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February 26, 2010

Exit strategy, tactics, and decision makers

Vincent Reinhart, resident scholar at the American Enterprise Institute and former senior official of the Federal Reserve Board of Governors, heard the Chairman speak and seems to have come away not wholly satisfied.

"… Bernanke will talk about reverse repurchase agreements and interest on excess reserves as congressional committee members nod in agreement. Mastery over tactics, the bet runs, will restore faith in an otherwise undefined future. It is a difficult trick, this confidence game. The Fed will provide enough detail about its tactical exit from its unusual policy accommodation to allay concerns, but not so many specifics as to lead market participants to believe it intends to head for the exit soon.

"Lost in this thicket of expertise will be important public policy questions basic enough to be assigned as homework in a high-school journalism class.

"When will the Fed begin to raise the short-term market interest rate?"

Interestingly, Reinhart himself has his own answer to that question:

"The Fed has the dual responsibility of fostering employment and price stability. As of now, the Fed continues to forecast substantial and lingering unemployment that puts downward pressure on inflation. Until policy makers can produce a forecast that gives a reason to tighten, they will not tighten. That outlook is not likely to change until late this year."

That judgment is certainly not a matter of inside information or any special insight, as there are plenty of statements like this one from Dennis Lockhart, our boss here at the Atlanta Fed:

"I continue to support an interest rate policy described in recent FOMC statements as low for an 'extended period.' What does 'extended period' mean? I don't want to put a date on it. To me, it means the policy rate will be kept low until recovery has shown momentum that is based on private business and consumer demand, job growth is established or at least imminent, and the downside risks appear to be safely navigable. This unwinding is in the context of well-behaved inflation, of course."

In fact, Chairman Bernanke said very much the same thing Wednesday in the first installment of his semiannual testimony before Congress:

" 'The federal funds rate is likely to remain exceptionally low for an extended period,' Bernanke said, repeating language that has been in every Fed statement on monetary policy for the past 14 months…

" 'As the impetus provided by the inventory cycle is temporary and as the fiscal support for economic growth will likely diminish later this year, a sustained recovery will depend on continued growth in private-sector final demand for goods and services,' Bernanke said. 'The job market remains quite weak.' "

Though much of the discussion lately has been about the tools of implementing policy decisions, that is only natural. The objectives of the central bank—including a broad understanding of what sort of economic conditions will drive a change in policy direction—seem to be well understood. What is new is the instruments that may be brought to bear in light of the very large size of the Fed's balance sheet, a legacy of what I view as successful efforts to manage the fallout of the financial crisis.

Reinhart does make note of an interesting governance question that presents itself if the so-called "exit strategy" involves the payment of interest on reserves that banks deposit with the central bank:

"How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. …[T]he Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

"Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.)"

The institutional fact is certainly correct—the authority to set the interest rate paid on reserves is granted to the Board of Governors, not the FOMC. But, in my view, this is of more theoretical than practical interest. The minutes of the January meeting of the FOMC made clear that, though no definitive decision has yet been made, it may well be the case that the payment of interest on reserves is employed as a transitional tool employed along the road to an environment in which the federal funds rate again reigns supreme:

"With respect to longer-run approaches to implementing monetary policy, most policymakers saw benefits in continuing to use the federal funds rate as the operating target for implementing monetary policy, so long as other money market rates remained closely linked to the federal funds rate. Many thought that an approach in which the primary credit rate was set above the Committee's target for the federal funds rate and the IOER [interest on excess reserves] rate was set below that target—a corridor system—would be beneficial. Participants recognized, however, that the supply of reserve balances would need to be reduced considerably to lift the funds rate above the IOER rate. Several saw advantages to using the IOER rate, rather than a target for a market rate, to indicate the stance of policy. Participants noted that their judgments were tentative, that they would continue to discuss the ultimate operating regime, and that they might well gain useful information about longer-run approaches during the eventual withdrawal of policy accommodation." 

It is also worth noting that if you  pick up any old money and banking textbook, you will likely see listed a trio of tools that the central bank has to affect the money supply: open market operations, reserve requirements, and the discount rate. The latter two have always been the sole or primary province of the Board of Governors. In practice, however, they have been employed as adjuncts to the decisions of the FOMC. As of now, there really is no indication that this is likely to change.

By David Altig, senior vice president and research director at the Atlanta Fed

February 26, 2010 in Monetary Policy | Permalink

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If the fed funds rate is ultimately to trade in a corridor where the upper and lower bounds are set by the Board, then I have to wonder exactly how supreme the funds rate will reign. Nevertheless, given the way the Fed operates, it seems the distinction between whether policy is made by the Board or the FOMC is a rather meaningless one. Can you imagine the Board raising the upper and lower bounds and the FOMC refusing to raise the funds rate? I cannot.

Posted by: Douglas Lee | February 26, 2010 at 04:21 PM

Using the rate of Interest on Excess Reserves to conduct monetary policy will not work because raising the rate increases both reserves and bank income; the rate for loans may increase but the volume of loans (which is the Federal Reserves primary concern) will also increase as banks have more lending capacity.

Posted by: Rajesh Raut | February 26, 2010 at 09:03 PM

The Fed Funds rate vs. Iinterest on Reserves choice is a red herring.

There is no effective difference between IOR and FFR targeting regimes. In the IOR case, the Fed manages the rate to impact demand for conversion from Excess to Required Reserves. In the FFR case, the Fed manages the rate to impact demand for banking system reserves. In the former, banks have access to about $1tr in Excess Reserves at any given IOR rate. In the latter, banks have access to UNLIMITED reserves at any given Fed Funds rate. This is because the Fed commits to supplying as much in reserves to the system as it takes to maintain the FFR at target.

What's the difference between having access to $1tr in Excess Reserves under an IOR regime at any given rate and having access to unlimited reserves in a FFR regime at any given rate?

Posted by: David Pearson | February 28, 2010 at 01:07 PM

"What is new is the instruments that may be brought to bear in light of the very large size of the Fed's balance sheet, a legacy of what I view as successful efforts to manage the fallout of the financial crisis."

There is a fair argument out there that the Fed management of the financial crisis "did no harm" (the same cannot be said of its regulatory actions leading up to the financial crisis).

But, while the Fed can fairly argue that it was neutral to irrelevant in responding to the financial crisis, that case that it was successful or positively helpful in the response is unconvincing. One might as well call the charge of the light brigade a success; everyone showed up and did their jobs, but normally success is measured by positive outcomes, not effort.

Posted by: ohwilleke | March 04, 2010 at 07:44 PM

The money supply won't be contained pegging interest rates (FFR, discount rates, IORs, etc.).

E.g., Alan Greenspan lowered the FFR on Jan. 3, 2000. It wasn't until after 11 FFR reductions that monetary policy actually finally loosened up.

Then, around Oct. 2002, Alan Greenspan went on a monetary binge -- for 41 consecutive months (i.e., Alan Greenspan at no time ever -- tightened monetary policy.

Ever since 1965, when the New York "trading desk" reverted back to the pegging policies used prior to the Treasury-Federal Reserve Accord of 1951, the FED has had a dismal record of monetary management.

The fact is that by tying open market policy to an interest rate, is to supply additional (and excessive legal reserves) to the banking system when loan demand increases.

Posted by: flow5 | March 04, 2010 at 07:52 PM

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February 23, 2010

Looking behind the core inflation numbers

Last Friday's consumer price index (CPI) report showed headline inflation in January remaining stable from the previous month at a 2 percent annual rate, a bit above most private forecasts, boosted by higher fuel costs. But the show was stolen by the core measure. Excluding food and energy, consumer inflation saw the largest monthly drop in more than 27 years and its third largest decline in 47 years.

Several factors were behind the decline in the core index (such as falling airline fares, a dip in new car prices, and ongoing declines in prices for household furnishings and operations), but a sizeable drop in shelter prices, which account for more than 40 percent of the core CPI index, was a significant factor in January's dip. A concern that decelerating shelter prices could skew the core inflation measure was noted in the minutes of January's FOMC meeting:

“Though headline inflation had been variable, largely reflecting swings in energy prices, core measures of inflation were subdued and were expected to remain so. One participant noted that core inflation had been held down in recent quarters by unusually slow increases in the price index for shelter, and that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend.”

Chart 1 illustrates the recent decline the in shelter component of the CPI and how, excluding shelter, core inflation has been growing at a more robust pace than is indicated in the overall number.

Chart 1
022310a
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However, once we've opened the door for pruning sectors that have displayed unusual price behavior in recent months, we can find a slew of outlying components to pare. Take, for example, vehicle prices. With the impact of the ailing state of U.S. automakers, the federal government's “Cash for Clunkers” program, and the major recalls from Toyota, auto prices have been particularly volatile lately. Used car and truck prices have grown at annual rates between 20 percent and 44 percent in each of the past six months, skewing, some could argue, the core measure upward.

Chart 2 shows core CPI after subtracting both shelter and used vehicle prices, a picture that shows a lower inflation rate—more in line with the numbers in the overall core CPI.

Chart 2
022310b
enlarge

My point here is not to advocate lopping shelter and vehicles, along with the already excluded food and energy prices from inflation—which, by the way, would leave us with less than 45 percent of the overall CPI index. In fact, my argument is the opposite. There are always some components of the index that seem anomalous—on either side of the distribution. Discriminately cropping entire sectors from the CPI may not be the best method for teasing out true underlying price pressures.

Chart 3
022310c
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The Cleveland Fed uses a more methodical approach to exclude the CPI components that show the most extreme price changes each month. Their calculations show a more subdued underlying inflation environment, with median and trimmed mean CPI hovering around 1 percent for the past several months (chart 3). I'm not endorsing this method as a perfect estimation of “true” underlying inflation, but it does provide an example of indiscriminately trimming the outliers to see what's beneath.

By Laurel Graefe, senior economic research analyst at the Atlanta Fed

February 23, 2010 in Inflation | Permalink

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A couple of blogs found that BLS made an error. The actual core reading was a positive .1%, not the -.1 as reported. So much for colas.

Posted by: flow5 | February 23, 2010 at 02:24 PM

Another thing that Cleveland (CPI) and Dallas (PCE deflator) statistical rejiggering efforts do is to break out the share of components for which prices fell in a month, rose less than 3%, rose from 3% to 5%, more than 5% and so on. There has been a fairly dramatic shift toward falling prices and away from rapidly rising prices.

Posted by: kharris | February 23, 2010 at 02:49 PM

The median CPI is also very flawed.

How does one justify removing the impact of components with very large weights, such as housing, food, or energy? By doing so, one ends up with a CPI that's representative of as little as 50% of the original index.

You do also realize that the BLS adjusts other CPI components for changes in the energy prices. If there's a large spike in fuel prices, the BLS assumes that the lack of adjustment in the OER amounts to a subsidy and makes a corresponding change to the heating costs component in OER. If one is to remove energy costs because it's an outlier, then one must also back out all of its effects on the other CPI components.

Posted by: Les | February 23, 2010 at 03:00 PM

This post is well constructed. I enjoyed reading it.

There is reason, however, to omit shelter as opposed to cars or air fares. Shelter is different from other components of the CPI because of the presence of Owner’s Equivalent Rent (OER). Although the BLS does a masterful job of attempting to impute housing services to homeowners, these rents are inherently impossible to measure. The BLS makes every effort to sample rental prices of houses equivalent to the owned stock of housing. But the samples are small and biased. In any neighborhood, rental properties are inherently different from owned properties. This is likely particularly true now when many homeowners are unable to sell their houses and opt to rent, often below market rates, instead of selling at a steep discount.

Policy makers should not automatically exclude OER from measures of inflation; neither should they take it at face value. The good news is that at the moment it does not matter much. Although core and core ex shelter are evolving quite differently, both measures point to contained inflation and neither measure is accelerating.

Posted by: The Secret Economist | February 24, 2010 at 08:11 AM

I'm afraid before this is all over, wages will look like chart 1.

Posted by: FormerSSResdient | February 24, 2010 at 11:48 AM

I would point out to Les and to Secret E that policy makers have a fairly sophisticated knowledge of inflation measures, and make use of a number of them. If median CPI is flawed, well that's OK. In fact, its flaws are also its virtues, if used correctly. It is flawed in a particular way that is not entirely shared with other inflation measures. Tossing out the outliers does mask their impact in the single index from which they are tossed out, but conventional CPI measures, the PCE deflator, market based PCE deflator, Dallas Fed rejigger of the PCE deflator, GDP deflators of various kinds are all available to policy makers. Toss out food and energy, use a different, smaller housing component in the PCE deflator, toss out the most volatile components in a given month, look at a number of headline measures over a variety of periods, and then compare the trends among these many measures, and pretty soon, you have a detailed understanding of what is going on with consumer prices. Knowledge of how those measures are constructed, what their characteristics are and what drives them bolster their use. Given that range of information, we should welcome the "flaws" of each individual measure.

Posted by: kharris | February 24, 2010 at 01:18 PM

I really don't think food and energy should be removed. At best some type of rolling average should be included in the numbers. As food and energy make up such a huge part of peoples monthly expenses, it's misleading to exclude them.

Posted by: Ron Stone | June 02, 2010 at 11:55 AM

If there's a large spike in fuel prices, the BLS assumes that the lack of adjustment in the OER amounts to a subsidy and makes a corresponding change to the heating costs component in OER. If one is to remove energy costs because it's an outlier, then one must also back out all of its effects on the other CPI components.

Posted by: Homework Help | July 04, 2011 at 02:37 AM

Who doesn't like lower prices? Economists, for one. The good news is that many economists think the biggest deflation risk has passed.

Posted by: VMware course | October 12, 2011 at 01:15 AM

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February 19, 2010

Should the Fed stay in regulation?

One of the central issues in the postcrisis effort to reform our regulatory infrastructure is who should do the regulating. The answer to some in Congress is none of the above:

"… under consideration is a consolidated bank regulator, one aide [to Alabama Senator Richard Shelby] said. The idea is supported by [Connecticut Senator Christopher] Dodd, who proposed eliminating the Office of Thrift Supervision and Office of the Comptroller of the Currency, and moving their powers, along with the bank-supervision powers of the Federal Reserve and the Federal Deposit Insurance Corp., to the new agency.

"Negotiators are still deciding how to monitor firms for systemic risk, including how to define and measure it, what authorities to give a regulator and which agency is best suited to get the power, a Shelby aide said."

As reported in The New York Times:

"The Senate and the Obama administration are nearing agreement on forming a council of regulators, led by the Treasury secretary, to identify systemic risk to the nation's financial system, officials said Wednesday…"

Though the idea of a council to provide regulatory and supervisory oversight is still contentious (the Times article offers multiple opinions from Federal Reserve officials) the formation of a council is not necessarily the same thing as removing the central bank from boots-on-the-ground, or operational, supervisory responsibility. In other words, there is still the question of how to monitor systemic risk and which agency is best suited to get the power.

Earlier this week I made note of a new International Monetary Fund (IMF) paper by Olivier Blanchard, Giovanni Dell'Aricca, and Paulo Mauro, taking some issue with the proposal that central banks consider raising their long-run inflation objectives. Though that part of the paper seemed to attract almost all of the attention in the media and blogosphere, the discussion in the IMF article expanded well beyond that inflation target issue. Included among the many proposals of Blanchard et al. was this, on systemic risk regulation and the role of the central bank:

"If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both.

"The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators. They are ideally positioned to monitor macroeconomic developments, and in several countries they already regulate the banks. 'Communication' debacles during the crisis (for example on the occasion of the bailout of Northern Rock) point to the problems involved in coordinating the actions of two separate agencies. And the potential implications of monetary policy decisions for leverage and risk taking also favor the centralization of macroprudential responsibilities within the central bank."

Consistent with the even-handedness of the Blanchard et al. paper, the authors did not come to this conclusion without noting the legitimate issues of those who would separate regulatory authority from the central bank:

"Against this solution, two arguments were given in the past against giving such power to the central bank. The first was that the central bank would take a 'softer' stance against inflation, since interest rate hikes may have a detrimental effect on bank balance sheets. The second was that the central bank would have a more complex mandate, and thus be less easily accountable. Both arguments have merit and, at a minimum, imply a need for further transparency if the central bank is given responsibility for regulation."

But, they conclude:

"The alternative, that is, separate monetary and regulatory authorities, seems worse."

I wonder, then: Would a regulatory council of which the Federal Reserve is a member, combined with operational supervisory responsibilities housed within the central bank, be a tolerably good response to Blanchard's and his colleagues' admonitions?

By Dave Altig, senior vice president and director of research at the Atlanta Fed

February 19, 2010 in Banking, Financial System, Regulation | Permalink

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The Fed is ill suited to a regulatory role. Regardless of the general trend, we have to deal with this Fed in this country, not central banks in general.

Why?

First, the Fed utterly dropped the ball on AIG which it had regulatory authority over. It had a reputation at the time for lax regulation and nothing has happened to change this impression. The Fed simply isn't set up to be a regulator in the same way as other bank regulatory agencies.

Second, few agencies are dispositionally less suited to monitor systemic risk. No federal government player is more focused on the short term here and now concerns of the economy. The Fed is a day to day, month to month participant in and manager of the markets. It does so in a very stylized, through, predictable way. It is all about the trees.

Systemic risk monitoring is fundamentally a long run, see the forest operation. Systemic risk is particularly likely to be hiding precisely where entities like the Fed are not out there collecting data. It is hiding off the books and in novel relationships.

Third, systemic risk regulation is a voice in the wilderness job. The regulator needs to zig when everyone else zags and defy the conventional wisdom of the establishment. The Fed is the establishment. The Fed uses mainstream economic models. The Fed's actions establish conventional wisdom. The Fed is at its most inept when the usual tools stop working in the usual ways (see stagflation). Putting systemic risk regulation in the Fed is to doom that regulator to group think and ideological capture.

Posted by: ohwilleke | February 19, 2010 at 07:14 PM

Do councils in regulatory authorities work? Any examples of where this works today? Seems like an excuse to meet X times a year and yet do nothing.

And, I wish Shelby good luck with defining exactly what all constitutes risk. That could be everything from CDS to police on the street. I think what they mean is "Banking system risk". That's only one part of this apparatus.

Posted by: FormerSSResident | February 21, 2010 at 11:22 AM

I think that regulators need to pay much closer attention to market structure rather than writing rules. For example, in the cash equity markets, they allow dark pools of liquidity, delayed price and volume reporting, payment for order flow, internalization of order flow. These things lead to distortions in the marketplace.

Just wrote a piece on fungibility at pointsandfigures.com.

Posted by: Jeff | February 21, 2010 at 01:13 PM

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February 16, 2010

Do we need to rethink macroeconomic policy?

The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:

"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."

Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:

"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."

I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this

"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."

… which confirms the results of an earlier IMF study:

"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:

"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "

So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:

"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."

Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?

In fact, Blanchard and company acknowledge that…

"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."

… but follow up with this:

"But it is clear that the zero nominal interest rate bound has proven costly."

Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:

"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)

The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.

Update: Related thoughts, from Mark Thoma and from Caroline Baum.

By Dave Altig, senior vice president and research director at the Atlanta Fed

February 16, 2010 in Inflation, Interest Rates, Monetary Policy | Permalink

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The severity of the zero bound problem depends not only on the depth of a downturn, but also on the level of equilibrium (full-employment) real interest rates.

Keynes in his General Theory discusses how growing prosperity leads to a higher saving rate (a saving glut?) and lower equilibrium interest rates, which limits the effectiveness of monetary policy. This is one of the reasons why he advocates a strong fiscal policy. So if we indeed experience a global saving glut then we can either follow Keynes’s original advice and rely on fiscal policy (maybe for a very long time) or we can increase the target inflation rate. This is something Keynes did not think about because his model did not include inflation expectations, but it would be a natural extension of his ideas.

From this perspective, the key questions are whether the saving glut is real, whether it is likely to persist and how much it affects equilibrium interest rates. If we indeed experience a permanent decline in equilibrium real interest rates that would in my view constitute an important argument in favor of a higher inflation target.

Is there enough evidence to support the ‘saving glut’ argument for a higher inflation target?

1) First of all, the Flow of Funds Accounts show that in the 00s full employment became possible only when net borrowing (adjusted for net issuance of equity) reached 15% of GDP, compared to 8% of GDP in the 1990s.
2) This increase in the full-employment level of net borrowing strongly correlates with the US current account deficit, suggesting that it reflects various trends in the real sector, rather than simply an increase in the level of leveraged financial investment.
3) It seems likely that the high level of borrowing observed in the 00s could be sustained not only because the interest rates remained low, but also because the real estate prices were going up (the collateral effect). Without the collateral effect, full employment would most likely demand much lower interest rates than what we saw in the 00s. It is possible that the real fed funds rate may remain negative even at full employment. If this is indeed the case then a 2% inflation target would put a very serious constraint on monetary policy.

So, at first sight there is at least some evidence in favor of a higher inflation target. This evidence is far from being conclusive, since the relationships between various macroeconomic variables are very complicated, but I think this particular argument in favor of a higher inflation target deserves much more attention than it now receives.

Posted by: Doctor Who | February 16, 2010 at 06:30 PM

Blanchard's reason for suggesting a higher rate of inflation is to give central banks more room to cut rates in an emergency -- to get farther from the zero bound. Why not consider negative rates instead? There is no reason depositors cannot be charged for leaving funds on deposit, which is effectively a negative rate. The Fed has the authority to charge depositors for holding excess reserves. This avoids many of the distortions introduced by higher inflation.

Posted by: Douglas Lee | February 17, 2010 at 09:13 AM

If I may say so, I think that you (not that you are the only one) are missing the point here, and treating Blanchard et al with too much respect. Whatever it actually says, I do not think that this proposal is about targeting 4% as opposed to 2% inflation in the abstract. It is probably true that the efficiency cost of 4% underlying inflation would not be much greater than 2%. But the real point of this proposal is to excuse a SHIFT from 2% to 4%, and the transfer of wealth from creditors to debtors that this would involve. It is not big thinking, it is dishonest thinking. Moreover, it is also unwise thinking, because it is the bias in favour of debtors that got us into our present mess in the first place. Blanchard should be sent packing from the IMF back to some academic position where he can express provocative ideas without any responsibility.

Posted by: RebelEconomist | February 17, 2010 at 01:31 PM

Hello all, first time posting. This is a great website with intelligent topics and discussions. If someone could please help me understand the above article and comments. Are we discussing how much further, and to what extent the Fed should artificially manipulate interest rates? Are we trying to find a model for the "correct" artificial rate? In all seriousness, why don't we let the market determine what the interest rate should be?

The original post says this:

"The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?"

Based on your paragraph quoted above, I think we would both agree that the Fed Funds rate is a powerful tool. Simply, if the economy slows down, lower the rate, more money, more elasticity; if the economy heats, raise the rate, less money, more expensive.
Looking at a Fed Funds chart, rates were lowered from January 2001 until August 2004, remaining under 2% for roughly 3 years, one of those averaging around 1%. Around September of 2004 rates started to climb, finally resting above 5% in March 07. We know the history since then.

Is it possible that the low rates from 01-04, and then the higher rates from 04-07 helped greatly to cause the situation we are in now? After all these years of working papers, models, assumptions, policy tools, and targets, we have yet to find anything smarter than the market itself. In my opinion, this paper on a new targeted inflation rate is laughable, it’s similar to the IMF's Guillermo Calvo paper "Is Inflation Effective for Liquidating Short-Term Nominal Debt?” If inflation is so fantastic for the economy, why don’t they give every person in America a counterfeit machine? Our GDP would be off the charts.

The inflation target paper raises a good question, if person is not happy with a 4% inflation target rate, shouldn’t the same person be unhappy with a 2% inflation rate?

To drive my point home, why are we trying to create answers for an interest rate that the market provides already?

Posted by: WilliamATL | February 17, 2010 at 04:06 PM

This has already been tried implicitly in the United States by watering down the inflation measures over the last thirty years to allow the Fed more room to keep an easy monetary policy. If the CPI had incorporated real estate inflation, market rates would've been higher and the Bush administration would've been less inclined to propose so much unwise and wasteful spending and tax cut programs.

Posted by: Les | February 17, 2010 at 07:50 PM

Better not to target any fixed rate but to adapt it to changing circumstance. When long term rates fall below their long term average indicating an increase in leverage, allow inflation to rise. When long term rates rise above their long term average indicating too much inflation, allow it to fall.

Posted by: Lord | February 18, 2010 at 03:15 PM

Great post. Anyone think the Federal Reserve needs to be audited?

Posted by: uspiggybank | February 18, 2010 at 06:25 PM

The inverse correlation between growth and inflation at rates above 2 is hardly surprising, even to a Blanchardian inflationist like me. Imagine a world where all nations follow passive monetary policies, perhaps increasing reserves at a certain fixed rate over time. The functions that relate reserves to nominal demand are mostly a lot of noise, but, taking the path of nominal demand as given, the function that relates inflation to growth is quite precise, and of course the relation is inverse. In this thought experiment, there is no reason to suppose an independent role for the inflation rate in determining growth. Rather, growth is determined primarily by growth in productive potential, and the inflation rate is a residual.

The real world may be different. Monetary policy is seldom entirely passive, and sometimes central bankers do achieve their intentions. But if you look at inflation and growth and ask which one should be treated as exogenous, it seems to me that growth is the obvious candidate. The supposedly active intentions of central bankers are often conditioned by growth expectations. (Surely, for example, a large part of the reason that the Greenspan Fed was able to maintain such low inflation rates in the period after 1995 was that high growth rates removed political pressure for inflationary policies, while a large part of the reason that the Miller Fed tolerated high inflation rates was political pressure resulting from the growth slowdown.)

Posted by: Andy Harless | February 18, 2010 at 07:23 PM

I am afraid the folks at Angry Bear, and Krugman have another agenda that a higher inflation rate plays into.

I think that first you start with the idea of stable monetary policy. Deflation is terrible, but inflation is also bad. Taylor does the best job of putting a rule to it.

As you say, there is a strong correlation between inflation rates higher than 3% in developed economies and negative effects in the economy. Rational people "get" that.

Clearly, the fiscal policy of this administration, and the administration before that was inflationary. The Fed policy has been inflationary as well, because it had to be.

Going forward, we need far better fiscal policy. It will allow the Fed to concentrate on the inflation picture and not concentrating on being the banker of last resort.

Posted by: Jeff | February 18, 2010 at 10:47 PM

Anybody catch the mistake in Friday's CPI report? The Shelter component of the CPI, which has a 32 percent weighting, was calculated incorrectly from the sum of its own components. This seems to indicate that someone at the BLS edited this field to override the calculation. Shelter inflation should have been 0.1 instead of -0.5. The CPI should have been 0.5, not the 0.2 that was reported.

Posted by: Les | February 22, 2010 at 11:55 AM

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February 13, 2010

The punch bowl, the party, the exit

Though weather of the sort usually reserved for Minneapolis, Chicago, and Cleveland kept Chairman Bernanke from delivering his message in person, a message was sent on Wednesday of last week nonetheless regarding one of the central monetary policy questions of the moment. That is, in terms of the nuts and bolts, what exactly is the Fed's "exit strategy?" Chairman Bernanke provided a general description in this excerpt:

"Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding. We have spent considerable effort in developing the tools we will need to remove policy accommodation…"

A summary of thoughts on Chairman Bernanke’s comments is provided by the Wall Street Journal’s roundup of economist’s reactions to the testimony. If you have ten minutes to spend, an interest in the federal funds market and how interest on reserve policy works, and the desire to hear a lecture that would usually cost you good money, I further commend to you the Mark Thoma’s video at MoneyWatch.com.

Here’s the way I think about the options addressed by the Chairman in his prepared remarks. Let's start with a well-traveled metaphor for how "policy accommodation" works:

Step 1: The Fed fills up the punch bowl (by buying assets and lending funds to financial institutions, which corresponds to a like quantity of liabilities on the central bank’s balance sheet, which includes bank reserves).

Step 2: Bankers spike the punch (by leveraging the quantity of bank reserves outstanding into a multiple quantity of loans to the private sector).

Step 3: The party's on (as businesses and individuals support production and consumption from the credit provided).

What does the Federal Reserve have against a party? Nothing, of course, and the provision of liquidity and specialized support in various parts of the financial system was exactly the point of filling up the punch bowl in the first place:

In addition to supporting the functioning of financial markets, the Federal Reserve also applied an extraordinary degree of monetary policy stimulus to help counter the adverse effects of the financial crisis on the economy… A range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in private credit markets and put downward pressure on longer-term private borrowing rates and spreads.

The concern, of course, is that, as the economy recovers, so much stimulus increases the potential of the party getting out of hand:

"The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. In due course, however, as the expansion matures the Federal Reserve will need to begin to tighten monetary conditions to prevent the development of inflationary pressures."

There is nothing new about this issue. This is exactly what monetary policy decision is always about: When is the appropriate time to apply monetary accommodation, and when is the appropriate time to reduce it.

What is different this time is that the usual approach—drain the punch bowl by selling assets on the Fed’s balance sheet—might well cause very large sales that could work at cross-purposes to the objective of maintaining orderly function in the financial markets that policy is still trying support:

"I currently do not anticipate that the Federal Reserve will sell any of its security holdings in the near term, at least until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery… Although passively redeeming agency debt and MBS as they mature or are prepaid… the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted. Any such sales would be at a gradual pace, would be clearly communicated to market participants, and would entail appropriate consideration of economic conditions."

If "gradual pace" implemented with "appropriate consideration of economic conditions" does not provide sufficient scope for removing monetary stimulus as the need arises, are we simply stick with a party that is destined to spin out of control?

To me, this is where the alternative tools emphasized by Chairman Bernanke come into play. These approaches would work not by altering the overall size of the balance sheet but by altering the composition of the balance sheet in important ways.

One strategy mentioned by the Chairman—reverse repurchase, or repo, agreements—looks a lot like the standard old drain the punch bowl approach. In outright sales, to put it in simple terms, the Fed sheds assets that are paid for with money (think of it as reserves) that the central bank simply takes out of circulation. A reverse repo does very much the same thing, except that it comes with a promise to repurchase the assets—putting more money back into the system—at some future date. Because this approach has more the character of renting assets versus selling them, the overall asset side of the Fed’s balance sheet stays the same, but the liability side shifts from providing reserves today to an agreement to provide reserves in the future. As long as repurchase agreements are rolled over, the quantity of bank reserves is reduced and monetary stimulus is managed.

Another strategy mentioned by the Chairman was the issuance of term deposits to banks. No need to stretch our imagination too much here. The basic economic intuition is really just like that for reverse repos, except that bank reserves are being exchanged for something like certificates of deposits issued to banks instead of mortgage-backed securities or the like.

The payment of interest to banks for the reserve balances they hold with the Fed, also mentioned, and in fact highlighted, by the Chairman, has a slightly different nature. Like reverse repos and term deposits, the amount of punch provided by monetary policy is not altered. What is altered is the incentive for banks to spike the punch by expanding the quantity of loans.

There is a good argument for the case that there is no need to alter those incentives in the current environment. As Mr. Bernanke indicates:

"The FOMC anticipates that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

But once the party heats up, the need to restrain credit expansion through the various tools available will be essential. On this, the Chairman gets the last word:

"… we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus. We have full confidence that, when the time comes, we will be ready to do so."

Update: Jim Hamilton adds his thoughts.

By Dave Altig, senior vice president and research director at the Atlanta Fed

February 13, 2010 in Monetary Policy | Permalink

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The issue, of course, is not how the Fed will remove stimulus but when, and what effect it will have on a nascent recovery. The question of which instrument to use is purely a choice of where on the yield curve the removal will have the most impact. This talk of having the "tools" is disingenuous and besides the point. Its about the future tradeoffs the Fed will be willing to make, or unwilling to make. On this key point, we remain unenlightened by the Chairman and by this blog.

Posted by: David Pearson | February 14, 2010 at 01:18 AM

I wonder how effective the Fed can be in curtailing loan growth through their various tools when the banks have so many options through the capital markets, hedge funds, private equity, etc to extend credit and move assets off their balance sheets when the party gets going.

Posted by: phil mckee | February 14, 2010 at 08:59 AM

The catch, of course, is that we never got to Step Three, because we're still in Step Two.

At this point, there are two reasonable choices: (1) pretend the banks are fully solvent and just Not Lending because they can't find anyone creditworthy (in which case we have the question of why you would raise rates, but no intrinsic reason not to) or (2) admit the banks are still broken and that it will take a long more capital to get them back into the business they are supposed to be pursuing (ibid, except for the coda).

Give Bernanke credit for planning ahead, and certainly for admitting (the anti-Hoenig) that nothing should be done any time soon. (Goldman's estimate of 2011 seems optimistic given that unemployment then will still be around 8.5-9.0% based on the CBO/ERP growth estimates.) But it would be nice if he had also acknowledged that weren't still spiking the punch bowl; the only drunken guests run financial institutions, and then had the flask.

Posted by: Ken Houghton | February 14, 2010 at 01:50 PM

Your step 1 & 2 suggests that increasing bank reserves gets things moving. The unprecedented and astronomic levels of bank reserves during 2009 combined with the obvious reluctance of banks to lend casts doubt on this idea.

I suggest, in contrast, that banks lend when they see commercially viable loan applications from ordinary households and businesses, i.e. from Main Street. Had half the money given to Wall Street gone to Main Street, the economy would be in a better position.

Posted by: Ralph Musgrave | February 14, 2010 at 02:39 PM

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February 09, 2010

Competing histories

If your economic forecast for the coming year embeds something like robust growth in consumer spending, last Friday's Federal Reserve report on consumer credit should probably give you pause.

020910
(enlarge)

At least some folks look at that picture and see a slow slog ahead. Calculated Risk sums up the concern:

"Consumer credit has declined for a record 11 straight months—and declined for 14 of the last 15 months and is now 4.8% below the peak in July 2008. It is difficult to get a robust recovery without an expansion of consumer credit—unless the recovery is built on business investment and exports (seems unlikely to be robust)."

At Angry Bear, the question is a little more pointed:

"Remind me again why all those banks were 'bailed out?' Wasn't it supposed to be to kick-start the economy again?"

Well, here's the thing. That consumer credit picture embeds both the supply of credit and the demand for credit. Though both tighter credit standards and weak loan demand are certainly at play, it is does seem that, at the moment, weak demand is the factor most responsible for slow loan growth in the United States. Recall, for example, this information from the Federal Reserve's January Senior Loan Officer Survey:

"The January survey indicated that commercial banks generally ceased tightening standards on many loan types in the fourth quarter of last year but have yet to unwind the considerable tightening that has occurred over the past two years. The net percentages of banks reporting tighter loan terms continued to trend lower. Banks reported that loan demand from both businesses and households weakened further, on net, over the survey period."

As regular readers of macroblog know, our own Atlanta Fed surveys (here and here) are indicating that soft customer demand, not credit access, is a significant story in business capital expenditure and expansion plans.

Of course, we don't really know whether credit availability will become a more significant problem when demand begins to recover. This uncertainty is behind what is the real back story at this critical point of the recovery. As we peer ahead, we essentially have two competing, and contradictory, economic histories as our guides. First, there is the statistical regularity that deep recessions in the United States have in the post-WWII period been reliably followed by rapid recoveries. But second, there is the Reinhart-Rogoff statistical regularity that recoveries from financial crises are slow and difficult.

A Wall Street Journal interview with Carmen Reinhart provides reasonable arguments as to why slow and painful is a sensible bet. On the other hand, one could argue that the advance fourth quarter gross domestic product figure is consistent with the sharp bounce-back scenario. (If you are looking for that argument, Brian Wesbury and Robert Stein oblige.)

One thing is certain. At least one history is going to be revised.

By Dave Altig, senior vice president and director of research at the Atlanta Fed

February 9, 2010 in Banking, Business Cycles | Permalink

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E-forecasting has January GDP at 5.5% annualized: http://e-forecasting.com/US_Monthly_GDP.html

Looks like Wesbury and Stein take the lead out of the gate, but it's a long race.

Posted by: Steve | February 09, 2010 at 06:08 PM

The data for Reinhart-Rogoff study was _heavily weighted down_ by data from developing nations. The financial systems and economies of developing nations are a lot less mature and robust compared to developed nations. If developing nations were excluded from the data set, the numbers in the study would not have been as bad. Whereas today's crisis is a US and Europe crisis.

Furthermore, the current crisis is already into it's 2nd year. Its already the worse by all developed nations statistics since the great depression.

Lastly, the consumer credit chart clearly show that consumer credit is a very lagging indicator. Today we are just turning corner of the current recession. Why are you trying to look into the future by studying a lagging indicator's current reading?

Just to really put a nail into this, take a look at the credit curve after the 2002 tech crash. That curve would have suggested the US consumer never recovered after the tech crash! If that credit curve was prescient, would we have an over leveraged consumer today?


Posted by: silly things | February 09, 2010 at 06:50 PM

It's the deleveraging, stupid...

Posted by: Bob_in_MA | February 09, 2010 at 06:58 PM

Thank you very much for the lovely post, and for highlighting that weak demand is a major part of the consumer credit story today. And while I agree that road ahead may be slow and painful, I'm not sure that the figure you present supports this.

When I look at the figure of yoy percent change in consumer credit, I note several salient features including the that the rate of change in change in credit accelerated downwards through the recession, but has finally stopped accelerating several months after the recession has ended. I then look back at previous recessions and note similar patterns in 1991, 1980, and 1975 (and possibly 1970). In the earliest 3 examples, the rate of change in change of consumer credit quickly accelerated upwards (although there was a lag in 1991).

I wonder how these earlier episodes were similar and different from today. In those episodes was the drop in consumer credit supply driven, or demand driven? Could another parameter perhaps give some insight on what we might expect next?

Posted by: Kosta | February 09, 2010 at 06:59 PM

The reason that demand is down is probably due to the banks cutting down consumer's credit. Even consumers with excellent credit scores found their credit cut in half and further credit (even for small purchases like a computer) declined!

The fact is simply that banks have tightened the credit noose around consumers' necks to the point where even those that still enjoy regular incomes and can afford to spend the money - find themselves constrained.

Brilliant!

Posted by: EconoGineer | February 10, 2010 at 04:15 AM

I think, at least with the typical consumer, it's also a psychological thing. Who feels comfortable to buy that newer bigger car now? That second home? That new boat? Very few. Even if you've got the dough, high uncertainty remains.

The suits and big whigs running the show need to help make people feel better if they want to spark the consumer.

Posted by: FormerSSResident | February 10, 2010 at 11:26 PM

Supply and demand for credit are always important, but there is one bit of this story being overlooked. In 09Q3, consumer credit fell by $21.5 billion, of which banks charged off $14 billion. The Fed has not reported charge offs for Q4, but this will likely explain a large part of the decline shown in the chart.

Posted by: Douglas Lee | February 12, 2010 at 08:45 AM

The behavior of "banks to big to fail" have
ruined the trust of main street . Their concern for their bottom line at the expense of the middle class has demonstrated the most dispicable element of capitalism. With slashed credit lines along with gangster interest rates on credit card debt, they've shown no regard for the country that has given them the opportunity to amass such wealth. Greed has replaced their concern for their nation

Posted by: Herbert Riley | February 13, 2010 at 07:27 AM

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February 05, 2010

Is good news hidden in bad employment numbers?

In case you needed a reminder that the nascent recovery in the United States is, well, nascent, today's employment report should do the trick. You can find a discussion of the ins and outs of the report at Calculated Risk (to give but one example), but overall the news was a mixed bag of a little better news than was expected (the fall in the unemployment rate even as the labor force participation rate rose), a little worse news than was expected (the net three-month loss in payroll employment), and some relatively bad news that was largely expected (the large downward revision in employment growth for the period April 2008 through March 2009).

Certainly, the employment picture is a lot better than this time last year, but it is still a good distance from what anyone would regard as "cheery." Hence the focus in the Administration's latest budget proposal on programs aimed at job creation.

Over at the Becker-Posner blog, Gary Becker strikes a skeptical chord about at least one element of the Administration's package, the element related to subsidies designed to spur job growth in the small business sector. Despite his reservations about the specific tax credit in play, Professor Becker is fully on board with the proposition that "smaller businesses are an important source of innovation and progress." One particular observation in the Becker post caught my eye:

"The US is tied for first place [according to estimates by the World Bank] on the ease of employing workers. It is much easier for American small and medium size business to reduce their employment during bad times than it is for similar-sized companies in Europe, Latin America, or India. This helps explain why employment fell, and unemployment rose, more sharply during this recent recession in the US than in say Germany, Italy, and many other countries that have much less flexible labor markets, even when other countries experienced larger recession-induced falls in GDP."

The outsized negative employment effect in the United States relative to most other developed countries is a striking feature of the labor market data of the past two years. The following chart shows the trajectory of employment in the United States, the United Kingdom, Canada, Japan, and the Euro Area since December 2007 (the beginning of the U.S. recession).

020410a
ENLARGE

The outsized drop in employment in the United States is the mirror image of another crucial feature of the last several years: outsized productivity growth in the United States.

020410b
ENLARGE

What are we to make of the productivity gains in the United States relative to other countries? Does this difference merely reflect labor hoarding in other countries, implying that the productivity levels will become more consistent among advanced economies as employment recovers in the United States? Or is there something more fundamental at play, as Professor Becker seems to imply? Have businesses in the United States found ways to permanently enhance efficiency, locking relatively high productivity growth—and perhaps a slower recovery in employment levels—into the future?

Good questions, all.

By David Altig, senior vice president and research director of the Atlanta Fed

February 5, 2010 in Labor Markets | Permalink

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Man, Labor is such a good topic to discuss.

My thoughts- yes some firms are finding ways to do more with less, maybe permanently. The double edge sword to the internet seems to lower barriers such that costs and prices can drop, and output stays put. That's bad news for poor old employees, and it sure has been lately.

The other thing that strikes me is a change in what we call management. Companies today, big ones, pay millions of dollars to people who can cut costs. The incentives can be completely driven not by making money, but by saving money.

Long term and when enough do this, I think this causes a 'chink' in the armor of the system. It may even destroy real wealth.

Posted by: FormerSSresident | February 08, 2010 at 10:43 PM

One contributing factor: employers sack their least productive employees first – retaining the relatively productive ones.

Posted by: Ralph Musgrave | February 09, 2010 at 01:58 PM

I am new to economics and could be completely wrong about this, so don't be afraid to criticize this post. I dont necesarilly think that this means that the US firms can do more with less workers. I think output and productivity declined globally, but coutries like germany which have tax structures that incentivise employment, while still less productive, don't experience the same loss in employment. Therefore, the US sees productivity increase per employee, because it has less employees. So, isn't it more beneficial to retain employment and lose productivity than to have higher unemployment than necesary

Posted by: Matthew Gement | February 17, 2010 at 10:01 PM

There is an interesting debate in the blogosphere exploring the reasons for the persistent high unemployment rates in the US and elsewhere. Conservatives lay the blame on the structural skills mismatch and argue that this cannot be resolved through any stimulus spending measures. Liberals claim that the massive slump in aggregate demand from the boom, means that there are massive idling resources which can be brought to work with an appropriately structured stimulus program.

Posted by: Employment Genius | April 12, 2011 at 12:38 PM

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February 01, 2010

Southeast businesses offer insights on capital spending plans

With last week's capital orders data giving signals of renewed growth in business fixed investment in equipment and software in the fourth quarter, the question turns to whether this growth will be sustained. In early January 2010, the Federal Reserve Bank of Atlanta reached out to our contacts in the Southeast through our Regional Economic Information Network as part of our monetary policy information-gathering efforts to inquire about businesses' capital spending plans. We received responses from 320 businesses across Alabama, Florida, Georgia, Mississippi, Louisiana, and Tennessee. (I want to note we were helped significantly in this effort by colleagues at the Kennesaw State University Econometric Center, who conduct a monthly PMI survey of manufacturers in the Southeast.)

As with our recent small business finance survey (discussed in this macroblog post), readers should be cautious about the results because of the tendency, for example, to sample established, relatively successful firms. That said, we still believe the results are instructive. Of note, 36 percent of respondents indicated that they planned to increase spending over the next 6–12 months relative to actual spending over the past 6–12 months. Another 42 percent said they would leave their spending at about the same level (unchanged), and 22 percent indicated that their spending would fall. The difference between those planning to increase spending and those planning to decrease spending equals a net positive of 14 percent. Across industries, construction firms were the group least likely to increase spending, while retailers were the most optimistic group. Our manufacturing contacts and the "other industries" group of firms (firms across a myriad of industries such as transportation, healthcare, and business services) expressed intentions similar to the overall response (see the chart).

020110
(Enlarge)

For those who planned to increase spending on new plant and equipment, the most commonly given reasons (respondents could select more than one reason) were that they expected growth in sales to be high (37 percent of those respondents), or they needed to replace information technology equipment (37 percent of those respondents). Also, 61 percent of those planning to increase spending indicated that at least some of that spending reflects investment that had been postponed because of the recession. Not surprisingly, for those who did not plan to increase spending, the most commonly cited reasons were the expectation of low growth in sales (cited by 47 percent of those respondents) and heightened economic uncertainty (cited by 39 percent of those respondents).

Interestingly, cost and availability of external financing were among the least frequently cited reasons for either increasing or not increasing capital spending (cited by 9 percent and 15 percent of respondents, respectively). This theme is consistent with the findings of our recent small business survey, as well as the trend in the National Federation of Independent Business (NFIB) survey of small businesses. According to the NFIB, "finance" was reported as the number one small business problem by only 4 percent of respondents in December 2009. The number one single factor was poor sales.

The NFIB survey also found that while plans to increase capital spending by small firms rose modestly in December 2009 to a net 18 percent, they remained near historic low levels—in December 2007, the net percentage stood at 29 percent and 17 percent in December 2008. This performance suggests that our finding of a net 14 percent of firms planning to increase rather than decrease spending on plant and equipment should not be read too encouragingly.

So where does that leave things? Probably with more questions than answers. For instance, the fact that about two-thirds of the firms that are planning on increasing spending are doing so because they had postponed capital expenditures during the recession would be consistent with some bounce in capital spending by businesses following the most recent recession. But how sensitive are firms to changes in economic conditions? Currently, we hear a lot anecdotally that cash is a high priority on firms' balance sheets as a precaution against economic uncertainty. If sales were to increase more than expected, how fast would firms rethink their investment spending plans? The answers to these types of questions are important, and we are consequently planning to conduct a follow-up survey in due course. As always, we'll keep you posted.

By John Robertson, vice president in the Atlanta Fed's research department

February 1, 2010 in Business Cycles, Saving, Capital, and Investment | Permalink

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