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Ben Bernanke, backed in a corner

By Joe McClintock

February 22, 2012, 10:13 am

Ben Bernanke, the chairman of the Federal Reserve, has been having a rough time lately. He’s received criticism from politicians, pundits, and other central bankers, and has been attacked for doing both too much and too little. The actions of the Federal Reserve have not received this much scrutiny in a long time, undoubtedly due to the rising scope of their actions and the heightened sense of urgency surrounding them.

I don’t wish to discuss the legitimacy of the Fed’s past actions. Instead, I want to discuss the actions they will have to take in the next few years. As the economy begins to tentatively recover, the Fed must walk the thin line between encouraging growth and causing uncontrollable inflation. And as Bernanke’s critics reveal, there are arguments for doing more to address both issues.

For inflation hawks, images like this are seriously frightening:

Such a dramatic increase in money supply would lead to dangerous inflation during any normal economic time. However, these are not normal economic times, and expanding the money supply cannot cause inflation while demand is suppressed. So, while the Fed should keep an eye on inflation as the economy recovers, there has been little evidence that rising inflation will warrant action in the short term.

On the other hand, the weak economy still has far to go before it is fully recovered. Improvements in employment and output are good news, but aren’t enough to bring a rapid recovery. More importantly, the lingering weakness stems from a lack of demand, which the Fed is ill-suited to address. Like the proverbial dehydrated horse, it can’t force the markets to expand growth, and further expansionary policies would only serve to feed inflationary pressures when the markets do recover.

So what can Bernanke and the Fed do? I would suggest the simple task of waiting, and making sure not to make promises they aren’t prepared to keep. While a reasoned resolution of Europe’s debt crisis, or a similar solution to our own debt situation, would be helpful, there is little Bernanke can do other than make speeches. He would be best off to let monetary policy be, and prepare a response to rising inflation or a Europe-related confidence crisis; problems that the Fed is well suited to deal with.

Joe McClintock is an intern with the economics department at AEI.

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The Fed: The new Supreme Court?

By Joe McClintock

February 16, 2012, 5:43 pm

The Supreme Court was designed to be politically independent, with justices appointed to life terms and removed only in cases of great indiscretion. However, since the Senate’s rejection of Robert Bork, Reagan’s nominee for the Supreme Court in 1982, scholars of political science have recognized that the Supreme Court is far more politicized than its independent nature implies. Confirmation battles are fought on party lines, citizens protest rulings with the same furor as they protest bills from Congress, and justices and the decisions they hand down are more politicized than ever.

This divisiveness has developed over a quarter century, yet we can see similar developments in another semi-independent agency whose decisions have large impacts on Americans: The Federal Reserve. The comparisons between these two institutions reveal both similarities and differences. Like the Supreme Court, the Federal Open Market Committee (FOMC) is a small group of elites whose decisions have a great impact on the United States. Though FOMC members do not enjoy lifetime appointments, they are largely independent, with seven of the twelve members appointed, similarly to the Supreme Court, and five of the twelve chosen by banks, with no citizen input.

The Fed had its Bork moment last summer with Peter Diamond, a decorated economist whose nomination to the FOMC was blocked by Republicans for ideological reasons. This came amidst many calls to audit, or even eliminate, the Fed, led initially by Texas Congressman Ron Paul but later adopted by many Republicans. Strong criticism of the Fed’s Chairman, Ben Bernanke, have also featured prominently in the 2012 Republican primaries, with most candidates calling for his resignation or arguing for changes to the Fed’s statutory mandate.

So, how does this bode for the Federal Reserve? It is unclear. Criticism of the Fed will likely wane as the economy recovers and its expansionary policies are scaled back and forgotten. In the meantime, attacks on the Fed’s independence are dangerous, since, like the Supreme Court, independence is crucial to its operations. Calls for audits and greater transparency are less concerning, and the Fed has already adopted many of these programs; changes to the statutory mandate are very concerning.

So, yes, the Fed will doubtlessly face greater scrutiny and criticism in the future, but Bernanke seems to have addressed these attacks well. On the small things, he has made concessions; on the big things, he has defended the Fed’s independence. Hopefully his inevitable replacement will be similarly dedicated to keeping the Fed independent.

Joe McClintock is an intern with the economics department at AEI.

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If Obama wins, he should thank Bernanke

By James Pethokoukis

February 16, 2012, 2:59 pm

In a speech to community bankers today, Fed Chairman Ben Bernanke addressed a complaint that superlow interest rates are hurting bank profitability by squeezing net interest margins. Bernanke’s response was interesting:

The purpose of the Federal Reserve’s policy of low interest rates is to speed the economic recovery, which will increase loan demand and opportunities for profitable lending, among many other benefits, and thus, ultimately, lead to higher net interest margins. In short, it is necessary to set the negative effects on net interest margins against the positive effects of a strengthening economic and lending environment. Moreover, the benefits of a stronger economy for the performance of existing assets should also be taken into account; as you know, delinquencies decline as the economy improves. Putting all these considerations together, in the longer term the overall effect on bank profitability of an appropriately accommodative monetary policy is almost certainly positive.

In short, Bernanke was saying the economy would be much worse today without various Fed actions, including asset buying. In fact, Fed models suggest the current unemployment rate would around 10 percent. I’m guessing White House economists wouldn’t disagree.

I wonder what the political chatter would be about Obama’s reelection chances if unemployment were still around 10 percent?

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John Makin

What if the Fed had done nothing when the U.S. economy tanked?

By John Makin

February 15, 2012, 9:25 am

The Fed has been accused of risking higher inflation for having undertaken repeated rounds of rate cuts and quantitative easing since the 2008 Lehman crisis. The stimulus has been likened to a drug that will lead to a nasty inflation hangover with no benefits for the economy. Before jumping to the conclusion that the Fed has performed poorly after the financial crisis, it is important to consider alternative scenarios that might have followed from Fed inaction:

The Austrian school would say that if the Fed had remained inert after the Lehman crisis, prices would have fallen sharply at first, but expectations of a subsequent rise in prices (higher future expected inflation) would have pushed down real interest rates enough to stimulate investment. The higher investments and subsequent growth would lead to a self-sustaining recovery.

That experiment [waiting for prices to stop falling] went badly in the Great Depression [during 1931-32] and has gone badly in Japan over the past twenty years. Little empirical evidence exists for the Austrian counterfactual assumption that deflation leads to expected inflation. In any case, the economy and investors now heavily depend on low real interest rates, and abruptly withdrawing them could lead to financial collapse and deflation. This might be called cleansing the system, but unless prices somehow started to rise in the midst of an equity, housing, and economic collapse, a very doubtful outcome, we would face another Great Depression and some nasty bank failures. For better or worse, the Fed is stuck holding interest rates low and steady for at least another year, and probably longer.

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Desmond Lachman

European doublespeak while Athens burns

By Desmond Lachman

February 13, 2012, 12:47 pm

Orwellian doublespeak is alive and well and living in Europe. Today, seemingly oblivious to an Athens in flames, Ohli Rehn, the European Union’s Economic and Monetary Affairs Commissioner, sternly warns Greece that “disastrous consequences would follow if Greece did not avoid a disorderly default.” And he does so with the intent of bullying Greece into continuing to hew the misguided policy line of its IMF-EU taskmasters that has brought Greece to its present terrible socio-economic pass.

Apparently, nobody seems to have informed Rehn that Greece’s economy is already in a state of collapse. Over the past year, Greece’s manufacturing output has declined by 18 percent while its youth unemployment is now around 50 percent. Nor does it seem that anyone has explained to Rehn that this collapse has occurred as the direct result of IMF-imposed hair-shirt fiscal austerity within a euro straitjacket that precludes currency devaluation as a means to promote the Greek external sector. And it seems to have escaped Rehn’s notice that Greece is rapidly moving to a state of becoming politically ungovernable as a direct consequence of the economic hardship that it has been forced to endure.

As if to add insult to injury, the IMF and EU are now prescribing to Greece even more of the stiff medicine that has brought the Greek economy to this painful pass and that will guarantee Greece a lost economic decade. Little wonder then that the Archbishop of the Greek Orthodox Church has been warning Europe of a social explosion in his country.

And, again, nobody seems to have informed Rehn that Greece is already well into the process of a disorderly default on its debt. For Greece is using the legislative threat of retroactive collection clauses to get its private sector creditors to “voluntarily” accept a 70 percent write down in the present value of their Greek sovereign debt holdings. Someone might inform Rehn that this is very little different from Argentina’s take it or leave it offer to its private creditors in 2005, which involved a 72 percent write off of its debt and which was widely regarded as a disorderly default.

An even more pernicious form of European doublespeak is that Greece is but a special case and that what is occurring in Greece could not happen elsewhere in Europe. Maybe someone should inform Rehn that Portugal is going down the very same road as did Greece and that it will be no more successful than was Greece in restoring fiscal sustainability by engaging in draconian budget austerity within the constraint of euro membership.

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Categories:  Economic Policy, Europe and Russia, Fiscal Policy and Taxes, Monetary Policy, Trade   |   Tags: ,

Painful inflation lessons for the United States and China

By Daniel Hanson

February 9, 2012, 1:56 pm

Much to the chagrin of party officials, China’s inflation rate rose by 0.4 percent in January, ending a much-needed five-month drop in the rate. While commentary has rightly noted that the rise in prices is largely due to holiday shopping, the continued volatility of China’s inflation rate has to be a concern. As the chart below shows, inflation levels have been elevated since 2007, and the range in which inflation varies is more than twice that of the decade prior.

The most pressing problem of the volatility is the problem presented to lower class Chinese families who are trying to plan for basic cost-of-living expenses like food and shelter. The lack of price stability has exacerbated the political tensions surrounding Chinese economic inequality, a problem so large that it led the Chinese government to reduce income taxes to zero for millions of low-income Chinese taxpayers last spring. Party higher-ups have made it clear that economic inequality will continue to be a focus of China’s economic development as they maintain their push to create a stable middle class.

More instructively, the volatility underscores the warnings issued by certain U.S. policymakers regarding the Pandora’s box of unanchored inflation expectations. Some Fed officials and members of Congress have mounted an offensive to dissuade the Fed from its hyper-focus on price stability, relying on the notion that a trade-off between inflation and unemployment could help our abysmal job numbers.

The problem is that unanchored expectations are hard to re-anchor, and, as the Chinese are learning, regaining an environment of low and steady inflation can be painful. Or, as Paul Volcker pointed out in September:

… the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

The Fed may not be perfect, but its emphasis on price stability is well-founded. China’s painful experience should only serve as a reminder to meddlesome congressmen and dissenting Fed presidents.

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The key assumption of Obama’s budget

By Daniel Hanson

February 9, 2012, 10:40 am

In preparation for the president’s budget proposal next week, it’s important to discuss one of the assumptions on which all figures will be based.

Over the past few years, interest rates on federal debt have fallen to historically low levels thanks to manipulation by the Fed and risk aversion by markets. An unintended consequence of these low interest rates is that the federal debt has been financed very cheaply. Still, interest payments on federal debt have rising sharply since the end of the Clinton era.

The average maturity of the national debt is just over 62 months. This means that once every five years, almost all of our national debt is refinanced into new contracts. The CBO does its budget projections with this in mind, and guesses at what the interest rates will be. For their most recent projections, they assume interest rates will stay low until they begin to slowly rise until 2014.

This is a big assumption. Any number of things could cause interest rates to rise, from a market shock to another debt ceiling debacle to a debt downgrade and so on. Assuming interest rates don’t stay low, the cost of financing the public debt could rise extremely quickly. The chart below shows the national debt picture 62 months from now under different interest rates.

If interest rates rise to where they were at the end of the Clinton presidency, when the economy was rosy, the federal debt will be $4 trillion higher in five years. It’s amazing what a difference a little assumption can make.

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Categories:  Economic Policy, Fiscal Policy and Taxes, Monetary Policy, U.S. Economy   |   Tags: ,

The Swiss keep their anchor in the Eurozone

By Daniel Hanson

February 2, 2012, 3:58 pm

Acting Swiss National Bank head Thomas Jordan seems determined to stay the course on devaluing the franc, as I mentioned he would following Hildebrand’s resignation. In the FT today, he says:

We will enforce this minimum rate with the utmost determination and we are prepared to buy foreign currency in unlimited quantities if necessary… Our profits have been and will be very volatile … because our balance sheet is four to five times as big as it was five years ago. Last year, we had a loss of SFr20bn, but this year we have a gain of SFr13bn … I am convinced central banks should have sufficient capital for the long run. But, in the short run, central banks can bear heavy losses and even go into negative equity if necessary. In the case of the SNB there is no legal need to recapitalise the bank immediately. We will simply recapitalise the bank through future profits.

The SNB has undertaken the largest quantitative easing in the world by percentage since the financial crisis hit, and they have sustained massive losses in the process. In just two months of 2011, the SNB injected 40 percent of GDP into the money supply in an effort to drive the exchange rate with the euro down to SFr1.20 per euro.

For now, the Swiss don’t need to worry about their central bank’s losses because the bank is, as Jordan claims, sufficiently capitalized. Of greater concern to the Swiss should be the prospects for the franc should the eurozone collapse. In that context, the Swiss economy would be saddled with both rapid appreciation of the franc and the fallout from the prior interventions. Essentially, the SNB has bet 40 percent of its GDP that the eurozone is going to work out its problems.

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Inflation fears, Ron Paul, and the big, bad Fed

By Daniel Hanson

February 2, 2012, 12:19 pm

Gold bugs like Ron Paul like to argue that economists have conflated inflation with price inflation. Paul says that inflation is, by definition, growth in the money supply. Some thoughts based on this perspective:

  1. By this analysis, assuming a 1-to-1 direct relationship between an increase in the supply of money and an increase in inflation (see below for why this is silly), we would have experienced an annual rate of inflation of about 1.5 percent per year in the postwar period if our money was gold. This is the rate at which the global gold supply has expanded. Also, while expanding at a fairly stable rate, the supply of gold has sometimes unexpectedly changed. We would have inflation and uncertainty in Ron Paul’s utopia.

  1. Price inflation has been quite low for the past decade. Since 2000, the CPI has gone up about 2.5 percent per year on average. Core inflation, which excludes food and energy, has gone up 2 percent per year over this span. The Fed thinks core inflation is a more appropriate measure for their purposes because they can control it more directly than they can headline inflation.

  1. Food and energy prices have been extremely volatile. Gold standard advocates such as Paul argue that such volatility is caused by the Fed; meanwhile, the Fed maintains that the shocks on these prices are outside of their control. Here’s a chart of oil price pressures over the past two decades; you decide which story is more plausible. (A similar chart could be made for food prices.)
  1. There are libraries of ink spilled over the relationship between money supply and inflation, but two things are clear. There is a relationship between how much money is in an economy and how much things cost, but that relationship is not very easy to track because price changes are influenced by many things other than the supply of money. Gold standard advocates understand this, but their rhetoric often makes it seem as though the Fed is the lone villain behind price inflation. Observe, then, the relationship between the quantity of money in the economy and price changes since 1980.
  1. Price inflation in the wake of QE-1 and QE-2 has risen from near zero, but inflation in general has been especially low, something that gold bugs, with their sole emphasis on the relationship between money supply inflation and price inflation, have yet to explain.

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Fear and loathing of the Fed

By Daniel Hanson

January 26, 2012, 12:00 pm

As the GOP primary heats up, it appears that Ron Paul’s “End the Fed” message is catching on. In South Carolina, Gingrich dove head-first into the Gold Standard fray, promising a “gold commission” modeled after the double-digit inflation-battling commission built by Ronald Reagan (that, coincidentally, overwhelmingly rejected returning to a gold standard, and had Ron Paul as a member).

Ron Paul, a subscriber to Austrian Economics, has been advocating a return to gold for years. Part of his argument is that gold’s meteoric rise signals impending doom for the dollar. Between the massive debt overhang and distrust of the Fed, Paul argues that people will lose faith in the U.S. financial and monetary system.

Noteworthy, then, are the returns on asset classes in 2011.

If, as Paul and Gingrich argue, we are facing economic doom, shouldn’t gold be at the top of the list? And shouldn’t interest rates be rising? And shouldn’t inflation be going through the roof?

Yet, as AEI economist John Makin notes:

First among the reasons for low interest rates is the fact that actual inflation has been coming down. U.S. headline inflation is almost a full percentage point below where it was about four months ago and it is expected to fall further toward midyear. Inflation in Germany is coming down and Japan is actually experiencing deflation… The negative shocks of 2011 including the Arab spring, Japan’s tsunami-nuclear disaster, the ugly midyear battle over the U.S. debt ceiling, and the 4th quarter intensification of Europe’s sovereign debt crisis, all contributed to elevated risk aversion. As inflation risks abate, the safe haven represented by high-grade government bonds looks even safer.  For households and firms wishing to hold a high level of very liquid safe assets another alternative is U.S. treasury bills that are highly liquid and continue to be favored assets.

In other words, inflation is low and dropping, interest rates are low and will remain so, and markets view U.S. sovereign debt as their safest haven. Maybe the gold-bug-predicted crisis is still yet to come?

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The 5 things you need to know about the next Swiss Bank head

By Daniel Hanson

January 10, 2012, 9:23 am

With the shocking resignation yesterday of Philipp Hildebrand as Swiss National Bank chairman, it seems clear that Thomas Jordan will be his successor. Here are the things you need to know about Jordan:

1. Jordan is an academic technocrat. He has a long academic CV but no private sector experience, putting him in company with many new European financial czars. His views on the Swiss system are the result of decades of literature review, but lack real-world perspective. Consequently, he has repeatedly shown little respect for actual business practices, like promising banks would have no trouble magically raising capital buffers to meet cautionary guidelines.

2. Jordan, a long-time Hildebrand ally, will only add fuel to the fires of opposition to the SNB’s current battles over massive reserve accumulation. Jordan has long urged a more aggressive reserve accumulation strategy, and the powerful political opposition to this move will grow under his tenure. The real takeaway here is that the SNB will continue to lose legitimacy as it fights this war of public opinion.

3. All signs point to Jordan being the architect of the Franc-Euro currency peg the Bank set up in September amid rising exchange rate concerns. Jordan was the principle defender of the peg in the media, established the public case for the legal framework of a peg, and dropped hints in interviews for months before the peg was announced about its possibility. Don’t expect a marked deviation from it.

4. Just like Bernanke, Jordan is terrified of deflation in 2012, and he is a major advocate of both inflation targeting and central bank coordination. Expect the SNB to undertake more liquidity operations with the Fed and ECB over the next months. Swiss voters should be concerned that, thanks to the SNB liquidity operations, the Swiss economy has chained itself to the eurozone. When the crash comes in Europe, Switzerland will feel the pain too.

5. Jordan’s push for more integration means that the scope of the de facto QE-3 currently being employed by the world’s central banks is only going to expand. In order to counter funding shortages, central banks have taken on more deposits and offered more loans. They have succeeded in supporting the liquidity of the world’s banks, but they have also engaged in credit allocation that makes them vulnerable to large-scale defaults. Jordan will only exacerbate this condition.

The short version of events is that anyone hoping for a change of direction in the post-Hildebrand Switzerland isn’t going to get what they want. Jordan will be more of the same.

 

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The shock resignation of Swiss banker Hildebrand: Credibility must be continuously earned

By Daniel Hanson

January 9, 2012, 4:30 pm

It’s hard not to feel bad for Philipp Hildebrand, the former head of the Swiss National Bank who resigned this morning amid allegations of insider trading. His resignation came as a surprise, but was not altogether unwarranted given the scope of the charges against him and his wife. The reality is that his resignation is merely a symptom of a much large central banking problem.

Hildebrand has been an audacious policymaker since he took over the SNB in 2010. He has done a fairly good job reacting to the global financial crisis and European debt crisis, urging policymakers to implement academic solutions to real-world problems as a means of providing stability for average Swiss citizens. Hildebrand’s unique background of real-world bank experience and research acumen has made him a fantastic fit for the SNB as he has weathered the storms of the financial crisis by making bold decisions based on a solid theoretical footing. Not all of these decisions have panned out, as evidenced in the exchange rate interventions from March 2009 to June 2010, but Hildebrand has been quick to acknowledge failures and change course, something American policymakers could do more frequently.

Hildebrand is, in many ways, the wunderkind of European financial circles, as he joined the SNB governing board in 2003 at the relatively young age of 40. He participated in the World Economic Forum at Davos while still pursuing his university degree, and he began co-authoring papers on central bank policy while still a young student. His angling for the head of the SNB appears to have begun at a very young age.

The tragedy is that Hildebrand broke his own cardinal rule. Throughout his writings, he has consistently pointed out that the credibility of the central bank is the single most important feature of monetary policy; above and beyond the actual currency moves and financial interventions, markets must believe that the central bank is trustworthy. As he wrote in 2007, “credibility is not a permanent characteristic of a central bank, but must be continuously earned.”

The charges against Hildebrand are personal, but they are part of a broader climate of distrust in central banks. Central banks the world over have lost massive amounts of credibility since 2008 and have been unable to recover most of it. The Fed has been mired with the balance sheet problems of QE-2, high unemployment, stagnant housing and financial sectors, the perils of TBTF, and the limits of accommodation in monetary policy. The SNB has been battling high inflation and excessive appreciation with a bold currency peg. The ECB has recovered some sliver of credibility since Mario Draghi took the helm, but they are still viewed as impotent against the rising tide of recession and debt in Europe. Moreover, the last two years has seen the ECB raise interest rates at all the wrong times. And China’s central bank continues to fight unanchored inflation expectations and a bursting housing bubble. In the aggregate, these incidences constitute a massive crisis of confidence in the institutions governing the world’s major currencies.

Hildebrand, who may or may not be guilty of the accusations heretofore leveled at him, forgot that, far more important than the letter of the law is the respect of the markets. By forgetting his own principles, he caused his own downfall and jeopardized the credibility of the central banking system the world over. Let’s hope this incident serves as a wake-up call for the spate of central banks who have long stopped continuously earning their credibility.

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Will Ben Bernanke and the Federal Reserve bail out Europe?

By James Pethokoukis

November 21, 2011, 8:35 am

Federal Reserve chairman Ben Bernanke is a student of the Great Depression. And he has an apologetic view of the Fed’s role in it. As he said in a 2002 speech on Milton Friedman’s 90th birthday, “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna [Schwartz, Friedman's coauthor]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

And with the European Central Bank about to reprise the role of the Fed in the 1930s, economic analyst Ed Yardeni thinks Bernanke may well ride to the rescue of the eurozone and the global economy:

Given the ECB’s reluctance to act, I suspect that the Fed will spearhead the formation of a Global Liquidity Facility (GLF) to avert a global financial meltdown. Fed Chairman Ben Bernanke demonstrated that he is a master at putting together such emergency measures back in 2008. In effect, it would act as the world’s central bank. Mr. Bernanke is clearly very worried about the prospect that the European sovereign debt crisis is a contagion that could spread to the US, as evidenced by his bizarre town hall meeting with troops returning from Iraq on November 10. The GLF would receive deposits from the Fed and other participating central banks, including the ECB. The funds would be used to buy the bonds of debt-challenged governments that would be required to accept strict supervision of their fiscal and regulatory policies by the IMF.

You might be thinking that I’ve gone mad. Actually, I’m simply predicting the behavior of our wild and crazy Fed officials. Last Wednesday, Boston Fed President Eric Rosengren noted that the Fed and the ECB worked together during the 2008 global market meltdown, and “if there was a (new) crisis I would expect that there would be some coordinated activities (again). We would want to make sure … that people have access to short-term credit markets.” He added, “We’re not at that point right now, but there are clearly stresses in short-term credit markets.” He said, “We’re watching that very closely, and if it becomes appropriate for us to take more actions to try to relieve that, I fully assume that we would do something.” Mr. Rosengren isn’t on the FOMC, but he is one of Mr. Bernanke’s most supportive colleagues.

There would certainly be a firestorm in Congress, but Bernanke is unlikely to seek (or if he did, get) another term anyway.

 

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Alex J. Pollock

How small a capital ratio should a central bank have?

By Alex J. Pollock

November 18, 2011, 2:13 pm

Federal Reserve Banks are banks—quite special banks, to be sure, but banks nonetheless. Like all banks, they must have equity capital to support their assets, and you look at the ratio of that capital to the assets to see how much support there is. If you flip the ratio over, you get the leverage of the bank, its ratio of assets to capital—this leverage ratio is usually used in discussing riskiness.

The New York Federal Reserve Bank is by far the biggest and most important Federal Reserve Bank, and always has been. It has more than half the vastly increased assets of the whole Federal Reserve System. Here’s an update on its assets, capital, and leverage:

As of November 9, 2011, the New York Fed has assets of $1.6 trillion, which includes about $485 billion of mortgage-related securities, mostly issued by the failed Fannie Mae and Freddie Mac. Its capital is $15.6 billion, for a capital ratio of less than 1 percent (0.98 percent). A regular bank would be severely criticized by the Federal Reserve itself and all other regulators for having so little capital. The proponents of “Prompt Corrective Action” would argue such a bank should be closed down.

Put the other way, the New York Fed’s assets are more than 100 times its capital—the leverage ratio is 102. What does this mean? An ordinary American bank might have leverage of 15. Over 20 is getting high. At leverage of over 30, the investment banking firms set themselves up for disaster in the financial crisis. Fannie Mae and Freddie Mac ran at leverage of 60 or so and are now flat broke. So 102?

But it is true that a Federal Reserve Bank is definitely special. How small should its capital ratio be? How risky should its balance sheet become? Should it have a minimum capital requirement? If the net worth of a central bank became negative, would we care? Would it stop paying its dividends to shareholders? Would it have to issue a capital call on these shareholder commercial banks? Would we still accept the dollar bills it prints? Federal Reserve Banks are the most profitable banks in the country—would the high profits of an insolvent one simply offset the negative net worth?

These are questions without generally understood answers, even among banking experts. They are worth considering as the Fed, and the New York Fed in particular, runs up its leverage and its risk.

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Romney adviser Glenn Hubbard on NGDP

By James Pethokoukis

November 16, 2011, 4:21 pm

The idea of having the Federal Reserve target nominal GDP has gotten a lot of play lately. So I thought I would ask Glenn Hubbard, a top economic adviser to Mitt Romney, his thoughts on the matter. He’s someone, after all, that I could see as the next Fed chairman if Romney gets elected. I included some of his answer yesterday in a Q&A, but here is Hubbard (speaking for himself and not the campaign) at more length on NGDP:

It’s certainly something that economists have talked about for years. … Economists routinely look it. Having said that, I’m not sure the Fed would be driven to do much more than it’s doing right now. It already has an amazingly accommodative monetary policy and it’s hard to see how they could make it ever more accommodative. … The Fed is almost pushing on a string right now because the usual housing channel for refinancing is blocked. And on the business side, people are sitting on mountains of cash, but it’s not whether the 10-year yield is 1.9 percent or 2.3 percent that’s going to ignite U.S. investment. … What makes me nervous is anything that looks like temporary increases in inflation because our experience is that’s a genie that’s very hard to put back in the bottle. I would much rather see us do the restructuring in the economy that we need for conventional monetary policy to work, which would mean clearing up the policy uncertainty that is limiting the willingness of business to invest, and help facilitate the deleveraging on the household side. Part of the problem is that the Fed is trying to do the job of the government, too, because the government’s has been sitting on its hands.

Are you concerned such a policy wouldn’t work or maybe it works but then we face higher inflation expectations for a long time and it is self defeating long term?

Actually, it’s a bit of both. In the near term, it’s hard for me to imagine that it would work much differently than what the Fed is currently doing, which isn’t exactly a booming success. And then in the longer term, I would worry about inflationary expectations becoming unhinged. And I think that’s something the Fed would find very difficult to reverse.

 

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John Makin

What’s the Fed supposed to do?

By John Makin

November 3, 2011, 9:56 am

The first question for Fed Chairman Bernanke at his post-FOMC press conference was about the rising criticism of Fed policy from congressional leaders and presidential candidates. He largely sidestepped the question by saying simply that “politics is politics” and remarking on the Fed’s need for independence on specific policy conducted within the framework of broad congressional oversight.

In fact, the Fed is in a bind given the rising tensions over the direction its policy should take in coming months. On the one hand, most of the criticism coming from Congress and Republican presidential candidates asserts that the Fed is risking runaway inflation and a dollar collapse following QE2 and Operation Twist—its latest easing steps. On the other hand, as the Fed noted in its latest FOMC policy statement, “there are significant downside risks to the economic outlook, including strains in global financial markets”—the intensifying European sovereign debt crisis and the bankruptcy filing this week of MF Global. Meanwhile, year-over-year core inflation has stabilized at 2 percent, right where the Fed has consistently said it wanted to see it. Core inflation has begun to slow, with the latest month’s annualized rate at below 1 percent. (See chart.) Long run market measures of expected inflation have dropped sharply since summer.

At some point, Chairman Bernanke will have to confront his critics by asking what they would have him do in the face of significant downside risks to the economy, persistent high unemployment, and an absence of runaway inflation or a dollar collapse. What would markets have done today if the Fed had announced plans for some form of tightening—higher interest rate targets or reserve draining? It’s a pretty safe bet that we would have seen a sharp collapse in stock prices and a stronger dollar. Is that what the politicians want?

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The Big Ugly: Fed massively cuts its economic outlook

By James Pethokoukis

November 2, 2011, 2:22 pm

Let me sum up the new Federal Reserve forecast in one word: pain! Note especially next year in the table below.

No boom. No bounce. No last minute surge. Just more of the same-old muddle right though Election Day 2012. What was the Obama’s White House worst-case scenario is now the baseline—and that’s assuming no worsening of the EU financial crisis. And who wants to bet on that right now.

And here is how Goldman Sachs interprets things:

1. The Federal Open Market Committee downgraded its views on economic growth, as expected. The “central tendency” of 2011 real GDP growth forecasts was taken down more than a percentage point, to 1.6-1.7 percent (vs. our 1.4 percent); the 2012 forecast central tendency was revised down 80bp and the 2013 range 60bp on average. The 2013 and 2014 growth forecasts were less optimistic than we expected, centered on growth in the low-to-mid 3 percent range—still fairly modest given the expectations of still-high unemployment at that horizon.

2. The expected unemployment rate in 2013 was revised up to 7.8-8.2 percent, from 7.0-7.5 percent previously. Also, the implied FOMC view on the economy’s “equilibrium” unemployment rate has moved up slightly—the midpoint of the long-term “central tendency” range is now 5.6 percent, vs. 5.4 percent previously.

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Bernanke Announces the End of the Bernanke Put

By James Pethokoukis

October 4, 2011, 2:10 pm

The Ben Bernank today to Congress:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies—pertaining to labor markets, housing, trade, taxation, and regulation, for example—also have important roles to play.

Easy money can be a powerful tool—but not necessarily for good. AEI’s Desmond Lachman in the Financial Times:

The 2008-2009 U.S.-led subprime banking crisis could not have been as acute as it was without the ample and reckless financing provided by the American financial system over many years. So too is the case with the present European sovereign debt crisis. In the absence of an extended period of overly-generous provision of bank credit at low interest rates, the Greek government would not have been able to finance its excessive spending. Nor would the Irish and Spanish property bubbles occurred to anywhere near the degree that they did without reckless bank lending.

What America needs now is pro-growth tax and regulatory policy, particularly if Europe’s problems become ours. Indeed, during his testimony, the Federal Reserve chairman was anything but cheery about the economic outlook. As the econ team at Barclays describes what Bernanke said:

He did note … that more persistent factors are continuing to weigh on the pace of the recovery, such as households that have been “very cautious in their spending decisions” and lower house and financial asset values that have lowered household wealth. He also cited “the poor performance of the job market” as the “most significant factor depressing consumer confidence” and that recent indicators “point to the likelihood of more sluggish job growth in the period ahead.” Other factors, such as a weak housing sector, tight access to credit and elevated volatility, are also continuing to weigh on the pace of the recovery. In terms of the crisis in Europe, he said that “it is difficult to judge how much these financial strains have affected U.S. economic activity thus far,” but noted that it has “hurt household and business confidence” and poses “ongoing risks to growth.

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QE3? Not Yet

By Rohan Poojara

August 26, 2011, 3:54 pm

At this year’s Jackson Hole meeting, Bernanke steered clear of laying the groundwork for QE3. Bernanke admitted that the lingering aftershocks from the financial crisis had “acted to slow the natural recovery process,” an issue extensively covered in “After the Fall,” a paper presented by Carmen and Vincent Reinhart at the Jackson Hole conference last year which looked at the experiences surrounding the fifteen worst financial crises in the second half of the twentieth century. The Reinharts’ research found that real GDP growth slows about 1.5 percentage points in the decade after the crisis relative to the one before in crisis countries. Additionally, in ten out of fifteen cases studied, the unemployment rate does not return to its precrisis low for the entire decade after the fall.

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Joseph Antos

How the Debt Deal Will Really Work

By Joseph Antos

August 18, 2011, 1:52 pm

Most financial analysts breathed a sigh of relief when the president signed the Budget Control Act into law just a few hours before we hit the limit on the national credit card. But that was premature. The new budget law does little more than establish a process by which our fiscal crisis may be addressed, and there are ample opportunities for that process to be overturned. If that does happen, we can look forward to another debt-driven political crisis in 2013.

The new budget law raises the amount that the government can borrow in two steps, from $14.3 trillion to $16.4 trillion, in exchange for an equivalent reduction in federal spending. The president and Congress only settled how much to cut, not what to cut, in the debt deal. The appropriations committees and a new joint committee are tasked with the dirty work.

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Alex J. Pollock

Negative Interest Rates Arrive

By Alex J. Pollock

August 9, 2011, 12:47 pm

I have previously pointed out that although theoretical economists often talk about a “zero bound” to interest rates, in fact negative interest rates are perfectly possible and actually happen from time to time.*

Now they have arrived again, with the Bank of New York Mellon’s announcement that it will start charging a fee on large zero-interest bearing deposits from “investors searching for havens to stash their cash” (as the Financial Times put it). This creates, by a slightly different name, a negative interest rate for holding cash.

Meanwhile, the banks themselves are holding about $1.6 trillion in excess cash reserves at the Federal Reserve, on which the Fed is paying them interest of 0.25 percent. This is much better than most people are getting on their money market accounts.

Will the Fed take a page from the Bank of New York Mellon, and change that to a negative interest rate, in order to encourage the banks to lend or invest the money instead? It could.

* We are speaking of nominal interest rates, not real interest rates (i.e. interest rates net of inflation). With CPI inflation at 3.6 percent, real short-term interest rates are very negative already.

 

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Alex J. Pollock

Rating Agencies: Some Scribblers Are More Equal Than Others

By Alex J. Pollock

August 9, 2011, 8:32 am

In the wake of all the angst and discussion of the downgrading by Standard & Poor’s of the credit of the U.S. government to AA+, we need to consider what rating agencies are.

In fact, they are exactly what they themselves say they are: publishers of opinions. Because of this identity, they claim First Amendment protection for the opinions they publish. In other words, they are one bunch of scribblers among others, trying to forecast the future and its risks like hundreds of other people, naturally making many mistakes, just like everybody else.

It is a delicious irony that the opinions of these particular scribblers get special weight only because the U.S. government has given it to them through its financial regulations. One of these scribblers has now turned on the source of its franchise and duopoly profits. If the government does not like the force of this disloyal pontification, it can reflect that it is its own fault.

The Federal Reserve hastened to announce that the S&P downgrade would have no effect on the zero risk-based capital requirement for U.S. government debt. There is no reason it would need to, but nota bene: the financial regulators have a deep conflict of interest. They are employees of the government which issues the debt in question and needs to keep on issuing great amounts of it. The regulators are not likely to be very strict in their assessment of debt of their employer—indeed we can count on the opposite.

In overall financial perspective, it is perfectly logical to think that internationally diversified, positive cash generating, well-managed companies with low leverage are better credits than nationally concentrated, negative cash flow, poorly managed, highly leveraged governments.

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Philip I. Levy

China’s Undervalued Currency

By Philip I. Levy

August 6, 2011, 9:32 am

China’s undervalued currency has been a major preoccupation of U.S. international economic policy for much of the last decade (a history I review here). It’s an open question whether the focus on the renminbi has been excessive or justified. Within the last couple weeks, House Minority Leader Nancy Pelosi (D-California) argued that legislation on China’s currency must be taken up again, that it “could create more than 1 million American jobs and enhance our economic and national security.” Meanwhile, House Ways and Means Chairman Dave Camp (R-Michigan) said that currency was only one of many concerns the United States had with Chinese economic practices and that it had been a mistake to focus on it exclusively.

What’s the harm in fixating on the renminbi-dollar exchange rate? First, it can displace other pressing issues, such as Chinese intellectual property or investment policies. Second, U.S. pressure can actually be counterproductive, by making advocates of appreciation in China look like they are kowtowing to U.S. interests. Third, China already has very strong incentives to appreciate its currency and will do so when it can overcome its inhibitions.

On this last point, there was a remarkable piece Friday in the Financial Times. Yu Yongding, a former member of the monetary policy committee of the Chinese central bank, laments the potential losses that China may suffer on its massive foreign exchange reserves (the recent debt ceiling brinksmanship served as a reminder). He regrets that gradual measures to address China’s imbalances have not worked and concludes:

The People’s Bank of China must stop buying US dollars and allow the renminbi exchange rate to be decided by market forces as soon as possible. China should have done so a long time ago. There should be no more hesitating and dithering. To float the renminbi is not costless. However, its benefits for the Chinese economy will vastly offset those costs, while being favourable to the global economy as well.

Yu’s advocacy demonstrates that China already faces strong incentives to appreciate its currency. But he is likely underestimating the costs. A quick and dramatic appreciation could cause economic (and thus political) turmoil within China. These are the difficult choices and consequences being weighed by the Chinese leadership. A scolding from the U.S. Congress is unlikely to tip the balance in favor of action.

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The Government Debt Ceiling: What Did Eisenhower Do?

By Alex J. Pollock and Anne C. Canfield

July 27, 2011, 4:34 pm

“Nothing is ever new, it is just history repeating itself”—at least in finance. In his A History of the Federal Reserve,¹ Allan Meltzer describes what happened during the Eisenhower administration when the Treasury ran out of debt authorization and Congress did not raise the debt ceiling. This was in 1953.

In order to keep making payments, the Treasury increased its gold certificate deposits at the Federal Reserve, which it could do from its dollar “profits” because the price of gold in dollars had risen. The Fed then credited the Treasury’s account with them, thereby increasing the Treasury’s cash balance. Treasury then spent the money without exceeding the debt limit.

By the spring of 1954, Congress had raised the debt ceiling from $275 to $280 billion (2 percent or so of today’s limit), so ordinary debt issuance could continue.

The Secretary of the Treasury still is authorized to issue gold certificates to the Federal Reserve Banks, which will then credit the Treasury’s cash account.² This is correctly characterized as monetizing the Treasury’s gold, of which it owns more than 8,000 tons. An old law says this gold is worth 42 and 2/9 dollars per ounce, but we know the actual market value is about 38 times that, at more than $1,600 per ounce.

Should we follow Eisenhower’s example?

Alex J. Pollock is a resident fellow at the American Enterprise Institute.  Anne Canfield is president of Canfield & Associates, Washington, D.C.

1. Allan Meltzer, A History of the Federal Reserve, Volume 2, Book 1, pp. 110 and 168.

2. Federal Reserve Bank of New York, 2010 Annual Report, p. 39.

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Nick Schulz

Inflation Hawks and Doves

By Nick Schulz

July 24, 2011, 9:37 pm

David Henderson notes that, contrary to conventional wisdom, there are lots of libertarian/conservative economists who were in favor of QE2 and other policies anathema to inflation hawks. I’d add a certain University of Chicago trained economist here.

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