Friday, January 08, 2010

2010 Forecast: No, no different

Is it really different this time? In other words, is this recession really different from past recessions? I argue only in terms of magnitude. It was a bad recession, but it ultimately wasn't any fundamentally different. Will the recovery be muted? I actually don't think so. I just think we went down so hard that it will take a long time to recover. Unemployment, for example, will be relatively high through 2010, but mainly because it got so high in the first place. I expect fairly consistent improvement in all economic indicators through the year.

If you disagree with the above, fair enough. Clearly the Fed should accommodate if the economy isn't growing. But what if we are recovering? Even if its a slow recovery? What should the Fed do? If this time really is no different, then they should do what they always do after a recession. Tighten policy.

Milton Friedman argued, quite convincingly I think, that the perfect monetary policy was to have relatively small and stable growth in money supply year after year. He actually argued that this could be done robotically, and that actual human judgement was a detractor to the process rather than additive. While I'm very sympathetic to this view, its clear that given today's banking system, we can't measure the de facto money supply accurately enough to implement the computerized Federal Reserve that Friedman envisioned.

John Taylor then argued an alternative in the 1980's. If we can't measure money directly, let's measure its impact and try to target that. He said we could measure the output gap (difference between real GDP and potential GDP) and the difference between actual inflation and ideal inflation, then set monetary policy to push these numbers back toward the goal. This is the genesis of the Taylor Rule.

Now let's back up for a moment. Look at the history of the Taylor Rule vs. actual policy during the so-called Great Moderation.



Taylor has argued that if we look at most of this period, actual policy seems to follow the Taylor Rule quite nicely. He argues that the Great Moderation occurred because of this enlightened policy.

Then we get the 1999-2006 period.


Policy was consistently off, mostly being too low from 2001-2004. What did we get? A pretty poor decade of economic performance.

Where are we now based on the Taylor Rule? Right this minute my estimate is that its calling for Fed Funds to be -2%! Hence why I thought QE made sense. We can't get traditional monetary policy easy enough. But if GDP growth is just 2% in 1Q and 2Q and CPI hangs around 1.5, the Taylor Rule suggested Fed Funds rates jumps to 0.75%. If inflation accelerates to just 2%, the recommendation is 2% by the end of the second quarter.

Realistically, the Fed can't (or won't) hike 200bps in just a few months. They are more likely to move in 25bps or 50bps clips lest they spook the market too much. Given that they meet every six weeks, it would take them 10 months to get from 0.25% to 2% at 25bps per-meeting hikes. If we throw a couple 50bps moves in there, it still takes them 7-8 months. This is why they need to start removing extraordinary accommodation now.

Remember, that monetary policy isn't really about interest rates. Fed funds is just the tool the Fed uses to alter the money growth rate. As such, we could say that the Fed's extraordinary liquidity measures are creating a de facto funds rate well below zero. The flip side of this is that with the economy improving, the effective funds rate is even further from its proper spot. So even if the Taylor Rule suggested rate is zero, the Fed would need to slow the money growth from its current pace considerably.

Ben Bernanke is currently talking about the lessons of 1938. I say learn the lessons of the Great Moderation and stick with a stable monetary policy.

Next up... what happens if the Fed keeps rates low? (I'll tell you what, we'll all end up working for this guy or spending more time designing Facebook layouts. Scary :) )

28 comments:

getyourselfconnected said...

"Next up... what happens if the Fed keeps rates low?"

I will wait for that post as it is the most likely event.

getyourselfconnected said...

P.S.
Did you not hear that this was the greatest recession since the Great Depression and only the FED/Treasury saved us from "tanks in the street"? Hardly a common downturn lol.

Flow5 said...

Neat graph. I hadn't seen the Taylor rule as applied to 1999-2006But it doesn't surprise me. His rule is ex-post. Monetary lags are ex-ante, as they are of a fixed length.

I'm no expert on the term structure of interest rates. But bank credit is flat. The preponderance of short-term governments, with exceptionally low yields (3 month T-Bills secondary market @.06%, 6 month T-Bill @.18%, 1 year constant maturity @.45%, as of 1/4/2010, etc.), doesn't provide a spread sufficient, or incentive to invest, and profit in these instruments? Is it no wonder that the FED is trying to lengthen the maturities in SOMA?

The member banks certainly won't borrow much at the primary credit rate (@.50%), from the FED's liquidity facilities, unless they reach out in the yield curve (as they must be doing -- buying 10-year Treasury Notes and 30-year Treasury Bonds, with yields of 3.8%and 4.6%, --or at a minimum duration (assuming a 2% spread, of 4 years?)

But this end of the spectrum (with inherent inflation expectations, & the Federal Government's insatiable appetite for loan-funds), there is much risk.

So there aren't enough credit-worthy customers (or suitable investments), in the private sector, and or in the public sector, which are both necessary to expand bank credit and new money.

Isn't this the reason for the abnormally steep yield curve? I.e, the term-structure of interest rates, which is determined by borrowing short to invest long, is unattractive on both ends?

jack said...

Interesting post. The period from Dec 90 to Dec 94 looks an awful lot like the period from Sept 01 to March 05. What would make the first period different from the second period?

Tom Lindmark said...

Realistically, the Fed can't (or won't) hike 200bps in just a few months. They are more likely to move in 25bps or 50bps clips lest they spook the market too much.

I don't disagree that they can't or won't but i would suggest that the reason is driven more by politics than a concern about spooking the market. Actually, it seems as if the market is assuming the fear you cite and reverting somewhat to a bubble mentality. Perhaps a bit of a shock would be a good thing. It seems as if all of the good intentions about getting back to fundamentals have been lost in the belief that profits are to be made on the assumption of unlimited support from fiscal and monetary policy.

Flow5 said...

"the so-called Taylor rule...It was shown on a chart included in Mr Bernanke’s presentation to the American Economic Association"

"The chart suggested the optimal rate moved above zero around the middle of 2009....a similar Fed staff analysis suggested the optimal interest rate was minus 5 per cent.
http://www.ft.com/cms/s/0/74c23e0c-fbe8-11de-9c29-00144feab49a.html

In Debt We Trust said...

ISM #s are improving.

http://www.ism.ws/ISMReport/content.cfm?ItemNumber=10752

And NFPs are going to get a big bump in Q2 from the temporary jobs that the Census is offering.

All this will put pressure on the Fed to hike. I say the Fed will raise sometime this year. How much I don't know. Looks like a good year for some put spread trading in commodities when the carry trade reverses. (and it will eventually).

Disclosure - I am short March 24-27 Sugar #11 put spread.

John (Ad Orientem) said...

"Next up... what happens if the Fed keeps rates low?"

I will wait for that post as it is the most likely event.


Yup.

Advant Guard said...

So is 4% growth of M2, really all that inflationary? What about negative growth of M3? If the goal is stable growth of money supply, then tightening now would be the wrong policy.

Despite the Federal Reserve policy actions, very little liquidity is getting to the actual engines of the economy, instead flowing to commodity speculation. We should not be fooled by the gyrations of the oil and gold markets, the continued pay down of credit (as reported recently) indicates that current levels of interest rates are still deflationary.

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Flow5 said...

The Fed has completed $159.9 billion of its $175 billion agency debt purchase program
through January 6 (making it 91% complete). The last purchase, on December 21, was made
for $0.49 billion.

The Fed purchased a net total of $9.3 billion of agency-backed MBS through the week of
December 30. This brings its total purchases up to $1.115 trillion, and by the end of the first
quarter 2010 the Fed will purchase $1.25 trillion (thus, it is 89% complete).

http://www.frbatlanta.org/documents/research/highlights/finhighlights/FH_010610.pdf

LDH said...

kind of an aside.. your polling re: cnbc lookalikes... tell me that bob pisani doesnt moonlight as matthew lesko, the guy with question mark suit on late TV who shouts that you can get free money from the US govt? great blog you have, by the way

Flow5 said...

John Taylor critices Bernanke:
1/11/10

http://online.wsj.com/article/SB20001424052748703481004574646100272016422.html

Thomas Hoenig during the past decade: "real interest rates—the nominal interest rate adjusted for inflation—remained at negative levels for approximately 40 percent of the time" That coincides with your graph.

The problem with the Taylor rule has to do with what variables are chosen for his equation.

You have reporting lags, significant revisions to the data, which inflation measure? & lag (which is influenced by our Trade Deficit), GDP gap? (inconsistent), what nominal interest rate? used (which is influenced by the Federal Budget Deficits, etc).

Flow5 said...
This comment has been removed by the author.
ronald said...

While ISM manufacturing numbers have been going up manufacturing positions are still being lost. Dec employment showed 27K manufacturing job lost and today Alcoa conference call speaks for itself:

"To boost savings, Alcoa chief financial officer Chuck McLane said the company identified 24,600 cuts to make in its workforce to save an annualized $600 million. In 2009, the company shed 21,500 positions to save $325 million in cash.

Alcoa's headcount is down to 59,000, and the company plans to make the remainder of the cuts by the end of the first quarter of 2010. About 75% of the eliminations are permanent reductions, McLane said during a conference call."

Looks like business will need to continue to cut staff in order to show any decent numbers in 2010...bad!

Flow5 said...

Greenspan's FFR Folly: To counter what Greenspan described as “irrational exuberance” (at the height of the Doc.com stock market bubble), Greenspan initiated a very "tight", even "contractionary", monetary policy (for 31 out of 34 months). Normally a “tight” money policy is one where the rate-of-change in monetary flows (our means-of-payment money times its rate of turnover) is no greater than 2-3% above the rate-of-change in real output.

Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the unemployment curve), and reverted to a very "easy" monetary policy -- for 41 consecutive months (despite his 17 raises in the FFR).

Then, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a "tight" money policy, for 29 consecutive months (out of a possible 29, or sufficient to wring inflation out of the economy). For the last 15 successive months (since Aug 2008), the FED has been on a monetary binge.

Did you catch it??? Nobody got it. Greenspan didn't start "easing" on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn't change from a "tight" monetary policy, to an "easier" monetary policy, until after 11 reductions in the FFR (where Greenspan's tight money ended, just before the FFR reduction, on November 6, 2002 @ 1 & 1/4%).

I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), and high inflation (August 2007, widespread commodity speculation's peak), and now once again in 2010, higher unemployment (10.1%).

This must have to do with the problem of a dual mandate; because the last reduction in the FFR occurred in the same month as the peak in unemployment (June 25, 2003). It is a fact that the FED is only able to achieve stable inflation. So how many T-Bills does the "trading desk" have to purchase to reduce the unemployment rate by 1%? This is utter naiveté.

THE POINT IS: GREENSPAN DID NOT EASE UNTIL OCTOBER 2002. HOWEVER IF YOU WERE TO JUDGE BY THE CONVENTIONAL WISDOM, THE FFR, GREENSPAN STARTED EASING ON JANUARY 3, 2000. AND THEN GREENSPAN NEVER EVER CHANGED OVER TO A "TIGHT" MONETARY POLICY.

Unfortunately the Federal Reserve doesn’t gauge the volume and timing of its open market operations in terms of the amount and desired rate of increase of member commercial banks legal reserves, but rather in terms of the levels of the federal funds rates (the interest rates banks charge other banks on excess balances with the Federal Reserve).
By using the wrong criteria (interest rates rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve became an engine of inflation.
MONETARISM HAS NEVER BEEN TRIED.

Flow5 said...

"turns out banks won’t lend till rates rise"....

"You can’t make money borrowing short if you’re not willing to lend long"....

"Indeed, banks are shrinking their loan What looks like a healthy interest rate spread today (5.3% – 1.6% = 3.7%) is going to tighten.
books while socking away cash"....

"banks have been plowing assets into more liquid securities according to Paul Miller of FBR Research. But as credit markets have healed, the interest rate spread on these assets have also come down, limiting profit potential"


http://blogs.reuters.com/rolfe-winkler/2010/01/11/yield-curve-cant-drive-profits-if-banks-wont-lend/

Flow5 said...

"No, the headline is not a misprint. According to CNBC, the Federal Reserve bought approximately 80 PERCENT OF THE U.S. TREASURY SECURITIES ISSUED in 2009"

Bernanke on the Taylor" Rulehttp://www.econbrowser.com/archives/2010/01/guest_contribut_6.html

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traffic trial said...

great graph for 2010 forecast

enjoy your day

Matt Johnson said...

it seems you're using gdp's growth rate rather than the output gap-i don't think that's how the fed see's it. if you follow sf fed refscnider's method, optimal is still around -5

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http://thegreatloanblog.com/

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Anonymous said...

Even if the Taylor rule suggests that the Fed should increase the policy rate, doing so could be a mistake. Japan used to tighten policy whenever they saw a mild improvement, and the result is the beginning of their third 'lost decade'. I see the rate being close to 0 for most of 2010, unless Bernanke is not reconfirmed, and Obama appoints a very hawkish governor (unlikely)

Gokul

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mannfm11 said...

Friedman was wrong