January 2008 Archives

GDP increased by a paltry 0.6% in the 4th quarter of 2007 according to the Bureau of Economic Analysis. But there are reasons to be guardedly optimistic. First, real final sales were up 1.9%. Residential investment may be in the tank but households continue to consume at a steady pace. Obviously the major reasons for the low GDP number were the decline in residential investment and the decline in inventories. The decline in inventories, however, is not all bad. This means that producers may have already been slowing production on the expectation of falling demand. If there are further drops in demand, the adjustment may be smaller and smoother. If a drop in consumption doesn't materialize, production will need to increase to build up the inventories again.

James Hamilton's take on the inventory picture is similar. King Banaian at SCSU Scholars is less optimistic. He notes that the inventory/sales ratio has been in decline for some time and that if this was planned that it doesn't imply a turnaround in the current quarter.

Perhaps not. Perhaps the support provided by the consumer will weaken (but that's what the stimulus is for, right?). This report doesn't give us those kind of answers. We now await the employment report, which, according to some, might be better than you think.

As always, let's lead off with the statement itself. From the Federal Reserve website (which was noticeably slow due to heavy traffic around the time the statement came out):

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.

I expected that if it turned out to be 50 basis points that someone might have preferred 25. To see Fisher vote for no change at all was a moderate (but not a complete) surprise. The lackluster GDP report probably didn't swing the committee one way or the other, but it does give them a little bit of room to say that these significant cuts are warranted in the face of an obviously slowing economy.

Notably there is nothing in this statement to suggest that they are done anytime soon. There is one token reference to inflation that is now almost boilerplate language. They lead off with a statement about "stress" in the financial markets, and I think that choice of word is very appropriate. It is no secret anymore that these measures are meant to head off any possibility that the financial markets would seize up and accelerate the downturn. They are taking the stand that it is more important to mitigate that risk than to doggedly pursue continued inflation reduction. They are betting that when the risk passes that they can remove this accommodation (faster than in '04-'05, I would both hope and expect) with little long term inflationary consequence.

At least it looks like that's the plan. I expect another cut at the next meeting, or possibly between meetings if there is significant "stress" in the financial markets. Size to be determined later. Some call it the "Bernanke put". But the article to which I link explains the nuances:

"It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions," [Bernanke] told a central bank gathering in Jackson Hole, Wyoming.

"But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy," he added.

The Fed's job is harder these days. In the old days they just worried about walking the tightrope between inflation and recession. Today, that problem still exists, but they must also worry about protecting the broader economy from the consequences of bad decisions in financial markets while still allowing those responsible for the bad decisions to get their comeuppance. In the end, the latter may actually be the more difficult problem.

From the Wall St. Journal Real Time Economics Blog comes this comment from Mark Gertler,

Now why did the Fed have to move on Tuesday — why not wait until the next FOMC meeting? To date, the Fed has done a good job of separating the explicit timing of funds rate cuts from stock price declines (e.g. witness last August). However, given the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy. The Fed action offset this potentially disruptive chain of events. Of course, we can’t do the counterfactual of examining what would have happened had the Fed done nothing (just as we can’t for the intervention last August). But many would agree that a real disaster might have ensued.

Read the whole thing. Gertler has a point. And so here we are at the beginning of a two day FOMC meeting waiting to see if there will be another cut tomorrow and how much it will be. The market seems torn between 25 and 50 basis points. 25 seem the most reasonable (though not necessarily the most likely) to me at the moment, but I certainly wouldn't rule out 50.

Much ink has been spilled and many pixels have been lit up over the 75 basis point move last week. Like you, I've been thinking a lot about it, but I have been reserving judgment. I have to admit that the timing of the move was a surprise. In the days leading up to the cut, I had been leaning towards a 50 to 75 basis point move at this week's meeting, but if I had been in the chair I would have wanted to avoid pulling the trigger right before a scheduled meeting. No doubt Mr. Bernanke would have wanted to avoid it too, if we were in a perfect world. So as an outside observer, I have to believe that Mr. Bernanke's main concern at that moment last week was the potential for a financial shock that would have immediate and long lasting impact on the real economy--a financial accelerator, to use the term that he used this summer. Real Time Economics also pointed this out at the end of last week.

So if the move last week was a calculated effort to cushion the financial markets to prevent such a shock, it may have worked, at least temporarily. The problem, and Mr. Bernanke no doubt knows this all too well, is that he spent a good bit of his ammunition on this one. The odds that there will be another in the near future are probably better than 2 to 1. I don't know many people who think that all the ugly surprises have been revealed. Even if the economy can technically avoid a recession (which it still may), we're still in for a bit of a bumpy ride. Another intermeeting cut in '08 is not out of the question.

And while I have tended to the hawkish side throughout the last couple of years, I agree with the general easing of monetary policy in recent weeks. It's a policy of containment. But I would also like to see rates go up more quickly (no more measured pace) when the current troubles have subsided.

I don't see last week's move as a case of "propping up" the market except to the extent that it may have bought the market some time to work things out. If you buy into the financial accelerator theory, that's not necessarily a bad thing. What remains to be seen is how well the Fed can transition back to a more balanced (i.e. more concerned about inflation) policy stance. I'm not 100% optimistic. I worry that the markets will get addicted to the rate cuts just as voters get addicted to fiscal stimulus. There's a Kydland and Prescott result lurking around here somewhere and I'm not sure it has a happy ending.

But this week, those concerns are pushed to the back burner, for better or for worse. While I agree with Gertler in the context of the near term concerns, I just wish that this policy stance didn't have the lasting ramifications that I fear it does. I hope that the Fed did not choose the lesser of two evils only to wind up with both. Only time will tell.

If you crave an "inside baseball" sort of look at the financial markets, you'll probably enjoy Across the Curve. The blog is authored by John Jansen. His bio lists him as a 30 year veteran of the bond market. I like what I see so far.

This is the largest rate cut in the modern era in which rate changes have been publicly announced. In fact, it's the largest cut going at least as far back as 1990. (UPDATE: This link says that it is the largest cut since October 1984.) Here is the full announcement. I'll be in class most of the day, but occasionally checking to see how the markets are doing.

The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin.

In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

Today we commemorate Dr. Martin Luther King Jr. Of all of his writings, his "Letter from Birmingham Jail" is probably one of the most widely read. It was required reading when I was in college. Is it still?

I considered appending this to the last post as an update, but decided it was already long enough. This will be brief.

Tomorrow's NY Times has an article on the disagreement among economists about how best to implement fiscal stimulus. The usual arguments against it have been hashed out already. But here's a defense of timely stimulus from John Taylor.

Stimulus packages of the less recent past are often cited as examples of how not to make policy. Economists say that in the recession of the mid-1970s, spending and tax cut measures were enacted too slowly, having an effect only after the economy had already picked up. In 1992 and 1993, partisan squabbling derailed plans for a stimulus package as the recession came and went.

The measures seven years ago sent a different lesson, according to John B. Taylor, a professor of economics at Stanford and a former Treasury official under Mr. Bush. “People look back at 2001 and are more positive about this kind of approach,” he added.

Taylor's point, which is present in his textbook and which he reiterated in a Bloomberg podcast with Tom Keene, is that timing is everything. However, in the podcast, Taylor reminds us that the 2001 rebate was actually an advance payment on the cut in tax rates (that are set to expire soon). In that way it was different from what is being proposed now.

In my opinion, that is a pretty big difference, and leads me to the view that the rebates being proposed now will be less effective than those in 2001.

Listen to the podcast with Taylor. He has some interesting comments on monetary policy as well. "Bloomberg On the Economy" is a good thing to have on in the background while you're blogging.

It did not take long for the stimulus/rebate discussion to take on a life of its own. Why it was just earlier this week that the presidential candidates were telling us how they would stimulate the economy. As if any of this would be timely or meaningful by the time they take office. As if green collar job programs are the way to help avoid recession. Well, the current president got the message and looks like he is going to try to steal at least a little bit of their thunder. Mr. Obama will have to either come up with something new or claim victory in that the president is proposing something similar to what he suggested.

Enter Mr. Bush... (NY Times)

WASHINGTON — President Bush called on Friday for about $145 billion worth of tax rebates for American families and incentives for businesses to provide “a shot in the arm to keep a fundamentally strong economy healthy” and avert a slide into recession.

The president said the package “must be big enough to make a difference” in an economy as large as that of the United States, meaning it should be worth about 1 percent of the gross domestic product, putting it at $140 billion to $150 billion, Treasury Secretary Henry M. Paulson Jr. said later.

“This growth package must be temporary and take effect right away,” Mr. Bush said. The president said Mr. Paulson would work with Congressional leaders to get a bipartisan relief package ready as soon as possible.

As soon as possible could be really soon. Over at CNN/Money the sub-headline was "Lawmakers are still working out final details on cutting checks to all Americans to fight recession." We're already on the final details? Considering how long it usually takes to get things done in congress, that is fast. Almost frighteningly fast. Back in the NY Times article, they quote Senator Reid,

The Senate majority leader, Harry Reid of Nevada, was low key and cautious in his initial reaction. “I am encouraged and share the president’s view that we need prompt bipartisan action to strengthen our economy,” he said. “I also agree that our focus must be on finding temporary measures that will do the job effectively. I look forward to working with the president to implement responsible solutions that revive our economy for the benefit of all Americans.”

Reid's "initial reaction" as lawmakers work out the "final details"? Like I said, this took on a life of its own this week. So can we quantify how fast this is rolling ahead? Apparently so. Back to CNN/Money:

On Friday afternoon, House Financial Services Chairman Barney Frank (D-Mass.) told CNN he believed lawmakers could pass a stimulus package, including a rebate, by March 1.

And that means money in your pocket by summertime.

But I ask again, as I asked the other day, is this this the way to go?

I'll stop short of calling it a 100% unmitigated bad thing. Sure, we all know that the link between the rebates and increased spending is tenuous. Shapiro and Slemrod find that only about 22% of households would spend the rebate (link via Angus at Kids Prefer Cheese). So the stimulus part is a little dubious. King Banaian repeats the skepticism he voiced the other day. Bill Thomas and Alex Brill express their displeasure with all the stimulus talk in this Wall Street Journal commentary. The Journal's editorial page also questions the need with a swipe at Nixon's famous line, "We're all Keynesians now." Andrew Samwick just calls it deficit spending. Everyone seems to be piling on, and it's hard to blame them. Still, in defense of the rebates, it's probably faster and, if targeted at low and middle income households, more effective than many other forms of fiscal stimulus.

Yet it's far from clear that fiscal stimulus is what is necessary to fight whatever recession, downturn, slowdown, or whatever you want to call it may be on the horizon. My main concern which I don't think I've seen mentioned elsewhere in the econ-blogosphere (but correct me if I'm wrong) is that politicians might become addicted to these rebate checks. There are all sorts of political games that can be played with them. The president doesn't have to worry about getting re-elected, but clearly the rebates could give him a small victory on the way out. Congress, however, is up for re-election in November, and wouldn't it be nice to be able to go back to their constituents after Labor Day and tell everyone how they are responsible for those checks. Not that the American voters can be bought, of course.

So despite the protests from many quarters, I'd say that the rebate checks (in some form) are just about a sure thing. Shapiro and Slemrod will have a chance at a sequel.

UPDATE: Bruce Bartlett pulls no punches.

I received a link to this article via a listserv on teaching economics. It's a sobering look at the effects of bread subsidies in Egypt. Here's a sample:

“The most corrupt sector in the country is the provisions sector,” said a government inspector who asked not to be identified for fear of punishment. His job is to go to bakeries to ensure they are actually using the cheap government flour to produce cheap bread that is sold at the proper price.

The inspector explained why the system was so open to abuse. The government sells bakeries 25-pound bags of flour for 8 Egyptian pounds, the equivalent of about $1.50. The bakeries are then supposed to sell the flatbread at the subsidized rate, which gives them a profit of about $10 from each sack. Or the baker can simply sell the flour on the black market for $15 a bag.

Read the whole thing.

A lot of it you know already, but some of it you probably don't. Go, read, and enjoy.

Hat tip to Marginal Revolution.

Hat tip to Greg Mankiw. The article is from the Telegraph (UK). Here's the opener:

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

One thing is certain. The first sentence is right on the money.

Probably not.

But consider the following. Brad DeLong writes:

Bear in mind that I don't yet believe that the case for a fiscal stimulus is strong--although I may change my mind in a month or two, depending on how the data flow looks. The principal organization for successful stabilization policy is the Federal Reserve. Congress and the president have a role to play only in two situations: first, if monetary policy has shot its bolt and cannot do anything more--and we are far from that point--and second, if the Federal Reserve has been caught flat-footed in the wrong policy position, unemployment is rising rapidly, and it is important to get cash quickly into the hands of people who will spend it and so keep the rise in unemployment from being as large. We are not there yet--at least I don't think so--but we may be there in three months.

From this perspective Obama's plan looks pretty good:

Obama stimulus package emphasizes quick cash in hand: a $250 tax credit to 150 million workers to offset the payroll tax paid on the first $8,100 of earnings. He urged a further $250 tax credit per worker if employment declines three months in a row. He also would give a one-time, $250 payment to Social Security recipients who would not benefit from the tax credit, followed by another $250 payment if employment declines three months straight. The immediate relief would cost $45 billion, plus another $45 billion if the economy weakened...

...

John Edwards's and Hillary Rodham Clinton's plans look, to me, likely to be less effective. Consider Hillary Rodham Clinton's:

Talking Points Memo | Clinton offers economic stimulus plan: a $30 billion housing crisis fund to help states and localities deal with the fallout of foreclosures... ease the effects of vacant properties with anti-blight programs and helping local housing authorities buy and rent out vacant properties. Setting a 90-day moratorium on subprime mortgages of at least five years, or until housing lenders have converted mortgages into loans families can afford. The proposal also would increase the portfolio caps at Fannie Mae and Freddie Mac. Providing $25 billion in emergency energy assistance for families facing rising heating bills.... Providing $10 billion to extend unemployment insurance for those struggling to find work while supporting families. Providing $5 billion in energy efficiency by doing such things as giving tax credits to encourage purchases of low emission vehicles and efficient appliances windows and other clean technologies. She also proposes funds to train and put to work people making public buildings more energy efficient...

These are all worthy causes--things that the government should be spending more money on. But this is not a bill that can be passed quickly--the housing provisions, at least, are one of those things where the devil is in the details of the drafting and where quick, clean passage and implementation is almost impossible. Funds to train and put to work people making public buildings more energy efficient--well, those aren't timely. The proposal is not Obama's: we are going to stimulate demand by cutting a lot of identical checks via a refundable tax credit--a thing that the government can do well and quickly....

...

John Edwards and Hillary Rodham Clinton and their staffs--they don't seem to have grasped that governance is best when you ask congress to do things that are within its competence, and ask the administrative branch to do things that are within its competence. They might respond that these stimulus packages are political rather than policy documents--acts of campaigning rather than acts of governance--and they are right, up to a point.

And so my question: Is a rebate check the quickest and most effective fiscal stimulus? It would seem that there is an argument to be made that it is better than many other alternatives. This document from the CBO circulating through the blogosphere gives rebate checks a mixed review. Their report gives the best rating to extensions of unemployment insurance and increasing food stamp benefits. King Banaian is skeptical given that long term unemployment doesn't seem to be our biggest problem. I concur. If indeed we are turning toward recession, then I'd fire the first salvo from the monetary cannon rather than the fiscal one.

There are other problems with the idea of rebates as stimulus. Unless they are coupled with long term tax reductions there is a risk that they will be nothing more than an illustration of the permanent income hypothesis at work. It is unclear that the money would be spent, especially if the rebates are broad-based rather than targeted--and the broad-based ones are the most efficient put into play.

That said, the more complex proposals of Clinton and Edwards would certainly take longer to get through congress. And that's going to be the biggest problem of all.

Menzie Chinn has much more at Econbrowser.

There will be a lot more discussion of this in the next few weeks, but here's a start. From the NY Times:

Senator Hillary Rodham Clinton of New York has proposed $70 billion in emergency spending programs, with an additional $40 billion in tax rebates if the economy worsens. Senator Barack Obama of Illinois has a $75 billion plan based largely on immediate tax rebates of $250 to most workers to encourage consumer spending.

...

The Republican presidential candidates have been more skeptical about short-term stimulus measures than President Bush has been. Mr. Bush signaled last week that he would propose a package of measures, probably dominated by tax cuts, in his State of the Union address on Jan. 28.

The debate among candidates about stimulus measures is largely academic, because economic conditions are almost sure to be entirely different by the time a new president takes office a little more than a year from now.

You would be seeing those rebate checks in the summer of 2009 at the earliest, just like we got Bush's rebate checks in the summer of 2001. Depending on how things go this year, the timing might not be as fortuitous. I would be interested in hearing what my readers think about various plans floated by the candidates.

Well folks, I am back in the saddle. It has been the semester break and so I've had a lot of other things to keep me busy. Not to mention the fact that for the past week I have been fighting a nasty cold/cough/sore throat and haven't felt much like doing anything except trying to heal up before the first day of class.

Plus, with politics on the brain there hasn't been a lot to get worked up about except the daily changing prospects for recession. That may change as the candidates propose various economic stimulus packages. I predict there will be much to say on that in the weeks ahead. As for the prospect for recession, it does seem that there are some parallels with the early presidential campaign of 2000 when everyone knew the economy was slowing, including the candidates, but the data wasn't showing it yet. It almost seemed as if all the talk about recession during the campaign made people even more concerned. Will that happen again and will the consequences be worse? Those are interesting questions that I think we might be addressing in 2008.

And China's inflation seems to be getting worse. Faster revaluation might be coming sooner than you thought. More on that later.

But of course, the item of immediate interest is mentioned in the Real Time Economics blog today:

Federal Reserve Chairman Ben Bernanke, responding to criticism that the central bank has sent confusing messages about interest rates in recent months, has decided to speak more forcefully and more often about the outlook for the nation’s economy.

The Fed’s new communications strategy comes after five months in which Wall Street analysts, academics and some former Fed officials have blasted the central bank for repeatedly implying it wouldn’t cut rates further, and then doing just that, and for sending other contradictory signals. Some Fed insiders shared those concerns.

Either Mr. Bernanke or Fed Vice Chairman Donald Kohn are likely to address the economic outlook in public at least once between policy meetings as long as the economic outlook remains unsettled. The idea is to help the market identify the Fed’s central view without relying solely on comments from lower-ranking members of the Federal Open Market Committee, the group of Fed governors and regional bank presidents that sets the target for short-term interest rates.

That would certainly be interesting. After thinking about this off and on for a while now, I've come to the conclusion that Mr. Bernanke's biggest mistake so far has not been underestimating how much the financial markets would depend on his comments, but underestimating how certain the markets would be about their interpretations. That's where the communication process seemed to break down. The analogy would be between the size of a coefficient and its standard error. It's as if sometimes the chairman's speeches were trotting out a coefficient for the markets and they ran with it only to find afterwards that the confidence interval was pretty wide. Presumably the more the chair (and vice-chair) speak to the markets the smaller the confidence interval becomes.

All through the autumn, my expectations had to remain pretty fluid. There were a lot of times when after reading the speeches and the data that I had to say that I couldn't predict with any certainty what might happen two or three weeks ahead. But the markets found that situation undesirable. Obviously they wanted more aggressive cuts. To an extent they may have helped prod the Fed in that direction. It was as if the market was saying, "We don't care about your uncertainty as long as your central tendency is leading you in this direction." Mr. Bernanke probably underestimated the trouble that would cause. I think that would be among the more easy mistakes to make, and one that has been made throughout history in other situations. A lot of the time you don't want to tip your hand to show what you don't know.

But central banking should probably take a more enlightened approach then clamming up. Instead, it may be beneficial to talk more frequently about what we do know, what has changed, and how to interpret the change. Now while I don't think that this new strategy will lead Mr. Bernanke or Mr. Kohn to talk in terms of percentages or odds. I do think it might be helpful if they would use the opportunity their new soap box will give them to talk specifically about how they interpret the latest data.

And while the last few months have been a little too exciting for the tastes of some market participants, I don't think this has been all bad. A time traveler from 1979 would look at the events of 2007 with awe concerning how well the markets aggregate information and expectations. It is a new and changing environment for central banks, and transparency clearly has some kinks to be worked out. Communication needs to be stronger about what we do know and perhaps dwell less on the uncertainty. I wouldn't argue with the proposition that the Fed needs to maintain an image of decisiveness--an image which it lost somewhat in 2007 through circumstances not entirely of their own fault. But I would take the current Fed/market relationship over the previous era where everything happened behind the curtain. Let's see how this new communication strategy works out.

Oh, and at the moment I'm torn between predicting 50 or 75 basis points for the next meeting. But I've got a gut feeling about which way the market is going to try to take it in the next few days.

Ok. I just applied the law of iterated expectations. I'm better now.