Monday, April 20, 2009

Ben's Shakespearean dilemma

Inflation or deflation? That is the question.

For all the increase in unemployment and excess capacity that this recession has brought (arguably, the perfect incubator for DEflation), there are people out there raising the INflation alarm.

Me thinks it’s the Fed’s fault. Not because of its aggressive expansion of (base) money. The usual monetarist argument that a large-scale expansion of money supply leads to inflation appears na├»ve at present, as it assumes a stable demand for money. But this has clearly not been the case: The financial crisis led to a sudden surge in the demand for money, as institutions and individuals fled riskier/less liquid assets in favor of liquid alternatives.

The problem has been communication. The Fed, with its actions, has created confusion about its priorities and objectives. Let me explain.

The “positives” first… Since September 2008, right before the “fireworks” began, the Fed’s balance sheet has expanded by $1.2 trillion. But almost half of that is the result of lending facilities (the TAF, CPFF, PDCF and ABCPMMMF) established to fill the funding gap that financial institutions faced, as counterparty risk skyrocketed and banks lost their traditional sources of funding. The corresponding expansion in money supply is therefore a response to a surge in the demand for liquid assets and, as such, it’s inflation-innocuous. Moreover, by design, these facilities are short-term and set to expire once the need for them is eliminated.

Secondly, in his communications Ben has been careful to subsume every single unconventional measure the Fed has taken under the “credit easing” sphere instead of “quantitative easing” (QE). In other words, the arch objective of these measures, we are told, is to help improve conditions in private credit markets (rather than to help create inflation, which was the case in Japan during 2001-06).

Very importantly, Ben has been talking time and again about the Fed’s menu of exit strategies, presumably with the view of addressing fears about inflation once financial conditions normalize.

But that’s where the clarity ends. Then come the (other) deeds.

Beginning with the Fed’s decision to purchase longer-term Treasuries. Not only are there theoretical reasons why they are likely to be ineffective in lowering long-term yields (I promise a post on this). Not only is there empirical evidence from Japan’s own QE suggesting that the so-called portfolio rebalancing channel through which it’s supposed to work had a small impact at best. Not only have long-term yields here in the US actually increased since the Fed’s announcement that it will start buying Treasuries on March 18th…

…Basically, not only are Treasury purchases a waste of money from a “credit easing” perspective; they are also a mistake, in so far as they breed concerns that the Fed is monetizing the government deficit and/or has inflation as an implicit objective.

This is not paranoia. We are in a world where the menu of unconventional central bank policies that Ben talked about in his famous “Deflation speech” are handicapped: The banking system is broke and thus incapable of fulfilling its role in the monetary transmission process (e.g. by lending out the cheap money the Fed is providing). Household and financial sector leverage is high, which means that, even if rates came down, the room for additional borrowing is limited. Importantly, the economy is in recession and the government is engaging in a massive fiscal expansion which, per CBO’s projections, would raise the government debt by a shocking 30% of GDP by 2012.

In other words, the Fed’s Treasury purchases were announced at a time when the Fed’s tools are impaired by a broke banking sector; and when high household debt and a huge fiscal deficit are creating strong incentives for inflating our way out. I mean, sorry, but this is the perfect setting for a “helicopter drop” of money—a measure proposed by Ben himself in that same “Deflation” speech. Combined with the dubious theoretical and empirical case for them, Treasury purchases can only confuse as to the Fed’s policy priorities and objectives.

Priorities, objectives… So here is a second source of confusion. The Fed has a LOT of objectives at the moment. Take a look at the March 18th FOMC statement:

The Fed “will employ all available tools to promote economic recovery and to preserve price stability.” The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities [..] and to increase its purchases of agency debt this year [..] to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses […].”

Everything but the kitchen sink! I should add of course the objective (me now) “to prevent a financial sector meltdown”, which has seen the Fed acting as lender of last resort to Bear Stearns, Citi and AIG; or (coming shortly) “to promote the orderly deleveraging of greedy financial institutions” through the Fed’s participation in the PPIP.

Luckily for Ben, for the moment all his objectives—stirring economic activity, credit easing and “price stability”—point in the same direction. That’s because “price stability” in this environment means avoiding deflation. But what happens if this alignment is broken? What would he do if the objectives become conflicting?

The answer looks unclear right now. On one hand, for the Fed to effectively bring long-term rates down, in the hope of stimulating aggregate demand, it has to credibly guide the private sector to expect that short-term rates will stay near-zero for a long time, even after economic recovery picks up. The Fed has indeed tried to do so, per the FOMC statement above (“conditions are likely to warrant [...] for an extended period”). Upward price stability would be a secondary objective, under this line of thinking.

On the other hand, Ben’s talk about exit strategies suggests that the Fed is very alert to the inflationary implications of the its current policies and stands ready to fight. Sounds reassuring but, if that’s so, it undermines the credibility of the Fed’s “promise” to keep rates low “for an extended period”.

There is no simple solution, obviously. But my preference would be (a) do away with the “try everything and see what happens” approach to policy-making; (b) do away with (or, at this point, contain) Treasury purchases; and (c) clarify that upward price stability will be *the* priority, if the environment warrants it, even if such clarity comes at the cost of a smaller “expectation effect” on the yield curve from the commitment to keep rates low for some time.

Ben is trudging through tough territory, I admit. But by dispelling “the question” about inflation once and for all, he might find he will not have to “suffer the slings and arrows of outrageous fortune”!


Paul W said...

Is there that big a difference between buying Treasuries and buying agencies? Obviously, yes, but I mean from an monetary stability perspective. It seems that the purchase of both is pro-inflation, but the exit from agencies has to be harder because of the extension risk and political factors.

Great blog.

bb said...

i think you are ignoring the possibility for deflation in debt and levered assets in general and inflation in everything that can be purchased with cash.
sort of to let asset prices adjust to a more sustainable level of incomes and consumption patterns.

David said...

How does one conclude that the banking system is unable to provide credit? Perhaps it is simply that people are (wisely) not wanting to borrow. How does one tell the difference?

Andrew Foland said...

I think Ben is trying to send us a message: I'm going to inflate back to 2%, and then stop. I think that's a path nominally within his power, and consistent with all statements. But I think that it's nominally, but not practically, within his power.

I worry that Ben is going to find that unwinding the short-term programs is harder than he thinks. There are going to be a lot of institutions that find themselves dependent on one or another of the programs, and they'll be deploying all the political power they can muster to keep those programs alive.

If that happens, we'll zoom right past 2%...

Briangobosox said...

HI, just stumbled on your blog - great post. I've been advocating a much more forceful Fed response for some months now. I actually thought they should have stepped in to buy equities last October - just put an ink-money floor below the S&P at say 950, and they might have short-circuited the asset deflation cycle.

I believed then, and am even more convinced now, that we face a choice between inflation and mass defaults. It appears we're headed down the latter path, with "credit easing" designed as an air bag to soften the crash. To my mind the much more sensible response to a widespread and severe decline in asset prices in a heavily levered system is to generate some serious inflation. Yes, its amoral and patently unfair. But lets face it - the little guy is gonna get screwed here one way or another.

As to mechanics, I suspect turning inflation expectations (and hence velocity) meaningfully would take more direct action that buying Treasuries (which the Fed really does see as a compliment to credit easing - they saw the BoE got a quick 50bp off the curve on their announcement, so decided to take the 50bps to get corp yields down). The Fed needs to either support asset prices directly (by buying a basket of equities), or they could decrease the value of the unit of account directly via massive unsterilized intervention.

Charles M said...

The US (and world) balance sheet is so bloated that there is only a choice between massive defaults in the banking system/ Govt Bonds (a la Great Depression) and strong inflation (that raises nominal GDP while leaving the Balance Sheet kind of constant). Ben knows it.
People who think we can "grind slowly our way out of the hole" without massive bank/sovereign defaults or inflation are deluding themselves. Japan failed to do it in a middle of a global boom of credit. How anyone could make it in the middle of a global slump ?
The dual mandate is a catch 22, but popular pressure will inevitably lead to giving "full" employment the highest priority. Why not state the ensuing high inflation goal explicitly right now ? Because every month that passes where petro monarchy and Chinese exchange an overvalued dollar (in terms of purchasing power) against real goods, brings seignoriage free lunch to the US. It would be stupid from the US to stop this from its own initiative.

Reminds me of the following joke :
An inebriated man enters into a bar and tells the bartender "One whiskey before it begins !"
After finishing his glass,he yells "One more before it begins !"
and again, and again, and again, until the bartender tells him "well now, if you want one more, you got to show me the money"
to which the man answer "There it is, it begins..."

DocG said...

Insightful post! No one knows anymore which way to go. Raise prices and you lose customers. Lower prices and you can't pay your creditors. Keep them the same and you lose the customers AND can't pay the creditors. Bernanke's dilemma isn't all that different: to inflate or not to inflate. Either way we're screwed. Reminds me of that old physics problem: is light a wave or a particle? Apparently both -- and neither.

The same issue comes up in 20th Century philosophy, in a variety of forms, e.g., the mind-body problem, indeterminacy, undecidability, Russell's paradox, the real vs. the simulacrum, the medium vs. the message, the arche vs. the supplement, differance, etc.

It's an old problem also, as in: Does a dog have the Buddha mind? or the old definition of the Zen koan: it's like a hot coal stuck in your throat, you can't swallow it and you can't spit it out.

What it all amounts to, as I see it, is the necessity for a fundamental paradigm shift. We could argue endlessly about whether this or that traditional economic strategy is best, but in our hearts we know it's all over for that sort of thinking, if not for economics itself. We need to stop thinking in terms of the old alternatives and start imagining new ones. As in:


There are some other interesting things in my blog, give it a try, you might like it.