Thursday, February 7, 2013

Why Fed policy is hurting the economy

John Taylor wrote a very interesting article in the WSJ last week, "Fed Policy Is a Drag on the Economy," in which he argues that the Fed has been hurting the economy by keeping short-term interest rates extremely low, and promising to keep them extremely low for a long time. This of course runs directly counter to what we have been led to believe.

He describes a variety of problems created by super-easy monetary policy (e.g., encouraging people to take on too much risk, creating great uncertainty about the Fed's ability to reverse its QE efforts, making it easy for the federal government to fund its massive spending plans, and forcing other central banks to follow suite.) More importantly, perhaps, he argues that very low interest rates create disincentives to save, and this limits the economy's ability to grow. "While borrowers might like a near-zero rate, there is little incentive for lenders to extend credit at that rate. ... lenders supply less credit at the lower rate. The decline in credit availability reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence of the policy."

In other words, while everyone, including the Fed, thinks that ultra low interest rates provide an important source of stimulus to the economy, it's quite likely that they do just the opposite. The Law of Unintended Consequences strikes yet again!

Taylor had a somewhat-related blog post the other day in which he discusses the "strong inverse relationship between fixed investment and the unemployment rate." He accompanied the post with a chart that got my attention, because I saw a way to improve it.

The above chart uses the same data as Taylor's original chart, but includes data going back to 1960 (his only went back to 1990). The interpretation of the chart remains the same. There is a strong inverse relationship between fixed investment as a share of GDP (fixed investment includes private residential and nonresidential construction, and private investment in equipment and software) and the unemployment rate, which is a good proxy for the health of the economy. He is careful to note that while the correlation is strong, we cannot infer the direction of causality. But this does illustrate how a lack of investment could go a long way to explaining why the recovery has been so weak. 

It then occurred to me to put his two ideas together, to see if the Fed's monetary policy was correlated with the amount of fixed investment. Where Taylor's WSJ article focuses on how artificially low interest rates limit lending and therefore aggregate demand, and his chart compares fixed investment to the unemployment rate, I wanted to see if there was a link between Fed policy and fixed investment.

As the chart above shows, Fed policy is indeed highly correlated to fixed investment (even more so than the unemployment rate is). This fits hand and glove with the first chart, which links fixed investment to the unemployment rate. The red line in the above chart is the real Federal funds rate (using the Core PCE deflator), since that is a good proxy for the degree to which monetary policy is "tight" or "easy."

This puts some meat on the bones of Taylor's WSJ article. The Fed's unusually accommodative monetary policy stance, which promises extremely low interest rates (negative in real terms) for a long time to come, does appear to be a factor in limiting the amount of funds available for investment, and in reducing aggregate demand, and that in turn helps to explain why the recovery has been so weak.

How else to explain the fact that fixed investment is almost always very strong when monetary policy is very tight, and weak when monetary policy is easy? How else to explain how a decade of extremely low interest rates have failed to stimulate Japan's economy?

Food for thought and controversy...


Gloeschi said...

I think you might have mixed up the dog and the tail. In the past (before we hit the $55 trillion total credit market debt outstanding invisible ceiling) the Fed had to raise rates when growth was getting to hot. That coincided with periods of strong investment.
According to economic theory, low rates allow funding of even the lowest yielding projects, so theoretically, a maximum of investment should be seen at low rates. But that also means that crappy projects are getting funded, with low returns (and possibly high leverage), and that usually doesn't pan out so well.
Like for everything, there's a demand and a supply side. And, apparently, the Fed can lower rates as much as she (?) wants - the proverbial horses still won't drink if they are not thirsty.

Any thoughts on the -2% productivity number today, or the +4.5% unit labor costs?

Benjamin said...

Well, Scott Grannis' own charts show C&I lending rising nicely....housing purchases rising (meaning more lending).

And banks do not have to lend at rates tied to their cost of funds (as Taylor mysteriously suggests).

Banks can charge whatever the market will bear for business, industrial and real estate loans. That's a free market.

I don't know what to make of Taylor's WSJ editorial, and it conflicts with much of what he has advised Japan to do---that is, print a lot more money.

BTW, many think the Fed is actually being passively "tight.

When the CPI drops in six of the last eight reports, it is hard to say the Fed is being "easy."

Sheesh, do we need sustained deflation before people say the Fed is "tight"?

I think Taylor must have had an off day. And, sadly, the WSJ op-ed and editorial pages usually have off days.

It ain't the 1970s anymore.....

Flow5 said...

This is a trillion dollars of proprietary "intellectual property":

Under monetarism, the first rule of reserves & reserve ratios is to require that all money creating institutions have the same legal reserve requirements, both as to types of assets eligible for reserves, as well as the level of reserve ratios. Monetary policy should limit all reserves to balances in the Federal Reserve banks (IBDDs), & have uniform reserve ratios for all deposits, in all banks, irrespective of size.

The International Monetary Fund (IMF) said.”Raising reserve requirements could dampen capital inflows better than tweaking policy rates, with “limited” effects to economic growth”

The roc in MVt (the proxy for inflation) = 24 month delta
The roc in MVt (the proxy for real-output) = 10 month delta

Required reserves are substituted for bank debits as the proxy for MVt since the G.6 release was discontinued.

Legal reserves lag transaction deposits 30 days.

Economic prognostications are infallible.

Flow5 said...


Quantitative Easing and Money Growth:

Potential for Higher Inflation?
Daniel L. Thornton

Note: you have to back date the required reserve figures by 30 days in order to sync up the data points between rr & total checkable deposits.


Reserve Maintenance Manual


The drop in M2 is seasonal (principally related to the drop in total checkable deposits). Total transactions based accounts represent the economic driver. Legal reserves represent the base. The multiplier equals total checkable deposits divided by the base (required reserves).

The Fed simply accommodates the seasonal demand for money & loan-funds:

"In the original federal reserve act of 1913 "It was anticipated that credit extended by the Federal Reserve Banks to commercial banks would rise & fall with seasonal & longer term variations in business activity"

And: "From the beginning, the Federal Reserve was reasonably successful in accommodating the seasonal swings in the demand for currency—in the terminology of the act, providing for “an elastic currency”."

The FOMC is tasked to provide yearly seasonal adjustments as business activity waxes (the FRBNY's "trading desk" injects reserves) & wanes (mops them up). And the problem is the FOMC doesn't recognize that the theory & mechanics are the same for seasonal mal-adjustments & the "real Bill's" arguments.

Flow5 said...

Member Commercial Bank Legal Reserves (some notes)
Reserve Computation Period….(current period days)
14 Days – 2 weeks -- Begins on Tuesday -- Ends on second 2nd Monday
(1) daily average vault cash held during the computation period that ended 3 days prior to the beginning of the maintenance period
(2) applied vault cash is deducted from the amount of the institution's required reserves
(3) balances due from other banks do not include: -- balances due from Federal Reserve banks;
(4) pass through accounts (respondent banks) or from banks located outside the U.S.
(5) cash in the process of collection and due from other banks may be excluded from deposit and Eurocurrency liabilities
(6) computed on the daily average of deposits subject to reserve requirements
Reserve Maintenance Cycle (lagged period days) required Reserves
30 days after the beginning of the computation period
14 Days – 2 weeks period in which to maintain and settle required reserves
begins on Thursday -- Ends on second Wednesday
Required Reserves
Reservable Liabilities = Pass-thru-s + Vault Cash + IBDDs (inter-District bank demand deposits)
The 14 days ending --(17 days before the start) of the maintenance cycle.
I.e., Weekly reporting CBs maintain reserves on current Liabilities with a 30 day lag.
Computation…………..lag ………………...maintenance
14 days<--------------17 days------------14 days
Maintenance begins 31 days after beginning of computation period.
Reserve Maintenance Cycle (lagged period days)
required Reserves 30 days after the beginning of the computation period
14 Days – 2 weeks Begins on Thursday Ends on second Wednesday

Flow5 said...

The seasonal demand for money must be reserved 30 days hence. So reserves lag total checkable deposits.

The roc in total checkable deposits is your trading yardstick.

Flow5 said...

The PDs have their cake & eat it too. They can tell from their dealings with the FRBNY's "trading desk" when the supply of (& demand for), reserves are either "easy" or "tight" (& make their speculative trades accordingly).

Isn't this Adler's "Wall Street Examiner's" mantra?

Flow5 said...

The relative strength of stocks can be seen by comparing their current movement with the seasonal trend. Seasonal strength depends upon how fast stocks begin to fall in the last 2 weeks of Feb.

Seasonality is nothing more than the Fed's accommodation of the money & loan-funds markets during the holidays, etc. It's different every year because the Fed's operations are dependent upon its biweekly reserve computation & maintenance periods. Last year the 2 week maintenance period began on the 2nd. This year it began on the 4th, etc.

The FOMC is tasked to provide yearly seasonal adjustments as business activity waxes (the FRBNY's "trading desk" injects reserves) & wanes (mops them up). The problem is the FOMC doesn't recognize that the theory & mechanics are the same for seasonal mal-adjustments & the "Real Bill Doctrine's" arguments.

(1) "In the original federal reserve act of 1913 "It was anticipated that credit extended by the Federal Reserve Banks to commercial banks would rise & fall with seasonal & longer term variations in business activity"

(2) And: "From the beginning, the Federal Reserve was reasonably successful in accommodating the seasonal swings in the demand for currency—in the terminology of the act, providing for “an elastic currency”."

There are other considerations. Banksters have up until "bank squaring day" to meet their legal reserve requirements, & Fridays count as 3 days, & with Reserve Simplification effective 1/24/2013, there is a penalty-free band, & maintenance is lagged 30 days, etc.

Nonetheless RRs represent the economy's pulse rate (don't listen to the MMTers like Mosler, Mitchell, Auerback, Fullwiler, Wray that say: “Banks are capital constrained, not reserve constrained”)

Listen to the President of the FRB-NY's WILLIAM C. DUDLEY (also the Vice Chairman & a permanent member of the FOMC), who stated: “For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply & credit [Reserve & commercial bank] outstanding”

Flow5 said...

Life is not fair & our leaders are unethical.

Ben Bernanke was directly responsible for causing our Great-Recession.

Using a surrogate metric, here is my 34 year old secret - the Gospel - a trillion dollars of "intellectual property" (given to me by Leland J. Pritchard, Ph.D., Chicago, Economics, 1933)

Some people think Feb 27, 2007 started across the ocean. "On Feb. 28, Bernanke told the House Budget Committee he could see no single factor that caused the market's pullback a day earlier". In fact, it was home grown. It was the seventh biggest one-day point drop ever for the Dow. On a percentage basis, the Dow lost about 3.3 percent - its biggest one-day percentage loss since March 2003.

Feb 27 coincided with the sharpest decline in the absolute level of “costless” legal reserves (an historically large peak-to-trough reversal).
“Black Monday" Oct. 19, 1987 coincided with the sharpest decline in its roc (the proxy for real-output), since the Great-Depression.
Ben Bernanke conducted 2 contractionary monetary policies leading up to the 2008 4th qtr crisis. Bernanke pricked the housing bubble by draining legal reserves for 29 consecutive months. Then he drove a knife into our backs:
POSTED: Dec 13 2007 06:55 PM |
10/1/2007,,,,,,,-0.47,... -0.22 * temporary bottom
11/1/2007,,,,,,, 0.14,,,,,,, -0.18
12/1/2007,,,,,,, 0.44,,,,,,,-0.23
1/1/2008,,,,,,, 0.59,,,,,,, 0.06
2/1/2008,,,,,,, 0.45,,,,,,, 0.10
3/1/2008,,,,,,, 0.06,,,,,,, 0.04
4/1/2008,,,,,,, 0.04,,,,,,, 0.02
5/1/2008,,,,,,, 0.09,,,,,,, 0.04
6/1/2008,,,,,,, 0.20,,,,,,, 0.05
7/1/2008,,,,,,, 0.32,,,,,,, 0.10
8/1/2008,,,,,,, 0.15,,,,,,, 0.05
9/1/2008,,,,,,, 0.00,,,,,,, 0.13
10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
Exactly as predicted:

Even as the Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006. Bernanke should have seen this coming in Dec. 2007 - I COULD.
Ben Bernanke was the direct cause of May 6th's Flash Crash:
Written on Mar 30 11:31 am:
"Contrary to economic theory, & Nobel laureate Dr. Milton Friedman, monetary lags are not "long & variable". The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length. However the lag for nominal gdp (the FED's target??), varies widely."
Assuming no quick countervailing stimulus:
jan..... 0.54.... 0.25 top
feb..... 0.50.... 0.10
mar.... 0.54.... 0.08
apr..... 0.46.... 0.09 top
may.... 0.41.... 0.01 stocks fall
Been saying this for the last 6 months. Should see shortly. Stock market makes a double top in Jan & Apr. Then the real-output of final goods & services falls/inverts from (9) to (1) from Apr to May.
Recent history indicates that this will be a marked, short, one month drop, in rate-of-change for real-output (-8). So stocks follow the economy down (with yields moving sympathetically?)"
flow5 Message #10 - 05/03/10 07:30 PM
The markets usually turn (pivot) on May 5th (+ or - 1 day).

Actually what pivots is the level of legal reserves. But our public servants want to rid the bankers of this tax [sic].

Why has this gone unnoticed? One reason is that the Fed covers up their errors. They can "undo" their miscalculations. When you try & construct a time series to see if there’s any cause & effect relationship you will find that the calculations are only valid ex-ante & not ex-post.

Another reason is that”: e-mail 11/16/06: “Spencer, this is an interesting idea. Since no one in the Fed tracks reserves…” V.P. Fed’s technical staff

This is how I made the prediction that AAA Corporate yields would reach 15.48% in 1981. They actually hit 15.49%.

Flow5 said...

By using the wrong operating criteria (interest rates, rather than member bank legal reserves) in formulating and executing monetary policy, the Federal Reserve exaggerated the boom & then the bust.
(1) Ben S. Bernanke - Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body.

“At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.”

2) European Central Bank (ECB) Central Bank for the EURO

“The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…”

3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco

“You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.”

(4) Thomas M. Hoenig - President of Federal Reserve Bank of Kansas City

“Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.”

(5) William Poole - President, Federal Reserve Bank of St. Louis

“However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.”
(6) Robert W. Fischer – President Dallas Federal Reserve Bank
November 2, 2006: "In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data."
(7) Governor Donald L. Kohn
“I think a third lesson is humility--we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.”
(8) James Grant (Grant’s Interest Rate Observer)
“Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings. And because matter doesn’t talk back or change its mind in the middle of a controlled experiment or buy high with the hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats.”

Flow5 said...

First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” :
(1) “Money” is the measure of liquidity; the yardstick by which the liquidity of all other assets is measured;
(2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits - Vt) that’s statistically significant (i.e., financial transactions are not random);
(3) Nominal-gDp is the product of monetary flows (M*Vt) (or aggregate monetary purchasing power), i.e., our means-of-payment money (M), times its transactions rate of turnover (Vt);
(4) The rates-of-change (roc’s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;
(5) Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus;
(6) Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, & for (2) inflation indices (for the last 99 years), are historically mathematical constants. However, the FED's transmission mechanism (interest rate target), is indirect, varies widely over time, & in magnitude;
(7) Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not an arbitrary date range); as demonstrated by the clustering on a scatter plot diagram);
(8) Not surprisingly, the companion series, non-seasonally adjusted member commercial bank “costless" legal reserves (their roc’s), corroborate both of monetary flows’ (MVt) distributed lags –-- their lengths are identical (as the weighted arithmetic average of reserve ratios remains constant);
(9) Consequently, since the lags for (1) monetary flows (MVt), & (2) "costless" legal reserves, are synchronous & indistinguishable, economic prognostications (using simple algebra), are infallible (for less than one year);
(10) Asset inflation, or economic bubbles, are incorporated: including housing, commodity,, etc. This is the “Holy Grail” & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified after 45 years on March 23, 1983.;

Flow5 said...

(11) The BEA uses quarterly accounting periods for real-gDp and the deflator. The accounting periods for gDp should correspond to the specific economic lag, not quarterly. Because the lags for gDp data overlap roc’s in MVt, the statistical correlation between the two is somewhat degraded. However the statistical correlation between roc’s in MVt, & for example, the bond market is unparalleled;
(12) Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real-gDp;
(13) Combining real-output with inflation to obtain roc’s in nominal-gDp, can then be used as a proxy figure for roc’s in all transactions. Roc’s in real-gDp have to be used, of course, as a policy standard;
(14) Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is advisable to follow a monetary policy which will permit the roc in monetary flows (MVt), to exceed the roc in real-gDp by c. 2 – 3 percentage points;
(15) Monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels;
(16) Some people prefer the “devil theory” of inflation: “It’s all Peak Oil's fault", ”Peak Debt's fault", or the result of the “Stockpiling of Strategic Raw Materials/Industrial Metals” & Soaring Agriculture Produce. These approaches ignore the fact that the evidence of inflation is represented by "actual" prices in the marketplace;
(17) The "administered" prices of the world's monopolies, and or, the world’s oligarchies: would not be the "asked" prices, were they not “validated” by (MVt), i.e., “validated” by the world's Central Banks;

Flow5 said...

These are the FACTs:

At the height of the stock market bubble, Greenspan initiated a "tight" monetary policy (for 31 out of 34 months). A “tight” money policy is defined as one where the rate-of-change in monetary flows (our means-of-payment money times its transactions rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), & reverted to a very "easy" monetary policy -- for 41 consecutive months (i.e., despite 17 raises in the FFR, -every single rate increase was “behind the inflationary curve”). I.e., Greenspan NEVER tightened monetary policy.

Then, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a "tight" money policy (ending the housing bubble in Feb 2006), for 29 consecutive months, or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression).

The FOMC continued to drain liquidity despite its 7 reductions in the FFR (which began on 9/18/07). I.e., despite Bear Sterns two hedge funds that collapsed on July 16, 2007, & immediately thereafter filed for bankruptcy protection on July 31, 2007 -- as they had lost nearly all of their value), the FED maintained its “tight” money policy (i.e., credit easing, not quantitative easing).

I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers later filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market), on September 15, 2008.

And Greenspan didn't start "easing" on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn't change from a "tight" monetary policy, to an "easier" monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4% (approximately coinciding with the bottom in equity prices).

I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), & high inflation (rampant real-estate speculation, followed by widespread commodity speculation).

Bernanke then relentlessly drove the economy into the ground, creating a protracted un-employment, & under-employment rate, nightmare.