail on practical terms as well.

Let’s assume that hypothetically the Fed liked this idea and wanted to enact this as part of its monetary policy. In order to legally make the donation, the Fed would likely have to enact open market operations in foreign countries by buying up bonds from central banks (or, if absent, the central government) in developing countries. While the Fed might expect that the banks would lend this money out to the citizens, thus stimulating the local economy, this may backfire given higher levels of corruption in these developing countries (corrupt and ineffective governments are often important reasons why many countries remain in the “third world”). Many of the most impoverished countries do in fact score highest on indices of political corruption, such as Sudan and Haiti. These banks and governments may decide to shower the money upon themselves, leaving the citizens still impoverished. Furthermore, government debt in third world countries is likely to be far riskier than in developed countries, and the bonds are more likely to loves their value and perhaps even become worthless. In these cases the Fed might be accused of the wasteful funneling of money to corrupt dictators and enterprises. Therefore, it would be unlikely that the Fed could effectively channel foreign aid to developing countries and ensure that the funds would reach the citizens and companies that need them most.

Overall, these are only a few of the many problems the Fed would face if it actually decided to consider this type of policy. It appears that there may be some large problems in Mr. Metcalfe’s solution to the foreign aid gap that would have to addressed before this could become feasible government policy.

 

Fed’s remarks influential in Stock Market performance today

All of the markets were up today on a solid Yahoo earnings report and factory output data but I believe that there was a bigger signal that caused the market to rise almost 1%.  Yellen announced today that the Fed weighs three big questions when they analyze the economy to determine if the economy is healthy enough to raise interest rates.  The Fed focuses on low inflation, labor-market slack and an unknown third.  Yellen stated today in a speech to the Economic Club of New York that the Fed believes a too-low inflation rate is a bigger worry than easy money causing a hike in consumer prices.  The Fed is also still worried about the labor market even with the positive report that came out last week.  The Fed’s remarks continue to illustrate their concern about the economy and the labor market even though there have been positive signs of growth.  Full employment is now thought to be somewhere between 5.2% and 5.6% and the Fed doesn’t expect to meet its goal of full employment and price stability till 2016 at the earliest.  Many analysts believe that the interest rate will begin to increase sometime around the middle of 2015.  Many of the Fed’s policy opponents consistently worry about high inflation.  The Fed though, believes that it is more likely that inflation stays below 2%, which would make it really difficult for businesses and households to pay off their debts.

At the end of the day, I believe that the Fed has a dramatic influence over the stock markets.  The markets had a scare last week with the positive jobs report and this led to a large sell off in the technology sector because investors were afraid of losing the easy money from the Fed.  The Fed’s announcement today gives investors a sign that the low interest rates are going to continue for a while.  While many people might view the Fed’s reports that the economy isn’t as healthy as we would like as a bad announcements, the markets actually viewed this as a positive report.  I believe that the market no longer takes into account “negative” outlooks from the Fed because the sentiment is that the this means the Fed will continue with its buy back programs.  The negative outlook of Yellen’s announcements helped lead to a rise in the stock market while last month’s Fed announcement that it no longer considered an unemployment rating of 6.5% as grounds to maintain low interest rate caused the market to drop.  It’ll be interesting to see if the trend in Fed’s announcements and the stock market continue to be inversely correlated.

Don’t Blame Ben!

The Economist has a comment on central banks financing governments in the wake of the financial crisis. Basically, the point is that central banks that did QE bought tons of government bonds. At the same time, at least some of them – the Bank of England, for example, but the Fed as well – wrote their respective governments a yearly check, transferring any profits they made (after paying salaries). They always do that, but now, some of the money they made was from interest earned on their huge government bond positions. So the government paid them interest, they collected it, and at the end of the year sent it back to the government. Which, you know, isn’t too far from monetizing government debt – i.e. financing the government.

But what’s the problem? In the continued absence of hyperinflation, you might conclude that there really isn’t much of an issue here. However, says the Economist:

But another reason why monetisation has always been frowned upon is that it is an easy option. Why should governments finance spending with unpopular taxes or borrow from suspicious bond investors when they can get the money from a friendly central bank? The process makes democratic leaders less accountable; by boosting asset prices, which are mostly owned by the rich, it may well have led to a rise in inequality, without the sanction of any vote. Perhaps in ten or 20 years’ time, recent events will be seen as the moment the world crossed a line.

I have a couple of miscellaneous points on this, and one bigger point on the idea that this promotes inequality.

Why government bonds?

One of the questions we have to ask ourselves in this context is obviously, why only allow the central bank to buy government bonds (and a very limited set of other ‘save’ assets)? We obviously had this discussion in class: the Fed (or BoE, or other central bank of your choice) being able to buy stocks would give them a lot more firepower. They could reduce interest rates that are much further from zero than a three-month T-bill. Beyond that, buying stuff that isn’t issued by the government also means you’re not monetizing government debt. So here’s another argument for giving the Fed freer reign with regards to asset purchases!

Who’s afraid of government financing?

The Fed, BoE, and central banks around the world generally pay their governments yearly checks, even in times when none of their profits come from interest on government bonds. Something has to happen with their profits! Sure, if the US, England or other places had a sovereign wealth fund, that would be one place to put them, and it might be at least semi-autonomous from the government. So that’d be nice. But nobody has those, so not an option right now. But yet another reason to have them!

By the way, in better times, central banks raising interest rates hurts the government, in so far as that it has to pay higher interest on newly issued bonds. So it’s not clear that the government generally benefits from central bank actions, at least not directly (although it does reap the benefits of a smoothly running economy if the central bank does a good job and doesn’t have to worry about the ZLB).

Inequality and all that

The point about QE raising asset prices and helping the rich is actually quite interesting. For one thing, QE also reduces interest rates (that’s just the flip side of higher asset prices), so it’s not quite clear that all rich people benefit from it. Specifically, the classic rentier would actually suffer. On the other hand, people sitting on tons of assets may of course benefit. but the question is: when did they acquire those assets?

If they held them throughout the financial crisis, chances are they’re about back to break-even now, because they probably copped huge capital losses throughout the crisis. If they bought them right in the depth of it, well… smart investment on their part, but some of their profits were certainly subsidized by the central bank. The question is: did the Fed (BoE, any other central bank) have an alternative strategy, given the ZLB? Not in the absence of electronic money. And not doing anything would have prolonged the crisis. It’s not obvious to me that the middle class or the poor would have preferred a longer crisis to what we had. So as long as we’re unwilling to have electronic money – this is as good as it gets!

I think that next time (which I’m sure will be different) we should have a new set of tools at the ready. That may contain a sovereign wealth fund, a more powerful central bank, or electronic money. And maybe that way, expansive monetary policy – which was absolutely necessary, macroeconomically speaking – won’t have as many side-effects as it may have had this time around, and be more effective. But ultimately, it’s difficult to fix the economy without the rich taking their share of the recovery. And more importantly, that’s not the central banks domain; distribution is government’s domain. And if it’s unwilling or unable to act, don’t blame Ben (Bernanke, or really any other central banker)!

Fed Officials Expect Overshooting Unemployment Rate

Following the Fed’s March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are “based on FOMC participants’ individual assessments of appropriate monetary policy.” Therefore, these number’s aren’t actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials’ own appropriate policy. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member’s policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed’s policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

ProjectionFed_March

 

From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials’ expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn’t always mean expansionary monetary policy as Milton Friedman put it, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

ProjectionFed_MarchUn

 

The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed’s future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation

 

As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed’s target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn’t be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials’ projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.– if we assume these projections are made with rational expectation

How fast is too fast for the Fed?

At the March FOMC meeting, Narayana Kocherlakota,the president of the Federal Reserve Bank of Minneapolis, dissented against the issued statement, objecting to the lack of numbers based guidance in regards to the taper.  According to WSJ, Mr. Kocherlakota, “believed the change in the Fed’s language weakened its commitment to push very weak levels of inflation back to the official target of 2%”.  Instead, he wanted to make 5.5% unemployment the new threshold for raising short-term interest rates.  Keeping interest rates low until unemployment reaches 5.5% could take some time, and is certainly a more stimulate monetary policy than that of the current Fed regime.  This so-called forward guidance would further drive down long term interest rates, and potentially stimulate the economy further.

While I may be slightly pessimistic about the recovery of the American economy, I’m not sure the Fed needs to have as loose of a monetary policy as Mr. Kocherlokota desires.  Despite that disagreement, I believe it would be wise for the Fed to make it’s trigger for raising interest rates less nebulous than in the most recent statement.  Even though I believe a 5.5% unemployment target might be too extreme, it certainly sends concrete and easy-to-interpret signals to the financial markets about the Fed’s future policy actions.

The vagueness of the Fed’s statement about keeping interest rates near zero “for a considerable  time” after the taper ends seems especially strange in light of recent G-20 summits that were “essentially all about clearer communication”.  I believe the Fed risks global instability when signals that could be interpreted in a variety of ways.

Others in the financial community have other worries about the policy of the Fed.  A recent International Monetary Fund  (the full report is here) report warns that if the U.S. grows faster than expected and begins raising interest rates too soon, the global economy would be weaken as a result of the increased borrowing costs for emerging nations.  The IMF warns that a slowing growth in emerging markets might cause investors to pull money out of those countries and result in a global shockwave, perhaps a worse version of what we saw earlier this year.  This is essentially a call for the Fed to be more cautious about the effect that their policy has on the world economy.  As I wrote about in a previous post, I don’t believe that the Fed should worry too much about the global economy when setting their own policy.  The Fed’s stated dual mandate is to help the U.S. economy achieve full employment and stable inflation levels, not to ensure global market stability.unemploymentcpi

The case of Mr. Kocherlakota and the opinion of the IMF provide both an internal and external criticism of the current Fed policy.  Both seem to be indicating that the Fed should wait longer than expected to raise interest rates and return the economy to normalcy.  As the graph to the right shows, employment has been steadily dropping over the past several years (although the unemployment situation is worse than the number implies), but inflation been much lower than the desired two percent target.  These two facts combined seem to support Mr. Kocherlakota’s argument that the Fed enacting a more stimulative monetary policy would be more in line with the stated goals of the Fed.  A more stimulative policy would keep interest rates near zero longer, coinciding with the IMF’s desire for lower rates.

However, there is certainly a downsize to the Fed making their policy more stimulative.  A change in it’s course could destabilize markets and increase uncertainty.  Perhaps the Fed doing a “good enough” job that everyone is currently positioned for would be better for the economy than the Fed strongly adjusting it’s expectations for a slightly expedited recovery.  Frankly, determine the benefits from either policy is difficult, and personally I would prefer stability in such a situation.

Pros and cons in Larbor Market’s update for March

The labor market has its track on a gradual improvement. According to the Labor Department’s address yesterday, nonfarm payrolls rose a seasonally adjusted 192,000 in March and figures for the prior two months were revised up by a combined 37,000, and the unemployment rate stays at 6.7%. Even though many expected strongly a sharp upward trend in labor market early this year, the sheer number of new-added payrolls were not performed as so.

Ever since the recession start from 2008, the job supply was struck down to a low point where over 8.8 million positions were lost during the crisis. It is said that the private part jobs hit a level that surpass the apex before recession, while the government positions still remain well below the peak.

The moderate growth in jobs addressed by Fed chairwoman Janet Yellen as a cause for pausing the plan of raising interest rate. She seems to worry that those signs of softness in labor market imply the economy is still on its way toward positive. Her points suggest that the figure of unemployment rate cannot work as a mere criteria to evaluate market’s health.

Besides that, we already knew that there is a big reason behind the declination of unemployment rate, which is more and more jobless people are giving up on seeking new positions. Those people’s quit shrank the denominator and narrowed the unemployment rate. According to CNN, 347,000 people dropped out of the workforce last December and drag down the participation rate for men alone matched a record low dating back to 1948. If add up the share for women, the number still weaker than is was in 1978.

This March, only 63.2% of Americans 16 or older are participating in the labor force, a number even higher than past months. In fact, the participation rate has been declining since the year 2000, but the 2008 recession accelerate this progress. There is a substantial question raised after all this: Where Have All the Workers Gone?

One possible explanation given in this article in WSJ is that the expansionary monetary policy raises the risk of inflation and shrinks the paycheck, thus subdues their inspiration of job seeking activities. This could be the reason for those who earn few from hourly work but may be irrelevant for those who get high paid. However, I think people who quit pursuing a job must earn their lives somewhere else, in this case, I think investment in stock market could be the new source of income for them. The rumor about minimum wage policy could also play a role in this. Millions of American are working part-time. Those jobs could be affected severely by a bit raising in minimum wage. But mostly, I think the long-last softness in labor market caused more people to lost faith and choose to quit.

It’s been a long way to go before reaching the normal economy level and get unemployment rate back to its healthy situation. However, the participation problem is becoming severely and required for more attention.

Should We Print Money For Aid?

I recently sat down to watch an interesting TED talk by Michael Metcalfe, a senior managing director at State Street Global Markets, who brought up a few interesting ideas about the way we fund our foreign aid programs. Metcalfe begins the talk by introducing a few interesting observations about the global economy. He first addressing the contradiction in foreign aid policy in developed countries. Metcalfe points out that, although the United Nations has put forth the incredibly ambitious Millennium Development Goals, which include halving extreme poverty rates and halting the spread of HIV/AIDS by 2015, the ratio of foreign aid to national GDP of developed countries has stagnated around 0.35%, even though aid targets remain at 0.7% of GDP. He asserts that foreign aid payments have also dropped since the financial crisis, and that progress towards our ambitious development goals will remain slow if this problem is not properly addressed. His solution? Simply print money for foreign aid.

At the basis of Metcalfe’s idea is the suggestion that the money supply doesn’t affect inflation as drastically as many believe. He explains that despite the U.S. Federal Reserve’s multi-trilion dollar asset purchasing program, the inflation rate in the U.S. has remained relatively unaffected 6 years later. Indeed, if we use the Consumer Price Index as a strong proxy for annual inflation in the U.S., then it does appear that the price level, apart from a small and temporary increase during the recession, hasn’t dramatically risen since the financial crisis. Screen Shot 2014-04-05 at 9.19.05 PMBuilding the foundation of his argument upon this information, Metcalfe asserts that we should take a fraction of the money that was printed to stimulate the economy and send it to countries who rely on foreign aid. Like a firm that matches the charitable donations of its employees, the U.S. central government could encourage the Federal Reserve to match its contributions to its annual foreign aid payments. Furthermore, since these payments would be going overseas, he explains that it’s not obvious how this form of funding would directly contribute to inflation in the central bank’s home country. According to Metcalfe, this could dramatically increase the amount of foreign aid payments to developing countries with limited risk to creating inflation and smaller requirements from the central government’s coffers.

At first glance this looks like a very interesting idea, and one that seems certain to garner praise. I mean, who wouldn’t want to eliminate eliminate global poverty with a few keystrokes from the FED? On the other hand, there do appear to be a few inconsistencies with his logic and methods that could prove problematic. First, I would be careful not to make the assumption that just because inflation didn’t appear to increase much after QE, that printing money doesn’t cause high levels of inflation. While it is true that the central banks of the U.S., UK, and Japan created around $3.7 trillion to help push the global economy out of a recession, that doesn’t mean that all of this money made it out into the economy. As we’ve all learned in Econ 102, the Federal Reserve adjusts the money supply though Open Market Operations, in which it buys securities from national banks. These banks are then supposed to take this newfound money and loan it out to individuals, whereupon it the money will have a multiplicative effect after individuals deposit their loans in other banks, who lend out a share of this money to other individuals, who deposit it in other banks, so on and so forth. A problem occurs, however, when banks decide not to lend money to individuals. This was an apparent phenomenon during the financial crisis when banks decided to hold on to the Fed’s newly invented money in in fears of the risk of financial collapse. We actually see there is a steep decline in the number of loans make by commercial banks after the financial crisis, so not all the money created by the fed actually entered the U.S. economy. Therefore, it’s not fair to use the Fed’s dramatic monetary policy and subsequent small blip in price levels during the recession as evidence that we could simply print money for aid without affecting inflationScreen Shot 2014-04-05 at 10.25.44 PM

 

It seems surprising that a senior managing director and supposed global macroeconomic expert would make such a statement based on shaky evidence, so perhaps he is more privy to the more quantitative effects of QE on inflation than he lets on in his talk (he only has 15 minutes after all). Regardless, I would also contend that his strategy may also fail on practical terms as well.

Let’s assume that hypothetically the Fed liked this idea and wanted to enact this as part of its monetary policy. In order to make the donation, the Fed would have to enact open market operations in foreign countries by buying up bonds from central banks (or, if absent, the central government) in developing countries. While the Fed might expect that the banks would lend this money out to the citizens, thus stimulating the local economy, this may backfire given higher levels of corruption in these developing countries (corrupt and ineffective governments are often the reason why many countries remain in the “third world”). Many of the most impoverished countries do also score highest on indices of political corruption, such as Sudan and Haiti. These banks and governments may in some cases decide to shower the money upon themselves, leaving the citizens still impoverished. Furthermore, government debt in third world countries is likely to be far riskier than in developed countries, and the bonds are likely to become worthless. Therefore, it would be unlikely that the Fed could effectively channel foreign aid to developing countries and find the money reaching those that need it most.

Overall, it appears that there may be some large problems in Mr. Metcalfe’s solution to the foreign aid gap that would have to addressed before this could become feasible government policy. 

 

Overshooting Unemployment Rate

In recent discussions regarding the Fed’s timing of raising the interest rate and stopping the QE, the possibility of overshooting the unemployment rate to make sure the the economy doesn’t slip back to the panic after the Fed’s move. What overshooting the unemployment rate means is that the Fed waits the unemployment to get below “natural rate”, let’s say 5.5 percent, to raise the interest rate. Advocates of overshooting say that by doing so, the economy can gain lost capacity during the recession, and slightly higher inflation and nominal interest rate can benefit the economy in terms of more monetary policy room to kick another panic.

This argument of overshooting unemployment rate is one of the fundamental macroeconomics topics Milton Friedman addressed in his 1967 American Economic Association speech, titled “The Role of Monetary Policy”. According to him, lower than “natural” rate of  unemployment can be achieved through only increasing inflation. The key word here is increasing, since at the moment when he gave the speech, there was spreading view that there is trade-off between higher inflation and lower unemployment. Friedman argues that when the central bank raises the quantity of money supplied by buying bonds, it increases the money supplied higher than the amount people want to hold; therefore, it reduces the nominal interest rate and increase demand for goods. Companies would respond to increase in demand by first supplying more of the goods without increasing the prices. But eventually price would adjust to the demand by rising. At the same time, wages doesn’t rise as much as the price rises. Therefore, real wage would be decreased during this phase. 

Decreasing real wage would lead to higher employment. This is why we could see higher employment or lower unemployment through unexpected inflation rise. However, once the workers starts including the higher inflation rate to decide what wage to receive, they demand higher wages. Since the unemployment was lower than natural rate and the higher wage demand, the real wage starts increasing. The increase in real wage would then increase unemployment back to the normal level. If then the policymakers still want to pursue lower than natural unemployment rate, they now have to increase the supply of money  at higher than previous rate. Hence, we could see increasing price level or inflation as this process goes on forever until the policymakers decides to not target unemployment rate lower than natural rate.

How this discussion relates to current policy making is that if the Fed decides to pursue the unemployment rate below natural rate, 5.5 percent in our case, permanently, the Fed will face a problem of increasing inflation. i believe, the Fed will pursue it for one or two years if it indeed decides to it. Even though one or two years isn’t permanent, it is neither temporary. Therefore, the Fed will face some inflationary pressure. Some might say there won’t be high inflation since we are having low inflation now, but at the moment we pass the natural rate of unemployment, say 5.5 percent, the inflation will be back to the level of normal times.

When making decision of pursuing a low level of interest rate even after the unemployment rate reaches natural rate, the Fed policy makers should calculate the risk of increasing inflation.

(Revised) Fed Keeps Steady Policy Course

In the past months, the Federal Reserve has executed a steady tapering in their purchases of  long-term treasury bill and mortgage backed securities, although not without opponents.  As expected, the Fed voted in January to reduce the QE scheme from $75 billion to $65 billion in purchases, in the midst of slumping developing markets, and the exchange rates of many foreign currencies fell in response to changing expectations in the domestic market.  As U.S. investors saw potential for higher U.S. returns as government demand for T-bills decreased, they pulled funds out of foreign markets, causing net capital outflows and the weakened currencies in those markets.

By continuing with the intended tapering policy, the Fed made a decision not to consider the potential adverse effects of their decision on foreign markets.  In fact, “Fed officials made no mention of these trends in the statement released [in January].”  In recent years, this has been the general strategy of the Fed, with chairman Ben Bernanke stating in 2011, “It’s really up to emerging markets to find appropriate tools to balance their own growth.”  Foreign central banks took this policy to heart in January, with the Turkish central bank raising it’s overnight lending rate over 400 basis points , and other small central banks enacting similar policies.  While their policies weren’t very effective, these emerging markets clearly understand that the U.S. will not shape their policy to accommodate them.

At the March FOMC meeting, the Fed stuck to it’s stated plan, further tapering purchases from $65 billion to $55 billion in the coming months.  Perhaps the key feature of the March statement was the change in language about when the federal funds rate would start to rise.  No longer was the the federal funds rate to float between 0 and 25 basis points, “at least as long as the unemployment rate remains above 6-1/2 percent” as in the January press release. Instead, the March statement stated rates will remain low, “for a considerable time after the asset purchase program ends”.

 

fredgraph

This key feature highlights the Feds respect and compliance with their dual mandate to both keep inflation and employment at their natural levels.  The March statement cuts the tie between unemployment and the federal funds rate.  As Chairwomen Yellen has mentioned recently, the labor market is still weak, and has much room to improve despite the increase in employment.  The graphic illustrates how unemployment has dropped, but along with it labor force participation as well.  These facts, coupled with the increase in workers only able to find part time employment skew the actual health of the economy, and thus why the Fed has stepped away from using unemployment as a measure for the economy as a whole.

fedholdingscpi

Although the Fed has seemingly deviated from past statements, the policy actions are consistent with their overall mandates.  The Fed initially chose a 6.5% unemployment number to try and avoid overheating the economy and driving inflation up.  However, this is no concern, because inflation has actually been far lower than desired in recent years, hovering between one and one and a half percent, despite the influx of money into the economy by way of the present quantitative easing.

I believe that the Fed has made the correct decision not to react to the fluctuations in the foreign markets or faulty economic data in their recent policy decisions. The Fed has recently show discipline not to venture from solid fundamentals and also to be willing to adjust expectations to what is best for the economy.  Although unheralded, the Fed has been key in propelling the economy towards recovery and stability, and has probably save tens or hundreds of thousands of jobs.

Fed, Raise the Inflation Target

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”. In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?