Wednesday, April 27, 2011

Fed Funds Trajectory - Before and After the Fed Annoucement

Fed Funds futures fell very slightly in response to today's speech and Q&A with Bernanke. Take a look at the response in other markets.

S&P 500
Before : 1347
After : 1357

2 year
Before : 0.66
After : 0.64
10 Year
Before : 3.35
After : 3.35
30 Year
Before : 4.42
After : 4.45

Inflation Expectations (based on 2 year inflation swaps)
Before : 2.66
After : 2.65

Bloomberg Commodity Index
Before : 1764.38
After : 1766.98

There's nothing shocking here because there was nothing shocking about the Bernanke's speech. Still, all of these moves are entirely consistent with the view that 1) The Fed can increase AD -- and that 2) Higher AD won't push prices significantly higher, even in the short run.

It's also worth noting that 30 Year Treasury yields rose 6.9 basis points today, while 30 Year TIPS rose 5.6 basis points. 10 Year Treasury yields rose 4.8 basis points and 10 year TIPS rose 4.5 basis points. That strongly implies that higher interest rates (as well as higher equity and commodity prices) are not a result of higher expected inflation, but of higher expected real growth.

Monday, April 25, 2011

Don Boudreaux makes a good point (about why NGDP should be the focus of macro)

On this podcast Don Boudreaux makes the best argument I've heard in defense of the Fed's monetary policy since 2008 (ironic, since he is anything but a friend of the Fed), at least if you think like the typical economist.

He asks what the difference is between changing the rate of inflation from say, 14% to 4% is from changing it from 3% to 0%.

It could be argued that at 4% inflation real wages were gradually pushed down whereas at 0% they aren't, but all things considered his point stands up very well so long as you are focusing on inflation.

If you look at NGDP however, this question can be easily answered. The Fed hasn't allowed NGDP to adequately grow. Compare the early 80's with the late 00's for example.

FRED Graph

FRED Graph

Looking at it like this it's pretty obvious that money was tighter in the Great Recession than in the early 80's.

Boudreaux also makes the Austrian argument that inflation should be defined as an increase in the money supply as opposed to an increase in the price level. I've never really understood this. I suppose Austrians are implicitly trying to apply the negative associations people have with the word "inflation" to increases in the money supply, which Austrians don't like. But people don't care about the money supply, they care about inflation.

And what about the early to mid 90's, when the money supply fell and velocity rose? Will Austrians really admit that they thought this period was deflationary? If not, they are admitting that velocity matters. If velocity matters than the recent, massive decline in velocity merits an equally large increase in the money supply. If only the money supply matters then I guess they don't really believe that the supposed stock market bubble was caused by monetary policy, not in the way they define it anyway.

(Edit: Another obvious problem with lowering the inflation target is that we were in the midst of a financial crisis!)

Fetishization of the First Derivative, Food, and Energy

We keep hearing inflation hawks claiming that inflation is upon us. This claims can only be taken seriously if one ignores price levels and focuses on year over year changes in prices.
FRED Graph

It's quite clear that headline CPI (meaning including food and energy prices) is still well below its longer term trend.

Another claim is that rising food and energy prices somehow more accurately reflect inflation than non-food and energy prices. This is another reason we should focus on NGDP and not CPI inflation. NGDP is clearly below trend, and is continuing to grow below its trend rate. Unless this changes, there either 1) no risk for inflation, or 2) nothing the Fed should do about it.

1) If this recent bump in inflation doesn't coincide with higher NGDP growth, not only shouldn't the Fed worry about it, they should try ease policy more. Any response to the recent "bout of inflation" will lead to more instability, not less. Unless we see higher NGDP growth, we can't see higher inflation unless the US undergone a real supply shock.

2) Now, if the US has undergone a supply shock and its productive capacity is greatly below 2008 levels, the Fed is damned either way. Either they can allow higher inflation (and keep NGDP growth at a similar rate), or they can keep inflation "in check" at ~2% (even though CPI is still well below trend!) and allow much higher unemployment (lower NGDP growth). Given the fact that unemployment is 8.8%, I think it's obvious that higher inflation would be preferable in this case. It would erode real wages and real debts could lower unemployment and reduce housing/financial problems.

The good news is that, at the moment, case #1 appears to be correct.

FRED Graph