How long should we expect high inflation?

There was bad news on the inflation front this week, with the CPI rising 6% over a year ago.  We have not seen 6% inflation in 30 years.  This is a worrisome development for those on fixed incomes, as well as for those whose income growth fails to keep pace with inflation.  

The consensus among economists is that the current inflation is a classic case of too much money chasing too few goods.  Compounding the problem is the covid-induced shift in demand from services to goods.  

Economic history suggests one of two alternative scenarios will play out.  One possibility is that the inflation will prove to be temporary, just like it was in the aftermath of World War II.  In that case there was pent-up demand for everything (many goods were rationed during the war) along with the need to shift the economy away from tanks and aircraft carriers toward housing and education.  Option B: a replay of the 1960s and 1970s, when a vicious circle developed with rising prices feeding into higher wages, which in turn increased costs even more requiring even higher prices.  

Jerome Powell, Janet Yellen and other White House and Fed economists say inflation will be temporary.  Companies will need a few more months to ramp up supply, but once that happens we will be down to 2-3% annual rates.  But not everyone is buying this!

Two clues about the future direction of inflation can be found in the bond market.  First look at the actual yields for five-year and ten-year bonds, which are 3.1% and 2.7%.  Interest rates adjust upward in response to expected inflation, so these rates indicate that the bond market does not expect inflation above 3% over the next five years.  

The second clue: the Treasury sells two types of bonds: those with a fixed yield and those where the yield is indexed for inflation.  Adjusting for maturity, a comparison of the yields tells us what financial markets expect.  So take a look at this chart from the St Louis Fed.  At the beginning of the year, the yields implied an expected inflation rate of 2%.  From March through September, the expected inflation rate increased to 2.5%.  Now it is up to 3%.  

My advice: keep an eye on the bond markets in the months ahead.  

Will the Fed's rate cut matter?

Yesterday the Federal Reserve cut the federal funds rate from 2.50 to 2.25 percent.  Financial markets reacted adversely, perhaps because they anticipated a larger cut or the prospect of more cuts in the future.

But what economic impact will this cut in interest rate have?  Chicago Booth economist Austan Goolsbee questions whether it will do much at all.  Lower interest rates historically stimulate household purchases of durables (furniture, appliances, cars, homes) and corporate spending on investment.  Goolsbee points out that interest rates have been at historically low levels for 10 years, so there is not likely to be much pent-up demand for durable goods.  Also, rates cannot fall much further from their current rates; zero is a lower bound!  Banks are not going to pay borrowers interest.  

Long term rates are just as low as short term rates, indicating the market expects interest rates to remain quite low.  Proponents of the rate cut argue that slower growth in Europe and China dictates stimulus in the US.  However, the rate cut also led to the dollar raising in value to its highest level in two years (not what we would have expected, by the way; lower interest rates usually imply a declining currency value).  If this holds up, expect net exports to decline which will further slow growth.  Also the interest rate cut is bad news for savers.

Two members of the Fed's Open Market Committee voted to not make any change in interest rates, believing that an economy with 3.5 percent unemployment does not need any more stimulus.  If Goolsbee is right and the rate cut does not offset the drag from trade wars and slower growth in other countries, it will be interesting to see if the Fed doubles down on yesterday's action.

A goldbug for the Fed?

When I teach my Essential Macroeconomics for Managers course, I spend some time on exchange rates.  I emphasize the role of trade balances, inflation, and Federal Reserve policy, reflecting the consensus of economic research.  I spend no time on the gold standard, as research has shown that it makes economic growth and inflation less stable.  

President Trump has nominated Judy Shelton for a vacant position on the Federal Reserve's Board of Governors.  Dr. Shelton (PhD in business administration from Utah) advocates a return to the gold standard.  Greg Ip has a great WSJ column explaining her views, which are based more on politics than economics.  Her core belief is that the gold standard would impose fiscal discipline on Congress and the President and monetary discipline on the Federal Reserve.  She went ballistic in the aftermath of the Great Recession when quantitative easing led to a massive increase in the money supply and, she argued, an inevitable surge in inflation.  Guess what?  She and other goldbugs were dead wrong; inflation has been at rock-bottom levels for the last 10 years.

Now she is criticizing the Fed for keeping interest rates too high, claiming it is slowing down the economy.  This is hard to swallow in a world where 10-year Treasuries yield two percent and the June jobs report showed 224k new jobs last month.  Will she make it through tough questions at her Senate confirmation hearing?  Stay tuned.

Kudos to the Fed

Chicago Booth finance expert (and all-around free-market kind of guy) John Cochrane has a great WSJ piece on how and why the Federal Reserve Board has made the right call on a set of very big decisions.  If you happen to run into a politician ranting against the Fed, I strongly encourage you to ask him/her how he/she disagrees with Cochrane, a world-class finance expert who expresses his views on his well-read blog Grumpy Economist.  My guess is that you will not get a straight answer.

No way to fill the FRB chair

I do not ordinarily comment on political matters in this blog, but the highly unusual process that has been used to handle the selection of the next chairman of the Federal Reserve is likely to have lasting economic effects.  It started last June when the President made comments in an interview that, in effect, Ben Bernanke had overstayed his welcome.  Then we have seen the spectacle of Larry Summers and Janet Yellen being vetted for the job in the press.  Endorsed by Senator Foghorn, unendorsed by Representative A far cry from the day when Jimmy Carter introduced Paul Volcker and everyone applauded.

David Gergen points out the peril of having a public competition for the post in this CNN Opinion piece.  First, if you start disqualifying people who have taken strong stances on critical issues, you simultaneously discourage the best and the brightest from being considered for the job AND from saying what they really think in public forums.  Second, you turn what has been a nonpartisan position (Reagan kept Volcker, both parties kept Alan Greenspan and Obama kept Bernanke) into a partisan one.  The FRB chair is by far the most powerful economic position in government; do we want the best person or the person who has done the most to win favor with politicians.

Now that Summers has dropped out, the pressure is on the President to nominate someone with equal qualifications.  Janet Yellen would be great.  But will we get instead one of the lesser lights in the current administration who would do his masters' bidding?

Dr. Doom on the Fed

NYU Stern's Nouriel Roubeni takes a hard look at the Federal Reserve's quantitative easing policy in a recent blog post.  Roubeni, aka Dr. Doom for calling the 2008 recession, thinks the Fed is creating another asset bubble that will end badly.  With interest rates at historic lows, investors are pumping more and more cash into risky assets: stocks, junk bonds, and emerging markets.  Of course there is a significant downside to increasing interest rates, a move that likely would decrease investment.  Roubeni thinks the Fed is likely to keep interest rates too low for too long, and we will see a repeat of the same movie we saw in 2006 and 2007 with the same sad ending. 

Welcome to QE3

Yesterday the Fed announced it would buy $40b of mortgage-backed securities each month and committed to keep interest rates low through mid-2015.  The idea is to reduce the supply of these securities and thereby push investment funds into other outlets such as the stock market, real estate, and corporate bonds.  The hope is that long-term interest rates will fall, the private sector will have more liquidity, the stock market will rise and good times will be here again. 

Will it work?  WSJ reports that economists are split: of 51 surveyed, 28 said that more quantitative easing will not help and 17 said that it would.  Not exactly a ringing endorsement, and not surprising either because (1) banks continue to hold unprecedented levels of excess reserves and (2) interest rates are already at historic lows.  People may want to make big-ticket purchases or re-finance their houses, but with a large share of consumers still carrying high debt burdens, their key issue will be qualifying for any loan, regardless of interest rates. 

Bernanke's midyear report

Fed chair Ben Bernanke gave his midyear report on the state of the economy to Congress yesterday, and the news is not encouraging: "The U.S. economy has continued to recover, but economic activity appears to have decelerated somewhat during the first half of this year."  Investment by businesses in plant, equipment and inventories is especially worrisome, Bernanke said.

Some lawmakers encouraged Bernanke to do more to stimulate the recovery.  However, his means to do so appear extremely limited.  The Fed's main tools are lowering interest rates and buying bonds to create more liquidity.  Yet banks have mountains of excess reserves and have decided it is better to keep them at the Fed to earn 0.25% than to loan them out. 

Feldstein on inflation risk

Great article by Harvard's Marty Feldstein on the pressures facing the Fed to stimulate the economy while keeping inflation in check.  The Fed has flooded the banking system with liquidity.  So far banks have sat on their excess reserves and received 0.25% interest from the Fed.  But at some point, Feldstein argues, banks will start loaning these funds out to households and businesses.  Even though unemployment remains over 8 percent, Feldstein is concerned about capacity constraints. 

Half of the unemployed have been out of work for a year or more; there is a significant risk that the long-term unemployed will not be reabsorbed into the labor market very quickly.  Feldstein's fear: the unemployment rate gets stuck at 7.5 percent, causing Congress to press the Fed to keep the stimulus going at a time when all the excess money in circulation starts leading to higher prices. The Fed has never injected this much liquidity into financial markets before; will the Fed know when and how to remove the excess liquidity?

Starting to 2nd guess the Fed

NYT's Gretchen Morgenstern issued the first salvo I have seen in the mainstream media in her column today.  She openly questions the wisdom of keeping rates at near zero levels, given that (a) this is significantly penalizing savers and (b) very few people qualify for the low interest rates, especially for mortgages.  Isn't the whole idea of low rates to stimulate borrowing?  Don't get me wrong; I'm not drinking the Ron Paul Kool-Aid about abolishing the Fed, but some serious questions about its interest rate policy need to be raised in this year's campaign.  I give Ben Bernanke very high marks for his moves in 2008 and 2009, but I have real concerns about the Fed's stated commitment to keep rates low for as much as another two years.   

EU signals interest rate shift

The European Central Bank is sending signals that its two year commitment to 1% interest rates is nearly over.  Bank President Jean-Claude Trichet did not signal how much rates would rise, but the consequences for the Fed's policy of zero interest rates are clear -- the dollar will weaken, making imports more expensive and exposing the US to greater risk of inflation.  Bernanke may be forced to move US rates up as well to prevent this from happening. 

Plosser on monetary policy

Philadelphia Fed President Charles Plosser (also former dean at Rochester's Simon Business School) is interviewed in today's WSJ about monetary policy.  Plosser is a QE2 skeptic:

You can't change the carpenter into a nurse easily, and you can't change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they'll find jobs in other industries. But monetary policy can't retrain people. Monetary policy can't fix those problems.

Stiglitz on easier money

Nobel Laureate Joe Stiglitz writes in this weekend's WSJ about the Federal Reserve's plan to pump more money into the economy.  Stiglitz is quite skeptical that this will do any good.  The most interesting part of this op-ed is his description of the lending market for small and medium size firms who are starved for cash and have seen their main form of collateral (real estate) drop in value.  Hard to see how lower interest rates will help out firms that cannot get a loan in the first place.  Stiglitz also appears concerned that interest rates might actually rise as greater money growth spurs fears of inflation. 

The problem with low interest rates

Raghuram Rajan, a finance professor at Chicago's b-school, explains the downside of near-zero interest rates today on NYT's Freakonomics website.  Rajan uses the following scenario to make a key point: suppose that instead of lowering interest rates the government instead decided to subsidize the price of another key input, say energy.  MBA 505 veterans can easily outline the adverse consequences: if the suppliers of energy do not get a subsidy they will shut down and if they do get a subsidy the costs to the budget are the same as traditional stimulus (tax cuts, government spending).  In financial markets the parallel is that either (1) lenders have little incentive to make loans with super-low interest rates and (2) the cost of low interest rates to savers is massive, perhaps on the order of $400 billion. 

Rajan points out additional distortions: too much borrowing will lead to future bubbles that once again will burst with lenders expecting another bailout.  He thinks the Fed should gradually begin to raise rates to 1.5 to 2 percent over the next year.  He also urges a rethink and expansion of programs that prepare workers for the jobs of the future (easier to say than to do, as any labor economist will tell you). 

My own take: low short term rates worked historically to shorten recessions by stimulating housing and consumer durables (such as cars, furniture).  One reason the stimulus is not working so well is that real estate and automobiles are going through structural transformations that will make these sectors permanently smaller. 

Economists gone wild

The American Economic Association recently held its annual meetings in Atlanta. WSJ reports that this was probably bad news for Atlantans whose livelihood depends on the convention trade because --- economists tend to be cheapskates. My favorite anecdote in the article was the one about Milton Friedman returning reporters calls collect. My own claim to fame: I continue to cut my own grass. But is it because I am a cheapskate, or because I have so few earnings opportunities on the weekend?

On a more serious front, there was much talk about the current economic crisis. Ben Bernanke's speech got the most attention, as one would expect. Bernanke warned that the Fed may very well act to pop any future bubbles. Last week WSJ ran another article that gave some interesting perspectives on how to deal with the financial crisis, growing federal debt and our old friends Fannie Mae and Freddie Mac. Money quote from Stanford economist Robert Hall:

If the banks really feel that they are insured, then we have a dangerous situation. The incentives are to take a very risky position. They get to pocket it if they win and it's the federal government's problem if they lose.

If Paul Volcker had a hammer ...

According to NYT blogger Simon Johnson (Sloan MIT prof and former chief economist at IMF), former Fed chair Paul Volcker is going rogue on the Obama administration by pushing for much tighter regulation of the financial services industry. Although Volcker was originally going to be a senior economic advisor to the President, he has been eclipsed by Larry Summers and Treasury Secretary Tim Geithner. Now that financial services regulation is moving to the front burner in both the House and the Senate, Big Paul (he is 6'7" in case you wondered) has picked the perfect time to make his pitch.

Monday's WSJ had an interview with the former fed chairman where he shared the following insights: (1) forget CDOs, the most important financial innovation in the last 20 years is the ATM; (2) there are huge moral hazard issues; and (3) commercial and investment banks need to be separated. It will be interesting to see how Volcker's arguments influence the upcoming deliberations.

Cooley on financial market regulation

Scary piece by NYU Stern School dean Thomas Cooley in Forbes today about the prospects for genuine changes in regulation of financial markets. Cooley points out that the draft bills in both the House and Senate exempt large portions of the financial sector from the proposed new regulations on consumer protection.

What are the major financial decisions made by households? The purchase of durables like automobiles and appliances, the purchase of homes and retirement planning. But the house bill H.R. 3126 exempts financing provided by automobile dealers, any person regulated by the Securities and Exchange Commission, any person regulated by a state insurance regulator, smaller banks and credit unions (those with $10 billion or less in assets), mortgage, title, credit insurance, real estate brokers and agents, attorneys and most retail transactions involving credit. The Senate proposal has fewer carve-outs but does exclude small banks and credit unions, merchants, retailers and other non-financial institutions that extend credit to consumers. So who is left to regulate?

Another area to watch is whether the final versions of the bill will allow the federal government the ability to break up the largest financial services companies into smaller components. Normally I am a free market sort, but as long as there is an implicit contract that the government will continue to bail out failed firms, there needs to be some mechanism to cap the liability.

What they fear more than anything else is losing access to the tremendous money pump they have at present. The large complex financial institutions, in case you haven’t noticed, are making money hand over fist. They are greatly enabled this by the fact that they have a very low cost of funds. Why? Because they have unpriced too-big-to-fail guarantees and access to the Fed. This means taxpayers are underwriting the low internal cost of funds that these firms have. They can turn around and invest these in their own proprietary trading, hedge funds and asset management businesses--things they're afraid of losing.

We really do have reason to be thankful

Great column in yesterday's WSJ by James Stewart about why we should be thankful for Henry Paulson, Tim Geithner, and Ben Bernanke. Stewart's message in a nutshell: Many of us seem to have forgotten how close the economy came to a total meltdown last fall. The Paul Krugmans and Glenn Becks of the world are making emotionally charged arguments (and collecting huge salaries and speakers fees, I might add) second guessing the bailouts and stimulus packages respectively. But guess what? The Bush and Obama economic teams made the right calls on the biggest issues. Without the bailouts 2009 would have been an economic rehash of 1930. Without the monetary and fiscal stimulus (from both Bush and Obama) unemployment would easily be 12 or 13 percent. Stimulus packages in other countries also have been effective; the global economy is starting to recover. Money quote:

We're a lot better off today than we were a year ago. This week I'll be giving thanks for that.

When will the Fed start raising interest rates?

We will be talking about the Fed in MBA 505 this coming week. The big question right now, according to this recent WSJ article, concerns when will the Fed start raising interest rates. The fed will be looking at GDP, unemployment and inflation signals. Before raising rates, the Fed is likely to send out signals weeks, if not months, in advance. Next year's midterm Congressional elections will not make the Fed's job any easier. It is quite possible that the Fed will need to raise rates some time in 2010 to defend the value of the dollar and send a strong signal about its commitment to fight inflation even though unemployment is likely to be 8-9 percent when the rates start going up. Congress may choose to challenge the Fed's independence in such a situation.

Who pays the bill for "too big to fail" banks that fail?

Lots of discussion going on in various circles. Paul Volcker (former Fed chairman) and Mervyn King (governor of the Bank of England) have been pushing for regulations that essentially would restore the Glass-Steagall regulations separating commercial and investment banking. The former would be regulated and insured; the latter would be "let the buyer beware." In practice, FT columnist Martin Wolf points out that it would be very hard to separate the safe from the risky business lines in today's financial institutions. Thought: weren't mortgages thought to be safe, nonvolatile investments not too long ago?

Ben Bernanke proposed last week that we should have privately funded insurance to bail out banks whose failure would endanger the entire financial system. The model would be the Federal Deposit Insurance Corporation, which levies fees on banks to protect consumer deposits up to $250,000. Of course bank customers would end up paying these fees, but Congress might be happier with that compared to the alternative -- another bailout.