Tag Archives: Bernanke

The Bernanke Speech

Bernanke gave a speech at the AEA meetings defending the actions of the Federal Reserve in the early part of the decade. Scott Sumner makes a keen observation:

Bernanke’s explanation for the Fed’s actions in 2002 show exactly how monetary policy failed in 2008. In particular, Bernanke made the following three observations regarding 2002:

1. Monetary policy needs to focus on the macroeconomy, not specific sectors.

2. Monetary policy must be forward-looking, must target the forecast.

3. Monetary policy must be especially aggressive when there is risk of liquidity trap (which would render conventional policy ineffective.)

In 2008 the Fed did exactly the opposite. Between September and December 2008 the Fed focused on banking, not the macroeconomy, they adopted a backward-looking Taylor Rule, and they were extremely passive when the threat of a liquidity trap was already obvious.

BTW, the quote of the day comes from Sumner’s post as well:

Unlike [Arnold] Kling, the stock market does believe monetary policy has a near-term impact on the economy.

UPDATE: David Beckworth on why we should doubt the claims put forth in the speech.

Should We Fear Rising Bond Yields?

There seems to be some concern as to the rising yields on long-term bonds. Our friend Jimmy P. (now of Reuters) quotes Scott Grannis, who writes:

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an to keep their yields low is a self-defeating strategy … Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world’s demand to own bonds, and yields will rise. … So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise.

This presents two interesting questions:

1. Is the Fed trying to lower long-term rates?

2. Are rising long-term rates a bad thing?

I think that the answer to (1) is ‘no’. Counter to what seems to be the conventional wisdom, I believe that the Fed is buying long-term bonds because because short-term bonds and cash having largely been near perfect substitutes for quite some time. Thus replacing an asset that banks are gladly holding at near zero yield for an asset that earns zero yield isn’t likely to create the proper incentive to expand the money supply and stimulate economic activity. Buying the longer term debt, on the other hand, serves the purpose of creating the incentive to replace said debt with something that earns a return, thereby promoting lending and monetary expansion. What’s more this monetary expansion, if successful (or, more appropriately, credible) will begin to create an increase in inflation expectations, reduce the real interest, and therefore create demand for investment.

This latter point brings us to question number 2.

I similarly think that the answer to (2) is ‘no’ as well (or at least ‘not yet’). The creation of inflation expectations will temporarily lower the real interest rate, but as these expectations become more widespread the nominal interest rates will start to creep up. The recent increase in nominal rates is seen by some (including Scott Grannis, above) to be a sign that investors are worried about inflation. I am not convinced that this is the case for two reasons.

First, the nominal rates on bonds have been at historically low levels for some time. These low rates are largely the result of expectations of deflation and, more importantly, the flight to quality. Given this diagnosis, it is not surprising that these longer term bond yields have started to rise. Indeed, Martin Wolf (HT: David Beckworth) notes:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone.

The most important point to take away from this is that inflation expectations are in line with rates in which the Federal Reserve is quite comfortable. Thus, I am not trying to argue that rising inflation expectations have played no role in the rising bond yields, but rather than these increases are the result of a return to normal conditions (hence my reason for offering the qualification ‘not yet’).

The second reason that I remain unconcerned about the rising yields is that the phenomenon is not unique to the United States. One of the main points underlying the inflation expectation concerns is that the Federal Reserve will monetize some of the growing debt (or similarly about the risk of default). However, if increases in bond yields were the result of the growing budget deficit and debt, then one would expect to see such increases in the United States, but not countries with relatively small deficits. With that being said, Stephen Gordon’s recent comparison of the yields on Canadian and U.S. bonds throws a wet blanket on this hypothesis. He notes:

As we all know, Canada’s deficit and debt picture resembles in no way that of the US. But a US recovery is a sufficient (although perhaps not necessary) condition for a Canadian recovery.

If investors were suddenly concerned about default, it’s hard to see why Canadian bond yields should be affected in the same way that US yields would be. But if investors are anticipating a US recovery that would spill over to Canada, then we would expect long-term interest rates in both countries to increase.

Thus, like Gordon, I would argue that the rising yields are a good thing as they seem to indicate a return to normalcy rather than runaway inflation expectations. This is also a sign that the Fed’s policy of quantitative easing is working (at least in terms of what I believe to be the Fed’s goals).

Bernanke pushes the accelerator

From the FOMC statement:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of evolving financial and economic developments.

[Emphasis added.]

Treasury Announces Plan to Back Fannie and Freddie

The WSJ reports:

The U.S. Treasury and Federal Reserve, capping a weekend of high-stakes maneuvering, attempted to shore up confidence in Fannie Mae and Freddie Mac by announcing a plan that placed the federal government firmly behind the battered mortgage giants.

In a statement timed to precede the opening of Asian markets Monday, as well as a closely watched auction of debt by Freddie, the Treasury said it plans to seek approval from Congress for a temporary increase in a longstanding Treasury line of credit for the two companies.

The Treasury also said it would seek temporary authority so that it could buy equity in either company “if needed” to ensure they have “sufficient capital to continue to serve their mission” of providing a steady flow of money into home mortgages. The plan, which requires congressional approval, also calls for a provision to give the Federal Reserve a “consultative role” in the process of setting capital requirements and other “prudential standards” for Fannie and Freddie.

The Fed’s Board of Governors met Sunday in Washington and voted to grant the New York Fed authority to lend to Fannie Mae and Freddie Mac “should such lending prove necessary,” the central bank said in a statement. The move would effectively give the two companies access to the Fed’s discount window if necessary, providing a backstop in case the firms were to face a short-term funding crisis down the road.

Officials are hoping that, by promising bold action if needed, they can instill enough confidence in the battered companies that such intervention will ultimately prove unnecessary.

Meanwhile, James Hamilton has written an excellent post on how we got to this point.

The Fed Meeting, Redux

Perhaps we should offer Ben Bernanke a do-over. On Wednesday the FOMC decided to hold interest rates steady despite the fact that global inflationary pressures are heating up. The statement released by the Fed hinted that they may raise rates in the future, but simultaneously talked of the weakening labor market and the perils of the credit markets. In doing so, the statement sent shivers down the spines of both those who are worried about inflation and those who are worried about rate hikes.

As an inflation hawk, I have been a bit careless with my recommendations to raise interest rates and I have not sufficiently answered those who are concerned with unemployment and the fragility of the economy. Thus, allow me to elaborate.

In a recent Bloomberg interview, Nobel laureate Ned Phelps wondered aloud whether or not the Fed understands anything about modern monetary policy. What Phelps was communicating is the fact that the Federal Reserve seems unable to distinguish between transitory changes in unemployment and those driven by structural changes in the economy. As Phelps rightly pointed out, the collapse of housing boom has created a restructuring within the economy. It is highly probable therefore that the natural rate of unemployment has risen. If so, any attempt by the Federal Reserve to combat rising unemployment with lower interest rates will prove to be futile. In light of such thinking, it is quite understandable that talk of rising unemployment in the FOMC statement was particularly troubling.

Worries about the credit markets are similarly overblown. So long as the Fed stands ready to serve as lender of last resort, a task they have admirably performed thus far, further crisis should remain averted even in the midst of higher interest rates.

Bernanke and the FOMC made a mistake by not raising interest rates on Wednesday (as indicated by the rising prices of gold, oil, and other commodities). The rise in unemployment is not temporary and therefore need not be of concern to the Fed. In the meantime, global inflation and inflationary expectations are on the rise. Let’s hope that the Fed doesn’t make the same mistake when August rolls around.

Preventing Deflation

In response to a question regarding the current credit crisis with the Great Depression, Ben Bernanke offered this:

“I believe the difference today is that, you know, that we will address financial issues and try to maintain the integrity and stability of our financial system. We will not let prices fall at 10% a year. We will act as needed to keep the economy growing and stable.”

Of course, the Fed actually caused the decline in prices during the depression.