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The Fed’s Dangerous Game

e21 | 10/29/2010 |

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The Federal Reserve’s commitment to pursuing another round of quantitative easing (QE) has been well telegraphed. There were the minutes from the Fed’s meeting in September and also some well timed speeches by Fed governors over the past few weeks. In addition to all the QE2 discussion – large scale asset purchases financed through printing money – FOMC members have considered “targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.”

In short, the Fed has now moved beyond the esoteric “portfolio balance channel” to full-throttled support for policies designed to engineer higher inflation. Recently, the Fed has been eager to communicate to market participants that low inflation is somehow inconsistent with “price stability.” This is unfortunate and unlikely to be in the long-run interest of the U.S. economy or millions of households currently dealing with the fallout from prolonged unemployment.

The Fed has a dual mandate: to promote full employment and low inflation. For decades, the two seemed to be in conflict due to faith placed in the Phillips Curve, which held that there was a trade-off between inflation and employment. The same general idea holds today among many at the Fed, but the preferred measure is now the monthly Industrial Production and Capacity Utilization data release. In general, inflation only occurs when the economy is all full employment, or when capacity utilization is high. Under these circumstances, incremental capacity additions have the effect of “bidding up” the price of production inputs, causing a generalized rise in the price level. With capacity utilization still below its 1991 recession low and unemployment so high, the Fed sees very little chance of inflation.

This is not unreasonable. The low yields on nominal Treasury securities and continued declines in business and consumer sentiment make inflation seem unlikely at the moment. What there is less empirical support for, however, is the insistence that inflation is too low or that, as Chairman Bernanke argued last Friday, “the risks to price stability had become two-sided: With inflation close to levels consistent with price stability, central banks, for the first time in many decades, had to take seriously the possibility that inflation can be too low as well as too high.” Over the three months ending in September the consumer price index (CPI) increased at an annualized rate of 2.8%. The Fed’s preferred inflation measure, the “PCE deflator”, increased by 2.4% over July and August. Despite these healthy inflation readings and record levels for key commodity prices like gold, key members of the FOMC seem to have convinced themselves that the U.S. is destined for the prolonged deflation of Japan and have decided to target the price level or nominal GDP.

The basics of price level targeting are as follows. If today’s price level is 100 and inflation is 3% per year, in five years the price level would be 116. If inflation were to fall below 3% in the early part of the period, the only way the Fed could hit its price level target would be through higher inflation later on. For example, if we were to have 1% inflation for the first 3 years, to hit its five year price level target of 116, the Fed would have to accept 6.1% annualized inflation for the next two years. But once inflation reaches those levels, bringing inflation back to 2-3% per year may not be so easy. Unmooring inflation expectations is a dangerous game and using the “price level” as a target seems especially dangerous now given that most market participants think in terms of changes to prices – inflation and returns on assets. The targeting of nominal GDP could be even more dangerous since it would deemphasize real changes in output in favor of “catch-up” based purely on increases in the price level.

Why is the FOMC moving in this direction? The best explanation was offered by William Dudley, current President of the Federal Reserve Bank of New York and formerly an accomplished U.S. business economist at Goldman Sachs. That Dudley was recently cited by leading monetary academician Michael Woodford on the topic also suggests that his is the view on the FOMC worth paying attention to. In Dudley and Woodford’s telling, the economy suffers from insufficient spending by households. Engineering a little inflation would force them to spend more money today by eroding the future purchasing power of the dollars they decide to save. Once the households spend more money, businesses will have to rebuild inventories, hire more workers, and buy more capital equipment. The self-reinforcing cycle will accelerate economic growth and lead to a self-sustaining recovery that will be able to absorb the interest rate increases needed to tamp down inflation a few years down the line.

The problem with this view is that it risks a potential monetary disaster – systemically higher inflation expectations – to correct a problem – inadequate consumer spending – that’s not necessarily evident in the data. According to Dudley:

The factors responsible for the failure of the recovery to pick up speed include: (1) the gradual petering out of the contribution from the swing in inventories from rapid liquidation during the first half of 2009 to a modest increase in the second quarter of 2010; 2) the sluggish recovery in consumer spending; and 3) the continued weakness in housing.

The problem with this analysis is that consumer spending is actually the most robust portion of the recovery thus far. And while the reduction in residential investment and slow rebound in inventories has, unquestionably, slowed the recovery, the decrease in these categories hardly differs from the overall decrease in overall investment. In short, blaming continued economic weakness on consumers seems to be a misinterpretation of what appears to be a slowdown driven predominately by reluctance on the part of businesses to invest or hire.

(Chart 1)

The above chart provides a scaled measure of GDP, consumption expenditures, total investment (gross fixed investment) and investment net of inventories and housing. Scaling GDP components so that the 2008 GDP peak equals 100, we can see that 2010-Q2 consumption was actually 2% higher on a nominal basis than it was in 2008 (102 versus 100). By contrast, gross fixed investment is actually 17% off its 2008 level and 22% off its 2006 peak (which was obviously somewhat inflated by residential investment). But when excluding residential investment and inventories, investment is still down 16% from its 2008 peak. If consumption expenditures were held constant and investment returned to its 2008 level, GDP would be 2.56% greater today. Had investment grown at the same pace as consumption expenditures since 2007 (4.8%), GDP would be 4.2% higher today.

The chart below provides similar data in a different format. It shows the net change in GDP and three of its components from 2007 to 2010-Q2. Consumption expenditures increased over this period by 4.83% – growing about one-third faster than the overall economy. At the same time, investment fell by 22.15% and investment net of housing and inventories fell by 14.13%.

(Chart 2)

The final chart (below) looks at consumption expenditures, total investment, and investment net of housing and inventories as a percentage of GDP. Since 2007, consumption expenditures have actually increased as a share of GDP – from 69.74% to 70.53%. Gross investment, by contrast, is down about one-third relative to GDP (4 percentage points) since 2007. After stripping out residential investment (the last legs of the housing expansion) and inventories, net investment has fallen from 11.6% of GDP at the end of 2007 to 9.6% at the end of the second quarter, a 17% drop relative to GDP (2 percentage points).

The message from these data is that concern about household consumption is misplaced. Concern about business investment is understandable. However, focus on the residential and inventory components of the investment decline is odd given that all investment is down by roughly the same amount. More significantly, the nonresidential portion of investment represents declines unrelated to the bursting of the housing bubble which, in many ways, should be more troubling because it doesn’t have an obvious causal factor. No one should be surprised residential investment is so low given the rise in mortgage defaults and decline in homeownership rates. But why is the rest of investment falling in lockstep?

(Chart 3)

In the minutes, the staff economists and FOMC members offered their views:

Many businesses had built up large reserves of cash, in part by issuing long-term debt, but were refraining from adding workers or expanding plants and equipment. A number of business contacts indicated that they were holding back on hiring and spending plans because of uncertainty about future fiscal and regulatory policies.

While concern about final demand is certainly part of the reason business investment has been so weak, according to the minutes, “several participants observed that data on retail sales had been a bit stronger than expected over the intermeeting period.” Inflation, final sales, and aggregate expenditure numbers continue to surprise to the upside. Of the components of GDP, none has been more reliable than consumer spending. To expect consumers to bear more of the burden for generating growth is, to hope to relive the 2003-2008 period.

The U.S. economy appears to be mired in problems that monetary policy cannot solve. And, attempting to use this blunt instrument looks like it will only make matters worse. As Bank of America chief economist Mickey Levy noted in a paper prepared for the recent e21-Shadow Open Market Committee meeting, the Fed’s “rationale for more QE has changed.” Formerly judged to be a tool to avert deflation, QE is now thought to be a mechanism to “stimulate economic growth or job creation.” Unfortunately, there is little to no data on which to base this assumption because QE is such a novel policy tool. By attempting to generate inflation to boost current expenditures, the Fed is playing a dangerous game in experimental monetary economics where the benefits are speculative but the downside risks are all too real.


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