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.”

August Jobs Report

The economy added 96,000 jobs in August. A lower number than last month was expected, by me at least for no other reason than it fits the pattern (see last report). But it seems that the continuing/worsening crisis in Europe and the slow down of Emerging Economies (most notably China) has taken its toll in slowing down US job growth even more.

Worse, the number of people looking for work declined as well, bringing the Unemployment Rate down to 8.1%. Previous month's numbers were revised downward a total of 41,000, as indicated by the red line (which shows figures from before the last revision).

Economist Quotes

''I am often considered almost not a part of the profession of Establishment economists. I am even referred to as a sociologist. And by that economists usually do not mean anything flattering."

- Gunnar Myrdal

Credibility

This is a funny book. I haven't read it, but the cover is so hilarious that the rest of the book has to be[1]. It’s easy with hind-sight, but I can’t imagine how this could have ever been a reasonable theory.

The only way for the Dow to reach 36,000 in the time the authors gave (closer to 36,000 than 10,000 by 2010) would be if the economy was about to experience explosive growth or a massive bubble the developed world has, still, never seen. The Dow currently stands between 13,000 - 14,000[2]. The book was written in 1999; the authors were arguing that stocks were cheap at precisely the time they were overvalued due to the dot-com bubble. 

A common measure of stock valuation is the Price to Earnings (P/E) ratio. It is the price of a share over the annual earnings one would receive from owning the share[3]. A high P/E ratio means either profits will increase in the future or there is a bubble. As the graph below shows, the long run average P/E ratio is around 16.

At the end of 1999 the P/E ratio for the S&P 500 was around 30, for the Dow it was around 27. On top of that record setting overvaluation the authors thought stocks could only go up.

I bring this up because one of the authors, Kevin Hassett, is now a Romney adviser, and recently criticized the Tax Policy Center (TPC) for explaining[4] that Romney’s tax plan would result in a higher tax burden for the poor and middle class, and a much lower tax burden for the rich. For some reason, I just don't trust him to be correct.

July Jobs Report

Better than last month but not good pretty much sums it up. 163,000 non-farm jobs were added in July. Previous months were little revised and the labor force shrank slightly. It's further evidence that this is just what the pace of recovery will be; the jobs market has produced these results for three years now.

It is almost uncanny how repetitive the process has been. Encouraging job growth over the winter followed by months of disappointingly low numbers, followed by a upward blip in late summer before diminishing until winter. This is the late summer blip, last year it came in August, the year before in September. It's slightly good news in that following months shouldn't be as disappointing as previous months, until next spring.

What this means for policy is that nothing will change there either. Policy has remained essentially unchanged since the recovery started. In fact, job growth is slightly higher. Since February 2010 job growth has averaged around 138,000 per month, while in the past year it has averaged 153,000 per month. This certainly means that the Fed won't act, if conditions aren't changing their policies won't change. But the Fed does expect growth to pick up next year, not that their forecasts have been all that accurate. Generally speaking that puts the unemployment rate reaching 2008 levels in 2016.

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.

Economics, Politics, Sailing, and Realism

"The same persons who cry down Logic will generally warn you against Political Economy. It is unfeeling, they will tell you. It recognises unpleasant facts. For my part, the most unfeeling thing I know of is the law of gravitation: it breaks the neck of the best and most amiable person without scruple, if he forgets for a single moment to give heed to it. 
The winds and waves too are very unfeeling. Would you advise those who go to sea to deny the winds and waves - or to make use of them, and find the means of guarding against their dangers? My advice to you is to study the great writers on Political Economy, and hold firmly by whatever in them you find true; and depend upon it that if you are not selfish or hard-hearted already, Political Economy will not make you so."

- John Stuart Mill

Outsourcing is a Good Thing

Recently the topic of outsourcing has again become popular in the news. The scandal is currently over whether Mitt Romney was working at Bain Capital when they closed down some companies and moved jobs overseas. I would like to point out that if these companies had not either already gotten themselves into trouble or been out-competed elsewhere, a company like Bain wouldn't be buying them. It’s not Bain’s fault the most profitable thing they could do was declare bankruptcy. Second, it doesn’t matter if Romney was at Bain when they outsourced jobs. Outsourcing is in fact good for the world economy, and good for the poor. As economist Paul Krugman put it back when he was still cool:

“The lofty moral tone of the opponents of globalization is possible only because they have chosen not to think their position through. While fat-cat capitalists might benefit from globalization, the biggest beneficiaries are, yes, Third World workers.”

The jobs that have left the United States in search of cheap labor left because wages here are too high relative to destination countries to economically justify keeping them in the United States. This is a good thing; it means we are a developed country. The flip side of this is that the wages outsourced jobs offer to developing country workers are as good or better than the alternatives for those workers, otherwise they would not take the jobs. The increased availability of outsourced jobs increases competition for workers, and increases wages of the world’s poorest. And there is overwhelming evidence of this in the 1 billion people who have been raised out of poverty in the past couple decades.

It gets even better, because outsourcing is good in net for the countries that jobs leave. First, outsourcing, if rational, reduces the cost of production, which inevitably gets passed on to consumers. The effect is upward pressure on the real wages of consumers who can now buy more for the same money. And many of our imports are inputs for final production in the United States, meaning more profitable production, and thus more jobs here.

In spite of all this it could very well be possible that the effect on jobs and wages is negative for developed country workers, but only in the short run. Increasing wages in developing countries eventually reduce the incentive to outsource jobs in the first place. Already thousands of jobs that were outsourced to China are returning to the United States as wages rise in China. And there is much higher domestic demand for products all around the world in developing countries. The United States’ trade deficit has closed considerably in recent years. And despite decades of outsourcing the export sector in the remains one of the bright spots in our economy.

Mitt Romney should stand up for himself. He need not have been motivated by anything more than profits to have brought benefits to the poor in developing countries, and to consumers in developed countries. And the opponents of outsourcing and globalization should realize that their opposition keeps people poor for the benefit of the few, hardly a sound strategy to reduce inequality.

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. 

June Jobs Report

 
Another terrible jobs report, only 80,000 jobs were added in June. The numbers for previous months were barely changed (red line). Just like last year, the economy has stagnated after a strong winter. The trend is now pretty ingrained and growth forecasts the world over are being cut. In other news inflation has decreased and is below the Fed’s low 2% target. So unemployment is above target (ie. “The natural rate”) and inflation is below target. The Fed is now missing on both ends of its mandate rather than just the employment side, yet it doesn’t act. And crazy people continue to worry about inflation.

At the end of this year we face what is being appropriately called a “fiscal cliff”. Taxes across the board are going to go up and discretionary spending (the part that isn’t contributing to our unsustainable debt) will be slashed. The combined effect of this will likely put us back into a recession. The CBO recently estimated that the full effect of the fiscal cliff will cut growth to 0.5% of GDP next year (it is currently around 2%). And unemployment will rise above 9%. What CBO projections don't include is psychology. If growth decreases that suddenly and unemployment increases the negative effect on confidence and expectations could easily put the economy into a recession. If politicians continue to fail us, this may be the best economy we'll see for years.

Ethics

In November 1929, a month after the stock market crash, a letter was sent to the American Economic Association asking what its Code of Ethics was for practitioners of economics. The secretary of the association replied, in full:


“You should know that our middle name is “Ethics”, but we have no particular code, consequently, I cannot comply with your request.”

The Economist Formatting Errors pt. 3

May Jobs Report

The May Jobs Report has come out and it’s certainly bad news. Only 69,000 jobs were added in May; the unemployment rate stands “essentially unchanged” at 8.2%. Long term unemployment increased by 300,000. Additionally, the numbers for March and April were revised down. March job growth was revised from 154,000 jobs added to 143,000; April was revised from 115,000 jobs added to just 77,000 (the red line shows the unrevised numbers). The only piece of not terrible news is that the participation rate (people who have jobs plus people who are actively looking for jobs) increased. 

If numbers like these continue, job growth won’t even keep pace with population growth. Factoring in population growth the economy needs to add roughly 200,000 jobs a month to return to levels of unemployment seen in early 2008 by 2015, and recent growth is nowhere close.

Just Saying

Not to risk politics, but this is a useful demonstration of why budget policy matters all the time, even when times are good. Coming out of the 2001 recession, the CBO projected sustained and increasing budget surpluses. Granted, one should never put too much faith in the CBO baseline scenario coming true; it is based on current law continuing unchanged, even if it is highly unlikely.

This graph demonstrates what could have been. Any number of policy changes, especially less tax breaks and wars, could have given the government far more room and flexibly to act in a counter-cyclical manner.

A Follow up on a Follow up on the Futures Market and Gasoline Prices

Gas prices continue to fall, which was to be expected since that's the direction the futures market was going in anyway. But, the futures market is now expecting prices to drop more than before.