A long post from Erwan Mahé – but immensely readable. It shows how ideas from academic scribblers (especially about the nature of money and (un)employment) directly guided central bank discussions and policies in a crucial period (some articles are even explicitly mentioned by Yellen!). Don’t forget, however, the anonimous data produced by economic statisticians, which with their strengths, weaknesses and unavoidable biases guide policy too. In the end it’s about wich theory is, at a central bank, used to understand this data. MK.
As part of my research conducted in preparation for the FOMC meeting this week, which largely explains the brief hiatus in the publication of the Thaler’s Corner, I had the pleasure of plunging into the full minutes of FOMC meetings held five years ago, just as I have in previous years, but this time, they include all of 2009. http://www.federalreserve.gov/monetarypolicy/fomchistorical2009.htm Like those of 2008, the examination of these few thousand pages of courteous yet frank discussions were well worth the effort, considering the extraordinary circumstances under which those meetings took place! I have surely put more work into today’s newsletter than I have in a long time. Even if you view the excerpts as long and daunting, I strongly recommend that you take the time to read them to the end.
It would be hard to exaggerate the instructive value of the minutes, starting with the inflation targeting discussions, the launch of the LSAP (QE treasuries), the comments about how the Fed would exit from the QE, the support for the newly established (alphabet soup) liquidity programmes (TAF, PDCF, TSLF, CPFF, AMLF, MMIFF, TALF, etc!), and the currency swaps with the other central banks. However, aside from the pleasure of delving into these critical moments in history at a time when our eyes were glued to the news screens in the hope of receiving some divine word, the reason I delved so enthusiastically into these documents was to better understand the Fed’s reaction function, such as it is today, as we await new big decisions in the months ahead. My focus was mainly on Janet Yellen’s comments, because she would later become the Fed chairman. Although the FOMC generally makes its decisions on a consensual basis, we cannot neglect the key role played by the leader of the institution.
After scrupulously analysing the comments, I have shortened my time prediction for the Fed’s rate hike, although it remains a bit later than the consensus view. But first, check out the following excerpts, which illustrate perfectly the degree of confusion of certain FOMC members and the clairvoyance of others.
Loans make Deposits!
Banks do not lend from their reserves!
Longstanding readers of this newsletter are aware of just how much I insist on the conceptual and operational reality that loans make deposits. In other words, commercial banks do not rely on either reserves or deposits to make loans.
In practice, they create money ex-nihilo. They credit their clients’ accounts for the loan amounts granted, thereby balancing the assets and liabilities (loans vs deposits). If said deposits are then transferred to another bank, all the banks need do is trade them back on the interbank market. In the extreme case where a commercial bank is unable to reconstitute its required reserves amount (given that some countries do not have such required reserves levels), the central bank can provide it funds as the lender of last resort, since it wants to maintain control over its target overnight lending rate. Once we grasp this point, it is easier to understand why the massive injection of surplus reserves by some central banks, within the framework of their QE, had little direct impact on the capacity of commercial banks to lend money to the real economy. Conventional wisdom notwithstanding, said reserves are not necessary to grant loans.
This is what Janet Yellen said on the matter at the 16 January 2009 meeting:
“There is growing concern that the Fed is printing money with abandon to stimulate the economy, and the combination of trillion dollar deficits and trillions of dollars of money creation can have only one outcome in the long run, which is high inflation that debases the currency. Now, I think this reasoning is completely misguided, but it is out there, and I think we need to consider it because it is dangerous for our credibility as an institution.”
She later commented at the meeting of 17 and 18 March:
“But I would emphasize that I don’t agree with the underlying theory that says that there is a relationship between the size of the monetary base and our impact on the economy, and I would associate myself with the comments of President Rosengren and Governor Kohn on this. So I don’t like the language that suggests an emphasis on the size of our balance sheet and the size of the base. I think we have a real theoretical disagreement among ourselves as to exactly how our policy works, and I just wouldn’t endorse going in that direction.
One thing is for sure: Ms Yellen was not afraid of expressing opinions that could have rubbed her colleagues the wrong way, but she also did so with diplomacy! Many FOMC members (Yellen, Evans, Kohn, Pianalto, Dudley, Rosengren) argued eloquently that, although the QE programme induced macroeconomic incidences, mainly via indirect effects (interest rate and currency levels, the portfolio rebalancing channel), it had little direct impact on the bank lending business and that the excess reserves did not amount to adding dry tinder to the fire, despite the claims of the Fed’s Austrian School partisans (Plosser, Fisher, Hoenig). This is what Mr Dudley said at the meeting of 11 and 12 August 2009:
The last time the view was expressed that excess reserves sitting on banks’ balance sheets are essentially dry tinder that could quickly fuel excessive credit creation and put the Fed behind the curve in terms of tightening monetary policy. I have to admit that, in terms of imagery, this concern does seem compelling. The banks are sitting on piles of money that could be used to extend credit on a moment’s notice. However, I think this reasoning ignores a very, very important point. Based on how monetary policies have been conducted for the past several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of dry tinder in the form of excess reserves to do so. That’s because the Fed has committed itself to supply sufficient reserves to keep the federal funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. So in terms of the ability of banks to expand credit rapidly, it makes no difference whether they have lots of excess reserves or not. I think it is an important point.
On the contrary, you can see how Mr Fisher unconsciously expresses his beliefs, below:
Chairman Bernanke. Thank you. President Fisher— back from the Galapagos, by the way.
Mr. Fisher. Yes, and where you can see how creative destruction works over very prolonged periods, Mr. Chairman. Chairman. I recommend it to anybody who would want to truly get away from what we constantly worry about.
My views are clearly recorded. I was quite concerned about the politics of this, given my background and given that I am neither an academic nor as intellectually potent as the rest of the people around this table or on this video screen.
I could not help but draw the parallel between this wink to “creative destructive”, dear to Joseph Schumpeter and to the Austrian School, and his acknowledgement of a lack of macroeconomic background! I know it is a bit cruel, and I look forward to hearing the reaction of outrage from some of my readers who follow this economic school of thought, but if you take the time to read the accumulated nonsense offered by the Dallas Fed president, I promise you will be far less indulgent. I do not know if we will ever be able to appreciate just how much of a thin line Mr Bernanke was forced to tread for years in order to gain support for his decisions, given the archaic views held by some Fed members, who were driven by a mix of deformed monetarism and “rational expectations”.
That said, Mr Bernanke does not appear to have been very clear either on the link between these excess reserves and bank loans. I would like to believe his lack of clarity was due to tactical considerations.
Yellen and the Output Gap
One of the constants throughout 2009 was the San Francisco Fed president’s unrelenting focus on the size of the output gap and her systematic advocacy of a more accommodative monetary policy than that already in existence. She spoke much less often than some other members, and there were hours of conferences calls, like in February and June 2009, when she said nothing. But when she spoke, she had a way of making herself perfectly understood by all. Here are a few excerpts (which are a bit long, but they represent barely 5% of the texts, and they are well worth the read):
27-28 January 2009
Still, even with a large fiscal stimulus, it will take many years before the economy returns to potential and economic slack is eliminated.
17-18 March 2009
I would be supportive of going ahead with purchases of Treasuries at this point, as well, on various grounds. One is that the economy is just a disaster area. The economic outlook is utterly dreadful, and we have said we stand ready to do absolutely everything that’s needed to support the economy. We have let some time pass without doing anything, and in light of the outlook I would want to do everything we can. The optimal policy simulations would take the fed funds rate to negative 6 percent if it could, and because it can’t, I think we have to do everything we possibly can to use our other tools to compensate. There’s a principle elucidated by William Brainard 30 years ago that, when policy actions have uncertain effects, you should simultaneously use all of your instruments, and I think that’s a worthwhile principle for us now.
28-29 April 2009
(She was the only member at this meeting to ask for a hike in the amount of the already begun LSAP!)
I am particularly concerned about the labor market, where the data are appalling… What is worse, the unemployment rate appears to understate the true magnitude of the labor market deterioration.
Indeed, the optimal policy simulation indicates that we should lower the funds rate to negative 7½ percent, if that were feasible.
The Greenbook projection, with which I broadly concur, assumes no change from our announced asset purchases. It foresees unemployment remaining above 9 percent through the end of 2010 and inflation well below our preferred rate for even longer. I consider this unacceptable in light of our mandates. I think we need to do more to get the economy moving forward.
23-24 June 2009
The output and employment gaps are, at a minimum, quite large, so it will take a long time to regain full employment under current monetary and fiscal policy settings.
And, of course, labor markets continue to deteriorate badly. It’s a sign of how bad things really are that near euphoria broke out with the announcement of 345,000 nonfarm jobs lost in May. …
With a GDP gap of about 5½ percent, the economy is in a deep hole, and it will take a long time to climb out, even if growth is rapid.
As the Bluebook points out, … this translates into a cumulative loss on the order of 10 percent of GDP, or $1½ trillion, and creates a very strong case for doing everything possible to stimulate the economy.
Christina Romer recently wrote a pertinent essay for The Economist on “The Lessons of 1937” that you may have read. As many of you know, in that year, following two years of robust recovery, the Federal Reserve tightened policy too soon because it was worried about large quantities of excess reserves in the banking system. The economy plunged back into depression, and I believe that a parallel can be found in Japan’s experience of the 1990s as well. So I think we need to do all that we can to avoid creating the impression that we intend to raise the federal funds rate any time soon.
11-12 August 2009
Even if we are lucky enough to get sustained, robust GDP growth of, say, 4 to 5 percent for the next two years, we are still likely to fall short of our full employment goal, given the size of the output gap and the pace at which potential output appears to be growing.
These inflation fears notwithstanding, the main threat to the attainment of our price stability goal over the next several years stems from the disinflationary forces that have been unleashed by the enormous slack in the economy.
I support the revised version of alternative B. I do want to emphasize, though, that I believe a strong case exists for further monetary stimulus.
22-23 September 2009
Turning to inflation, it will surprise no one around the table that I anticipate that the prospect of high unemployment for years to come is a key factor shaping the outlook.
Under any reasonable interpretation of the evidence, both labor and product markets have a considerable amount of slack. And the existence of a causal link between slack and resource utilization and wage and price inflation is not only theoretically sensible, it’s also consistent with both anecdotal and econometric evidence.
I see a strong case on policy grounds for further monetary stimulus. Core inflation is currently below my price stability goal of about 2 percent, and the unemployment rate is well above my full employment goal of about 5 percent.
I am pretty sure that, if it were possible, we would at this point have taken the federal funds rate into negative territory … Unfortunately, so far this year, the nominal funds rate has been fixed near zero while core inflation has fallen. So the real funds rate has risen. In this sense, monetary policy has actually tightened this year, although circumstances—namely, the increase in unemployment and decline in core inflation—seem to call for more monetary stimulus.
3-4 November 2009
Against this backdrop of substantial slack, a key factor putting a floor on the decline in the inflation rate is the public’s confidence that we will do whatever it takes to bring the economy back from recession and keep inflation from falling too low. If we waiver from that pledge and tighten too soon, confidence in our commitment to economic recovery and price stability could be undermined, and that could be a recipe for an extended episode of disinflation or even deflation like the one Japan suffered through. A commitment to low and stable inflation involves defending the inflation objective on both the upside and the downside.
Of course, our policy decisions must depend on how economic developments actually unfold. But if we signal a tightening of policy before it is justified by the evolution of inflation and economic slack in the economy, perhaps partly out of concern that market participants see us as getting behind the curve, we could upset confidence in our policies, cause longer-term rates to rise, and end up in a more dangerous deflationary situation.
15-16 December 2009
There is, of course, some range of opinion on the extent of slack in the economy. Some of my directors characterize it as very large. Others insist it is so massive that we will end up with a lost generation of people whose skills and labor market attachment atrophy from disuse.
Last week I showed a forecast much like the Greenbook’s to my directors. Frankly, they were incredulous. Every single one of them thought we were overly optimistic about employment.
The high degree of slack in labor markets is also making it harder to achieve what I view as a desirable inflation rate of 2 percent for core PCE prices.
The bottom line is that we are faced with a situation in which inflation is undesirably low, and, even with large monthly employment gains, the level of resource slack will remain high for an extended period. In my forecast, the zero bound and the limits on unconventional policy constrain us from pursuing a more desirable and more expansionary policy for some time to come.
I favor alternative B, but I would like to emphasize something that I’ve said in the past. I continue to see a persuasive case for further policy easing.
We need to remind ourselves of this fact to counteract the very natural instinct to tighten policy as the economy recovers. It’s true that, if we had been free to lower the federal funds rate into negative territory, it would probably be appropriate to start tightening in the not-too-distant future. But we were constrained on the way down by the zero bound, and, in the face of that bound, systematic policy calls for us to hold the federal funds rate near zero for a long time to come.
The lesson I draw from examining these texts is that Janet Yellen was extremely prescient in her comments about the output gap’s impact on the behaviour of inflation in the subsequent years. She spearheaded the fight to increase monetary stimulation at a time when worries were already being raised about how the Fed would be able to exit its first QE programme. We now know that the first QE programme, evoked during the meetings in 2009, was increased to $2.1 trillion and extended in June 2010 ! The Fed then carried out a reinvestment policy in August 2010 to prevent its balance sheet from contracting.
It then launched a second QE programme from November 2010 to mid-2011. A Twist operation was then launched in September 2011 to replace $667 billion in short-term maturities with long-term maturities. A third QE, an open-ended programme entailing $40 billion of monthly purchases, was launched in September 2012. This monthly purchase amount was increased to $85 billion in December 2012 before it was phased out and ended in October 2014.
At that time, the Fed’s balance sheet totalled $4.5 trillion!
The Janet Yellen of 2015 is not the same person she was in 2009, and the economic conditions have significantly changed, especially on the jobs front, which is the key criterion in the models used by the current Fed chairman. If we concentrate on the reaction function, she should hike benchmark interest rates in June of 2015, as per the consensus forecast. The latest employment data are very good, as highlighted by the fall in the unemployment rate from a high of 10% at year-end 2009 to 5.50% in February 2015 ! My initial forecast was that the Fed would not raise rates before September 2015, and probably not even before the end of the year. Common sense says that I should align myself with the consensus view of a rate hike in June, and I agree that the Fed will probably make its move before the end of 2015. But I am sticking with my target of September 2015 at the earliest, because three factors lead me to believe that the Fed will be a bit more patient. After all, we are far removed from any serious risk of an upsurge in inflation, which would undermine the Fed’s second mandate, namely inflation.
In the first place, the dollar has substantially appreciated since the summer of 2014, as seen in the following graph, taken from the web site of the St-Louis Fed. (A gold mine!)
Trade Weighted U.S. Dollar Index
It has appreciated more than 14% in the past nine months, which may not appear much in comparison with other forex movements, but it represents a significant shift in a basket of US trade-weighted currencies. This will have a big impact on import prices, and we will have to keep a close watch on these changes between now and June. And this does not account for the international financial stability criteria, given that any acceleration in the dollar’s appreciation could destabilise certain emerging regions where external or bank debt is still denominated in USD, thus revisiting the “tapering” problems of spring 2013. While the Fed must respond to its domestic mandate, it is nonetheless responsible for the monetary policy of the “world’s reserve currency”, and cannot ignore the consequences of its actions on the rest of the planet. This is so much more the case in that economic conditions abroad influence those of the United States. More precisely, they could lead to the “importing of disinflation” in a global context characterised by a deficit in aggregate demand and a surplus in supply.
The second point, which I believe should reassure Ms Yellen and put a brake on calls for normalisation within the Fed, is the labour force participation rate. This ratio provides a more accurate gauge of changes in the output gap, so dear to Ms Yellen, because, if the employment market were to show signs of tension, this labour pool should play its usual role as safety valve.
Here is the graph from 1975.
US Labour Force Participation Rate
As you can see, the labour force participation has fallen to the lowest level since 1978! This probably explains why salary growth in the United States has been stuck at around 2% per annum, well below the pre-crisis level of about 3.5%. In short, there is no upward inflation potential from the labour front. I do not agree that the decline in the labour force participation rate is structural, notwithstanding those who would like to hike the infamous NAIRU. As the employment market picks up steam, many of those who opted out in the past few years will return.
The third point that leads me to a more patient stand is the recent behaviour of commodity prices. As readers know very well, I am no fan of linking commodity prices with monetary policy, given my criticism of the ECB’s underlying idea that a rate hike would lead to the opening of more oil spigots in 2011. Likewise, a central bank must show symmetric restraint in the face of collapsing commodity prices. However, the graph below displays a very real relationship between these prices and the subsequent inflation indices, including the core index.
CRB and US Inflation
The yellow curve tracks the CRB’s changes year-on-year, as opposed to its nominal level. I view this measure as a more appropriate way of evaluating its impact on the PCE price index.
Given the commodity price declines of the last quarter, prices are declining at a rate close to that of 2009. Although certain other deflationist criteria of that time (dislocated financial system, skyrocketing unemployment) are not present today, this development should prevent the PCE core index from rebounding in the coming months. Like for the dollar with which the CRB may be significantly correlated, we must monitor it closely from now until June. That is all I have to say for today. I hope I have provided all the information, with the description of Ms Yellen’s mindset, you need to form your opinions, in accordance with your scenarios. I had a number of links to share with readers, but, given the level of reading already, it can wait for a future Thaler’s Corner.
One last word. Despite her austere demeanour, Ms Yellen has a tremendous sense of humour, which eases considerably the reading of these uncensored FOMC minutes. I provide below a few cases in point:
27-28 January 2009
The residential housing sector has now shrunk so much that the only real assurance that it will ever stabilize seems to be the fact that construction spending cannot go negative. This is just about the only zero lower bound that is working on our side. [Laughter]
11-12 August 2009
Thank you, Mr. Chairman. Winston Churchill once remarked that nothing in life is so exhilarating as to be shot at without result. [Laughter] Well, exhilaration may be an exaggeration, but I am at least hugely relieved that our financial system appears to have survived a near-death experience. And I am optimistic that you will not be the Chairman who presided over the second Great Depression. [Laughter]