It’s inflation that the Federal Reserve is after. Everyone knows this. The Fed has made it explicit. The sentence from the FOMC that Marshall highlighted yesterday shows you that:
"The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate”
My interpretation of this sentence is that the Fed is prepared to do whatever it needs to do, if the recovery falters or if (dis)inflation tips the core rate below say 1%. If that means going unconventional and buying up long-dated treasuries in trillion dollar quantities, so be it.
When I asked "why deflation is bad?" I suggested it was bad only insofar as it increases the real burden of debt and lessens the Federal Reserve’s influence on interest rates, inflation and the economy. Deflation is not "consistent with its mandate" because it means the Federal Reserve would lack mechanisms to "fine-tune" the economy.
Here’s the thing: The Federal Reserve Board is located in Washington, DC and Washington is a political town. As such, the Fed must mind its manners or it will find its mandate diminished. You may recall that the Fed has already taken a lot of unconventional measures in lending to AIG, in setting up the TALF, and in its program of credit easing (what I called qualitative easing) by focusing on the asset side of the Fed’s balance sheet in printing money during the credit crisis. I see all of this in a dubious light, as do many others like former Fed Chair Paul Volcker and Fed stalker Ron Paul.
In early April, Paul Volcker, who chaired the Fed from 1979 to 1987, told the Economic Club of New York, “Sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank.” The Fed’s job is to act as “custodian of the nation’s money,” Volcker went on, not to take “many billions of uncertain assets onto its own balance sheet.”
Read more https://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy?currentPage=all#ixzz1170IYone
Moreover, much of this has been done in secret. Hence the ‘Audit the Fed’ movement and the need for Bloomberg News to sue the Fed to gain more information regarding its credit crisis lending practices. Congressmen like Ron Paul are still at it, looking to "End the Fed" once and for all. Just yesterday, Ron Paul was on Fox News saying – contrary to what Marshall correctly asserts – that the Fed’s desire to inflate as a way out of the crisis is tantamount to default. See the video below.
What Rep. Paul really meant to say is:
It’s as if someone reached into your pocket and stole money from you. That’s how inflation feels.
That’s how I described it in the deflation post. There is no actual default. After all, we have had much higher inflation than we do today. As an aside, I would add that this is exactly how the British got out of a debt crisis after two world wars – inflation.
Putting all of these arguments aside, the issue here is the politics of the matter. The Fed has already spent its political capital. And if you want a reason why the Fed isn’t doing anything about the renewed economic weakness despite Bernanke’s famous 2002 helicopter speech, this is it. The Fed knows darn well it has spent its political capital.
So what do they do? That’s the question I asked a few friends in the market. Here is the gist of the conversation:
The reason the Fed isn’t doing anything is because they are saying in effect "central bankers alone can’t solve the world’s economic problems." The subtext being they feel politically constrained and will not act until they get political consensus that they should do so. Moreover, when you have Fed governors like Charles Plosser or Thomas Hoenig saying something different, it makes it difficult politically to go all in. So you wait.
One friend said:
I’m frankly of two minds. Number one says, as you do, that with all the apparent disagreement, it will be difficult to take action until there is a lot of evidence of dramatic slowdown; i.e. things need to get much worse before they move, and therefore they will be entirely reactive rather than anticipatory or proactive, and behind the curve. (Not that I think they can be effective in any event…) Number two says, Bernanke, Dudley, and Yellen rule the roost, and the “dissension” is kabuki to jawbone the dollar away from collapse.
Then there is a third possibility my friend pointed out, namely that the Fed never really stopped QE1 or at a minimum has started buying "Treasuries far in excess of whatever refi’d or maturing MBS have rolled off the balance sheet."
Here’s my question:
What would happen in the event of a more disorderly drop in the dollar’s value? It’s not clear that interest rates would rise. So why would the Fed be conducting open mouth operations (as John Brynjolfsson calls them) to jawbone the dollar away from collapse?
I suspect the Fed can begin and may well have already begun some QE type stuff. They won’t announce it until later and I don’t believe they will have done so in a big way. But, if they announce on Nov 3 that they already are doing QE, this could be beneficial to asset prices – because I think that’s what they’re concerned about.
One response was:
I think they see asset prices (read, the stock market, because it’s the only one they seem to have any control over) as the only transmission mechanism for monetary policy they’ve got. And I think a disorderly drop in the dollar would be bad for the stock market. If the market is holding up, going higher, hanging in there, however you want to characterize it, in part because of a belief in a Bernanke put, which seems a defensible position to me (That seems the essence of the David Tepper interview), a disorderly drop in the dollar might well indicate that the Fed is losing control of things, mightn’t it? And thereby call into question the efficacy of the Bernanke put? I’m not positive that’s the line of thinking that would rule, but, for example, the fall of 1987 was certainly characterized by a dollar moving to the downside in a disorderly fashion, and stocks reacted negatively to that move.
This goes to control then. As I said, the Fed wants the control to return "inflation, over time, to levels consistent with its mandate." On the other hand, there are a lot of differences to 1987. Another friend wrote:
The long bond went from 7.25% in May ’86 to 8.75% in Aug ’87 too. My guess is that stocks are far more keyed off of interest rates than the FX value of the dollar.
All else equal, a weaker dollar is generally stock bullish.
And many of us doubt the central banks of the world would allow a disorderly decline in the dollar’s value any way. Remember, it’s not in Switzerland, Japan or the euro zone’s interest to allow the U.S. to beggar thy neighbour.
Here are the conclusions I made after the conversation:
- The Federal Reserve wants inflation. It has ever since debt deflation became a threat after Lehman. At this point, it may even secretly desire moderate inflation of the 6% variety that Ken Rogoff has been pushing.
- The Federal Reserve needs inflation. The only way to solve this crisis in a deflationary way is to cut spending dramatically and to cut taxes simultaneously. There is no political will for this.
- The Fed is engaging in ‘currency manipulation’. Obviously, quantitative easing weakens the US dollar. Doing this weakens arguments that it is only China which is manipulating it’s currency. The Europeans will like this less than the Chinese as they will bear the brunt of the depreciation.
- The Federal Reserve feels constrained politically. They will only act aggressively when they get a green light from Congress to do so. Until then, they will soft-pedal small measures unless the economy falls apart. Now I could be wrong since Bernanke has already been re-appointed; he may feel politically insulated. But, in my view, the political constraint means the Fed will be behind the curve.
- The Fed is most concerned about asset prices because with the zero bound having been reached this is the area where they have the greatest measure of control.
- The Federal Reserve is scared. They realize that they have reached a policy dead end. After berating the Japanese for their inability to re-ignite their economy after a credit bubble, Americans now find themselves in the same political and economic traps that the Japanese did. This frightens the Fed because once word is out that the Fed is largely impotent, they will lose complete control of any policy levers they still have.
Bernanke says the Fed wants "to return inflation, over time, to levels consistent with its mandate" but what does that mean? If we took the 2002 Bernanke at his word, he should have to credibly commit to trying for a lot more than 2% in order to have an impact. Make no mistake, the Fed wants inflation, maybe even a lot more than 2%. The question is: will it get it?
Update: Bill Dudley confirmed my view today that the Fed could move toward a higher inflation target over the medium-term. The Financial Times reports:
Mr Dudley also put an even more controversial policy on the table: a price level target in which the Fed promised to allow higher inflation in future years in order to make up for any below target inflation while interest rates are stuck at zero.
“One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years,” Mr Dudley said.
Dudley also confirmed my view that the Fed is worried about the “real burden of debt.” in a deflationary environment. This is very dovish language that supports the contention that there is a ‘Bernanke Put’ for the stock market which will keep asset prices elevated.