Informational Easing: A Change In F.O.M.C. Expectations

Let's analyze the latest FOMC policy move.
The FOMC met yesterday and changed up the communications strategy.  How so? Well, until yesterday the statement has been saying as of June 22, 2011:

"The Committee continues to anticipate that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate for an extended period." 

And now...

"The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

Notice the subtle difference? If not heres a hint: "Extended Period" to "At least through mid-2013". So something is happening here. First, the Fed is always getting accused (by New Classicals) of creating uncertainty for businesses and thus disrupting equilibrium.  What they are doing is making it clear (or more explicit) that short -term interest rates will be well anchored & for sometime.  In this way they are also signaling that they may be more focused on growth and unemployment figures than any inflation pressures.  


Why was this controversial? Well within the F.O.M.C. we saw three dissents (Richard W. Fisher, Narayana Kocherlakota and Charles I. Plosser) whom believed that including such explicit language limited the Fed's flexibility and thus presented a potential independence problem since action deviating from the language opens the Fed to criticism. Additionally, two of these votes (Richard W. Fisher & Charles I. Plosser) may have been reacting to their hawkish tendencies- clearly seeing a comment to low interest rates as a threat to inflation fighting credibility.


Keep Dancin'


Steven J.

Revised to be relevant and useful: TIPS and Inflation Expectations

In a previous post  I calculated expected inflation using some bond that was maturing in 2012 but we want to get a more accurate (and relevant) picture of expected inflation.  To do this we can go to the Federal Reserve and observe statistical release H.15 which are selected interest rates.  For example, 10 years from July 22nd expected inflation is:

E(p)= i - ir
Where E(p) is expected inflation,
i - nominal interest rate ( interest rate paid on nominal treasuries)
ir - real interest rate (remember the inflation index bonds are supposed to reflect these)

Looking at the statistical release if we want the 10 year inflation expectations we must look at the 10 yr bonds.  We will find that for July 22, 2010:

i (Nominal Treasury) = 2.9%
ir (Inflation indexed Treasury) = 1.78%

2.96% -1.78% = 1.18% 
E(p) = 1.18%
Therefore expected inflation for the next 10 years as of July 22nd is 1.18%

TIPS: A Gauge Of Inflation Expectations

Treasury Inflation Protection Securities or TIPS, are indexed bonds or bonds whose interest and principle payment are adjusted for changes in the price level.  The interest rate on these bonds provides a direct measure of a real interest rate. 

Using the Fisher equation:

i = ir + E(P)
where:
i - nominal interest rate
ir - real interest rate
E(P) - expected inflation

We can re-arrange the terms to get:

Expected inflation rate for the next 10 years  =  ( (i) - Ten Year Treasury Constant Maturity Rate, monthly) - ((ir)- 10 Year TIPS, Monthly)

Using FRED:

So the expected inflation rate for the next 10 years is around 3.2%.

The dangers of financial liberalization

The WSJ Economics blog recently highlighted a paper written by Ke Tang at Renmin University in China and Wei Xiong at Princeton University about how commodity prices are becoming increasingly more correlated with stock prices. This finding has to do with it becoming easier for investors to move in and out of commodities markets. Greater financial liberalization will mean increased volatility within a market as the prices of commodities will now be based more off of market sentiment, animal spirits and speculation rather than actual supply and demand and mark-up. There are also implications for monetary policy because a spike in investor optimism (pessimism) will cause input prices to increase (decrease) leading to greater uncertainty as to the direction of inflationary expectations. Fluctuations in stock prices have important household and firm wealth effects and similarly fluctuations in commodities may lead to the destruction of many firms balance sheets.

We can see this with a simple example:
“Company A” in Michigan's Upper Peninsula deals with the mining and production of copper and "company B" makes copper tubing. B buys copper from A at a set market price "P". Then say there is an unrelated debt crisis in the euro-zone that shakes up investor confidence in everything from bond markets, stock markets and commodities so that a sudden drop in the price of copper worldwide occurs. Company B who now has to pay the original market price P finds that they also have to charge less for their copper tubing. This is because the tubing price is based off of the current market price per pound plus some service markup. Not only did company B already order this copper from company A at price P but now they have to charge less than it cost them to purchase it thus leading to a potentially crippling loss.

I guess the lesson here is that without stable expectations we may suffer from further bankruptcies. One of the reasons that the Fed controls the price level so well is that they convince people that the price level will change by a set amount. Unfortunately it is extremely unrealistic to create a Fed for the stock market or commodities markets to ensure slow and rising asset inflation. Instead we have a bunch of profit seeking investors searching for the greatest yield. Goods and services are determined by supply and demand and the rest of the mark-up comes from expected inflation. When something get financially liberalized its price is no longer a function of the market conditions (supply/demand/mark-up) it becomes a function of continuously changing expectations.

A further example may help illustrate my point. Assume tv's get financially liberalized and people sell and buy tv's based off their expectations about others demand for tv's. We would see drastic changes in tv prices that would not necessarily reflect supply and demand as a dramatic fall or rise in the price of tv's would put electronics stores out of business or in business. Waves of optimism and pessimism might impact their prices while not necessarily reflecting the true cost of production and mark-up.

For the opposite view...

After writing the previous post on why budget deficits are a negative thing for the economy I stumbled upon an article that justified them. The Levy Economics Institute of Bard College recently released a Public Policy Brief on why we should stop worrying about U.S. Government deficits. The authors Yeva Nersisyan and L. Randall Wray point out that a budget deficit is just a transfer from the government to the private sector and that surpluses are the exact opposite net transfers from the private to government sector.
Furthermore, they dispute the often heard claim that deficit spending today burdens our grandchildren:

"in reality we leave them with government bonds that represent net financial assets and wealth. If the decision is made to raise taxes and retire the bonds in, say, 2050, the extra taxes are matched by payments made directly to bondholders in 2050”

Today's deficit leads to debt that must be retired later, and future tax increases that are supposed to service tomorrow's debt represent a redistribution from taxpayers to bondholders. Although this may be undesirable given that bondholders are wealthier than tax payers, but if one takes into account the U.S. progressive tax system it may just represent a transfer from taxpayers back to taxpayers. This is a reasonable perspective given that we as public bondholders get repaid even if it is a discriminating redistribution of income taxes back to rich people who could afford the bonds from poor people may not hold any bonds.

A government deficit is a transfer of income from the government to the private sector in the form of non-government income.

"A government deficit generates a net injection of disposable income into the private sector that increases saving and wealth, which can be held either in the form of government liabilities (cash or Treasuries) or noninterest-earning bank liabilities (bank deposits). If the nonbank public prefers bank deposits, then banks will hold an equivalent quantity of reserves, cash, and Treasuries (government IOUs), distributed according to bank preferences."

A surplus has the opposite effect as increased tax revenue from the private sector lead to a reduction in wealth and in order to maintain the same standard of living the private non-government sector has to borrow more.

"A government budget surplus has exactly the opposite effect on private sector income and wealth: it’s a net leakage of disposable income from the nongovernment sector that reduces net saving and wealth by the same amount. When the government takes more from the public in taxes than it gives in spending, it initially results in a net debit of bank reserves and a reduction in outstanding cash balances."

One important argument made is that the largest part of the current deficit results from automatic stabilizers like transfer payments and unemployment benefits. The flipside to increased unemployment benefits as the economy goes through a contraction is their tendency to fall back down as the economy recovers. As the leading driver of the deficit they are also the main reason for the reduction in the debt/gdp ratio as the economy expands. Along with increased unemployment, tax revenues that fall during the recession pick up during the expansionary phase.

In defense of Obama's stimulus:

"These automatic stabilizers, not the bailouts or stimulus package, are the reason why the U.S. economy has not been in a free fall comparable to that of the Great Depression. When the economy slowed, the budget automatically went into a deficit, placing a floor under aggregate demand."

After reading this article, one highly theoretical argument that I can make is that if the United States was forced to monetize part of the debt it could raise interest on reserves to soak up any additional liquidity created in the system. This would represent a massive transfer of Government debt from the Treasury to the Fed in the form of excess reserves. The excess reserves could then be manipulated with the appropriate raising and lowering of the interest paid on reserves relative to the federal funds rate. This is quite an exciting premise that represents an internal transfer of funds by the U.S. Government that would keep inflation expectations stable while also calming the fears of deficit hawks.