Wednesday, May 29, 2013

Volcker Calls on Fed to Return to Orthodox Central Banking
I started my career as an economist at the FRB-NY in July 1976. Paul Volcker was president of the bank at the time. We were on a first name basis: He called me "Ed," and I called him "Mr. Volcker." He went on to become the Fed chairman from August 6, 1979 to August 11, 1987, when he was replaced by Alan Greenspan. Volcker rarely speaks in public and rarely criticizes his successors. But that’s what he did today in a speech before the Economic Club of New York.

He started by recalling that during the 1930s and 1940s the Fed pegged interest rates close to zero. During the Great Depression, the Fed initiated that policy. It was kept in place during WWII to accommodate the Treasury's needs to borrow lots of money to pay for the war. The Fed was pressured by the Treasury to continue to peg both short-term rates close to zero and at 2.5% or less for the Treasury bond yield. The result was double-digit inflation. The Treasury-Fed Accord, announced March 4, 1951, freed the Fed from that obligation.

Financial markets were not severely disrupted by the agreement. Volcker fears that an “orderly withdrawal from today’s broader regime of ‘quantitative easing' is far more complicated.” The Fed has become “the world’s largest financial intermediator.” He hopes that the Fed “ultimately return[s] to a more orthodox central banking approach.”

He believes that the Fed is trying to do more than it can accomplish. It certainly shouldn’t be accommodating “misguided fiscal policies.” He certainly isn’t a fan of the “dual mandate,” judging it to be “both operationally confusing and ultimately illusory.”
(Based on an excerpt from YRI Morning Briefing)

Thursday, May 23, 2013

Hilsenrath: Guess What?
This morning at 6:27 a.m., Jon Hilsenrath posted a WSJ article titled, “Fed Leaves Markets Guessing.” This excerpt gives the gist:
The comments, given at a congressional hearing Wednesday, gave markets a dose of clarity for a few hours, though a subsequent release of minutes from the Fed's April 30-May 1 Fed policy meeting added to investor anxiety about the Fed's plans. The minutes disclosed that some officials were prepared to start pulling back the program as early as the Fed's next meeting in June, though the group as a whole, too, expressed hesitance.
Fed officials have struggled to fine-tune their communication strategy while they are struggling to fine-time their QE policy. So far, the results have been confusing. The noise-to-signal ratio coming out of the Fed has been rising. Here’s more from Hilsenrath’s article:
The next step by the Fed could be especially tricky. One worry at the central bank is that a single small step to shrink the size of the program could be interpreted by investors as the first in a larger move to end it altogether. [Yesterday,] Mr. Bernanke sought to dispel that view, part of a broader effort by Fed officials to manage market expectations.

If the Fed takes one step to reduce the bond buying, it won't mean the Fed is "automatically aiming towards a complete wind-down," Mr. Bernanke said. "Rather we would be looking beyond that to seeing how the economy evolves and we could either raise or lower our pace of purchases going forward. Again that is dependent on the data," he said.

Wednesday, May 22, 2013

Hilsenrath on Parsing Fed’s Minutes
At 2:03 p.m., just three minutes after the FOMC minutes were released, Jon Hilsenrath posted an WSJ article titled, “Parsing Fed Minutes: Debating When to Pull Back.” His conclusion is that the FOMC is “heading toward some difficult debates on when to pull back its bond buying program.”
April FOMC Minutes & Bernanke Unsettle the Markets
Fed Chairman Ben Bernanke testified today on the economic outlook before a congressional committee. In his prepared text, he warned against a “premature tightening of monetary policy,” saying it “could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

But then, in his Q&A session, Mr. Bernanke said that QE might be tapered in the next few months if the labor market continues to improve. That very same afternoon, the minutes of the April 30-May 1 FOMC meeting reported: “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth….”

Stock prices soared when Bernanke read his prepared text, but then dropped sharply after the Q&A and the release of the FOMC minutes. The Dow Jones Industrial Average finished the day down 80.41 points, or 0.52%, to 15307.17--having moved 276.44 points from peak to trough.

Tuesday, May 21, 2013

Dudley (FRB-NY) Impersonates Jackie Mason Doing Hamlet
FRBNY President Bill Dudley spoke at the Japan Society in NYC today. His speech titled, “Lessons at the Zero Bound: The Japanese and U.S. Experiences,” was long and long-winded, and reminiscent of Hamlet’s famous soliloquy. The Fed may either increase or decrease its QE purchases “[b]ecause the outlook is uncertain, I cannot be sure which way--up or down--the next change will be.” Near the end of his speech, he dwelled on how the markets might overreact to what the Fed does or doesn’t do:
There is a risk is that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month. Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.
Picture Jackie Mason playing Hamlet: "To be, or not to be--that is the question. Oy!"

Wednesday, May 15, 2013

US Treasury Study: Macroprudential Policy Hasn’t Worked in the Past
Three economists at the Office of Financial Research of the US Treasury released a working paper today titled, “The History of Cyclical Macroprudential Policy in the United States.” Guess what? It hasn’t worked very well in the past. If it had, we wouldn’t be in this mess. This is from the paper’s abstract:
Since the financial crisis of 2007-2009, policymakers have debated the need for a new toolkit of cyclical “macroprudential” policies to constrain the build-up of risks in financial markets, for example, by dampening creditfueled asset bubbles. These discussions tend to ignore America’s long and varied history with many of the instruments under consideration to smooth the credit cycle, presumably because of their sparse usage in the last three decades. We provide the first comprehensive survey and historic narrative of these efforts. The tools whose background and use we describe include underwriting standards, reserve requirements, deposit rate ceilings, credit growth limits, supervisory pressure, and other financial regulatory policy actions.
Their conclusion: “Both the practical issues discussed above in regard to specific historical actions and the preliminary statistical analysis suggest that cyclical macroprudential actions may indeed be worthwhile, but they are also difficult to implement effectively and subject to many cross-currents in the economy that reduce their effectiveness.”

Friday, May 10, 2013

Bernanke on Identifying Systematic Risk
Fed Chairman Ben Bernanke delivered a speech in Chicago today on “Monitoring the Financial System.” He assured us that the Fed’s Financial Stability Monitoring Program is doing just that, i.e., focusing on systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector.

The structure of this program is detailed in a recent working paper by the Fed's staff titled, “Financial Stability Monitoring.” The Fed is on the lookout for “evidence of low pricing of risk” in four areas, specifically:
First, the risks of SIFIs are assessed using stress tests, market-implied assessments of the SIFIs, network measures for exposures, and regulatory filings of the institutions. Second, the risks in the shadow banking sector are assessed using a variety of data sources on short-term and secured funding markets, securitizations, and new products. Third, the level of asset valuations is gauged across asset classes, including equity, credit, Treasuries and TIPS, housing values, commodities and farmland, exchange rates, and foreign markets. The assessment of asset valuations is tightly linked to the observed risk taking of SIFI and shadow banking institutions. Fourth, the risks of the nonfinancial sector are assessed in connection with the financial sector developments.
Don’t you feel safer knowing that Big Ben is watching? He has yet to ask, “But how do we know when irrational exuberance has unduly escalated asset values…?” That was the famous question asked by Fed Chairman Alan Greenspan in a December 5, 1996 speech. Nonetheless, the Fed is on the lookout for irrational exuberance, and Fed officials will plant stories and give speeches to remind us that they are ever vigilant.

In his speech, Mr. Bernanke did say, “Systemic risks can only be defused if they are first identified.” He didn’t specify if any have been identified lately. He also didn’t say what the Fed would specifically do if it found irrational exuberance. "Shocks of one kind or another are inevitable,” he observed. However, he believes that “macroprudential” regulations can be designed to reduce the “vulnerabilities” of the financial system to a crisis from such “triggers.”
(Based on an excerpt from YRI Morning Briefing)

Wednesday, May 1, 2013

FOMC Statement: Fed Ready to Dial QE Back Down or Back Up
Most of boilerplate language in today’s statement was unchanged from that of the previous statement on March 20, 2013:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
What’s new is the following: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” The previous statement’s language on this topic was: “The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.”

For the third meeting in a row, only Esther George (FRB-KC) dissented. She “was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.”