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November 23, 2010
Federal Reserve policies focused
This blog posting was originally an article in the Sunday, November 21, edition of the Atlanta Journal-Constitution. The article was written by Atlanta Fed Senior Vice President and Research Director David Altig.
On Nov. 3, the Federal Open Market Committee (FOMC)—the group within the Federal Reserve charged with formulating monetary policy for the United States—announced its plans to purchase, over the course of the next eight months, up to $600 billion worth of longer-term Treasury securities.
In many circles (maybe including yours), this decision has generated some controversy. A good deal of the controversy revolves around the view that this monetary policy decision is aimed at buying up government debt for the purpose of making it easier for the country to continue on the path of deficit spending. This view is inaccurate.
I understand the concerns that are triggered when the Fed announces a significant Treasury purchase program at a time when the fiscal situation is so challenging and unsettled. Be it the hyperinflations of Germany's Weimar Republic in the period between the two world wars; Hungary after World War II; or the more recent case of Zimbabwe, most of us have heard or read of extreme examples of countries that ended up creating big problems trying to finance government by printing money.
Generating government revenues via the printing press is a policy that is often referred to as "monetizing the debt." I think the emphasis in that sentence should be on the word policy. A policy is really a sort of rule—sometimes explicit, sometimes only implicit—that lays out a decision maker's objectives and how they are going to be attained. The objective of a policy of monetizing the debt is to create inflation as a means of lowering the burden of government debt by lowering the value of the debt and interest the government must repay in inflation-adjusted terms.
Monetizing debt is decidedly not the current policy of the Federal Reserve, at least not according to Federal Reserve Chairman Ben Bernanke. Speaking at a recent conference hosted by the Federal Reserve Bank of Atlanta, Chairman Bernanke was unequivocal: "We are not in the business of trying to create inflation."
So what business is the Fed in?
In short, the Fed's so-called dual mandate charges the FOMC with promoting sustainable growth and low and stable inflation. Though the economy is moving forward, it is doing so at a pace that is only slowly yielding job growth. This forward momentum has not yet proved robust or sustained enough to dent the unemployment rate.
More important, the economic landscape at the end of the summer was colored by the continuation of a declining inflation trend that was bleeding into expectations about the probability of deflation. In a still-recovering economy with very low interest rates, the emergence of deflation expectations would be a most unwelcome development that could seriously impede the prospect for continued recovery.
As Atlanta Fed President Dennis Lockhart has said, stabilizing inflation expectations is a key to policy success, and "managing inflation expectations requires following through with policy actions consistent with stated objectives—in this case ensuring that inflation trends remain in a desired zone. The FOMC's November decision should be seen in that light."
The policy represented by the November decision appears to be working. As markets came to expect the November announcement, price expectations that had been declining all summer began to stabilize and have now returned to pre-summer levels.
Could the policy be too successful? That is, there a risk that the policy will overshoot and replace declining inflation rates with too-high inflation rates?
There are, of course, always risks to action and inaction. Now that the FOMC's action has apparently mitigated the risk of a recovery-threatening disinflationary spiral, at some point it will be appropriate to turn attention to inflation risks. As President Lockhart recently commented, we at the Atlanta Fed are confident these decisions will be made independent of fiscal considerations.
The current focus is on rising commodity prices, and the Federal Reserve, including the Atlanta Fed, is watching those developments too.
As one of the 12 Federal Reserve Banks charged with bringing a real-time sense of the economy to the monetary policy process, the Atlanta Fed queries hundreds of contacts every month. In general, our contacts, while acknowledging some rising cost pressures, do not indicate they are likely to respond with price hikes of their own.
But we will keep asking, watching for signs that things are changing, and preparing in the event that a change in course is warranted.
And this vigilance is precisely the point. Intentions do matter, and President Lockhart has made his very clear: "Rest assured, should inflation begin to move above desired levels, I am confident the FOMC will work hard to keep it from getting away from us."
By Dave Altig, senior vice president and research director at the Atlanta Fed
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November 19, 2010
Just how does policy work?
In the immediate aftermath of the Federal Open Market Committee's November 3 decision to expand its net asset positions with an additional $600 billion in Treasury purchases, a theme emerged among the commentariat: the policy's aim, as the story goes, is to engage in competitive devaluation of the dollar, juicing the economy by prompting greater spending by foreigners via a cheapened greenback.
Earlier this week, Atlanta Fed President Dennis Lockhart provided his perspective:
"… I don't think it is out of line to state clearly that, as I see it, there is no monetary policy intent to engineer specific values—or even a direction—for the dollar. In other words, this policy was not undertaken to prompt dollar depreciation."
Of course, the value of the dollar against a broad basket of currencies did fall in the aftermath of Chairman Bernanke's comments at the Kansas City Fed's August Economic Policy Symposium and continued to fall through the latest meeting (the decline has reversed somewhat since then). These comments were widely interpreted as a signal of additional asset purchases.
While it is not appropriate for me to comment on what the value of the dollar should be, I believe it is appropriate to provide some perspective on how we think about dollar depreciation.
In addressing that topic, let me take a brief detour to ruminate on how monetary policy works. In spring 2009, near the end of the worst of the financial crisis, I wrote (in this space) of how I think about "nontraditional" monetary policy (the direct lending facilities created at the height of the crisis and the large-scale asset purchase program that was just under way at that time). The upshot was that I think of nontraditional tools as a way to, as best we can, replicate traditional policy in nontraditional circumstances. I personally believe that remains an appropriate way to think about what the Fed is doing. Chairman Bernanke provided this perspective in his remarks at a European Central Bank conference today.
"Although securities purchases are a different tool for conducting monetary policy than the more familiar approach of managing the overnight interest rate, the goals and transmission mechanisms are very similar."
So, how is traditional monetary policy implemented? Put simply, the first thing to note is that traditional policy is almost always implemented by open market purchases of assets, Treasury securities in particular. Though traditional policy is described in terms of targets for the federal funds rate, the fact is these targets are simply guides as to how big those open market purchases of securities by the Fed need to be. (The answer is, as big—or small—as necessary to hit the funds rate target chosen by the Federal Open Market Committee.)
But that is just a story about how policy is implemented. How policy works might go something like this: The central bank, by creating more short-term liquidity, alters the composition of assets held in private portfolios. Unless that additional short-term liquidity exactly matches an increase in the demand for it, the infusion of "cash" will result in portfolio rebalancing—a shift into other types of assets. The increased demand for those assets, of course, affects their yields.
That logic is a familiar textbook description of the monetary transmission mechanism. It is also, more or less, the description of how the current "nontraditional" asset-purchase policy is supposed to work, as explained by Chairman Bernanke at the aforementioned Kansas City Fed Policy Symposium:
"I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets."
What constitutes "broadly similar"? Well, one category would certainly be comparable assets denominated in different currencies. Savers operate in global capital markets, so it would not be the least bit surprising if some portfolio rebalancing associated with open market operations found their way to the exchange rate. But that is as true of traditional policy as it is of nontraditional policy. A potential effect on the exchange rate does not make the exchange rate an object of policy, traditional or otherwise. It does make the international value of the dollar one of the vast array of asset prices that might be impacted when a monetary policy action is taken.
But if the potential effect fails to materialize, or even moves in what seems to be a contrary direction, does that mean policy is a failure? I believe the answer is no. Markets are complex beasts, and there is no exact formula as to how, when, and where the impacts of monetary actions appear. This uncertainty exists even with traditional policy, for which we now have a fair amount of experience gauging how, for example, choices for federal funds rates feed into the objectives of monetary policy with respect to growth and price stability.
About this time in 2008, I noted that the extended episode of low interest rates in the 2002–2004 period had little discernible effect on long-term interest rates. Does that mean that the policy was ineffective in promoting price stability or growth objectives?
In the end, the proof is about whether policy objectives are being met, and those policy objectives are not about the specific value of the exchange rate (or the Dow Jones average, or even the 10-year Treasury rate). On those objectives, President Lockhart had this to say in his speech this week:
"In regard to price stability, this policy has already shown some signs of success by altering inflation expectations and reducing the risk of unwanted disinflation. To explain, inflation expectations extracted from Treasury inflation-protected securities, or TIPS, spreads over like-duration Treasury securities were declining persistently over the course of late spring through summer. Following the August 27 Jackson Hole speech by Fed Chairman Ben Bernanke, these spreads have recovered to previous levels. In addition, according to analysis we've done at the Atlanta Fed, deflation probabilities reflected in TIPS have fallen from the high levels prior to the September FOMC meeting.
"Managing inflation expectations requires following through with policy actions consistent with stated objectives—in this case ensuring that inflation trends remain in a desired zone. The FOMC's November decision should be seen in that light."
And that is a good last word.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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November 09, 2010
Entrepreneurs of necessity
On October 26–27, the Atlanta Fed's Community and Economic Development team, in partnership with the Bank's Center for Human Capital Studies, the Ewing Marion Kauffman Foundation, and the Federal Reserve Bank of Dallas, sponsored a conference titled "Small Business, Entrepreneurship, and Economic Recovery: A Focus on Job Creation and Economic Stabilization." The conference covered a large range of topics including employment, financing, and public policy issues, and material summarizing the findings from the conference and related information will be published in the coming weeks. (You can find the conference papers here.)
One of the things that struck me during the conference is the challenge of simply defining and measuring entrepreneurial activity. For instance, a paper presented by Leora Klapper from the World Bank described recent World Bank efforts to systematically collect country-level data on business formation using data on the number of new domestic corporations—private companies with limited liability each year.
Klapper presented a cross-country chart of this measure, by which countries are grouped into relative income buckets, with the United States being in the "high income" bucket. What chart 1 shows is that entrepreneurial activity declined in all categories of countries in 2009. For high-income countries (including the United States), entrepreneurial activity came to a standstill in 2008 and declined 10 percent in 2009.
This evidence is consistent with measures of job creation from opening employer firms (firms with a payroll) in the United States, such as those contained in the Business Employment Dynamics data. These data are from government administrative unemployment insurance records. On the first day of the conference, John Haltiwanger from the University of Maryland gave a fascinating presentation using the data on firms with a payroll and longitudinally linked versions of these data (the Business Dynamics Statistics) to illustrate a decline in job creation in recent years at businesses that have payrolls and, importantly, a decline in job creation at opening employer firms.
However, another paper at the conference by Robert Fairlie from UC-Santa Cruz showed a measure of entrepreneurial activity that has been on a rapid increase in recent years. Chart 2 shows a picture of Fairlie's measure, which is also published by the Kauffman Foundation as the Index of Entrepreneurial Activity.
This measure is based on the Current Population Statistics survey, which among other things asks respondents the question "Do you have a business?" Dr. Fairlie matches this response with the response in the previous month to identify the number of new businesses created (subject to meeting criteria, such as devoting at least 15 hours per week to this business, and restrictions, such as the exclusion of adults over age 65). Importantly, Fairlie's measure of new businesses picks up new nonemployer businesses, many of which are not incorporated.
What is particularly interesting about Fairlie's research is that he shows not only that this measure of entrepreneurial activity has surged, but that it is closely related to movements in local unemployment rates. That is, he has potentially uncovered an "entrepreneur of necessity" effect caused by high unemployment. For many unemployed workers, the benefits of starting a business during a weak economic environment outweigh the costs. It is noteworthy that the largest proportionate increase in this measure of entrepreneurial activity is by people with less than a high school diploma. This group has been especially hard hit by the recession and weak recovery, and it appears that many have responded by starting their own business.
If entrepreneurial activity is a source of economic growth generally, then a surge in entrepreneurial activity is good news for the economic outlook, right? Indeed, Fairlie cites a 2009 Kauffman Foundation study by Dane Stangler that finds over half of the current Fortune 500 firms started during recessions or bear markets. Also, a 2010 Kauffman study by Michael Horrell and Robert Litan find that, on average, start-ups are not affected in the long term if they start in a recession. However, Horrell and Litan also find negative impacts when the recession is prolonged. To the extent that historical patterns are repeated, one implication of the latter finding is that cohorts starting businesses right before or at the start of the 2007–09 recession may have worse outcomes relative to firms starting more recently.
More generally, this study raises questions about the current economic recovery. For example, if the number of new firms with payrolls is down but the number of nonemployer businesses is up, then what could be expected to happen over time? At what rate do new businesses with no employees become employers, and how fast do they tend to grow? This question is especially important because a new business with no employees generates fewer jobs than a new business with employees unless the nonemployer is purchasing labor services through some other means. As noted here, some researchers are skeptical of the economic importance of growth in nonemployer businesses without controlling for possibly important factors such as the industry they are in or their revenues. According to the U.S. Census Bureau, most nonemployers are self-employed individuals operating very small unincorporated businesses. It also seems reasonable to think that many of them are independent contractors providing labor services to other firms. Clearly, there is no shortage of need for more research on these topics.
By John Robertson, a vice president and senior economist in the Atlanta Fed's research department
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November 04, 2010
Some in Europe lag behind
Since around June, news of European fiscal deficits, financial markets stresses, potential sovereign debt defaults, or even a breakup of the euro zone has faded. The focal points of global economic policy have shifted to the sluggish recovery in developed countries and potential for further unconventional monetary stimulus.
A cursory look at a few key data reflects an improved European economic outlook from this summer. The simple dollar/euro exchange rate (see chart 1) shows that since June 1 the euro has appreciated nearly 15 percent against the dollar. While many different factors affect exchange rates—and increasing expectation of further monetary stimulus in the United States has helped the euro appreciate against the dollar—some of the appreciation seems to reasonably reflect the relative improvement of market sentiment about the fiscal situation in several European countries. Similarly, looking at the major stock indexes (mostly in Western European nations) shows a steady improvement from the lows of this summer, with the Euro Stoxx 50 index rising nearly 11 percent since June 1 (see chart 2). Thus, looking at most aggregate European data paints a picture of relative improvement, though most forecasters expect sluggish growth going forward. It's when one examines individual countries that it becomes clear some are lagging behind.
While the early stages of the European sovereign debt crisis centered on the fiscal scenario in Greece, market stress eventually spread to all the so-called PIIGS (Portugal, Ireland, Italy, Greece, and Spain) and even appeared to threaten the wider euro zone. Following an assortment of unprecedented interventions—highlighted by the 750 billion euro (approximately $1.05 trillion) rescue package from the European Union (through the European Financial Stability Facility) and support from the International Monetary Fund—market confidence slowly grew, and since this summer, various measures of financial market functioning have stabilized.
But while the threat of wider European contagion appears contained, fragilities remain. As has been documented in a variety of media reports, the recent improvement masks the individual euro zone peripheral countries' struggles with implementing fiscal consolidation, improving labor competiveness, resolving fragile banking systems, and staving off a crisis of confidence in sovereign debt markets.
Both bond spreads of individual European sovereign debt (over German sovereign debt) and credit default swap spreads show some stabilization for a few of the euro zone countries, but spreads in three countries—Greece, Ireland, and Portugal—are distinctly more elevated than the others (see charts 3 and 4).
The reasons for rising financing costs in these countries vary. In Ireland, for example, concerns about the Irish banking system (and the resolution of Anglo Irish Bank, in particular) were initially the driving cause. In Portugal, it was doubt over the implementation of necessary economic reforms that drove investor reluctance to provide financing; the recent adoption of austerity measures into the 2011 budget should alleviate some worry. But now much of the market action in both Irish and Portuguese bonds is focused on tough new bailout rules being implemented by the European Union.
On one hand, the renewed financing pressure brought upon these countries is less worrisome because of the backstop of the European Financial Stabilization Facility (EFSF). In fact, Moody's thinks it is unlikely there will be a euro zone default. Should market financing become too expensive for Greece, Ireland, or Portugal, the special purpose vehicle (SPV) imbedded within the EFSF could help by providing financing up to 440 billion euros ($616 billion).
But on the other hand, as part of the wider crisis prevention following the introduction of the EFSF, most European governments are implementing some level of fiscal austerity measures. From a political perspective, the implementation of these austerity measures varies widely, as demonstrated recently by the strikes in France over legislation trying to raise the retirement age. In addition to the uncertainty of implementing fiscal consolidation, there is pressure from the administrators of the EFSF to enforce burden-sharing on private bondholders in the event of any future bailout. This pressure is the primary impetus causing investors to shun the weaker peripheral countries.
One important player in this saga is the European Central Bank, which began buying European bonds for Greece, Ireland, and Portugal (among others) in conjunction with the EFSF announcement. Yet in recent weeks this bond buying has abated, and with money market pressures remaining in Europe, "something clearly has to give way," as Free Exchange wrote recently.
While aggregate market measures (exchange rates, stock indices, etc.) from Europe appear to be improving, a few specific countries face some hard challenges ahead.
By Andrew Flowers, senior economic research analyst in the Atlanta Fed's research department
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