Fed Funds and Aggregate Demand 8/4/2011

Data from : http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html

S&P 500

May 11 : 1342.08
June 8 : 1279.56
July 7 : 1353.22
August 4 : 1200.07

Treasuries

2 year

May 11 : 0.55
June 8 : 0.38
July 7 : 0.47
August 4 : 0.26

10 Year

May 11 : 3.18
June 8 : 2.94
July 7 : 3.16
August 4 : 2.42

30 Year

May 11 : 4.29
June 8 : 4.19
July 7 : 4.38
August 4 : 3.69

Inflation Expectations

2 year inflation swaps

May 11 : 2.16
June 8 : 2.01
July 7 : 1.92
August 4 : 1.65

5 Year TIPS Breakeven rate

May 11 : 2.19
June 8 : 2.02
July 7 : 2.10
August 4 : 1.79

10 Year TIPS spread

May 11 : 2.42
June 8 : 2.27
July 7 : 2.49
August 4 : 2.22

30 Year TIPS spread

May 11 : 2.53
June 8 : 2.45
July 7 : 2.67
August 4 : 2.58

Bloomberg Commodity Index

May 11 : 1672.35
June 8 : 1713.68
July 7 : 1717.93
August 4 : 1660.55

EUR USD

May 11 : 1.4249
June 8 : 1.4577
July 7 : 1.4351
August 4 : 1.4105

(Data from bloomberg.com)

Expectations have fallen dramatically the last couple weeks. Fed intervention of some kind is likely, but we still don't exactly know what the Fed's goal is. Will they react to past inflation rates? Commodities? Job growth? Financial markets? Inflation expectations? Only the FOMC knows. We also don't know how they'll intervene exactly. Hopefully they'll try something more flexible than QE2 was.

Here are predictions I made a couple of months ago. I think they've held up pretty well. The only thing I was off on was underestimating the importance of Europe's debt troubles. Although Europe's woes are also caused by tight money (the European Central Bank seems more concerned with what's good for Germany than what's good for Europe as a whole), there's no reason they should be lowering U.S. NGDP unless the Fed doesn't respond to higher dollar demand... but the Fed isn't responding (at least not until things get really bad), so Europe's woes are lowering U.S. NGDP.

No Surprises Here - Let's Hope Bernanke Has Learned His Lesson

Stocks, commodities and long term bond yields all rose in response to Bernanke's testimony today. Expected fed funds rates fell, which suggests any more stimulus is more about postponing tightening than anything else.

If the Fed does need to engage in additional asset purchases (and I think it's extremely likely it will) it should use more flexible policies than it did in QE2. Instead of announcing in advance it will purchase $X in bonds over a certain time period, the Fed should purchase or sell (if the economy improves rapidly) as many bonds as it needs on a month to month basis in response to changing economic circumstances. This would allow them to seamlessly transition between tightening and easing as if they were controlling the fed funds rate.

Better late than never...

How QE2's Announcement and Premature End Affected Asset Prices

Firstly, let me justify the beginning and end dates for QE2.

I consider August 27, 2010 to be the effective beginning of QE2. On this day Bernanke delivered the Jackson Hole speech in which he first hinted at another round of quantitative easing for the purpose of stimulating aggregate demand.

I consider April 27, 2011 to be the effective end of QE2 (although it would be more accurate to say "the end of any chance for additional easing of any kind unless things get much much worse"). The key quote by Bernanke was this :

“The trade-offs are getting — are getting less attractive at this point. Inflation has gotten higher. Inflation expectations are a bit higher. It’s not clear that we can get substantial improvements in payrolls without some additional inflation risk."

He hasn't given any indication he has changed his mind since, or that he plans to pursue any other form of easing.

Now that you know where I'm coming from, let's look at some asset prices!

No form of assets responded more clearly to the announcement and effective end of QE2 than equities did. Higher equity prices reflect better economic expectations and those expectations can become a self fulfilling prophecy through Tobin's q and wealth effects. Perhaps more importantly, higher stock prices also partially reflect a lower demand for dollars and that decreased demand immediately increases nominal spending. Also note the fall after QE2's "end".

Similarly, inflation expectations seem to have been strongly influenced by QE2's announcement. Again note the fall since QE2's end.

Treasury yields also noticeably rose in response to QE2. Many have pointed out that QE2 was supposed to reduce yields and have pointed to their rise as evidence against QE2's effectiveness (ignoring equity prices and inflation expectations), but higher yields were actually reflecting higher inflation real growth expectations. As Milton Friedman and Frederick Mishkin have pointed out, interest rates are NOT a reliable indicator of monetary policy and low interest rates can (and do) signal that money is tight. Higher interest rates usually reflect a healthier economy when rates are this low. Unsurprisingly, the lower rates of the past month have been associated with worsening economic conditions.

Finally, the dollar has almost certainly fallen as a result to QE2. A falling dollar can be a bad sign if it is associated with high inflation (or supply side issues), but high inflation is still not a concern. In this case, a falling dollar helped increase net exports (by cheapening domestic goods) and as reflected less dollar hoarding (which is associated with lower V and more NGDP at any given supply of money). And once again, just as any prospects for additional easing ended the dollar began to rise.

Several excellent economists including John Cochran and James Hamilton have expressed doubts about the effectiveness of QE2. It's true that from a purely mechanical perspective, QE2 was likely irrelevant. So why the impact on markets?

The most likely explanation is that QE2 impacted medium term (2-10 years in the future) NGDP expectations. Anything the Fed can do to convince people that they will push for a higher NGDP in the future will improve expectations. Improved expectations have immediate effects on NGDP as they raise expected inflation/real growth and reduce the demand for dollars (thereby increasing V) today.

If this is the case, why does the Fed seem so uncomfortable with higher future NGDP? I think it's mostly a year over year % change issue versus a level targeting one. The Fed is worried that even temporarily higher rates of inflation and NGDP growth (to catch up to past trends) will be hard to push back down. That would be reasonable if expected inflation was above 3%, but at barely 2% these concerns are completely unjustified. The Fed is also likely concerned about bubbles, but with unemployment at 9% and a tremendous amount of slack in the economy, those concerns need much more justification and evidence backing them before they can be legitimately used to prevent easier policy.

(Half way through creating this post I saw that Marcus Nunes beat me to it and posted something very similar. He makes somewhat different -- although equally valid -- points)

In the next few days I'll post something similar regarding the impact of QE2 on economic data.

Fed Funds and Aggregate Demand Watch 6/8/2011

Data from : http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html

S&P 500

April 27 : 1357

May 26 : 1325.69

June 1: 1314.55

June 8 : 1279.56

Treasuries

2 year

April 27: 0.64

May 26 : 0.48

June 1: 0.44

June 8 : 0.38

10 Year

April 27 : 3.35

May 26 : 3.06

June 1: 2.95

June 8 : 2.94

30 Year

April 27 : 4.45

May 26 : 4.22

June 1: 4.14

June 8 : 4.19

Inflation Expectations

2 year inflation swaps

April 27 : 2.65

May 26 : 2.12

June 1: 2.05

June 8 : 2.01

5 Year TIPS Breakeven rate

April 27 : 2.35

May 26 : 2.07

June 1: 2.01

June 8 : 2.02

10 Year TIPS spread

April 27 : 2.6

May 26 : 2.34

June 1: 2.28

June 8 : 2.27

30 Year TIPS spread

April 27 : 2.68

May 26 : 2.47

June 1: 2.42

June 8 : 2.45

Bloomberg Commodity Index

April 27 : 1766.98

May 26 : 1684.28

June 1: 1691.51

June 8 : 1713.68

EUR USD

April 27 : 1.4738

May 26 : 1.4129

June 1: 1.4329

June 8 : 1.4577

(Data from bloomberg.com)

Markets were mixed relative to last week. Stocks fell, commodities rose, and bond yields were mixed. Expected fed funds rates fell in reaction to Bernanke's speech; whether this reflects easier or tighter policy isn't completely obvious, but the fact stock prices fell in reaction suggests the lower rates reflect tighter policy. All things considered, market expectations over the past week would be best labeled as "disappointing". I stick with my previous prediction.

An Unsurprisingly Unsurprising Press Conference

But Bloomberg gets it. It can't be any more obvious markets want easier money. That's a pretty clear refutation of the US being in a liquidity trap. If markets believe monetary policy can work, then monetary policy can work (by reducing the demand for money).

That only leaves those who believe additional monetary stimulus will cause undesirably high inflation... But inflation expectations remain low, and prices are still below their long term trend.



In addition, whatever Bernanke means by "faster growth" isn't fast enough, and I don't expect stronger growth until the Fed takes additional actions.

What is Bernanke thinking?

Many good economists have expressed dismay at Bernanke's behavior during this recession. If they could have picked any man to preside over a financial crisis and zero interest rate policy at the Fed, Ben Bernanke would have been their first pick. So were they wrong?

I don't think so. While the chairman of the Federal Reserve is undoubtedly the most powerful member of the Fed, he certainly doesn't make policy decisions by himself. The Federal Reserve failed miserably in the crisis by letting NGDP fall dramatically, but that doesn't mean Bernanke hasn't done everything he can have to ease policy.

Here's a simple model of how the Fed Chairman might think about how he really affects policy. (In my examples I'm assuming the chairman wants easier policy than the median Fed voter but this could easily work in the other direction as well).

M = C – D^x

"M" is the easiness of the Federal Reserve as a whole, "C" represents the individual easiness of the chairman (Through statement wording, policy instruments and public statements) and "D" represents the number of dissents from official Federal Reserve policy. The variable "x" represents how strongly dissents serve to push policy in the opposite of the direction desired by the fed chairman.

Here's an illustration of the model:

(As Bernanke individually becomes more dovish he quickly runs into diminishing returns with regard to changing the Fed's overall stance)

The implications of this model are:

• The chairman individually promoting easier policy will ease actual Fed policy until it leads to dissents.
• At some point, the chairman attempting to ease policy will actually make policy tighter because it decreases the likelihood the chairman will have the votes in the future to continue current policy, and undermines his perceived power which decreases the likelihood he will be reappointed (and his replacement will likely be closer to the median board voter).
• If the chairman is going to ease his position enough to get a dissent, he should ease as much as possible without causing an additional dissent.
• The chairman needs to guess the value of x, although he will likely know the effect of C on D

So Bernanke is essentially keeping policy and his public statements much more hawkish than he really wants in order to prevent dissents from the board. He could ease policy, but doing so would cause board members to dissent and those dissents would undermine any additional easiness in policy. If you believe, as Bernanke does, that the expected path of monetary policy is monetary policy then this makes a lot of sense.

One question might be why there aren't more dissents than there already are. There is only one (Hoenig) and in addition to him not being a voting member this year, he is leaving the board in October.

A possible answer is that other voting members have formed a voting coalition with each other. If each member simply dissents when policy becomes too extreme according to their own individual opinion, the chairman would be left with a great deal of power to maneuver overall policy in his desired direction. If, on the other hand, they form an agreement to threaten dissent at the same time, they would ensure policy could become no tighter than their mutually agreed point of dissent. Since transactions costs are low with so few members, such negotiations seem highly plausible.

But where are the doves?A single dissent could theoretically make perceived policy easier and Bernanke wouldn't have to push past such a dissent in the same way he does a hawkish dissenter.

This is all speculation of course, but does anyone really think Bernanke isn't being constrained by other Fed board members? 

So maybe a better question than "Why hasn't Bernanke done more?" is "Why haven't Fed doves done more... by dissenting?"

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

Treasuries

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.