Yes, Monetary Policy is Important!

That's what markets are screaming right now. If monetary policy was out of bullets, the markets wouldn't react to a disappointing Fed meeting.

As I said previously,

Any kind of a long term anchor (explicit NGDP/CPI targeting) or adjustable policy (changing IOR or asset purchases monthly based on the latest data) will be more effective  than ambiguous and rigid policies (QE2, keeping the Fed Funds rate at 0% for "an extended period of time")

"Operation Twist" is even worse than QE2 or commitments to keep the Fed funds rate at 0%. Is it any wonder stocks, commodities, interest rates, and inflation expectations are plummeting?

We are in scary territory.

Why Yesterday's Meeting was so Disasspointing

Here's the full statement

Markets were hoping for lower interest on reserves, or a mention of other policies the Fed could enact at a future date. Instead, they got a policy most agree was previously ineffective and a very negative outlook about the economy, implying the Fed isn't willing to take the necessary steps to boost aggregate demand.

Krugman's double standard

Paul Krugman writes that even though monetary policy can work in theory, it won't work in practice

Now, in principle you can get traction by making money a less attractive store of value. In particular, if you can credibly promise future inflation, that will make the real return on money negative. But getting that kind of credibility is tricky, especially given the normal prejudices of central bankers.

The problem with this analysis is that it seems to imply that his preferred alternative, fiscal policy, does not have such issues. It does. Krugman himself admits policymakers won't ever do enough fiscal stimulus unless a world war breaks out (and that includes periods where all three branches of the government are controlled by democrats), so what is the advantage of fiscal stimulus then? It's much costlier, less proven, and even less likely than a commitment to inflation. Krugman simply isn't doing his job as a pundit if he's going to brush away monetary policy while continuing to advocate fiscal policy.

In addition, every believer in current fiscal stimulus should mention the low 2% implicit inflation targets as one of the largest policy mistakes leading up to the recession. If you really do believe that monetary policy only works through changes in short term interest rates, raising the inflation target to 4% is a virtually costless way to make monetary policy more effective. For reasons I can't explain, I have never seen this incredibly obvious implication of the liquidity trap argument made. They should be screaming it from the rooftops.

Fiscal policy is inferior from both practical and theoretical perspectives. Why advocate it and not monetary policy then?

Money Is Now As "Easy" As It Was During The Great Depression!

The Ten year is currently yielding 2.09%.

The only difference is in the Great Depression was caused by a collapse in the money supply while the current recession is the result of a massive increase in the demand for cash.  The results are the exact same (although much less severe this time).

Market Reaction To FOMC Announcement

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

(Before data was taken at 2:00 pm, After data was recorded at market closing prices)

S&P 500

Before : 1138.64
After : 1172.53

Treasuries

2 year

Before : 0.27
After : 0.20

10 Year

Before : 2.33
After : 2.26

30 Year

Before : 3.68
After : 3.64

Inflation Expectations

2 year inflation swaps

Before : 1.43
After : 1.39

5 Year TIPS Breakeven rate

Before : 1.81
After : 1.78

10 Year TIPS spread

Before : 2.27
After : 2.22

30 Year TIPS spread

Before : 2.64
After : 2.61

Bloomberg Commodity Index

Before : 1601.42
After : 1598.48


EUR USD
Before : 1.4221
After : 1.4339


(Data from bloomberg.com)


The market reaction to the Fed announcement today was certainly interesting. Fed Funds Futures unsurprisingly fell in reaction to the commitment to leave them at 0% until 2013. Equities took a while to figure out how they felt, seesawing up and down before finally rising about 3% from their pre-meeting rallies. Treasury yields fell, especially at the medium end of the curve (only because the short end can't fall any further). Inflation expectations also fell slightly as well, along with commodities and the dollar. 

Personally I think the Fed announcement was underwhelming. Committing (whether loosely or strictly, no one really knows how serious they are about this commitment, or even whether it is a commitment at all - are they simply predicting they will need to do this?) to leaving rates at 2013 is another way of telling us that they predict a significant output gap will remain at least until then and won't take the necessary actions to do anything about it. Is there anyone who isn't thinking about Japan now?

The dissents are puzzling... if 3 members are going to dissent, why not do something more like lower interest on reserves? Maybe they would have had even more dissents if they did, if so, we are in serious trouble... if not, they obviously should have tried more. Christina Romer said the dissents might be a sign Bernanke is now more willing to work without unanimous approval of policies, but why not do more right now?

I don't blame markets for their "confusion"... I'm not really sure how to read this either. It was certainly better than nothing, but not much better. Much more stimulus is needed. Still, today once again demonstrated that markets don't buy either liquidity trap or easy money stories.

Debt Problems Are All About Insufficient Aggregate Demand

Look at this chart comparing Debt to NGDP...

It's pretty obvious that had NGDP been allowed to continue its trend growth, the US government debt burden would be significantly lower. Of course, raising NGDP by unexpectedly inflating is always an option (and always a bad one), but we are talking about continuing a trend that was the implicit goal of the Fed for the previous 20 years!

And remember, Lower NGDP resulted in lower real GDP as well. This increased government debt burden far beyond what the decline in NGDP relative to debt implies. Had NGDP continued to grow at trend, its reasonable to assume public debt would be closer to $7.6 trillion than $9.6 trillion.

Assuming NGDP stayed on trend (but debt still rose to $9.6 trillion), Debt/GDP would be 56% rather than 64%. Under a more plausible scenario, debt would have grown more slowly had NGDP stayed on trend and Debt/GDP would be even lower at ~44%.

Obviously entitlements are the biggest problem in the long run, and I think S&P was incorrect in downgrading the credit rating of the US, but this recession has still needlessly and dramatically increased our debt burden. Any true deficit hawk should be screaming for easier monetary policy.

The Disaster That Is Federal Reserve policy.

Tim Duy nicely sums up how incompetent Fed policy has been over the past few years.

Bottom Line:  The market nosedive does not yet guarantee Fed action in the near future.  History has shown the Fed tends to react with a lag.  They should have learned better by now, but if they had learned anything, they would not have pushed forward with hawkish rhetoric earlier this year.  Arguably, they will hold firm, let the markets think they are out of the game and further bid down implied inflation expectations, and then, once the damage is done, up the level of stimulus.  Terrible way to run an economy, I know.

I think this is exactly right, and it shows how misguided the Fed is right now. If the Fed is looking at market inflation expectations (and they have made it clear they are) they seem to be forgetting that those expectations have expected monetary policy built into them. To the extent that expectations deviate from the Fed's implicit goal (2-3%), they already represent policy failure.

To use a "Sumnerian" analogy, it would be like the captain of the Titanic looking at market expectations of their eventual destination and saying "Expectations say we'll be in New York City on time, looks like my job is done!", without realizing those expectations exist because he is expected to appropriately react to changing conditions (and avoid icebergs!).

It's actually worse than this though, because the Fed will never make up for "lost" NGDP growth. They've already made it quite clear they aren't comfortable with inflation above ~2% under any circumstances, and so we are left with a permanently lower NGDP and price level trend.

To put this into perspective, in 2008, when the financial crisis began, a good guess for 2018 NGDP would have been about $26 trillion. Right now, even if we get 5% NGDP from this point forward it will be just over $22 trillion! Over the course of a decade this will have added up to a $27 trillion* difference in nominal income! Too bad for anyone paying wage contracts, but at least employees got a nice real wage boost! And sure, it hurts debtors, but investors have done fantastically! You may detect a hint of sarcasm. So much for the "trade offs" of inflation/deflation between creditors and debtors that some are pushing.

* I originally mistakenly wrote it would result in a $105 trillion difference because I forgot I was dealing with quarterly annualized numbers.