August Jobs Report

Definitely a bad one. Only 169,000 jobs were added in August. The unemployment rate dropped to 7.3% due to people leaving the labor force. And the past two months of lackluster job growth were revised down by a total of 74,000 jobs. The last three months have been the worst since the recent round of Quantitative Easing (QE) began.

Coincidentally, this comes as the Fed has been making noises about "tapering" or removing stimulus in the near future. Unexpectedly, after this began, around March, inflation expectations dropped (and were never high anyway). This is the same pattern as the previous rounds of QE: as their end became apparent inflation and hiring declined, leaving the economy stagnant and making future rounds of stimulus necessary. 

That being said employment data is always volatile, and other data such as car sales and new Unemployment Insurance claims still point to strong growth. But as long as inflation, and inflation expectations aren't high, and wages aren't rising, the Fed clearly has room to stimulate without much downside risk[1]. And the fastest way to stop using unconventional monetary policy, and thus reduce that risk, is to use it correctly the first time. Withdrawing stimulus in the near future would be a mistake, at least one person at the Fed understands this.

Update on the Federal Reserve

This week the Federal Reserve has taken further unconventional action to attempt to stimulate the economy. In September the Fed announced it would buy bonds and other securities with newly created money to increase the money supply (more details here). With not much sign of things getting better yet, the Fed has expanded its asset purchasing (as in money creation) from $40 billion to $85 billion per month.

But that is only half the story. In September the Fed said it would continue making new money until unemployment falls back to "normal" levels, but only if inflation stays low. The limitations and thresholds were somewhat vague, which dulls the effect of the policy. However, this time, the Fed explicitly stated that it will continue creating money until unemployment goes below 7%, and keep interest rates near 0% until it goes below 6.5%. And even when it does they will not stop immediately, but rather gradually wind down the program. This is conditional on inflation staying near or below 2.5% in the short run[1]. The benefit of this policy is that the Fed is now committed in a clear manner to its stimulus. And as conditions change economic actors will know at what point the Fed policy will change.

I previously spoke of how large a change outlining policy in this manner is for the Fed. This is the first time ever the Fed has set an unemployment rate target[1]. Past efforts have involved set dollar amounts and calendar deadlines. Now the policy is still clear and predictable, but flexible and limited only by the accomplishment of its goals (you can find information on how monetary stimulus helps the economy here and here). I am a huge supporter of the Feds recent policy changes. While its no magic bullet and the magnitude of the effect is a matter of debate, it speaks well of our monetary institution that the Fed has been so able to adapt and act to economic conditions. 

My only present concern is the focus on keeping inflation near or below 2.5%[2]. I've posted about why inflation is not a threat in this weak economy here and here. We would not be hurt by inflation in the 3 - 4 % range, inflation has been that high numerous times in the past two decades. Keeping inflation relatively low will dull the stimulative effect because the Fed can only reduce inflation by slowing down the economy. The low inflation ceiling could lead people to expect that stimulus will be withdrawn too early. Metaphorically, the Fed is giving the economy more gas while still keeping a foot slightly on the breaks.

QE3: The Fed Steps In

The Federal Reserve has decided to further stimulate the economy in a bold and unprecedented manner. The Fed announced, in a 12-1 decision, that it would “[purchase] agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate…in a context of price stability.” These purchases will continue so long as “the outlook for the labor market does not improve substantially.” And even if it does “[A] highly accommodative stance of monetary policy will remain appropriate for a considerable time.”

This action is very different from past Fed actions in that it’s theoretically unlimited in its commitment. In previous quantitative easing the Fed committed to specific dollar amounts. The new policy is limited only to $40 billion per month, for a length of time yet to be determined. The Fed buys bonds from banks with newly created money[1], this reduces the cost of lending, and thus of borrowing, which lowers the cost of consumption and investment. The focus on mortgage-backed securities will reduce the cost of mortgages in particular, stimulating housing demand. There are other channels through which QE stimulates the economy; however, if the banks aren’t willing to lend or individuals/businesses willing to borrow the stimulative effects will be lessened.

On the positive side, this action comes just days after the European Central Bank (ECB) made an unlimited commitment to buy bonds of European countries that are in a debt agreement with the EU/IMF. That the Europeans have made a similar commitment increases the simulative effects of Fed action. Economic policy works best when pursued in unison.

Some people are concerned about the inflationary effects of such policies. There are two basic possible outcomes: either it won’t work, in which case inflation won’t be an issue, or it will, in which case the Fed can withdraw the stimulus and reduce inflationary pressure (more details here and here). Inflation has been historically low and stable since before and especially after the recession. And the Fed doesn’t seem too concerned for now, stating, “If inflation goes above target, we take a balanced approach: bring inflation back to target over time but in a way that takes into account deviations of both [unemployment and inflation] from our target.” The Fed has a duel mandate to keep inflation and unemployment low. Currently inflation is below target and unemployment above target, so this policy is very consistent with the Fed’s mandate.

Now it’s up to the politicians, which isn’t as confidence inspiring. The Europeans need a political solution to escape their debt crisis; the ECB can only buy them time. The United States needs a political solution to the “fiscal cliff”, a detrimental combination of tax increases and spending cuts that will take effect in January. The Fed can only soften the blow slightly. Yet whatever happens, it is good to know that, like a good friend, “the Fed will be there to do what it can.”

Inflation, again

About six months ago I posted about the nonsense in worrying about inflation in the middle of a weak recovery. Since the topic keeps coming up as an argument against further monetary stimulus I want to point out that I was right then, and I still am. This is a dangerous thing to do in the economics profession: Irving Fisher, one of the greatest economists of all time, is best remembered for his statements about the “permanently high plateau” of stock prices months before the 1929 crash. But confidence abounds. Inflation won't take hold until capacity utilization is higher than average, driving the cost of production (and then prices) up[1]. The Fed can greatly influence inflation by raising (to lower inflation) or lowering (to increase inflation) interest rates.

It is pretty obvious that capacity utilization is still below average (think about the spare labor capacity). The people who have preached doom about inflation have been wrong now for four years, and have had a detrimental influence on government policy the whole time. In fact, since my original statement on the non-threat of inflation, inflation has dropped by over a percentage point.

Other measures of inflation tell much the same story.

Along with the fear of inflation, the Fed has been criticized for punishing savers and investors by keeping interest rates so low. Jim Demint recently admonished the Fed Chairman that he was costing Americans “about $400 billion a year on lost interest”. I didn’t bother finding out where the figure comes from because, though I understand the logic behind it, it is wrong.

All of this is related because during and after a financial crisis it is deflation that is the true threat. As Irving Fisher pointed out, the sever deflation that set in after the crash caused real debt burdens to increase. That is, deflation increased the value of outstanding debts faster than individuals, governments, and businesses could pay them off. The collective action of reducing spending to pay off debts merely increased the rate of deflation. 

 

The unshaded portions of the "1933" bars represent the amounts in 1929 $s. Notice that while national wealth decreased greatly internal debt actually rose.

The solution was easy, looser monetary policy to bring prices and inflation back to “normal” levels. By acting quickly and unprecedentedly this time around, the Fed stopped deflation and kept the downward spiral from kicking in. Since the average American household had debt of over 130% of disposable income, the Fed’s actions have saved Americans money by keeping their real debt burden from growing uncontrollably.

What's the Fed up To?

Given the bad economic news of late, many eyes have turned to the Fed as it seems to be the only institution left with the ability to act. Central Banks the world over have been stepping in: The Bank of England started a new round of Quantitative Easing[1], the European Central Bank, the Bank of Korea, the Central Bank of Brazil, and of China have lowered their target interest rates to ease lending[2]. 

Though it has not made big news, the Fed did recently act by embarking on a second installment of “Operation Twist” (OT). OT is a process where the Fed tries to twist the yield curve for government bonds to push down long term interest rates and push up short term interest rates (see out of date graph below). The Fed does this by selling its short term bonds and buying long term bonds, in this way the action puts no upward pressure on inflation. Basically, when one buys a bond they are purchasing the future stream of interest payments that bond will generate should the borrower not default, therefore, the higher the bond price the lower the real interest rate. Reducing long term interest rates is the more important goal because it will stimulate (in theory) capital investment and housing demand.

But this additional action is more appearance that substance. The effectiveness of the practice in general is still highly debatable. The law of diminishing returns holds that each additional bond sold and bought by the Fed will have less and less of an effect, another round of OT will thus be less effective than the first (which hasn’t exactly fixed the economy). The Feds stock of short term bonds is not infinite and it would be very unwise to sell them all and reduce the diversity of bonds held. According to Macroeconomic Advisers (a consultancy I enjoy referencing), as the Fed sells off its short term bonds it will eventually need to sell off short term bonds of a longer maturity, decreasing its effectiveness further.

So why do it? The Fed has constantly been saying that if the economy slowed further it would take stimulative action. In fact they just yesterday teased at this prospect again. Given their statements, and the poor state of the economy when the first round of OT ended, doing nothing more would have the appearance of withdrawing stimulus. Put simply, the Fed has acted to keep people from noticing that it has not really acted. 

That being said I think the Fed is a great institution. If only other institutions, such as the FDA and EPA were as politically independent with as clear a mandate. 

Hyper-Inflation

What happened to all those people who were freaking out about out of control inflation/hyper-inflation? It must have happened by now: crazy people, Ron Paul, some economists, etc. have been preaching inflationary doom since the crisis began. The urgency the matter was discussed with made it seem as if it was our most urgent threat. One which they were happy to trade a slower recovery for.


But wait, its all come to nothing. Inflation[1] since the 2008 financial crisis has been low relative to the rest of the post Gold Standard world. In fact, 2009 actually saw a slight deflation[2] of the Consumer Price Index (CPI).  Here's what's happened to inflation since January 2008:

In the aftermath of the crisis, deflation was the proper thing to worry about as demand contracted. Then the CPI began to increase slightly, stagnated, and has now returned to a pretty much normal rate. And it seems all the people who were yelling about inflation have quieted down, hoping they didn't put their names on too many crazy opinion pieces. Here's a historic look at inflation going back to 1914:

As you can see, inflation has been rather tame in modern times and is certainly not out of control[3]. Given all of this, inflation, while it should be a medium run concern for the Fed, is not and has not been a threat to our economy. If you are curious to know the mechanics of  inflation click "read more"