naked capitalism

By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

When you compare Bernanke’s “Deflation: Making Sure It Doesn’t Happen Here” speech of 2002 with his recent Jackson Hole speech, you cannot help but notice changes in his view of the economy and the financial system as well as a significant decline in his confidence in the ability of monetary policy to insure full employment,. The changes between the speeches and the possible explanations for the changes have implication for the course of Fed policy in the near and medium terms as well as the long-run health of the US economy. They suggest that the FOMC sees less upside to further stimulative policy actions and at the same time sees possible downsides where it had not seen them before. This, in turn, suggests that the FOMC will be more tentative in adopting further nonconventional stimulative measures than past behavior would indicate.

The 2002 speech reflected a confidence in the underlying health of the US economy and the robustness of the financial system, as well as the effectiveness of both the regulatory system and economic policy:

“…we read newspaper reports about Japan, where what seems to be a relatively moderate deflation…has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors

I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself….A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.

The second bulwark against deflation in the United States… is the Federal Reserve System itself… I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

The recent Jackson Hole speech has a decidedly different tone. In particular, the Fed appears to have doubts about the ability of further monetary stimulus to produce a stronger economic recovery:

“…… As I mentioned earlier, the recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed..

….In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting….

Beyond the general tone, the speech is telling. Past speeches and FOMC minutes frequently referenced discussions centered on differing forecasts, but I do not recall another speech or FOMC minutes in which the discussion indicated that the FOMC did a “benefit/cost” analysis of possible policy tools, i.e. “We discussed the relative merits and costs of such tools”. The speech also reflects the Fed’s recent decision to stand pat, at least temporarily, on the policy front despite painfully slow growth, continued high joblessness and continuing problems in the housing and financial sectors. This stands in contrast to the statement in the 2002 speech wherein Bernanke stated that “the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation (and presumably the attendant slow growth and high unemployment) that might occur would be both mild and brief.”

In the Jackson Hole, while Bernanke continued to be optimistic about the US economy in the long-run, he introduced a caveat that was not in prior speeches:

To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies.

This shift in tone along with the decision to refrain from pursuing additional stimulus and the litany of additional required policy changes raises questions.

1. Does the recent speech and the Fed hesitancy to pursue further non-conventional policies reflect a reappraisal of the expected net benefits of further monetary stimulus?
2. Does the FOMC weigh the factors behind the decision to “pause” so heavily that a resumption of unconventional policy is unlikely?
3. Has the FOMC come to recognize that there are limits to the effectiveness of monetary policy and that the economy’s problems reflect the failure of other policies and the need for structural reform?

FOMC members in the Bernanke inner circle among others have recently given speeches which suggest that the benefits of any stimulus that monetary policy might provide must be weighed against possible costs of resource misallocation, increased leverage/financial fragility as well as the cost of forestalling policy responses to a range of structural problems facing the US economy.

In a recent speech, “Assessing Potential Financial Imbalances in an Era of Accommodative Monetary Policy”, Fed Vice Chair Yellen outline avenues by which an environment of low and stable interest rates could contribute to financial instability and economic dislocations:

The severe economic consequences of the recent financial crisis have underscored the need for central banks to vigilantly monitor the financial system for emerging risks to financial stability. Indeed, such vigilance may be particularly important when monetary policy remains highly accommodative for an extended period. As many observers have argued, an environment of low and stable interest rates may encourage investor behavior that could potentially lead to the emergence of financial imbalances that could threaten financial stability….

But a sustained period of very low and stable yields may incent a phenomenon commonly referred to as “reaching for yield,” in which investors seek higher returns by purchasing assets with greater duration or increased credit risk….

But taken too far, this dynamic has the potential to facilitate the emergence of financial imbalances. For example, with interest rates at very low levels for a long period of time, and in an environment of low volatility, investors, banks, and other market participants may become complacent about interest rate risk. Similarly, in such an environment, investors holding assets which entail exposure to greater credit risk may not fully appreciate, or demand proper compensation for, potential losses. Finally, investors may seek to boost returns by employing additional leverage, which can amplify interest rate and credit risk as well as make exposures less transparent.

At present, we see few indications of significant imbalances, and the use of leverage appears to remain well below pre-crisis levels. That said, I’ve noted some recent developments that warrant close attention, including indications of potentially stretched valuations in certain U.S. financial markets and emerging signs that investors are reaching for yield. Should broader concerns emerge, I believe that supervisory and regulatory tools, including new macroprudential approaches, rather than monetary policy, should serve as the first line of defense.

While Yellen asserts that it would be preferable to have monetary policy specialize in macroeconomic concerns, leaving financial stability issues to be in the realm of supervisory tools, Yellen and FOMC are now aware that monetary policy and regulatory policy are intertwined.

In a recent speech, Andrew Haldane, the Director of the BOE’s Financial Stability Committee, also recognized that prudential policy (or the absence of it) has implications for the macro-economy.

…, however, these arms (fiscal and monetary policy-ed.) are at present close to fully stretched…

With fortuitous timing, there is a new tool in the box, a third arm of macro-economic policy. This is so-called macro-prudential policy. As its name implies, this policy tool is intended to meet macro ends using prudential means.

Haldane recognizes the fact that regulatory, monetary and fiscal policies are to some degree substitutes for each other. However, his statement, “With fortuitous timing, there is a new tool in the box.” is rather perplexing. The rediscovery of the fact that financial regulation has macroeconomic consequences can hardly be viewed as accidental (the first definition of fortuitous.) Policymakers and economists had been actively searching for non-conventional policy tools ever since Japan entered its lost decade.

Furthermore, this rediscovery was neither, lucky nor fortunate (the second definition of fortuitous). Changes in regulatory policy have always had the potential to have macro-economic consequences even if economists and policymakers chose to ignore them in the years prior to Lehman. If policymakers had stopped or reversed the erosion of the regulatory structure in the early 1990s, that would have been “fortuitous”’, i.e., lucky or fortunate. The post-2008 realization of the implication of the weakened regulatory regime was not lucky or fortunate. It is just a case of two decades late (literally) and more than a few Trillion Dollars short (figuratively).

Recognition that regulatory/prudential policy has a macroeconomic dimension also has implication for efforts to distribute the “blame” for the crisis and recession . Acknowledging that financial regulatory policy is to some degree a substitute for conventional monetary policy implies that the appropriateness of conventional monetary policy and regulatory policy cannot accurately be determined in isolation from each other. Hence the argument that monetary policy was exactly where it should have been and that regulatory policy is exclusively to blame for the crisis and its aftermath does not hold up to scrutiny. The changing pre-2008 regulatory regime reinforced monetary policy. Together they had the effects for better (real growth and stable prices) and worse (unsustainabilities including external deficit, depressed private savings, and fragility of the financial system) on the financial markets and real economy that have been reflected in US economic performance. If the regulatory regime had been more robust and had limited credit creation and risk taking, then growth would have been slower, etc. However, given the Taylor Rule framework, the Fed would have simply run looser monetary policy until the market innovated and avoided/evaded the regulatory constraints. In the absence of an acceleration in inflation, the looser policy would presumably have been pursued until such time as the economy reached the same state that it was in 2007.

It is not certain that the current regulatory structure will promote socially advantageous levels of leverage and risk taking. It is still possible that regulation will once again allow destabilizing leverage and risk taking. The FOMC must still fear waking up some day only to find excessive leverage and risk taking embedded in the system just across a political or regulatory border, or hidden in plain sight.

In a speech titled “U.S. Economic Policy in a Global Context,” William Dudley, President of the Federal Reserve Bank of New York, links the financial crisis and the current economic troubles to the interplay of globalization and policy choices made both here and abroad. Furthermore, Dudley’s analysis implies that successful US stimulative counter-cyclical policy (in the absence of the other policy changes mentioned by Bernanke) would at best contribute to a return to the unsustainable patterns of trade, debt accumulation, savings, and investment that characterized the period from the mid-1990s to 2008.

… even before the crisis, it was evident that the relationship between developed and emerging economies was becoming strained and needed to be adjusted; the status quo would clearly be unsustainable…

Some experts have summarized the arrangements as follows. The United States bought Chinese exports at low prices, which bolstered U.S. living standards and held down U.S. inflation. The United States did not take extreme steps to try to force China to revalue the renminbi upward against the dollar, and China, in turn, invested its trade surplus and capital inflows into U.S. Treasuries in order to keep the renminbi from appreciating too rapidly. The U.S. terms of trade improved as the cost of imported goods dropped, and U.S. interest rates stayed relatively low as China recycled its trade surpluses back into U.S. financial assets. For China, the benefits included strong economic growth, technology transfer and the creation of many manufacturing jobs. These developments, in turn, helped foster rising living standards and political stability in China….I think this is a reasonable, albeit overly simplistic, description of what happened.

For the United States, the consequence was elevated consumption facilitated by asset price inflation, easy underwriting standards for credit and structural budget deficits. Of course, this particular outcome was not preordained or caused by the EMEs. There were multiple combinations of domestic demand consistent with full employment in the United States during the pre-crisis period. For example, if the United States had adopted different policies, it might have shifted the composition of growth toward more business investment and less consumption and housing.

…While it is tempting to draw a line of causation from actions in one part of the global system to the other, this is overly simplistic. Rather, we have to think of the global economy as a single system, with outcomes based simultaneously on all the choices and preferences throughout the system. What is new is that the so-called periphery is now weighty enough to have a large impact on the pattern of economic activity in the core, as well as vice versa.

It is clear that the pre-crisis formula for global growth was not sustainable. This is obvious in the case of industrialized nations where private consumption and fiscal deficits reached unsustainable levels and needed to be cut back.

Dudley acknowledges that US macroeconomic variables, e.g. the real growth rate, the rate of unemployment and the inflation rate, are no longer exclusively domestically determined. Furthermore, in the absence of a US adjustment to the “globalized” world, the analysis implies that the US will only be able to achieve full employment by returning to something like the unsustainable pattern of consumption and debt growth relative to s that was experienced between prior to 2007.

It is likely that consideration such as those cited by Yellen and Dudley led to the FOMC’s discussion of the relative benefits and costs of the remaining tools of policy as well as to Bernanke’s addition of the caveat to his optimistic view of the US long-term economic prospects. But are these considerations, weighty enough to dissuade the FOMC from taking further steps to stimulate demand in the absence of a good reason to believe that inflation is about to accelerate?

The simple answer is no. Neither Yellen nor Dudley have dissented or voiced disapproval of pursuing further stimulative measures. Furthermore, while Bernanke has expressed reservation about monetary policy alone being able to return the economy to potential output, he does not appear to have linked 1)low interest rates to financial fragilities as Yellen has done nor 2) the external imbalances to domestic policy and the financial crisis as Dudley has done. In fact, in his recent speech Bernanke attributes the current recession and its costs to the financial crisis itself:

I have already noted the central role of the financial crisis of 2008 and 2009 in sparking the recession. As I also noted, a great deal has been done and is being done to address the causes and effects of the crisis, including a substantial program of financial reform, and conditions in the U.S. banking system and financial markets have improved significantly overall.

Conspicuous in their absence is any mention of the external imbalances, the low interest policy and the other unsustainabilities which were reflected in massive misallocations of real resources in the years before the crisis hit.

However, the most telling comment in Bernanke’s Jackson Hole speech is:

…the recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed..

It suggests that stimulative fiscal and monetary policies post-2008 have resulted in a shorter-lived and less vigorous recovery than had been expected by the FOMC. Some FOMC members may draw the conclusion that the possible benefits of additional monetary stimulus are smaller than they thought prior to past efforts at stimulating the economy.

Conclusion

Does the recognition that monetary policy has potential costs as well as benefits or the fact that there are non-cyclical (structural) impediments to a return to potential output preclude a role for stimulative monetary policy? No. Does the existence of structural impediments rule out stimulative fiscal policy? No. However, the market and institutional failures and the structural impediments do imply that 1) stimulative counter-cyclical policies entail risks and 2) counter-cyclical stimulative policies alone will not return the US economy to sustainable trend growth with full employment.

Bernanke and the current FOMC are not the Bernanke and FOMC of 2002, of QE1 or QE2. Nonetheless, the FOMC will almost certainly take additional stimulative steps. However, given:

1. 1) possible downside risks attached to continued low and stable interest rates,
2. 2) the failure to address the external imbalance and other structural problems, and
3. 3) the erosion of the effectiveness of monetary policy,

FOMC policy actions are likely to be tentative relative to earlier responses taken to the crisis.