The relative expansion of central banks’ balance sheets

Dave Altig's recent macroblog post on policy actions that affected the Fed's balance sheet made me wonder about how changes to the Fed's balance sheet since the financial crisis compared with other central banks.

Relative to before the financial crisis, the Federal Reserve's asset holdings are currently about 3.3 times larger. Initially, the source of that increase was the collateral associated with various temporary lending facilities that the Fed used to address the financial panic. Those assets were then replaced on net by purchases under the first large-scale asset purchase program in 2009. Then in late 2010, asset holdings increased further as a result of a second large-scale asset purchase program.

Of course, size isn't everything. While it might be tempting to try and interpret the change in the size of the central bank's balance sheet as a summary statistic of the degree of monetary policy accommodation, as Dave Altig's post points out, that interpretation is not so straightforward. Increasing the size of the balance sheet is not the only thing a central bank can do to ease monetary policy when short-term interest rates are very low. For example, in late 2011 the Fed began a maturity extension program that changed the composition of the assets on the balance sheet, but this program did not materially alter the size of the balance sheet.

With this caveat in mind, the following chart compares the proportionate changes in the size of asset holdings of five central banks over the period from the first quarter of 2007 through the first quarter of 2012: the Federal Reserve (FR), the Bank of England (BE), the European Central Bank (ECB), the Bank of Canada (BC), and the Bank of Japan (BJ).

One take-away from the chart is the large variation from country to country. Here are some observations:

1. Bank of England: Through mid-2011, the proportionate increase in the Bank of England's asset holdings was roughly similar to the Fed's. But then the Bank of England began a second round of large scale asset purchases that sharply increased the size of its balance sheet. By the first quarter of 2012, the Bank of England's asset holdings were about 4.2 times as large as they were before the financial crisis.


2. European Central Bank: Through mid-2011, the ECB's asset holdings were about 1.7 times their precrisis level. But the sharp increase in the ECB's longer-term lending programs in recent months has resulted in a large increase in the size of ECB's balance sheet. By the first quarter of 2012, the ECB's asset holdings were about 2.5 times what they were before the financial crisis.


3. Bank of Canada: In 2009, the Bank of Canada's asset holdings had increased to about 1.6 times their precrisis level—similar to the ECB's increase. But as liquidity pressures in Canadian financial markets eased, the Bank of Canada's asset holdings declined in 2010. By the first quarter of 2012, the Bank of Canada's asset holdings were around 1.3 times the precrisis level. (Note that the Bank of Canada's asset data are through February 2012.)


4. Bank of Japan: The balance sheet of the Bank of Japan did not increase materially during the financial crisis, but has increased somewhat over the last year. By the first quarter of 2012 the Bank of Japan's asset holdings were about 1.2 times the pre-crisis level.

While size isn't everything, it is something. A large expansion in a central bank's balance sheets can create broad policy risks. This study by researchers at the St. Louis Fed suggests that large-scale balance sheet increases are a viable monetary policy tool, provided the public believes the increase will be appropriately reversed (citing the experience of Nordic countries in the early 1990s) or that the reserves created by the expansion will remain within the banking system (citing changes to bank settlement systems in the United Kingdom and New Zealand in the mid-2000s). New York Fed President Bill Dudley touched on some risks in an interview on CNBC today:

"...We've expanded our balance sheet a lot over the last few years. And additional actions do have costs, and so we have to weight them relative to the benefits...

"One set of cost is the extent we expand our balance sheet or we sell short-dated treasury securities and buy long-dated treasury securities, we have more risk, in terms of our portfolio, interest rate risks...

"The second issue, of course, is if we expand our balance sheet, we could create anxiety among some people that this might actually sow the seeds for future inflation. I don't think expansion of the balance sheet, in any way, compromises the Fed's ability to keep inflation in check over the longer term. But it doesn't matter just what I think. If people in the market think that expansion of the balance sheet could cause future inflation, we have to take those expectations into consideration as a potential cost of monetary policy."

John Robertson, vice president and senior economist in the Atlanta Fed's research department

The three faces of postcrisis monetary policy

The latest edition of the San Francisco Fed's Economic Letter (written by Michael Bauer)has a nice review of the different channels through which the Fed's Large Scale Asset Purchase (LSAP) programs—QE, or quantitative easing more popularly—are thought to work:

"Central bank LSAPs potentially may affect interest rates through at least three channels. Notably, all three channels can broadly affect longer-term interest rates, extending beyond those securities that the central bank announces it will purchase:

• A portfolio balance channel, because the supply of long-maturity bonds available to private investors is reduced. The reduced supply of longer-term securities targeted by the Fed lowers the amount of interest rate risk in investor portfolios. That in turn decreases the risk premium that they require to hold both the targeted securities and other assets of similar duration. Longer-term interest rates are lowered across the board as a result. Gagnon et al (2011) emphasize this channel for QE1.
• A signaling channel, which arises when the Fed's announcements are interpreted as signals of its intent to hold down short-term interest rates further into the future. Bauer and Rudebusch (2011) argue that this channel played an important role for QE1.
• A market functioning channel, because QE1 provided relief when conditions in financial markets were dire, liquidity very low, and panic widespread. The Fed's intervention calmed investor fears. Thus, the intervention substantially supported a range of asset prices, including MBS and corporate bonds, lowering their yields."

The article references include links to the Gagnon et al. paper and the Bauer and Rudebusch paper, but none to any studies addressing the "market functioning channel." So I'll provide one: "Did the Federal Reserve's MBS Purchase Program Lower Mortgage Rates?" by Diana Hancock and Wayne Passmore, both senior staff members for the Federal Reserve of Board of Governors. According to Hancock and Passmore, the market functioning channel is key to appreciating the impact of QE1:

"We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid by homeowners in the primary mortgage market to measure how distorted mortgage markets were prior to the Federal Reserve's intervention, and the course of market risk premiums during the restoration to normal market functioning...

"We argue that this return to normal pricing occurred because the Federal Reserve's announcement signaled a strong and credible government backing for mortgage markets in particular and for the financial system more generally...

"More specifically, we estimate that the Federal Reserve's MBS purchase program over the course of 16 months reestablished normal market pricing in the MBS market and resulted in lower mortgage rates of roughly 100 to 150 basis points for purchasing houses. Most of the decline in mortgage rates occurred between the announcement of the program, on November 25, 2008, and the implementation of the program in the first quarter of 2009. After this point, both mortgage rates and risk premiums remained relatively stable until the end of the Federal Reserve MBS purchase program."

Hancock and Passmore note that the portfolio balance channel may have played a role after the completion of the QE1 purchases once market functioning had normalized, but the biggest bang was that renormalization itself.

Bauer's observations align with Hancock and Passmore's conclusions:

"QE1 had very pronounced effects on interest rates. The key announcements led to decreases of close to one percentage point. The announcements not only lowered yields on targeted Treasury securities and MBS, but also on corporate bonds...

"The two other programs, QE2 and MEP [maturity extension program], also affected yields of securities that were not targeted for Fed purchases... Generally though, QE2 and MEP affected interest rates much less than QE1 did. One reason is that bond market functioning had largely returned to normal. In addition, expectations of future short-term interest rates were already very low when these programs were announced, leaving little room for further signaling effects. Finally, QE2 and MEP were smaller than QE1."

Earlier this week, in a speech delivered in Tokyo at the Institute of Regulation and Risk, Federal Reserve Bank of Atlanta President Dennis Lockhart provided his view on this evidence:

"In my view, these [the QE1] purchase programs played an important role in the transition away from the emergency lending facilities created earlier in the crisis. The emergency credit facilities worked well to stem the downward spiral of the immediate post-Lehman period. Financial markets began the process of repair during the first half of 2009 but were still suffering from relatively serious liquidity pressures. The QE1 operation sustained the liquidity support that had been previously provided by lending through the emergency facilities.

"Because asset purchases largely replaced emergency loans made during the crisis, the net increase in the Fed's balance sheet was relatively modest. In this sense, the quantitative easing label is misleading. The intent and effect of the policy was not to inject a new and sizable quantity of reserves into the economy. Rather, the effect was to sustain liquidity in still struggling and fragile financial markets, particularly those related to residential real estate. For that reason, I prefer the term ‘credit easing' to describe this policy action."

However, the smaller impact of QE2 leads Lockhart to a different conclusion regarding the largest contribution of that program:

"I view QE2 differently. The FOMC [Federal Open Market Committee] formally announced QE2 in November 2010, with its decision to purchase $600 billion in longer-term Treasury securities. However, the policy was signaled in an important speech from Federal Reserve Chairman Ben Bernanke in August of that year. The circumstances at the time were dominated by a falling trend in measured inflation, weakening inflation expectations, and rising probabilities of outright deflation. Each of these developments was effectively reversed as the expectations for QE2 took root, expectations that were ultimately validated by FOMC action.

"Unlike QE1, QE2 did materially expand the size of the Federal Reserve's balance sheet. In my view, this distinction is important. The intent and effect of the two rounds of asset purchases were different. QE1 served to maintain liquidity at a time when financial markets were exceptionally unsettled. In contrast, QE2 was a more traditional monetary action to preserve price stability."

In a sense, this places the effects of QE2 in the signaling channel category, albeit with an emphasis on inflation expectations rather than interest rates directly.

Bauer's article also covers post-QE2 policy—the maturity extension program (MEP, or "Operation Twist") and the insertion of specific calendar dates (currently at least late 2014) to provide forward guidance on the period of time that the FOMC anticipates that the federal funds rate will remain at exceptionally low levels. Lockhart also describes these policies in terms of the "signaling channel," though in these cases with interest rate effects front and center:

"In terms of intent and effect, I think of the explicit forward guidance and the MEP in similar terms. We have entered a phase of the recovery in which sustained monetary accommodation is warranted in order to preserve and advance what is still modest progress on employment and economic growth. Importantly, this modest progress is occurring in the context of what, for me, is acceptable performance with respect to our price stability mandate. Actions that reinforce the maintenance of policy accommodation are appropriate. It is through that lens that I view the MEP and explicit forward guidance on policy rates."

Lockhart's remarks provide his perspective on three somewhat distinct policy challenges—market dysfunction, disinflationary pressures, and a need to sustain monetary policy accommodation—that motivate his support for the three major policy initiatives of the postcrisis period:

"Let me summarize this brief tour of postcrisis monetary policy. I view the sequence of nontraditional monetary policy actions as tailored responses to the particular needs of the economy and financial system at the time they were implemented. My conclusion is that by and large policy actions have been appropriate to the diagnosis of circumstances at the time. And in my assessment they have worked pretty well."

In this light, President Lockhart delivers his policy punch line:

"I have reframed to some extent the original question of what more can be done around the point that policy actions must be matched to circumstances. The challenge policymakers face is judging appropriateness of a tool for circumstances. As popular as it might be in some quarters to rule out further LSAPs (QE3, as it is known), I do not think this option can be taken off the table. QE3 will work under the right circumstances. But I don't believe such circumstances prevail at this time."

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

 

Is inflation targeting really dead?

Harvard's Jeffrey Frankel (hat tip, Mark Thoma) is the latest econ-blogger to cast an admiring gaze in the direction of nominal gross domestic product (GDP) targeting. Frankel's post is titled "The Death of Inflation Targeting," and the demise apparently includes the notion of "flexible targeting." The obituary is somewhat ironic in that at least some of us believe that the U.S. central bank has recently taken a big step in the direction of institutionalizing flexible inflation targeting. Frankel, nonetheless, makes a case for nominal GDP targeting:

"One candidate to succeed IT [inflation targeting] as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980's, since it did not share the latter's vulnerability to so-called velocity shocks.

"Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand—the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway."

That's certainly true, but a nominal GDP target is consistent with a stable inflation or price-level objective only if potential GDP growth is itself stable. Perhaps the argument is that plausible variations in potential GDP are not large enough or persistent enough to be of much concern. But that notion just begs the core question of whether the current output gap is big or small. At least for me, uncertainty about where GDP is relative to its potential remains the key to whether policy should be more or less aggressive.

In another recent blog item (also with a pointer from Mark Thoma), Simon Wren-Lewis offers the opinion that acknowledging uncertainty about size of the output gap actually argues in favor of being "less cautious" about taking an aggressive policy course. The basic idea is familiar. It is a simple matter to raise rates should the Fed overestimate the magnitude of the output gap. But with the short-term policy rates already at zero, it is not so easy to go in the opposite direction should we underestimate the gap.

No argument there. As I pointed out in a May 3 macroblog item, Atlanta Fed President Dennis Lockhart has said the same thing. But, as I argued in that post, this point of view is only half the story. Though I agree that the costs are asymmetric to the downside with respect to the FOMC's employment and growth mandate, they look to me to be asymmetric to the upside with respect to the price stability mandate. And I view with some suspicion the claim that we know how to easily manage policy that turns out to be too aggressive after the fact.

My issues are not merely academic. In an important paper published a decade ago, Anasthsios Orphanides made this assertion:

"Despite the best of intentions, the activist management of the economy during the 1960s and 1970s did not deliver the desired macroeconomic outcomes. Following a brief period of success in achieving reasonable price stability with full employment, starting with the end of 1965 and continuing through the 1970s, the small upward drift in prices that so concerned Burns several years earlier gave way to the Great Inflation. Amazingly, during much of this period, specifically from February 1970 to January 1977, Arthur Burns, who so opposed policies fostering inflation, served as Chairman of the Federal Reserve. How then is this macroeconomic policy failure to be explained? And how can such failures be avoided in the future?...

"The likely policy lapse leading to the Great Inflation …can be simply identified. It was due to the overconfidence with which policymakers believed they could ascertain in real-time the current state of the economy relative to its potential. The willingness to recognize the limitations of our knowledge and lower our stabilization objectives accordingly would be essential if we are to avert such policy disasters in the future."

With this historical observation in hand, it seems a short leap to turn Wren-Lewis's thought experiment on its head. Arguably, the last several years have demonstrated that nonconventional policy actions have been quite successful at short-circuiting the disinflationary spirals that pose the central downside risk when interest rates are near zero. (If you can tolerate a little math, a good exposition of both theory and evidence is provided by Roger Farmer.)

On the opposite side of the ledger, we know little about the conditions that would cause the Fed to lose credibility with respect to its commitment to its inflation goals, and very little about the triggers that would cause inflation expectations to become unanchored. Thus, I think it not difficult to construct a plausible argument about the risks of being wrong about the output gap that is exact opposite of the Wren-Lewis conclusion.

I end up about where I did in my previous post. Flexible inflation targeting, implemented in such a way that the 2 percent long-run inflation target rate exerts an observable gravitational pull over the medium term, feels about right to me. Despite what Frankel seems to believe, I think that idea is far from dead.

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

Symmetric goals, asymmetric risks

Mark Thoma has been hanging out with my boss or at least was at the same conference, where Thoma had a chance to try out his reporter chops:

"I just got out of a press conference with Dennis Lockhart (Atlanta Fed president) and Charles Evans (Chicago Fed president). I can't say there was any real news, but I did manage to ask a question... I asked whether the 2% inflation target was truly symmetric."

Thoma got an answer, though seemingly not one that left him totally convinced:

"Both insisted that the target is symmetric. However, Lockhart said that we know much more about the effects of inflation than deflation, and that preventing deflation was therefore job number one (which doesn't really answer the question). He didn't explain what he is so afraid of if inflation goes up...

"Evans, while explicitly agreeing the target was symmetric, made comments that indicated that it may not be. He said the Fed has not done a very good job of communicating its tolerance around the 2 percent target, both up and down, and they need to improve. But if the target is really symmetric, simply saying that (along with the tolerable range) is all that is required. Talking separately about tolerance for over and under-shooting isn't needed."

Evans' and Lockhart's statements stand on their own, but we've collected some information via the Atlanta Fed's Business Inflation Expectations survey that helps me think about the Thoma question. The chart below plots the answers, collected in the February and April surveys, to the following query: "Projecting ahead, to the best of your ability, please assign a percent likelihood to the following changes to unit costs per year over the next five to 10 years."

The question focuses on unit labor costs in order to elicit responses about what businesses may actually be planning for, as opposed to their guesses about a more abstract concept of overall inflation. The question focuses on expectations five to ten years into the future because the inflation goal of the Federal Open Market Committee (FOMC) is explicitly a long-run objective.

The obvious pattern in these survey responses is their asymmetry to the upside. The most probable outcome, according to the respondents, is that long-term costs will rise in a range that includes the FOMC's long-run inflation objective. But they also put an almost 50 percent probability on annual outcomes higher than 3 percent. Less than 20 percent probability is placed on costs rising at rates of less than 1 percent.

This picture is one of asymmetric risks to the inflation outlook, and as such it is an important element in thinking through policy choices. Symmetry in the sense of having an equal distaste for misses on either side of an objective does not necessarily imply symmetry with respect to the risks of meeting that objective.

To begin with, the Fed does have a dual mandate. Disinflation or, in the extreme, deflation has the potential to be problematic for growth and employment when interest rates are very low. The reason, if you buy the analysis, is that, with no room for rates to move lower, a decline in inflation raises the real cost of borrowing. A higher cost of borrowing restrains spending, creating an additional drag on economic activity in already tough circumstances.

The reverse argument has, of course, been made for temporarily tolerating inflation that is somewhat higher than the long-run objective. But even if you aren't quite sold on the wisdom of that approach—and I'll get to that in a bit—it is clear that, with policy rates near zero, misses to the downside on inflation bring risks to the Fed's growth mandate that are not implied by misses to the upside. Hence President Lockhart's comment regarding the importance of preventing deflation.

So why not respond to this asymmetric risk to growth by taking a chance on higher inflation? That question takes us back to the chart above. Taken at face value, the probabilities reported by our survey respondents suggest that the FOMC has been pretty successful in convincing folks that very low rates of inflation or deflation will not be allowed to set in. Perhaps this conviction is not surprising given the relatively aggressive responses of the committee to the disinflation scares of 2003 and 2010.

But the response to asymmetric risks to growth at low inflation rates may have had the effect of inducing asymmetric risks to the upside with respect to Fed's price stability mandate. Again taken at face value, the results of our business inflation expectations survey definitely imply a one-sided bet by businesses on how the FOMC might miss on its inflation objective. That could well explain why one would be so concerned if inflation rises. Just as there are asymmetric risks associated with below-objective inflation when it comes to the Fed's growth and employment mandate, there are asymmetric risks associated with above-objective inflation when it comes to the price stability mandate.

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

Taking a deeper dive into the definition of inflation

Sometimes our familiarity with a topic gets in the way of our understanding of it. I often think that about inflation. It's widely known that inflation is a condition of rising prices, or what my favorite macroeconomics text defines more precisely in this way: "Inflation is an increase in the overall level of prices in the economy." And while this idea is serviceable for some purposes, it's pretty inadequate if you try to think about how a central bank goes about the business of controlling inflation.

Here's an example. Friday's retail price report for March revealed that prices rose 3.5 percent from February and averaged 3.7 percent (annualized) over the first three months of the year. I think it's pretty clear we have seen an "increase in the overall level of prices in the economy" this year. But how should the Federal Reserve respond to this rise?

I'm not going to offer an answer that question. I'm a policy adviser, not a policy maker. But we need to dig a little deeper into the textbook to get a better understanding of the inflationary process and how a central bank contributes to that process before we offer up an opinion on the matter.

The inadequacy of the textbook definition of inflation is a topic that's been bugging me for a long time. It's silent about the cause of the rise in prices and therefore does not make any distinction about whether the price increase is a corollary of the policies of the central bank or from another source that a central bank can only nominally influence. This distinction is an important one. (For what it's worth, this 1997 article I wrote explains how I think the term "inflation" has come to be synonymous with "price increase." And here's why I think a deeper appreciation of what constitutes "an increase in the overall level of prices" affects how one thinks about the inflationary experience in real time.)

Here's how economist Irving Fisher put it in his 1913 article "The Monetary Side of The Cost of Living Problem":

"If it can be shown, for instance, that today the good things of this world are becoming scarce on the one hand while money and its substitutes are not becoming plentiful it would be reasonable to conclude that the fault lies with goods and not with money. If, on the contrary, it can be shown that money and its substitutes are becoming plentiful and that goods are not becoming scarce, it is reasonable to conclude that the fault lies chiefly on the monetary side."

Are all price increases inflation? Should central banks use their tools to fight against any rise in costs? The answers to these questions have important implications for how we measure inflation in the short run versus the long run, the horizon over which a central bank ought to be held accountable for achieving price stability, and how monetary policies should be calibrated in the face of rising prices.

In that spirit, the Atlanta Fed has developed an animated video that provides additional perspective on the issue of inflation—specifically, what sorts of price increases are part of the inflationary process that is under the control of the central bank, and which are not. This video is the first in a new series that covers economic issues and the work of the Fed. The video is part of the Atlanta Fed's new feature called "The Fed Explained," which includes a range of new and existing content. We hope these videos stimulate conversation on a range of topics important to the Federal Reserve. The format is targeted to the general public as well as to students and teachers, and we hope it provides an engaging supplement to the study of the Federal Reserve.

Let us know.

Mike Bryan, vice president and senior economist at the Atlanta Fed

Why we debate

It's been a while since we featured one of my favorite charts—a "bubble graph" comparing average monthly job changes during this recovery with average changes during the previous recovery, sector by sector.

(enlarge)

If you try, it isn't too hard to see in this chart a picture of a labor market that is very close to "normalized," excepting a few sectors that are experiencing longer-term structural issues. First, most sectors—that is, most of the bubbles in the chart—lie above the horizontal zero axis, meaning that they are now in positive growth territory for this recovery. Second, most sector bubbles are aligning along the 45-degree line, meaning jobs in these areas are expanding (or in the case of the information sector, contracting) at about the same pace as they were before the "Great Recession." Third, the exceptions are exactly what we would expect—employment in the construction, financial activities, and government sectors continues to fall, and the manufacturing sector (a job-shedder for quite some time) is growing slightly.

For the skeptics, I below offer a familiar chart, which traces the level of total employment pre- and post-December 2009, compared with the average path of pre- and post-recession employment for the previous five downturns:

(enlarge)

We are now more than 16 quarters past the beginning of the recession that began in the fourth quarter of 2007, and total employment is still 4 percent lower than it was at the beginning of the downturn. In the previous five recessions by the time 16 quarters had passed, employment had increased by about 6 percent. Even in the worst case, indicated by the lower edge of the gray shaded area, employment growth was flat—and that observation is qualified by the fact that the recovery from the 1980 recession was interrupted by the 1981–82 recession.

This unhappy comparison is not driven by the construction, financial activities, and government sectors. In the area of professional and business services, which has logged the largest average monthly employment gains in the current recovery, the number of jobs still sits 2.7 percent below the level at the outset of the last recession, as the chart below shows.

(enlarge)

Total private-sector jobs in education and health services, which never actually contracted during the recession, nonetheless remain abnormally low in historical context.

(enlarge)

In these charts lies the crux of some very basic disagreements about the appropriate course of policy. The last three graphs draw a clear picture of labor markets that are underperforming by historical standards—a position that I take to be the conventional wisdom. An argument against following that conventional wisdom centers on the question of whether historical standards represent the appropriate yardstick today. In other words, is the correct reference point the level of employment or the pace of improvement in the labor market from a permanently lower level? For the proponents of the latter view, the bubble chart might very well look like a return to normal, despite the fact that employment has not returned to prerecession levels.

One way to adjudicate the debate, in theory, is to rely on the trajectory of inflation. If there remains a significant amount of slack in labor markets, as the conventional interpretation of things suggest, there ought to be consistent downward pressure on prices. The case for consistent downward pressure on prices is not so obvious. Measured inflation appears to moving in the direction of the Federal Open Market Committee's 2 percent long-term objective.

(enlarge)

Also, the Atlanta Fed's own monthly survey of business inflation expectations, which surveys a panel of businesses from our Reserve Bank district, indicates that this inflation number (shown in our March release from earlier this week) is in line with what private-sector decision makers anticipate:

"Survey respondents indicated that, on average, they expect unit costs to rise 2.0 percent over the next 12 months. That number is up from 1.9 percent in February and comparable to recent year-ahead inflation forecasts of private economists. Firms also reported that their unit costs had risen 1.8 percent compared to this time last year, which is unchanged from their assessment in February. Inflation uncertainty, as measured by the average respondent's variance, declined from 2.8 percent in February to 2.4 percent in March, the lowest variance since the survey was launched in October 2011."

Does that settle it? Not quite. There may not be much evidence of building disinflationary pressure, but neither is there building evidence of an inflationary push that you would expect to see if the economy were bumping up against capacity constraints. Obviously, the story isn't over yet.

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

 

Unconventional policy or unconventional circumstances?

Lots of bloggers have expressed lots of different views on what they consider interesting in Roger Lowenstein's new profile of Federal Reserve Chairman Ben Bernanke in The Atlantic. Authors at The Big Picture, Free Exchange, Marginal Revolution, Modeled Behavior, and Real Time Economics, for example, all highlight distinct passages that piqued their individual interests. This is what caught my eye:

"Bernanke's unconventional programs have been implemented in two phases. During the financial crisis of 2007–09, he bailed out a handful of large banks and devised a series of innovative lending operations to disperse credit to banks, small businesses, and consumers (virtually all of these loans have been repaid at a profit to taxpayers). He also lowered short-term interest rates to nearly zero and made private banks run a gantlet of stress tests to ensure some minimal level of solvency going forward. Although fierce anger against the bailouts persists, there is little argument that this first stage was a success. However untidily the rescue was managed, the financial crisis is over.

"In the second stage, Bernanke has sought to revive a weak economy by maintaining short-term interest rates at close to zero, and by purchasing, in vast quantities, long-term Treasury bonds and mortgage-backed securities. This second phase has been, if anything, more controversial than the first. Its success is much harder to measure (we have no way of knowing whether the economy's improvement would have been less robust, and how much so, without Bernanke's efforts). And it has exposed Bernanke to charges of meddling too deeply in the private sector, of disrupting the economy's natural rhythms long past the point when such intervention is necessary. In particular, critics note that the Fed has stuffed the banking system with $1.5 trillion in excess reserves—money for which the banks have no present use, loan demand being modest, but which could one day spark an epidemic of inflation.

"Michael Bordo, a monetary historian at Rutgers, told me that in this second phase, 'Bernanke has moved into areas that were quite different from what the framers had in mind. One of the risks the Fed is facing is of overreach.' "

I want to point out up front that I respect Bordo a great deal. He is a friend and collaborator to many of us at the Atlanta Fed. In fact, he was the co-organizer of our 2010 conference that commemorated the 1910 Jekyll Island meeting that resulted in draft legislation (the Aldrich Plan) for the creation of a U.S. central bank. He is also the co-editor of the proceedings volume from that conference that will be forthcoming from the Cambridge University Press. But I may disagree with his assessment here.

First, just to dispose of the easy stuff, there probably isn't much about "normal" monetary policy that the framers of the Fed had in mind. Legislation creating the Federal Open Market Committee (FOMC) didn't arrive until 1935, and interest rate policy aimed at addressing broad macroeconomic conditions was not likely of much concern to folks preoccupied with birthing a lender of last resort.

But I don't think that is what Professor Bordo has in mind. I think the criticism is that the "purchasing, in vast quantities, long-term Treasury bonds and mortgage-backed securities" represents a discrete break from normal, well-established, plain-vanilla monetary policy as it was understood precrisis.

There are generally two aspects to this criticism, one related to the type of assets that the Fed has purchased and one related to the sheer size of those purchases. The first of these criticisms amounts to the contention that the FOMC should restrict itself to dealing in Treasury securities alone and that the foray into the mortgage-backed security market represents an unwise exercise in credit allocation. Personally, I have some sympathy with this concern ( articulated over a decade agoby former Richmond Fed president Al Broaddus and former Richmond Fed research director Marvin Goodfriend), but I have also expressed my view that such forays might be understood as substitutes for normal policy in conditions in which normal policy is constrained by circumstances.

And so it is with the scale of the Fed's asset purchases. Normal policy in normal times would drive asset purchases in the service of generating desired movements in short-term interest rates (leading, it is assumed, to effects on a broader set of asset yields). This particular routine is obviously not available when the federal funds rate is at its zero lower bound. But that does not mean the logic of this mechanism is absent in asset purchase programs implemented once that bound is hit. Specifically, one way to think about large-scale asset purchases is that those purchases can replicate the effects of federal funds rate reductions, if only those rate reductions could be implemented.

There are several ways to get at this question—one very nice summary has been provided by Sharon Kozicki, Eric Santor, and Lena Suchanek from the Bank of Canada. At the Atlanta Fed, we have our own version of gauging the effects of large-scale asset purchases. Our approach involves estimating a "virtual federal funds" based on the size of Federal Reserve asset holdings relative to total commercial bank liabilities. The details of how this virtual funds rate is constructed can be found here, but the upshot is in this chart:

Two points. First, the virtual funds rate, which combines the zero actual funds rate with the estimated interest-rate equivalent from the Fed's cumulative asset purchases, is about 200 basis points to the south of zero. Second, as a reference point, the chart compares our virtual funds rate to one version of the Taylor rule that relates the federal funds rate to deviations of gross domestic product from its estimated potential and inflation from the Fed's 2 percent long-run objective. As the chart depicts, this comparison is, as of now, just about right, despite the fact the federal funds rate is constrained near zero.

I hasten to add that the Taylor rule in the chart above is, for present discussion, for reference only. There are certainly plenty of arguments as to why the rule depicted in the chart may not provide the right policy guidance. For example, there are debates over how to appropriately specify the Taylor rule, as reflected in this post by David Papell at Econbrowser. Furthermore, there are arguments as to whether policy more generally ought to be more aggressive at present than any standard Taylor rule prescription.

My intent is not to argue whether policy is, at present, appropriately calibrated. My point is that rather than thinking of large-scale asset purchases as unconventional policy, perhaps we should think of them as conventional policy in unconventional circumstances.

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

How are we doing?

Near the beginning of the minutes of the January meeting of the Federal Open Market Committee (FOMC), released yesterday, you'll find a reiteration of the FOMC's historic decision explicitly endorsing a numerical definition of long-run price stability:

"The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate."

The minutes include the motivating force behind this decision:

"The Chairman noted that the proposed statement did not represent a change in the Committee's policy approach. Instead, the statement was intended to help enhance the transparency, accountability, and effectiveness of monetary policy."

In a speech given Tuesday at New College in Sarasota, Fla., our local participant in this decision—Atlanta Fed President Dennis Lockhart—provided his interpretation of this numerical inflation objective:

"The 2 percent inflation target is an aid to understanding how the FOMC will react to developments in the economy within an overarching approach that can be called 'flexible inflation targeting.'

"The word 'flexible' describes and qualifies the committee's exercise of judgment in reaction to adverse developments. The word 'flexible' also reflects the principle that it is not always feasible or desirable to hit the target in the short run. Short-lived shocks to the economy can temporarily move measured inflation well away from the 2 percent target."

The thinking behind that statement can be clearly seen in the following chart, which illustrates the volatility of annualized inflation rates as the horizon extends from one to five years:

(enlarge)

As the chart shows, volatility noticeably declines as the horizon extends beyond one year to two years, and a similar decline occurs as we move from a two- to five-year horizon. This picture is exactly the type you would expect if inflation were subject to temporary ups and downs that dissipate over time. In his speech, President Lockhart offered his thoughts on the policy meaning of an inflation process that has this characteristic:

"Consider last year's energy and commodity price increases. Those cost pressures pushed up inflation in the early part of the year. Then, as expected, their influence dissipated as the year progressed.

"Had the FOMC tightened monetary policy early last year in response to the inflation threat, we might have compromised progress on growth and employment to no particular benefit with respect to our inflation mandate…

"As I see it, this is a recent, real-world example of a balanced approach in action. It illustrates the idea of flexible inflation targeting."

Of course, that particular example might ring somewhat hollow if the record suggested that the FOMC just got lucky this time around. A criticism that emerged in the aftermath of the inflation target announcement was not so much that it was flexible per se, but that in its focus on an undefined long-run, it is essentially an empty commitment. That opinion was offered in a Financial Times article penned by Lorenzo Bini Smaghi:

"The first [question about the FOMC's definition of price stability] relates to the time horizon over which the Fed is supposed to achieve price stability, namely the long-run. This differs from most other central banks in advanced economies, where price stability is targeted over a horizon of two to three years…

"Monetary policy produces its effects with lags of one to three years. This is the period over which the central bank should be held accountable."

That thought was echoed on The Economist's Free Exchange blog:

"According to the Fed's projections, it hits its target—2% inflation—over the long term. Mr Bini Smaghi's point is that it doesn't make much sense to judge current Fed actions against a long-run inflation projection.

"…the Fed doesn't necessarily run into problems of inconsistency if it projects inflation above 2% 1 or 2 years from now—a timeframe over which markets readily understand this group of policymakers to have control—while maintaining the long-run 2% goal."

The second part of The Economist comments move the conversation to an operational middle ground between an inflexible commitment to a target in the very short run and a promise that provides little discipline because its attainment remains out in a perpetually undefined future.

In particular, think about monitoring policy performance against a stated inflation objective over some "medium-term" horizon. "Medium-term" is itself a term of art, but I find it attractive to think about a three- to five-year horizon. Given the continuous arrival of shocks to the economy, uncertainties about the timing of policy effects, and the desirability of trading off precise control over inflation against the risks of destabilizing influences on real economic growth, I think it is still unrealistic and unwise to expect that an inflation target will be hit precisely even over a medium-run horizon. This is the reason, I believe, that an exact point target for inflation is relegated to the long run. But I think it is realistic, and wise, to expect realized average inflation to fall within a reasonable tolerance range about a long-run target over something like a three-to-five-year medium-term horizon.

People can disagree about what constitutes a reasonable tolerance range, but one option that I find sensible would be along the lines of the average volatility of medium-term inflation (calculated over a period in which inflation outcomes were deemed to be acceptable, which I've chosen to be the period since the mid-1990s). With this in mind, the following chart plots realized inflation over three-, four-, and five-year horizons. (For reference, the chart highlights the 2 percent target with upper and lower limits that are plus and minus 1 percentage point.)

(enlarge)

The plus or minus 1 percentage point threshold in the above graph is somewhat above the standard deviation of medium-term outcomes shown in my earlier chart, so one might want to tighten up the bounds. But if you are willing to accept that it's close to your definition of tolerable deviation, the record does support the position that, over the past two decades or so, the Fed has delivered on the its now-explicit long-term objective, or taken sufficient to steps to correct matters when it wasn't.

Looking forward, if the midpoint of FOMC participants' most recent inflation projections comes to pass, the four- to five-year averages would remain near the long-run objective, with the three-year average moving away from its recent flirtation with the lower end of my hypothetical tolerance range.

I'm not saying that the above chart alone defines "appropriate policy"; performance against the other half of the dual mandate is obviously relevant. But I think it provides at least one way to think about what success looks like, and a sensible metric for whether the Fed is delivering on its long-run promise.

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

 

Keeping an eye on inflation

Where's inflation heading? Well, here's what the minutes of the December meeting of the Federal Open Market Committee (FOMC) had to say on the subject:

"Participants observed that inflation had moderated in recent months as the effects of the earlier run-up in commodity prices subsided . . . many participants judged that the moderate expansion in economic activity that they were projecting . . . would be consistent with subdued inflation going forward."

But not all FOMC meeting participants viewed these trends with equanimity:

"Indeed, some expressed the concern that, with the persistence of considerable resource slack, inflation might run below mandate consistent levels for some time."

According to Reuters, San Francisco Fed President John Williams said it this way:

"The data so far on the inflation front are confirming my view that inflation is ebbing and moving to be too low, and that is an important driver of my thinking about policy."

But as you might expect, some see the inflation risks weighing a bit on the other side of the scale. Again, from the December FOMC meeting minutes:

"Some participants were concerned that inflation could rise as the recovery continued . . . A few participants argued that maintaining a highly accommodative stance of monetary policy over the medium run would erode the stability of inflation expectations."

In fact, Philadelphia Fed President Charles Plosser had this to say in a speech earlier this week:

"I do anticipate that with many commodity prices now leveling off or falling, and inflation expectations relatively stable, inflation will moderate in the near term . . .

"But as a policymaker, my focus is less on the near term and more on the medium term. Looking further ahead, I believe we must monitor the inflation situation very carefully, particularly in this environment of very accommodative monetary policy. Inflation most often develops gradually, and if monetary policy waits too long to respond, it can be very costly to correct. Measures of slack such as the unemployment rate are often thought to prevent inflation from rising. But that did not turn out to be true in the 1970s. Thus, we need to proceed with caution as to the degree of monetary accommodation we supply to the economy."

What doesn't seem to be in dispute is that monitoring the data for any sign that the inflation trend is shifting—either higher or lower—is probably a good idea. And there are a lot of data to watch. In a speech last year to the Calhoun County Chamber of Commerce, Atlanta Fed President Dennis Lockhart had this to say about reading the inflation data:

"To achieve price stability, policymakers must detect inflation in its early stages before it is firmly established, especially in the psychology of consumers and businesses. This early detection is a challenge because inflation is not easily measured in the short term with any precision. No single price statistic enjoys a sufficient vantage point from which to assess inflation in the short term. With imperfect tools, inflation is more easily monitored than precisely measured."

The research department of the Federal Reserve Bank of Atlanta has taken pretty seriously the task of monitoring inflation developments. Where there are gaps in our information, we've been working to fill them with data, and we've aggregated it all into one place: the Inflation Project web page.

On the Inflation Project, we now report a sticky-price CPI statistic calculated from consumer price index data using only those components whose prices are slow to change. Joint research with the Cleveland Fed has shown this measure to be helpful when thinking about inflation expectations. Using Treasury Inflation-Protected Securities data, we now produce a weekly measure of the probability of a sustained deflation. And come January 27, we'll begin reporting the results of a monthly survey of business inflation expectations that examines firms' price-setting environment and the pricing pressures they face. From the responses, we'll generate a monthly measure of respondents' year-ahead unit cost expectations.

But of course, there are already a lot of data to keep an eye on. To make it a little easier to gain some perspective, we're also unveiling our inflation dashboard. The dashboard provides a platform for visualizing some of the data we commonly monitor to keep abreast of emerging inflation developments. It tracks 30 data series grouped into six major categories—retail prices, inflation expectations, labor costs, producer prices, material and commodity costs, and money and credit.

Our data and the inflation dashboard are available on the Inflation Project web page. Let us know what you think.

Mike Bryan, vice president and senior economist,

Laurel Graefe, economic policy analysis specialist, and

Nicholas Parker, economic research analyst, all with the Atlanta Fed

In the interest of precision

As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):

"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."

A similar description appeared in the Journal yesterday (again, emphasis added):

"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."

I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:

"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…

"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."

The minutes are pretty clear about what this information is intended to convey…

"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."

…and what it is not intended to convey (here too, emphasis added):

"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"

In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:

"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."

That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.

This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.

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