Friday, November 30, 2012

Monetary policy update

With today's release of the Core PCE deflator (the Fed's preferred measure of inflation), I thought I would update some monetary policy charts. Core inflation is relatively benign at 1.6% over the past year, but it is substantially higher than the short-term rates the Fed is targeting, and that results in negative real borrowing costs. Real short-term borrowing costs are the best way to measure how "easy" or "tight" monetary policy is. By this measure, the Fed has never been so easy for so long.

The chart above shows the real Fed funds rate, calculated by using the Core PCE deflator. There are several things to note, most important being the see-saw nature of Fed policy. Fed tightening was likely the proximate cause of every recession in modern times, and it was almost always done in response to rising inflation. The Fed typically starts easing as recessionary conditions develop, and stays easy for the first few years of a recovery. But after being easy for several years, inflation typically picks back up, to be followed a few years later by Fed efforts to tighten once again. We are currently in the longest period of negative real borrowing costs. It would not be surprising to see inflation start to pick up in the next few years, to be followed by a recession a few years later.

This next chart overlays the slope of the yield curve on the first chart. Note that the yield curve slope tends to move inversely with monetary tightenings and easings. Recessions typically follow the point at which the Fed tightens policy by enough to invert the yield curve.

If there is one comforting message here, it is that monetary policy does not pose any threat to the economy. Indeed, policy is quite easy, as it almost always is during the early stages of a business expansion. Put another way, if we experience a recession in the next year or so, it will not be because the Fed has tightened too much. There is absolutely no shortage of money in the system these days.

What the Fed is doing is to actively encourage people to borrow money. Borrowing money at or near the funds rate to buy anything that is likely to rise in price even just a few percentage points a year is likely to be a profitable speculation. Leveraged investments, in other words, are almost a license to print money in this environment, and the Fed is all but guaranteeing that this will be the case for the next several years.

The good news is that investors can benefit from leveraged investments. The bad news is that this diverts capital from other areas of the economy that might be more promising. The Fed is promoting speculation, not long-term investment with this policy. Similarly, Fed policy is punishing savers in order to reward borrowers. This does not help the economy grow, and it likely is one of the reasons that growth has been disappointingly slow in recent years.


McKibbinUSA said...

My advice to the 99% crowd is to borrow easy money from the government to earn a doctoral education in medicine, statistics, mathematics, econometrics, physics, or engineering (and do not waste your money on "soft" courses) -- take the hardest courses from the hardest professors -- tell your children -- go for it!

Gloeschi said...

@ Dr. William: Yes! Join the student loan bubble!

Great advice to the 99%... since last time they leveraged up big time ended so well.

There is a certain suspicion you are Bernanke's pen name.

I had to laugh out loud upon reading this: "If we experience a recession in the next year or so, it will no be because the Fed has tightened too much".

How comforting.

Public Library said...

I would rephrase this part:

"Fed tightening was likely the proximate cause of every recession in modern times, and it was almost always done in response to rising inflation."

To: Fed tightening was likely the proximate cause of every recession in modern times, and it was almost always done in response to prior money printing (inflation) as a result of overly loose monetary policy.

randy said...

"The Fed is promoting speculation, not long-term investment with this policy. [..] This does not help the economy grow, and it likely is one of the reasons that growth has been disappointingly slow in recent years."

The fed has led us into a trap with exceptionally low rates for an extended period. It's behind many of our problems. As you say, our economy, for years (decades?), has focused on speculation instead of investment. Huge misallocation of capital. It is one of the significant drivers of "the growing divide" because so much wealth has been acquired from financial intermediation instead of traditional investment. You cannot overstate that. It's sad really. Our political leaders should man up.

randy said...

BTW, I started reading a thread on Quora the other day about "what's it like to be a Goldman Sachs partner". I was so disgusted when I read one responder about how you get numb with the first 7 figure year, I couldn't finish it. Producing what. Waste of human and investment capital.

randy said...

excuse me.... it was an 8 figure year. I apologize, I'm not used to throwing those kinds of numbers around.

Benjamin Cole said...

With the PCE deflator at 1.6 percent, it is obvious the Fed is not an an expansionary mode.

Since when is 1.6 percent inflation considered "loose"?

If you take the last four years the PCE deflator comes in at 1.4 percent.

The Cleveland Fed index of inflationary expectations is near record lows, for all the post-war era.

We simply do not have an expansionary Fed. We have microscopic rates of inflation and that is worrisome, as the Fed should be trying to juice things up to get the USA economy out of a recession-slow growth trap.

No one is forced to save. Yet Treasury auctions are swamped. When Treasury auctions are swamped, what does that tell you? That rates are too low? I don't think so.

The correct view os that the Fed is passively tight. We have hit zero bound, much like Japan did 20 years ago. Keeping rates near zero is only passive tightening. Since the Fed cannot go to negative two percent interest, the Fed has been stymied if it sticks to timid, conventional policies.

At long last, the Fed has turned to QE in a sustained manner. Too little, and too late. But perhaps $40 billion a month will stave off recession.

BTW, John Taylor advised Japan go into QE, and they did from 2001-6. If you go to his website you will find a paper in which he gushes about Japan's QE. Taylor also says nice things about a recent book by Robert Hetzel, a market monetarists approach to monetary policy.

For now, the 2 percent ceiling on the Fed's inflation target should probably be revered into a 2 percent floor.

But large public organizations do not get run out of business when they do a terrible job. The Fed is impervious, just like HUD, USDA, the Pentagon.

The was some sense in the idea of Don Regan, who was Ronald Reagan's Treasury Secy, when he advised putting the fed into the Treasury Department.

McKibbinUSA said...

Before we get too cynical about QE3, note that lots of Americans got rich from all the public funding of railways, waterways, and roadways over the past 200 years -- we as citizens may be over concerned at times about how the government resolves its fiscal and monetary plights, when we should instead be working on building our personal estates -- my advice regarding QE3 is to recognize how it differs from previous quantitative easting efforts, and then seek to exploit those differences -- QE3 is likely to make lots of savvy Americans rich in the next few years -- for example, Norwegians are keen to make money in US real estate in the coming years -- more at:

My guess is the US national debt will never be paid back, but rather will be sustained indefinitely until events enable an orderly default (like world war or some new technology that replaces current monetary regimes fundamentally) -- that's how these things go in history.

On the other hand, opportunities to build one's estate must be seized with enthusiasm and commitment -- Americans should be more worried about becoming financially independent than they are on fixing fiscal and monetary policy in the US -- let's face it, our elected officials aren't that concerned, so why should we worry so much.

Becoming financial independent requires that one look at the world through a lens that is different than macroeconomics -- yes, the national economy effects our goals, but most the national economy effects the goals of national firms and organizations -- and note that those national firms and organizations are doing just fine these days -- I'm not as worried about Goldman-Sachs as I am my personal holding company.

My mantra is unchanged, invest in dividend and rent-earning equities over your lifetime, and acquire world-class skills that convert in premium wages and enable you to accelerate the growth of your estate.

The financially independent person will thrive somewhere in the world in any economy -- never forget that Scandinavian residency can be had with a plane ticket and a cash purchase of a residence, all of which takes only a few weeks to transact -- getting into the 1% club should be every American's urgent priority, goal, and dream.

My advice is to go to some local real estate meetings in your county or city and get involved in the deal flows coming your way.

In the mean time, the world will fall apart around us, as always...