The Fed has yet to take monetary reform seriously
Aug 29th 2016, 17:56 BY R.A. | WASHINGTON
LARRY SUMMERS is right; this year's Fed symposium in Jackson Hole was triply disappointing. In the weeks before the gathering, members of the Federal Open Market Committee (FOMC) publicly discussed their worries that the current monetary framework might leave the Fed unable to deal adequately with future slowdowns. They got our hopes up: enough that we published a leader giving the Fed some suggestions for new approaches. But as Mr Summers says, the Fed let us all down. In their public remarks, at least, the FOMC members present expressed little concern about problems with the Fed's toolkit or weaknesses with the current 2% inflation target. Worse, Janet Yellen and Stanley Fischer, the chairman and vice-chairman respectively, used the occasion to tell markets to revise up their expectations of near-term rate hikes. Several of the regional Fed presidents suggested that the second rate rise of the cycle could come as early as the September meeting, while Ms Yellen reckoned that the case for an increase in coming months has strengthened.
The utter lack of urgency regarding monetary reform looks all the more worrying given the hawkish bias at the FOMC. In theory, Fed members could both accept the need for a new monetary framework and believe that current conditions (and the current framework) argue in favour of a near-term rate hike. Given current economic conditions, however, a hawkish stance is an implicit statement that the arguments in favour of reform are without merit.
There are lots of reasons why one might want to tweak the way the Fed does its job, but the focus of most recent reform proposals has been the long-run decline in the global real rate of interest consistent with non-slump conditions. That is: most big economies seem stuck with low real interest rates, even when they're rumbling along close to their potential growth rates. Low real rates create headaches for central banks, because they limit how high central bankers can raise real policy rates without tanking the economy. If central banks are determined to keep inflation low (at or below 2%, for instance) then that also sets an upper limit on how high nominal policy rates can go. And that means that big economies are going to find themselves stuck with near-zero policy rates—and limited room to stimulate the economy—with uncomfortably high frequency.
Ideally, global real interest rates would stop falling and move back to a more "normal" range. But as there is little sign of this sort of reversal, the Fed's best option would seem to be to switch to a target that gives it more room to raise inflation. A higher inflation target—of 4%, for instance—would be one option. Targeting the level of prices or nominal GDP would also give the Fed room to generate catch-up inflation after a slump.
Fed members have clearly understood this critique and these proposals. But Fed members have not only decided not to set a new target. They also remain steadfast in their determination to undershoot the target they've already got. As they have for months, the Fed's hawks continue to note the strength of the labour market and dismiss low inflation as the transitory product of low energy prices and a strong dollar. Yet too-low inflation looks like a chronic affliction. The Fed's preferred measure has been below the 2% target since May of 2012! The latest data show a deceleration in inflation, which clocked in a 0.8% year-on-year in July. Unsurprisingly, both market- and survey-based measures of inflation expectations have been trending downward. Not even the FOMC seems to believe low inflation is transitory. The highest rate of inflation any FOMC member anticipates over the next few years is just 2.1%, arriving by the end of 2018.
This is crazy. Having undershot its 2% target for so long, the Fed could argue that a bit of overshooting is justified so that it hits its target on average, across the whole of the business cycle. It could argue that overshooting is justified as a way to nudge inflation expectations back up. It could argue that, having failed to reach its target for more than four years now, caution demands it hold off on rate increases until inflation is unmistakably on track to reach 2%. But no! Absurdly, the Fed is preparing to raise rates while inflation is both below target and decelerating.
Markets know exactly where this sort of behaviour will lead. Futures prices indicate that through 2019 the Fed's policy rate will remain below 1%. That's 2019: a full ten years after the recovery began, into territory which would make the current expansion the longest in American history. In each of the last three downturns the Fed responded by cutting its policy rate at least 500 basis points. Without a doubt, the Fed will go into the next one unable to cut rates even 100 basis points. The pre-Jackson Hole discussion makes clear that Fed members understand all of these dynamics. They're just not worried about them.
They should be. The reason not to care about this rotten outlook, if you are an FOMC member, is because you have complete confidence in the unconventional tools available. And indeed, the thrust of Ms Yellen's speech was that the Fed's other policies performed adequately during the Great Recession and its aftermath. But this is also too absurd to take seriously. This recovery, while long-lived, has fallen well short of reasonable expectations. Job growth during the first four years of the recovery was dismal, wage growth has been weak throughout, and employment and labour-force participation rates remain depressed. Neither should we expect unconventional tools to be as effective the next time around; long-term interest rates have much less room to fall now than they did in 2009-10, for instance.
The Fed appears to be institutionally incapable of grappling with the challenges posed by a low-rate world. But the low-rate world is probably not going away any time soon. And so institutional paralysis and the reliance on unconventional tools in this low-rate world seem destined to cause a shift in responsibility for the economy away from central banks and back toward elected governments. Not before time, if indeed the best idea the Fed can come up with in this environment is a rate hike.
The Jackson four
Should the Fed adopt India’s inflation target?
Aug 27th 2016 | HONG KONG |
IN THE latter part of this week, monetary policymakers and theorists from around the world were due to attend the Jackson Hole symposium, 6,800 feet up in the mountains of Wyoming. Many people—aggrieved savers and yield-hungry investors—probably wish they would never come back down. To their critics, central bankers seem strangely committed to two unpardonable follies: eroding the interest people earn on their savings and inflating the prices they pay at the shops.
It was, therefore, brave of one central banker—John Williams of the Federal Reserve Bank of San Francisco—to argue on August 15th that the Fed might need to raise its 2% inflation target or replace it with an alternative if it is successfully to fight the next downturn. Some economists favour an inflation target of 4%. This is not as outlandish as it sounds. Indeed, the notion that new circumstances require a new target may appear quite run-of-the-mill to central bankers from the developing world who are taking part in the symposium.
Much criticism of the West’s central bankers rests on the myth that they are wholly responsible for rock-bottom rates. In fact, they seek the highest rates the economy can bear, but no higher. When the economy is at full strength, they want a “neutral” (or natural) rate that keeps inflation steady, neither stimulating the economy nor slowing it. When the economy is overheating, they want a rate above neutral. And when the economy is weak, they want one below it. The neutral rate (r* in economists’ algebra) thus provides a vital reference point for their policy. As such, it exercises considerable influence over central bankers. But they, importantly, exercise precious little influence over it.
According to economic theory, the neutral rate reconciles the eagerness to invest and the willingness to save when the economy is in full bloom. As such, it reflects the productivity of capital, the promise of technology and the prudence of households, none of which are variables chosen by monetary officials. The neutral rate cannot be observed directly. But Mr Williams and a Fed colleague reckon it has fallen persistently: r-star (as he calls it) is close to zero, or about two percentage points lower than it was in 2004.
If r-star is lower than it was back then, the Fed’s policy rate must also be lower to be equally stimulative. That means today’s rate (of between 0.25% and 0.5%) is not as lax as it looks. Leo Krippner of the Reserve Bank of New Zealand estimates that American monetary policy today is already as tight as it was in July 2005, when the federal funds rate stood at 3.25%, having been raised nine times.
The question preoccupying most Fed-watchers is how much tighter policy will get in the next year or two. Mr Williams raises a different concern: how much looser can policy get during the next downturn. If the Fed sticks to its current inflation target of 2%, a policy rate of 0% would translate into a real cost of borrowing of minus 2% (because the money debtors repay will be worth less than the money they borrowed). That may not be low enough.
Such a rate would be only about two percentage points lower than Mr Williams’s estimate of the neutral rate. Raising the inflation target to 4%, say, would allow real interest rates to drop about four percentage points below neutral if necessary. (This is not the only reform idea. Another is targeting the trajectory of nominal GDP, which reflects both economic growth and price inflation; that might result in higher inflation when growth was weak and low inflation when growth was strong.)
But even if a 4% target is desirable, would it be feasible? The Fed has struggled to reach its current target quickly or consistently. What makes anyone think it could hit a higher one? One answer is that a higher target would free the central bank from a “timidity trap”, as Paul Krugman of the New York Times calls it. In such a trap the central bank sets its goals too low, and paradoxically falls short of them. A credible central bank might cut rates to zero and promise 2% inflation. If it is believed, inflation expectations will rise and the anticipated real cost of borrowing will fall to minus 2%. But if the economy actually needs a real rate of minus 4% to revive, spending will remain too weak, economic slack will persist and inflation will ebb, falling under target. Conversely, if the central bank promises 4% inflation, its pledges will be both believed and fulfilled.
Shooting r-star
Western policymakers dislike tinkering with their inflation targets. But in the wider universe of central banks, periodic revisions are no big deal. Indonesia sets its targets for a three-year period, as does the Philippines, Turkey and South Korea. This flexibility need not destroy a central bank’s sound-money credentials: South Korea’s inflation is even lower than America’s.
Although a target centred on 4% sounds scandalous to rich-world central bankers, it is not unusual elsewhere. Indonesia pursues one. Brazil’s inflation target is 4.5%. India is lowering its target from 6% last year to about 4% for the future. The committee recommending that figure was chaired by Urjit Patel, who will be the Reserve Bank of India’s next governor (see article).
One advantage many emerging economies enjoy over richer ones is a higher r-star, thanks to faster rates of underlying growth and inflation, as low local prices converge towards higher international prices. That gives their central banks more room to cut interest rates in the face of a downturn. Indeed, it is hard to think of any catch-up economy that has remained stuck at zero rates.
If Mr Patel succeeds in his new job and the Fed embraces reform, America’s inflation target may one day resemble India’s. But India will still worry more about overshooting its target than undershooting it, and America will still probably harbour the opposite set of concerns. Their inflation targets may match, but their r-stars will not be aligned.
More spend, less thrift
German budget surpluses are bad for the global economy
Sep 3rd 2016 |
ON AUGUST 24th Germans received news to warm any Teutonic heart. Figures revealed a larger-than-expected budget surplus in the first half of 2016, and put Germany on track for its third year in a row in the black. To many such excess seems harmless enough—admirable even. Were Greece half as fiscally responsible as Germany, it might not be facing its eighth year of economic contraction in a decade. Yet German saving and Greek suffering are two sides of the same coin. Seemingly prudent budgeting in economies like Germany’s produce dangerous strains globally. The pressure may yet be the undoing of the euro area.
German frugality and economic woes elsewhere are linked through global trade and capital flows. In recent years, as Germany’s budget balance flipped from red to black, its current-account surplus—which reflects net cross-border flows of goods, services and investment—has soared, to nearly 9% of German GDP this year.
The connection between budgets and current accounts might not be immediately obvious. But in a series of papers published in 2011 IMF economists found evidence that cutting budget deficits is associated with reduced investment, greater saving and a shift in the current account from deficit toward surplus. Two IMF economists, John Bluedorn and Daniel Leigh, reckoned that a fiscal consolidation of one percentage point of GDP led to an improvement in the ratio of the current-account balance to GDP of 0.6 percentage points. On that reckoning, the German government’s thriftiness accounts for a small but meaningful share of its growing current-account surplus; perhaps as much as three percentage points of GDP over the past five years.
That has helped to resurrect an old problem. Global imbalances were a scourge of the world economy before the financial crisis of 2007-08. Back then, China and oil-exporting economies accounted for the surplus side of the world’s trade ledger, which reached nearly 3% of the world’s GDP on the eve of the crisis. Other countries, notably America, ran correspondingly large current-account deficits, financed in part by flows of investment from surplus countries that flooded into the country’s overheating housing market. A similar dynamic played out in miniature within the euro area, as core economies like Germany ran current-account surpluses and peripheral countries like Spain ran deficits.
The recession that followed the crisis temporarily reduced these imbalances. Spendthrift consumers in deficit countries suddenly found themselves squeezed by joblessness and the evaporation of easy credit: that led to a collapse in imports. But a sustained era of balanced growth failed to emerge. Instead, surpluses in China and Japan rebounded. In recent years Europe has followed, thanks to a big switch from borrowing to saving (see chart). The countries on the periphery donned their sackcloth out of necessity, tightening belts and buying less from abroad than they produced at home. Ageing Europeans in core economies, like Germany and the Netherlands, saved for different reasons, such as preparing for retirement. German government-budget surpluses have piled on top of this glut.
That adds up to a big problem, given the state of the world. Within the euro area, the struggling Mediterranean economies need faster rates of GDP growth to bring down unemployment and stabilise government debt. Germany’s enormous surpluses mean that its households are buying less from other countries than they ought to. That hurts the growth prospects of the periphery, and raises the risk of a politically induced break-up.
The global picture is just as worrying. Interest rates have plunged since the financial crisis, indicating that the world’s savings are chasing too few investment opportunities. In normal times, this would be manageable. Central banks could cut their policy rates, reducing borrowing costs for firms and households and encouraging them to tap the reservoir of savings. Yet many central banks have cut rates to near zero, only to find people are still borrowing too little. As cash pours into safe assets like government bonds, demand slackens and economies stagnate.
In-the-black hole
This malaise appears to be contagious. In weak economies, battered consumers buy fewer imports and unemployment depresses wages, which can help boost exports. That provides a cushion for the suffering economy, producing a current-account surplus that siphons off spending from healthier countries. But this in turn weakens those economies, adding pressure on their central banks to cut rates. In a paper published this year Ricardo Caballero of the Massachusetts Institute of Technology, Emmanuel Farhi of Harvard University and Pierre-Olivier Gourinchas of the University of California, Berkeley, found that in a world of integrated financial markets, a slump in some economies can eventually engulf all of them. Once a few economies become stuck in the zero-rate trap, their current-account surpluses exert a pull which threatens to drag in everyone else. America, the world’s importer of last resort, remains pinned to near-zero rates, and economically vulnerable, thanks to this dynamic.
Theoretically, this black hole can be dodged. Surplus economies like Germany just need to borrow more. Bigger budget deficits would boost global demand and reduce current-account imbalances. But Germans favour frugal budgeting. Just as important, Germany’s government, which is seen as an unforgiving taskmaster across the euro-area periphery, would prefer not to be accused of practising something different from what it preaches. And even a change of heart in Germany, helpful though that would be to the euro-area economy, would not solve everything. Imbalances are a global problem which cannot be fixed by any one country.
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