Fed adopts de facto inflation target

Most news headlines, it looks like, have focused on the dissent of views about the launch of QE2 in minutes of the latest FOMC meeting. But what's more revealing is that the Fed discussed whether or not to adopt an inflation targeting, which Chairman Ben Bernanke once promoted but has withdrawn since getting the Fed job.

No decision was made on the adoption of "a numerical inflation objective or a target path for the price level" at this time, but instead the projected longer-run PCE inflation rate in the Summary of Economic Projection is left as a de facto inflation target, saying

participants noted that the longer-run projections contained in the Summary of Economic Projections, which is released once per quarter in conjunction with the minutes of four of the Committee's meetings, convey considerable information about participants' assessments of their statutory objectives.

The Fed implicitly acknowledges that its monetary policy, be it quantitative easing or rate change, is supposed to run for this goal, now 1.6-2.0%, which has just been revised down from 1.7-2.0% in June. PCE inflation rate is currently around 1.4%, a little bit lower from the target.

This de facto inflation target resembles that of the BoJ. Instead of the longer-run PCE inflation rate projection, Japan's central bank has "Understanding of Medium- to Long-Term Price Stability," which was introduced in 2006 to clarify the meaning of price stability in a mid- to long-term as an objective of monetary policy. According to the BoJ,

In today's Monetary Policy Meeting, there was a discussion of the level of inflation rate that each Policy Board member currently understands as price stability from a medium- to long-term viewpoint, in the conduct of monetary policy ("an understanding of medium- to long-term price stability"). While there was a range of views, reflecting the differences in the relative weight attached to factors affecting the understanding of price stability, it was recognized that the level was somewhat lower than that in major overseas economies. It was agreed that, by making use of the rate of year-on-year change in the consumer price index to describe the understanding, an approximate range between zero and two percent was generally consistent with the distribution of each Board member's understanding of medium- to long-term price stability. Most Board members' median figures fell on both sides of one percent. Given that the understanding of medium- to long-term price stability may change gradually reflecting developments such as structural changes in the economy, as a rule, Board members will review it annually.

Currently, the average of most Policy Board members' "understanding" is around 1% in terms of the year-over-year increase rate of CPI. The BoJ hasn't officially declared the adoption of an inflation target mechanism, but a 1% change of CPI is widely believed to be no less than the BoJ's price target. The latest figure is -0.6%, which means Japan is still mired in deflation and hence the central bank will continue the current monetary loosing.

The Fed has, on the other hand, one more target: unemployment rate. The longer-run unemployment rate is projected to be 5.0-6.0%, which has recently been changed from 5.0-5.3% in June, reflecting severe labor markets condition where the current unemployment rate is as much as 9.6%.

As is well known, the Fed has dual mandate: price stability and maximum employment. So, the question may arise as to what if one mandate is fulfilled while the other isn't. Stagflation, recession with rising inflation, is the prime example which could compromise the Fed's mission. As far as the recent minutes go, it seems that the Fed has much more fear of deflation than stagflation.

Lastly, some FOMC members raised concern that "additional expansion of the Federal Reserve's balance sheet could put unwanted downward pressure on the dollar's value in foreign exchange markets." As my previous post shows, Bernanke rebutted a claim that the Fed's quantitative easing has weakened the dollar. But now it's clear that some noticed a positive relation between the monetary easing and a cheap dollar, which would be a cause of later controversy on the Fed's role.

Politics, not economics

The US looks like much more paralyzed than before, which would ruin any chance of making an economic policy effective enough to weather one of the toughest times ever in history facing the country.

Recent attack against the Fed's quantitative easing is based on politics, not economics, largely encouraged by a huge gain of Republicans (and a terrible loss of Democrats as the other side of the same coin) in the midterm elections. Winners are ferreting out a pray for revenge. A pray worth while flaunting their new power. Then, the Fed has been chosen as a sacrifice. It doesn't matter whether the Fed Chairman Ben Bernanke is a republican or not.

Bernanke has just received two open letters to him: one from economists and the other from politicians, both of which criticize the latest Fed's move to buy $600 billion of Treasury securities, called QE2, for risking a cheap dollar, an asset bubble, and uncontrollable inflation.

This is not the first time for the Fed or Bernanke to be exposed in political backlash on the course of monetary policy. But it would be really daunting if the Fed is constrained by partisan politics when the US Congress is quite incompetent to churn out a timely policy as a result of the midterm elections, and hence monetary policy is the only way to counter the downturn.

In October, core CPI, CPI excluding volatile goods like food and energy, has increased only 0.61% over the year, the smallest on record. Taking it into account, few would doubt why printing more money is still justified to fend off disinflation or worse deflation which has crippled Japan for years.

By the way, the second smallest is 0.65% in 1961.

Inflation says it all

To rise or not to rise, that is the question.

A streak of the central banks' meeting last week signaled the age of divergence to achieve the desirable path to price stability. Among four of the largest economies' central banks, the Fed, the ECB, the BoJ, and the BoE, which discussed the course of monetary policy amid a weak recovery, only the Fed loosened its grip on monetary policy to start buying long-term Treasury securities, dubbed QE2, as widely expected. The other three central banks, which convened after the FOMC meeting, kept their stance, though the BoJ decided last month to pump more money into the economy by purchasing JGB, REIT, and corporate bonds.

What split their responses? Just look at inflation, and you'll have a clear reason behind it. CPI inflation rate in the UK and Euro zone, whose central banks didn't move, is higher than the US and Japan, both of which resumed printing money.

Let's see how they think about inflation. The FOMC statement declares that measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run. The Fed's Chairman Ben Bernanke, of course, hasn't forgotten the mandate of the central bank as holding inflation at a low level.

"We are absolutely committed to keeping inflation low and stable," Bernanke said in response to a question at Jacksonville University. "We have the tools to unwind and tighten policy at the appropriate time, when that time comes."

All the more important right now is, however, to keep deflation at bay.

"We're not in the business of trying to create inflation, our purpose is to provide additional stimulus to help the economy recover and to avoid potentially additional disinflation, which I think we all agree could also be worrisome."

...

"We've had a very significant disinflation since the beginning of the crisis. We should not be satisfied with a situation where we have both a large amount of slack on the employment side and inflation which is below our generally agreed upon level and seems to be declining over time."

The ECB President Jean-Claude Trichet, on the other hand, described risks to the inflation outlook as "slightly tilted to the upside," and even reiterated his intention to stick to an exit strategy, saying "the non-standard measures that we have taken are, by definition, of a transitory nature."

Thus, views on the outlook of inflation are one of the main drivers which divided the major central banks' reaction to the current economy last week.

Meanwhile, German Finance Minister Wolfgang Schaeuble wasn't patient enough to contain his complaint on the Fed's policy.

"I have great doubts about whether it makes sense to pump unlimited amounts of money into the markets," Schaeuble told Der Spiegel news magazine. "There is no shortage of liquidity in the U.S. economy. I can't see the economic argument for this move."

The U.S. central bank's decision to extend its program of quantitative easing raised uncertainty in the world economy, he said.

"It will make it difficult to get a reasonable balance between the industrial and emerging nations and it undermines the credibility of U.S. financial policy," Schaeuble said.

He has repeatedly criticized the U.S. plan to buy debt and pump more money into the economy to prop it up. He also defended Germany against criticism of its trade surplus.

"The German export success is not due to any currency tricks but rather due to the improved competitiveness of German companies," Schaeuble said. "The American growth model is stuck in a deep crisis."The United States has lived beyond its means for too long, its financial sector is disproportionally inflated and its industrial core neglected. There are many reasons for America's problems ... the German export surplus is not one of them."

Schaeuble also criticized U.S. foreign exchange policy. "It's not right when the Americans accuse China of manipulating exchange rates and then push the dollar exchange rate lower by opening up the flood gates by turning on the printing presses," he said.

On Friday he said U.S. monetary policy was "clueless."

German Finance Minister was also reported to liken the Fed's quantitative easing to China's currency policy.

"At the moment, from a European viewpoint, one could get the impression that the U.S. is doing through other means what it is reproaching China for," Schaeuble said at a conference in Berlin.

"One could get the idea that the instruments are different but the goal is the same, and the one who suffers are clearly...to a certain degree the Europeans," the minister argued.

Well, Germans definitely have something to worry.

The Japanese, in turn, seems like too well-behaved to raise a concern, despite the yen's sharp appreciation. Japanese Finance Minister Yoshihiko Noda made no comment when asked about the Federal Reserve's latest monetary easing, though admitting to have to closely watch the US economy and monetary policy (in Japanese). The BoJ Governor Masaaki Shirakawa dismissed the idea of monetary easing race, saying "I do not see Japan and the United States as in a monetary easing competition."

Bernanke rebutted critics who claim that the Fed's monetary policy has given birth to the weak dollar.

"The best fundamentals for the dollar will come when the economy is growing strongly," Bernanke said today in response to questions from college students in Jacksonville, Florida. "That is where the fundamentals come from. We are aware the dollar plays a special role in the global economy."

"A strong U.S. economy is critical not just for Americans but for a global recovery," he added. "So in that respect it is very important we do achieve a faster recovery in the U.S."

Surprised, NYT wrote, "In commenting on the dollar, Mr. Bernanke was making an unusual departure from custom. By tradition, the dollar is the purview of the Treasury secretary and monetary policy is the domain of the Fed chairman, and neither official steps on the other's turf."

Bank of Japanization of Fed

My capacity of English severely constrains how to make up a new word, but it seems to me that the Fed is clearly going to follow after the BoJ, in the sense that the next move would be nothing less than the de-facto inflation targeting where the BoJ is on the way.

At the FOMC meeting, the Fed decided to buy $75 billion of long-term Treasury securities per month by the end of June in 2011, which totals $600 billion. At the time of QE1, the Fed purchased $300 billion over 6 months. The magnitude and term of QE2 is at least larger than QE1.

A little bit interesting to me is that the Fed will keep reinvesting principal payments from its securities holdings. The Fed is now buying about $30 billion of long-term Treasury securities per month as a reinvestment of principal payments. It's not much compared with the new purchase, but the Fed's intention would be that there is no reason to stop it right now.

It would be better to gauge the impact of the mid-term election, where the Democrats were heavily blown, on the economy, but it's beyond my ability. My guess is that the congress will be so paralyzed that the next big push from fiscal arena is difficult to be taken into account as a reliable and expected economic policy. So, the next Fed's move would be far bolder and greater than thought to make up for fiscal inability.

If the Bank of Japanization means the incompetence of monetary policy, what would be left to stimulate the economy? Could paralyzed congress save the country? The US seems to be getting into a very, very hard time.

Future debate on monetary policy

It seems like the graph below is spreading in the econ-blogosphere. I took it from here. You can also see it here and here. The idea is simple: the US is falling into deflation like Japan.

Yup. It could be.

One might wonder how to avoid deflation, the worst case scenario for all policy makers in the current world. According to the Federal Reserve Act, the Board of Governors and the Federal Open Market Committee should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." So, the Fed is expected to act against deflation in the US. But should disinflation go on or turn to deflation, discussion would be sharply divided by two on how to do with monetary policy. I call the two "Enough" and "Not enough."

"Enough" camp refers to those who think that monetary policy isn't effective to combat deflation. Most central bankers would belong to this group if they see deflation entrenched despite every policy they make. Central bankers contrive some policy action more often than not at a monetary policy meeting, but they admit that it's no use to relieve the pain. Monetary policy would gradually turn to an excuse for dodging criticism from the parliament which is worried about reelection. They think that fiscal policy or structural reform or combination of both should be much more conductive to shore up the economy. Some of this camp preach more radical reforms like "Any monetary or fiscal policy won't work. Complete restructuring of the whole economy is the only way to survive." But it's not so many.

"Not enough" people are likely to regard deflation as the result of hesitation or inaction by central bankers which they think should give priority to price stability. Analysts or economists in private institutions would be eager to join this group. Whenever central bankers move, they think that it's not enough to root out deflation. Unless deflation is out of sight, they keep saying "It's not enough!", and accusing central bankers of their inertia or even lack of knowledge in basic economics. This group wants central bankers to buy every financial assets, no matter which is stocks, bonds, or REIT, and to degrade central bank's assets. One of the characters of this circle is to almost deny the independence of central banking and to promote the integration of monetary and fiscal policy.

Which party would you think you join?

Deflation or Inflation?

So, the Fed is going for QE2. Fed Chairman Ben Bernanke is ready to buy more Treasury. Or at least the markets anticipate it. His concern is now deflation, not inflation.

The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve's dual mandate in the longer run. In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable. Given that monetary policy works with a lag, the more relevant question is whether this situation is forecast to continue. In light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation--setting aside the inevitable short-run volatility--will be less than the mandate-consistent inflation rate for some time. Of course, forecasts of inflation, as of other key economic variables, are uncertain and must be regularly updated with the arrival of new information.

Then, why are people suddenly worrying inflation, not deflation?

Treasury 30-year bonds tumbled, pushing yields to the biggest weekly increase since August 2009, on speculation that Federal Reserve efforts to spur the economy will reignite inflation.

The 30-year yield rose above 4 percent yesterday for the first time in two months after data showed retail sales rose more than forecast and New York area manufacturing climbed. Fed Chairman Ben S. Bernanke said additional stimulus may be warranted, in part because inflation is too low. The Fed will release its regional economic survey next week. The U.S. sold $66 billion of notes and bonds to lower-than-average demand. 

The spread of both 5- and 10-year yields between conventional and TIPS bonds has been widening since last month. Is it a proof that Bernanke has already made some success in combating deflation? Or is it the wrong time for the Fed to start QE2, thus begetting uncontrollable inflation?

My guess is that knowing rising inflation expectations shown above, Bernanke and Co. is betting on the notion that underlying inflation is "too low." The Dallas Fed once claimed that

TIIS spreads are not a very good guide to inflation expectations because they are sensitive to changes in inflation uncertainty and the demand for liquidity. In particular, the recent increase in TIIS spreads probably overstates the extent to which investors' long-term inflation expectations have risen. It should not carry much weight as evidence for the proposition that the Fed has eased too much in response to the current economic slowdown.

So, according to the Dallas Fed, TIPS spreads are not a reliable measure of inflation expectations, especially when they are rising. It seems like Bernanke counts on more conventional measures of inflation like CPI or PCEPI, which has shown meagre inflation recently.

Vice Chairman dissents

Janet Yellen said the super low rates would prompt risk-taking.

Janet Yellen, in her first public remarks as the Federal Reserve's vice chairman, said low interest rates may give firms the incentive to engage in excessive risk-taking.

"It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system," the 64-year-old central banker said in a speech today in Denver.

Yellen warned that Fed policies may in some cases be encouraging firms to "reach for yield" and could present officials "with difficult tradeoffs" if "emerging threats to financial stability become evident."

She was just sworn in as vice chairman of the Federal Reserve Board a few days ago, filling a void left by Donald Kohn who served the Fed for 40 years. Earlier this month, Steven K. Beckner of iMarketNews.com suggested that

Yellen has not spoken publicly in months, but hers has been a consistent voice warning about the dangers of excessively low inflation in a weak economic environment.

His assessment on Yellen is consistent with her yesterday's remarks. The question at this moment is; Why now? We have three weeks before the next FOMC, so there is ample time to discuss what to do at the FOMC. But Bernanke looks like sure to head for QE2, and inflation rates are not about to rise significantly for now. Donald Kohn would not dissent from chairman's idea. Is this the new vice chairman's way of steering monetary policy? I have no idea, but we have to see how they cooperate at the FOMC.

Two Nobels (hopefully) in the team

The 2010 Nobel Prize for economics was awarded to three professors; Peter Diamond of MIT, Dale Mortensen of Northwestern, and Christopher Pissarides of LSE.

Peter Diamond has, I think, been among the candidates since at least a few ago. The other two are a little bit surprising, but their pioneering work in search theory deserves the award.

Obama administration is having two Nobel laureates; Obama himself for peace and Diamond for economics. The problem is that Diamond's nomination to the Fed governor has been postponed by the GOP who thinks that there is a "mismatch" between his experience and the Fed's job. Can his theory solve this problem?

Heading toward QE2

The Fed is starting out QE2.

Federal Reserve Chairman Ben S. Bernanke said the central bank's first round of large-scale asset purchases improved the economy and that further buying is likely to help more.

"I do think that the additional purchases -- although we don't have precise numbers for how big the effects are -- I do think they have the ability to ease financial conditions," Bernanke said in response to questions in Providence, Rhode Island, at a forum with college students. He said the first wave that ended in March was an "effective program."

Bernanke and other Fed officials have signaled during the past two weeks that the central bank may announce the purchase of more Treasuries as soon as their next policy meeting Nov. 2-3 in an effort to boost economic growth and reduce an unemployment rate persisting at 9.5 percent or higher for the past year.

Separately, Brian Sack, the New York Fed official in charge of carrying out FOMC decisions, said a further expansion of the central bank's $2.3 trillion balance sheet would help stimulate a recovery that is forecast to be "relatively tepid." Smaller steps of purchases may be warranted in contrast to the last round, Sack said in Newport Beach, California.

Richard Berner, co-head of global economics at Morgan Stanley in New York, said a second round of large-scale asset purchases, also known as quantitative easing, is a certainty.

"We're skeptical that you get a lot of bang for the buck because there are a lot of blockages in the transmission channel for monetary policy," Berner said during a radio interview on "Bloomberg Surveillance" with Tom Keene. "Nonetheless, with gridlock persisting elsewhere in the policy environment, it just seems to us like QE2 is inevitable."

The labor markets condition is likely to advance more than a few months ago, and the stock markets are also, albeit very gradually, on the surge. Nevertheless, the Fed seems like thinking that the current recovery is not enough to remove the pain in labor markets. When Bernanke says he'll do it, I'm sure he'll do it.