Recently in Economics-Inflation Category

T.S. Eliot wrote that April is the cruelest month.  In the academic year, November shares some similarities with April in that it's when we start to come to grips with the fact that this semester will end... and soon.  For me, blogging seems to take a hit in November.  I'd tell you what's been keeping me busy, but it really is academic minutiae.  You'd be bored to tears.

November has been a cruel month for the markets as well, especially the last couple days.  Some days I turn on CNBC and literally see things that I never thought I'd see.  Watching the 30 year Treasury yield take a dive like it did yesterday would be one of those things.  Seeing Citi at less than $4 would be another.  Hearing perfectly reasonable people fret about the possibility of deflation would be still another.

How do you title a blog post these days without sounding like a doom-and-gloomer?  I feel like I want to choose my words very carefully to avoid making things seem worse than they are.  (I know how you feel, King!)  But when you hear speculations of a pretty sizeable drop in GDP in the 4th quarter and graphs showing this to be the worst stock market decline since the Great Depression, it's easy to get caught up in it.

So as I work my way back into the swing of things over this Thanksgiving break, let's just set the stage.

The auto bailout:  Not a good idea, but probably going to happen in some way, shape, or form.  At the rate that they're burning cash, I don't see what a bailout would reasonably hope to accomplish.  A fast track to a government assisted bankruptcy would probably be better in the long run.  I would support proposals to protect the pensions of workers, especially those near retirement because that represents a past promise that people took into account when making decisions. That's probably a good topic for a future post.  But this decline has been a long time coming, and trying to stop it is just going to add to the problems later.

Paulson's reversal:  I, for one, found that episode at least somewhat refreshing.  Some say that he realized that $700 billion would not be nearly enough.  Perhaps.  But if that's the case, I'd rather he stopped at the brink of the canyon like he did rather than jumping in and then telling us.  Yes, we could use some more transparency in seeing where the money has gone so far.  But most importantly, the fact that they're holding back some of that money means that at least one agency is doing something to keep its powder dry.  Which brings us to...

What will the Fed do in December?   That's what my macro classes are working on figuring out.  After Thanksgiving, I'll be discussing Poole's 1970 QJE paper with my grad students.  I guess that will be as good a time as any to bring up this development: (Bloomberg)

``There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,'' said former St. Louis Fed President William Poole, now a senior fellow at Cato. ``Monetary policy works best when the markets understand what the central bank is doing.''

Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.

``It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,'' said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

Hat tip to Calculated Risk.

Indeed, when you see things like this, it makes you wonder what is going on.  I'm going to be thinking about that a lot this week during the break from classes.

So what about deflation?  I'm not in the camp that thinks it's a big problem yet.  It becomes a real problem if wage declines make it even more difficult for people to make their mortgage payments or if price declines are so widespread and expected that people hold off spending now as they expect prices to go down further.  I don't see us getting there yet, but I stand ready to revise my expectations as new data arrives.

And finally stock market:  I'm just as caught up in it as you are.  My explanations are no better than anyone else's.  It does appear that we're on the verge of something with Citi, and people are getting worried about commercial real estate.  Those make for some strong headwinds. 

As I go around town I hear comments both positive and negative.  Everyone complains about their 401(k)s, but local businesses are hiring.  I do think that we're in a recession as we would define one nationally.  However, the impact is going to be very different for various regions and economic sectors.  It's difficult to fight recessions like this because it becomes more tempting to try to target policies at one area or another, and that's not always good or successful.

But it does give us things to talk about.

FOMC press release:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 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, Cleveland, and San Francisco.

There are some new features in the exact wording, such as "the Committee expects inflation to moderate in coming quarters to levels consistent with price stability".  Seems like only six weeks ago that they expected "inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."

Readers wondering about why coordination among central bankers matters (as in today's coordinated rate cut) may benefit from this old post from 2006.  The subject is a NY Times piece by Hal Varian.

I've been in class all day, so I haven't had a chance to write about the days events.  Actually, there's not that much more to say other than that I really admire the fact that the Fed held the line on interest rates today.  As I said yesterday, the crisis is one of quantity, not of price.  The new lending facilities are much more important and useful than a 25 basis point cut in the funds rate.  So my confidence has been buoyed by this news.

Here's the link to the Fed's press release.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

My quick take is that it is very noncommittal about whether any rate cuts are forthcoming.  The inflation pressure still figures prominently in the press release, though they do expect inflation to ease.  This is an announcement that leaves all avenues open--and that is a very good thing.

In my intermediate macro class today, I lectured against a backdrop of the live (well, actually slightly delayed) tick-by-tick chart of the fed funds futures on the CBOT.  I was teaching macroeconomics as it happened.  You don't get to do that very often.

The Fed posted their minutes from the last FOMC meeting today. Check out the charts at the back that show the shift in the forecasts of the participants on variables such as GDP and inflation going out to 2010. There has been a noticeable shift since January. However, it does appear that the last meeting will be the last rate cut for a while. The Wall Street Journal's Brian Blackstone has a good summary of the minutes.

See also Donald Kohn's speech from yesterday.

Janet Yellen is on the lecture circuit. (Reuters)

"The 1970s were a horrible period. If there's one thing that has to be very high priority, we don't want to go back to a period that is anything like that," she said, critiquing presentations on the economy at a symposium for college students in Tacoma, Washington.

She is, of course, talking about inflation (not bell-bottoms or disco).

"During the 1970s the Fed failed to keep inflation low in the face of supply shocks (which) became incorporated into inflation expectations," Yellen said.

She acknowledges, as I think most of us do, that this is not a simple problem with a simple answer. She's worried about the prospects of lower growth as well. But the fact that she, as one of the more dove-ish members of the committee, is talking about inflation risks is a sign that the tide may have turned.

In my intermediate macroeconomics course, the final project is a simulation of an FOMC meeting where members of the class play the roles of Fed officials. They did exceptionally well. The presentations and discussion were excellent.

My class voted 9 to 7 to cut by another quarter point. (The 7 wanting to hold rates steady)

As far as I can remember, my class has never been wrong, and also as far as I can remember, when the class predicts dissent, there usually, if not always, is (though never as much in the real vote).

It's an unscientific indicator, to be sure. But it is very rewarding to see the students take it so seriously and really learn about how the Fed works.

The real meeting, of course, is tomorrow. More on that later.

I'm in the middle of a few things that are keeping me from blogging an extended analysis of the Fed's recent actions. But I did come across something today that will interest my readers. The WSJ Real Time Economics Blog opens a post with this:

Back in 2003, when the Federal Reserve cut interest rates to 1%, the world worried that the Fed was running out of ammunition and would soon have to turn to unconventional tools.

Now, in 2008, it’s worth asking if the Fed could run out of unconventional ammunition. Tuesday’s offer to lend $200 billion of its Treasury holdings to primary dealers in return for mortgage-backed securities both guaranteed by the government-sponsored enterprises (Fannie Mae and Freddie Mac) and not (private-label MBS) means it will have eventually sold or pledged half of its Treasurys, limiting how many more of these tricks it can pull off.

My first thought when I heard about this innovative move the Fed was that it would take the pressure off for a few days--maybe a week or two. And what then?

Meanwhile, on the other side of the Pacific...

From Reuters:

BEIJING (Reuters) - China's high January and February readings for inflation have increased the pressure on the government to take action to counter price rises, Commerce Minister Chen Deming said on Wednesday.

Annual consumer inflation jumped to 8.7 percent in February after hitting 7.1 percent in January, the worst in more than 11 years.

Here's a link to the new PDF version of the Beige Book. Here's the old html version.

The Wall Street Journal headline is "Beige Book Hints at Stagflation Amid Slow Growth, Prices Pressures"

I'm heading out the door, but I know what I'll be reading tonight.

... is from the Wall Street Journal's Greg Ip. In today's piece, "For the Fed, a Recession -- Not Inflation -- Poses Greater Threat", he writes:

So why is the Fed more worried about growth than inflation? First, it thinks run-ups in commodity prices explain the increases, not only in overall inflation but also in core inflation: higher energy costs have "passed through" to other goods and services. Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

...

For the current high inflation rates to become permanent, the Fed believes it has to become embedded in how workers and businesses set wages and prices. So far, surveys suggest consumers haven't raised their expectations of inflation much. In last year's fourth quarter, hourly wages and benefits were up just 3% from a year earlier, a slowdown from 2006, even though unemployment was below 5% for almost all that period. A wage-price spiral requires wages to cooperate.

Wages are even less likely to accelerate if unemployment, now 4.9%, rises to 5.25% this year and falls only gradually to 5% by 2010, as the Fed's Federal Open Market Committee forecasts. That implies three years with the unemployment rate above the FOMC's estimated "natural" rate of about 4.9%, and thus steady downward pressure on inflation.

The notion that higher unemployment reduces inflation has its skeptics, even at the Fed. "All you have to do is recall the 1970s, when we experienced both high unemployment and high inflation, to appreciate that slow economic growth and lower inflation don't necessarily go hand in hand," Federal Reserve Bank of Philadelphia President Charles Plosser said last month.

I must say that I get a little nervous about pinning my hopes for inflation reduction on a forecast that unemployment will be a couple tenths of a percent over the supposed "natural" rate. Even if you believe in some kind of an expectations augmented Phillips curve, you have to wonder about what has been happening in recent weeks. The genie may not be out of the bottle yet, but it's beginning to look like someone popped the cork.

Ip continues,

Critics say the Fed also took too long to reverse the ultralow rates of 2001-2003, thereby fueling the housing bubble -- if not rampant inflation -- whose collapse now threatens the economy. Federal Reserve Bank of St. Louis President William Poole became one of the first people who participated in that decision to repudiate it. "With the benefit of hindsight...it is not hard to argue that the [Fed] was too slow to raise the federal-funds target after taking the target down to 1% in 2003," he said at a conference on Friday.

Even Fed officials who don't share that view agree that both that episode and the 1970s experience argue for promptly reversing rate cuts once the current crisis passes.

That's easier said than done. The Fed is unlikely to face an outlook so unambiguously positive anytime soon that such a reversal will be a slam-dunk, and during an election year, it will face intense political pressure not to raise rates.

Whether the Fed reverses course "on an appropriate schedule" will be clear in five years or so, Mr. Poole said.

This is not the first place I've seen this sentiment (of rate hikes as soon as this crisis passes) expressed recently. That makes me think that there is a concerted effort to manage expectations here. At this point, I'd say the most likely time for the Fed to want to begin tightening again (barring any unforeseen developments) will probably be very close to election time. It will be a tough sell. Better start paving the way soon.

And Poole's final comment is very much on the money.

The news isn't good. The PPI is on the rise. (MSNBC)

WASHINGTON - Battered by bad economic news, consumer confidence plunged while wholesale food, energy and medicine costs soared, pushing inflation up at the fastest pace in a quarter century.

The Labor Department said Tuesday that wholesale inflation jumped by 1 percent in January, more than double the increase that analysts had been expecting.

The next paragraph isn't about inflation, but isn't great either...

Meanwhile, the New York-based Conference Board reported that its confidence index fell to 75.0 in February, down from a revised January reading of 87.3. The drop was far below the 83 reading that analysts had forecast and put the index at its lowest level since February 2003, a period that reflected anxiety in the lead up to the Iraq war.

And on another note, I was revising my homework solutions for my principles of macro course this semester. I always ask students to find the most recent rate of inflation by the CPI (12 month % change). Last semester, the answer was 2.0% at the time I asked the question. The answer now? 4.4%. (4.3% not seasonally adjusted)

Uh oh.

The Real Time Economics Blog conducts a Q&A with the president of the Philadelphia Fed. Among other things, Plosser says,

It’s a mistake to rely on the slowdown for much disinflationary effect.

However, he was in agreement with the recent 25 basis point cut, given the changes in the economy since October. Read the whole thing. A short article is also in the Journal.

Also in the Wall Street Journal today is a piece by Martin Feldstein. Here are some excerpts.

Further interest-rate cuts can reduce the risk of recession and increase output and employment in 2008 and 2009. The current 4.5% fed-funds rate is essentially neutral -- not low enough to stimulate growth and not high enough to reduce inflation. Although there are risks that the rise in oil prices and the falling dollar will raise the inflation rate, the greater potential damage of an economic downturn calls for a more stimulative policy. The Fed should reduce the fed-funds rate at its December meeting and continue cutting toward 3% in 2008, unless there is a clear sign of an economic improvement.

Because of current credit market conditions, there is a risk that interest rate cuts will not be as effective in stimulating the economy as they were in the past. The current credit crunch reflects not only a lack of liquidity, but also a lack of confidence in the creditworthiness of counterparties and in the accuracy of asset prices. This problem is now being compounded by the banks' loss of capital as they recognize past losses, and by their need to use large amounts of the remaining capital to support existing off-balance-sheet credits that have to be shifted to their balance sheets. All of this implies that lower interest rates may not raise lending and economic activity to the same extent that they did in the past.

The latter paragraph is a good follow up to Greg Ip's piece. In old fashioned Keynesian terms, what we've got here by this reckoning, is the basis for a liquidity trap. Later in the article, Feldstein adds the second part of his strategy.

What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level.

Enacting such a conditional stimulus would have two desirable effects. First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process.

You're probably familiar with the term "automatic stabilizers". Well this takes the concept to the next level. A tax cut conditional on economic data--that's an interesting suggestion. Unfortunately, the temporary nature of the cuts would tend to reduce their impact. Anyway, read on.

Even if the Fed decides that it should not cut rates further at the present time, it would not raise rates to offset the stimulus effect of the fiscal change. From the Fed's point of view, the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money.

Dust off your trusty old IS-LM model and let the fun begin.

Some reliance now on a fiscal stimulus rather than easier money would also take pressure off the exchange-rate adjustment. While further declines of the dollar are necessary to shrink the massive U.S. trade deficit, continued rapid declines might lead to counterproductive retaliatory actions by some of our trading partners.

Add a dash of Mundell-Fleming.

The excessive asset-price increases caused by some past monetary expansions -- especially the induced rise in the prices of real estate -- provide a further reason to use fiscal as well as monetary policy. By cutting the fed-funds rate to just 1% in 2003 and promising that it would be raised only slowly, the Fed contributed to the sharp rise in house prices and the market's current weakness. A mixed strategy that included a prospective fiscal stimulus would have reduced the Fed's perceived need for a sustained negative real fed-funds rate, and would therefore have produced a more balanced expansion of demand.

But didn't we cut taxes in 2001 and 2003? Yes, however those cuts were aimed in large measure at increasing long run growth--the success of which is a fair topic of debate. That's not to say that the short-run stimulative effect was nil. But the question is: would a temporary tax cut with a similar order of magnitude to the 2001 and 2003 cuts have any more stimulative effect? Or would people just save it?

Mark Thoma also mentions the permanent income hypothesis, but doesn't mention the 2001 and 2003 tax cuts. Interestingly, a lot of prominent economists opposed the 2003 tax cut because they thought it should be temporary (contrary to Thoma) in order to provide stimulus without threatening the long term budget outlook and that it should include a spending component (in agreement with Thoma).

I think temporary tax cuts won't work very well (in agreement with Thoma) and I have my doubts about temporary spending increases (more bridges to nowhere?), contrary to Thoma. So where does that leave us?

With a lower funds rate in 2008, that's where.

Chairman Bernanke spoke last night. Here's the full text. Here's the part that made everyone take notice.

With respect to household spending, the data received over the past month have been on the soft side. The Committee will have considerable additional information on consumer purchases and sentiment to digest before its next meeting. I expect household income and spending to continue to grow, but the combination of higher gas prices, the weak housing market, tighter credit conditions, and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

Ok, first of all, the Fed needs to upgrade its web server to handle the extra load if they are going to give us any more days like this. I think all the people checking in at 1:15 (Central) might have brought down the server. I'm getting nothing right now.

Here's the CNBC story. The link to the statement will have to wait until their server catches its breath.

UPDATE: And here it is... FOMC Statement

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.

My first impression is that it is a good statement... better than the last. In the first paragraph (not counting the opening sentence), I see a reiteration that this move, with September's, should help forestall adverse effects from the housing trouble. In other words, I see this as telling the market, "You didn't get it last time but let's try this again. We're serious." Ok, maybe that could have been stronger. But there is an additional sentence about the inflation risks. That's good. There is a statement that the balance of risks is roughly equal. That is the key. That is a much stronger way of saying that the predisposition is going to be towards doing nothing unless something really serious pushes them off of that stance. It is a lot stronger than the previous statement. Though it will be ruthlessly parsed word by word in the next few hours, my initial read is that this satisfies me.

Hoenig dissented. Poole did not. Some might be surprised, but I was not. Poole's interviews lately have been pretty balanced. He has been upfront about recognizing the risk from financial instability. Hoenig, on the other hand, didn't get as much attention. But I do remember this item...

TULSA, Oklahoma (Reuters) - Federal Reserve Bank of Kansas City President Thomas Hoenig on Wednesday said he was keeping an open mind about the future direction of interest rates but was on alert for fallout from financial market woes.

"Wait and see," he cautioned an audience at a dinner hosted by the Kansas City Fed.

That was from October 17. I kept that story in my feed reader for some reason... as if I thought I might want to reference it someday.

And as I said before, the fact that someone dissented and asked for no change does a lot for making this a credible statement that says that they are done unless something at least a standard deviation out of the ordinary occurs.

Well, that was an interesting couple of days. Let's do it again in about 6 weeks... with a little less drama, maybe?

As of 9:30 (Chicago time) November fed funds were trading at 95.485 after starting the day at 95.495. Greg Ip's article may have spooked Wall Street, but at the corner of Jackson and LaSalle the expectation is, at this hour, still a 25 b.p. cut.

Click the image for the full size version. Source: Chicago Board of Trade (10 minute delayed quotes)

Electronic trading in fed funds continues overnight. You can see that when Ip's article hit the internet, the reaction was immediate but short-lived.

It should be an interesting 27 hours or so.

The Philly Fed is upbeat.

Activity in the region’s manufacturing sector picked up in September, according to firms polled for this month’s Business Outlook Survey. Indexes for general activity, new orders, and shipments increased, reflecting continued underlying growth. Firms continued to report a rise in prices for inputs, but price increases for finished manufactured goods were not widespread. On balance, the forecast for growth over the next six months has not diminished appreciably, even though, according to responses to special questions this month, over one-quarter of the firms said they are scaling back employment and capital spending plans because of the recent deterioration in the construction industry and uncertainty in financial markets.

...

Respondents continue to report higher prices for inputs this month. The prices paid index increased eight points, after edging lower in the previous three months. Thirty percent of the firms reported higher input prices; 7 percent reported lower input prices.

Less than 10% of firms surveyed expected a substantial decline in employment or capital spending as a result of recent developments.

I think I just heard a bond price drop. The 10 year yield stands at 4.63% and climbing.

John Palmer reads this article in The Economist on Chinese inflation and points out the four... count them, four... things they missed.

UPDATE: Thomas Palley also has a post on Chinese inflation that gets it right.

Compared to Friday the news is that there isn't much news on the liquidity front. The Fed today injected only $2 billion. That effectively takes out nearly all of what they put in on Friday. There still is an extra $12 billion or so from a 14 day repo that took place last Thursday. But the upshot of all of this is that according to CNBC the fed funds rate is trading at or just a little higher than the target.

In other words, nothing too out of the ordinary, and the Fed might just be content to let the funds rate sit a little bit higher today. It's as if they are telling the market not to count their chickens before they are hatched when it comes to that rate cut the street has been calling for. Everybody and their brother is talking about moral hazard, and rightfully so. It is still my opinion that a rate cut is not desirable and would only be used if something like what happened on Friday turned into something close to a true global meltdown.

But it didn't. Mr. Bernanke won this one. He stared down the analysts calling for a rate cut and didn't blink. He did exactly what was required of him and the Fed. Simply put, the funds rate started trading above the target on Friday. So the Fed injected the liquidity to get it back down to the target. Full stop. Nice job.

As I watched CNBC this morning, I also began to get a fuller sense, as did anyone else who was listening carefully, of what was really happening. I heard one of the analysts say that the leverage in the hedge funds had dropped dramatically and that a significant amount of cash had been injected into those funds. That, of course, is exactly what needed to be done, and when you step back and think about it, everything that happened on Friday starts to make sense. A lot of people were in some pretty risky positions and got out of those positions and onto firmer ground. Of course, on Thursday and Friday, without knowing what was really going on it looked like more of a panic. If it is true that the leverage has decreased, then there should be less of a chance of something like that happening again, or worse.

Are the hedge funds and the other big financial firms hunkered down to weather any more fallout from subprime delinquencies? We can hope so. And if it is so, it is largely because of the Fed's injection of liquidity on Friday that made that process take place in a more orderly fashion. When the final story is written, that action may look pretty heroic. But like all good heroes, the Fed would say they were just doing what needed to be done.

Of course, hearing that July retail sales were up more than expected also helped everyone get off to a good start today. But I want to call your attention to some other news, which I think will be the most under-reported story of today.

China's inflation rate now stands at 5.6% with food prices rising around 15%. Why mention that in the context of what the Fed is doing? Because just as the Fed has to be on guard for deflationary pressures being transmitted internationally, they need to be on guard from inflationary risks overseas. Higher prices from China are already showing up on our shores. The Fed needs to make sure that we don't end up importing inflation from China.

Of course that was far from our minds on Friday, and rightfully so. However, with that danger passed, at least for now, we need to keep an eye on the other risks out there.

As I did yesterday, I focus on CBOT binary call options at a strike price of 94750. As of 3pm:

Sept07 down 9, currently at 13
Oct07 down 7, currently at 25
Dec07 up 3, currently at 35

As an aside, a put option with a strike of 94750 last traded at 3 points, up 2 from yesterday. That's a contract that pays if the target fed funds rate is higher than the current 5.25% after the December meeting.

I call the last couple weeks, "Denial."

I just checked the Fed Funds Binary Options on the Chicago Board of Trade. Here is a link, but I do not know how stable it is. When trading opens tomorrow, the quotes will be different anyway.

Note to self: WIU economics faculty and students usually make a trip up to Chicago to see the Board of Trade every year. I am one of the faculty who works on scheduling and arranging the trip. I must do what I can to see if we can get up there on an FOMC day this fall.

From the closing quotes, it looks like it was an exciting afternoon. In fact, I was watching CNBC when the announcement came and at the moment the reporter started reading the statement the trading pit in Chicago erupted. That's the only word that comes to mind. The quotes tell the story of what they were yelling about.

Rather than detail them all, I will focus on just the call options with a strike price of 94750 (pays 100 if the target funds rate is less than 5.25% on the expiration date).

Sept07 down 7 to close at 22.
Oct07 down 6 to close at 32.
Dec07 down 18 to close at 32.

I think these pretty much speak for themselves. Roughly speaking, the market is saying that if they do cut, they cut by October. But it's only a 1 in 3 chance that they do it at all (this year).

UPDATE: The NY Times editors are in denial.

Despite the Federal Reserve’s stay-the-course message yesterday, investors are betting on at least one interest-rate cut by January, intended to quell turmoil in the markets and to juice the slow economy.

A couple days ago the market was saying it was 50-50. Now the market is saying it's (roughly) 2:1 against (or 1 in 3 that they will, if you prefer). Looks to me like some of them switched their bets.

They would have done well to listen to Cassandra.

David Leonhardt explains why records are made to be broken and why one must always adjust for inflation. (NY Times)

The S.& P. 500, which is a much better measure than the Dow, closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs

Once again the FOMC decided to keep the fed funds rate unchanged at 5 1/4 percent. (Read the statement) There were some minor changes in the wording compared to the May statement. For example, in the second paragraph it is said that economic growth appears to have been moderate "despite the ongoing adjustment in the housing sector." Previously it had said that "adjustment in the housing sector is ongoing." Today's statement strikes me as conveying a somewhat more positive spin than before. No doubt many will think that is not warranted at this time.

The more important change seems to have been in the next paragraph. Here's the new language:

Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

And here is what they said in May:

Core inflation remains somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

The line about "sustained moderation...has yet to be convincingly demonstrated" is a clever way to word it. At the same time, they say that readings on core inflation "have improved modestly in recent months."

Reuters focuses on the first sentence: (Headline: Fed holds rates steady, nods to ease in inflation)

WASHINGTON (Reuters) - The Federal Reserve on Thursday held benchmark U.S. interest rates steady at 5.25 percent for an eighth straight meeting and dropped a description of core inflation as "elevated."

King Banaian focuses on the second sentence: (Blog post title: This'll be icky)

The Federal Reserve held rates steady, but the markets will not like the references to inflation here:

...

The Dow was up 50 when the news broke; I'd bet that won't last.

As of this writing, the Dow is up about 24 points. That's down from earlier, but hardly a sign that this news sent traders running with their tails between their legs. The bond market is another story. The 10 year is down 8/32 at this writing with the yield at 5.11%. King also points out that the WSJ Economics Blog says that tomorrow's release of the May PCE will be closely watched. Indeed.

But I'm of the opinion that nothing in today's statement is truly market moving news. Yes, bond traders are more touchy about this than stock traders perhaps. They may recover some of those 8 ticks today or tomorrow after mulling this over. This statement is not a clear sign that the FOMC intends to get back into a tightening mode. At least the market is not interpreting it as a clear sign, and that's what counts.

However the Fed doesn't want to telegraph its move quite yet. They don't want to be locked in on the off chance that the spillover from housing is worse than imagined, or something like that. That would cost them credibility. On the other hand, you can only sit for so long with core PCE outside your comfort zone without losing some credibility too. Before the end of the year, I think they will have to decide where they are going. If the growth picture looks about the same as it does today, and if core PCE is still on the high side, I think you know which way I would like them to go.

UPDATE: Dave Altig at macroblog links to some of the financial media coverage which was, as one might expect, all over the map. One of the more reasonable comments was from the Wall Street Journal (no link provided) which suggests that this really wasn't much of a substantive change. It's as if they were changing some of the wording (removing the word "elevated") just to keep people from fixating on the language that had been used for a while.

I'd like to think that's the case since it fits with a view that I have had ever since they overused a certain phrase a couple of years ago.

Last week, James Hamilton led off a post with the line,

Let's admit it-- the other shoe is not yet dropping.

Opinions differ on what it will sound like when it does. April employment numbers came out day (+88,000 non-farm payroll jobs), and PGL doesn't like what he heard.

The fall in the household survey reporting of employment was 468,000. The unemployment rate would have risen even more had it not been for the fall in the labor force participation rate (LFP). The decline in the employment to population ratio (EP) was disappointing. Maybe it’s time that the Federal Reserve lower interest rates.

Then Craig Newmark points us to a Bloomberg article that says,

April 30 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke's assertion that interest rates may need to increase to curb inflation is wrong. That's what Goldman Sachs Group Inc., Merrill Lynch & Co. and UBS AG are saying.

While Bernanke warned last month that the odds of worsening inflation have increased, chief economists at the three firms say the worst housing slump in a decade may drive the U.S. economy into a recession and stifle consumer prices. Their chief economists say the Fed will cut its target for overnight loans between banks at least three times this year.

...

Bernanke is missing ``the linkage between residential housing investment and the broader economy,'' Jan Hatzius, chief U.S. economist at New York-based Goldman, the world's most profitable securities firm, said in an interview. ``The housing downturn is of the first order of importance.'' Hatzius says the Fed will cut rates three times this year, to 4.5 percent from 5.25 percent.

Kash says it's too early to tell if and when rates will fall.

While disappointing, it is hard to imagine today's data having any impact on the outcome of next week's FOMC meeting, at least in terms of the policy action. Whether it will cause policymakers to prepare to soften their stance in the coming months is another question. My guess is, not yet. The change in language in the last FOMC statement made a lot of people thing that rate cuts are now off the table. I don't think that is the case, but rather that a rate cut in 6 to 9 months is more likely than it was a few months ago.

After today's employment report, my subjective probability assessment for the funds rate in 6 to 9 months has edged even a bit more towards a rate cut.

So as we head into the week of the FOMC meeting, the question is whether and when they will make a more direct reference in the press release acknowledging that the risk of slower growth is greater than the risk of inflation. Predicting when and if that will come is like predicting when "measured pace" would disappear last year. Lots of people will call it before it happens, and a few will be surprised. But the Fed knows that they have to choose their words carefully, and in this instance it may mean that a rate cut will come without a lot of advance warning provoking speculation in the financial markets. The relevant reference for you is January 2001. If a rate cut comes, it could very well take us by surprise in terms of its timing. If, on the other hand, things improve this summer and a rate hike becomes necessary, the signs will be much more clear.

And so we sit, still waiting for the other shoe to drop.

I'm still here. There were just a lot of other pressing demands on my time for the last couple weeks. Among them were three trips out of town that required some preparation time before each one and not much down-time between them. The most recent was last Friday when I, along with a couple of other faculty members, took a group of our economics students to Chicago to do some career networking as well as touring the Board of Trade and Federal Reserve. We have a number of Western Illinois alumni in Chicago working in a variety of capacities and utilizing their degrees in economics. It is rewarding to connect with them and let them interact with our current students. Plus, everyone should see the closing bell at the Chicago Board of Trade at least once in their life.

The last few weeks also took me to Minneapolis for the Midwest Economic Association annual meeting where I finally met Phil Miller in person after knowing him through the blogosphere for two years. Shortly after that, it was over to Peoria for a presentation to some old friends at Bradley University's Economic Workshop for Clergy.

Of course, all this time I was also trying to stay one step ahead of my graduate students who have, with 6 class sessions remaining, surpassed where I ended the semester last year. I keep raising the bar and they rise to the challenge. That is the kind of work that I don't mind doing.

I have not been oblivious to the news of the last couple weeks. The release of the Fed minutes last week almost brought me out of hibernation, but ultimately realized that most of what I would have said would have been a rehash of what I've said before. Recall that in my last missive to you before my hiatus, I made it clear that I wasn't buying the market's interpretation that we could see a rate cut by summer. Last week we read in the minutes...

The Committee agreed that further policy firming might prove necessary to foster lower inflation, but in light of the increased uncertainty about the outlook for both growth and inflation, the Committee also agreed that the statement should no longer cite only the possibility of further firming. Instead, the statement should indicate that future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

That is pretty consistent with my interpretation. The market balked but appears to have recovered. As you know I have not been impressed with the market's ability to interpret the Fed's words. One of my favorite sentences I have written on this subject in the last few months is...

...would you want to bet any amount of your paycheck that a more balanced assessment of risks would be interpreted correctly by the market? (December 6, 2006)

So in other words, I didn't really feel like anything had changed last week.

But this plateau in interest rates cannot last forever, and I would regard it as fairly likely that rates will move one direction of the other before the year is up. So there will probably be some excitement this summer. We will all be closely watching the GDP figures as they come in, beginning with the first quarter in a couple weeks. And with my schedule freed up a bit relative to the last couple of weeks, I look forward to blogging as much of it as I can. Putting some time into other pressing activities was necessary, but it has refreshed me for blogging. One might even say that I'm hungry to get back into the groove.

This NY Times article is right. Watching Zimbabwe over the last few years has been like watching a tragedy in slow motion. You don't know exactly how it will end, but you know it will end badly. Here's the latest installment:

JOHANNESBURG, Feb. 6 — For close to seven years, Zimbabwe’s economy and quality of life have been in slow, uninterrupted decline. They are still declining this year, people there say, with one notable difference: the pace is no longer so slow.

Indeed, Zimbabwe’s economic descent has picked up so much speed that President Robert G. Mugabe, the nation’s leader for 27 years, is starting to lose support from parts of his own party.

In recent weeks, the national power authority has warned of a collapse of electrical service. A breakdown in water treatment has set off a new outbreak of cholera in the capital, Harare. All public services were cut off in Marondera, a regional capital of 50,000 in eastern Zimbabwe, after the city ran out of money to fix broken equipment. In Chitungwiza, just south of Harare, electricity is supplied only four days a week.

The government awarded all civil servants a 300 percent raise two weeks ago. But the increase is only a fraction of the inflation rate, so the nation’s 110,000 teachers are staging a work slowdown for more money. Measured by the black-market value of Zimbabwe’s ragtag currency, even their new salaries total less than 60 American dollars a month.

The article goes on, and I encourage you to read it all. Here is just one choice example of how things are going so very wrong:

Seeking to revive farm production, for example, the government sells gasoline to farmers at a bargain rate of 330 Zimbabwe dollars per liter — and farmers promptly resell it on the black market for 10 times that, leaving their fields idle.

The anecdotes coming out of Zimbabwe are beginning to sound like scenarios made-up for textbook examples, but they are not hypothetical. This is happening...right now...to real people.

And you just know it is going to get worse.

PGL at Angry Bear picks up on my comments from last night, as I hoped someone would. He quotes extensively from the 10 point WIN proposal and notes that Ford also called for capital gains tax cuts and investment tax credits. So allow me to call attention to point number nine:

Number nine: Federal taxes and spending. To support programs, to increase production and share inflation-produced hardships, we need additional tax revenues.

I am aware that any proposal for new taxes just 4 weeks before a national election is, to put it mildly, considered politically unwise. And I am frank to say that I have been earnestly advised to wait and talk about taxes anytime after November 5. But I do say in sincerity that I will not play politics with America's future.

Our present inflation to a considerable degree comes from many years of enacting expensive programs without raising enough revenues to pay for them. The truth is that 19 out of the 25 years I had the honor and the privilege to serve in this Chamber, the Federal Government ended up with Federal deficits. That is not a very good batting average.

By now, almost everybody--almost everybody else, I should say--has stated my position on Federal gasoline taxes. This time I will do it myself. I am not-emphasizing not--asking you for any increase in gas taxes.

I am--I am asking you to approve a 1-year temporary tax surcharge of 5 percent on corporate and upper-level individual incomes. This would generally exclude from the surcharge those families with gross incomes below $15,000 a year. The estimated $5 billion in extra revenue to be raised by this inflation-fighting tax should pay for the new programs I have recommended in this message.

Ford was not a Pigouvian--that much is certain. However, one can see that his understanding of fiscal policy was probably more nuanced than that of many presidents due to his experience in the House. In point number five, he asked for spending to help provide public service employment during the time of recession (you might think he sounds like a quaint New Dealer at this point). But he realizes that this together with the investment tax credits would balloon the deficit if there wasn't some kind of offsetting tax increase. This is the point that I wanted to make earlier, and I thank PGL for the comment that gave me an excuse to refine the point.

This point number nine in the WIN proposal was, however, the only place I could find reference to Ford calling for tax increases, which is why in yesterdays post I was careful to state that he called for tax cuts as well. But, like PGL, I found this to be a rather curious thing. As PGL points out, Ford also calls for monetary restraint and lower interest rates as well. There were some contradictions there. After reading the whole proposal, I get the feeling that he was trying to be revenue neutral (increasing some taxes and decreasing others) while stimulating economic growth and reducing inflation. The cynic in me wonders why he didn't ask for a pony as well, since this was already an impossible list.

But the better part of me wants to cut him some slack. This was two months after taking office in a most undesirable way and one month after making a tough decision that cost him politically. Why not lay it all out on the line? WIN was an impossible dream. Anyone who thought it would whip inflation and bring back prosperity before the 1975 State of the Union Address was not being honest with himself. But Ford did start the ball rolling on some important initiatives that included tax reform and regulatory reform. And the WIN speech was where some of those ideas were rolled out. As usual, Gerald Ford was thinking beyond the next political cycle. Such thinking tends not to get one re-elected, but we could use a bit more of it. The biggest problem with WIN, as I see it, was that it was bound to fail as a short-run solution even though certain aspects of it would have carried long-term benefits. That is a familiar problem in political economy.

As the months wore on, it was the tax cuts that took center stage in Ford's economic policy, but his was not a policy of tax cuts for the wealthy alone. He vetoed a bill that didn't include enough tax relief for the middle class and that didn't include spending cuts.

PGL concludes:

By the time Gerald Ford made this speech, the unemployment rate had increased from 4.9% to 5.9%. By May 1975, the unemployment rate reached 9% and still at 7.7% when voters went to the polls to decide between Gerald Ford and Jimmy Carter. My problem with the WIN program was less its details and more with the fact that this President seemed to ignore the fact that we were on the verge of a rather significant recession.

Check that. By NBER dating, the economy had already been in recession for just short of a year when he made this speech and was only 5 months away from pulling out of it. The labor market is a lagging indicator, so while the unemployment rate was still high, it was trending downward as Carter took office. He was a victim of poor timing in that regard. That is, unless you are going to tell me that the continuation of that trend and a decline of 1% in the unemployment rate in Jimmy Carter's first 12 months in office was due to Carter's economic policies. If so, I would respectfully disagree. Remember also that Ford had to work with a heavily Democratic congress. The wheels turned slowly. The divided government, while perhaps slowing the recovery, also kept either side from pushing the pendulum too far to either side and led to a slow but sustained recovery until the oil crisis reared its head again in Carter's term.

President Ford was dealt a really bad hand. He restored a measure of respect to the office and kept a bad economy from deteriorating any further. He used the power of the veto pen to stand up for fiscal responsibility. He put the nation's interests ahead of his own more than once. He did all this with civility and grace that is becoming ever more rare. He is not the sort of person we tend to elect, but he was there when his country called. He leaves a meaningful legacy to American politics.

UPDATE: Macroblog has more discussion of WIN. David Altig writes:

Seen through contemporary eyes, it is clear that the President Ford's speech hopelessly entangled shocks to relative prices with ongoing inflation of monetary origins.

Indeed. It was, to be blunt, a rather confused attempt to set out inflation's cause and cure. It was a political attack on a monetary problem. It's more about taxes, spending, and conservation. Altig continues:

Are there are any kind words to be found about all of this? More thoughts to follow.

I have tried to find kind words. However, I want to be clear that my kind words are more about what Ford's longer term objectives may have been, and what some of the WIN proposals, and indeed Ford's proposals more generally, were designed to do. I still think that WIN was misleading advertising and a set-up for failure in the short-term. But it was better than Nixon's price controls. Are those the kindest words? I look forward to hearing David's additional thoughts.

UPDATE: Altig does have some nice words to say. James Hamilton, on the other hand, is less charitable. Hamilton says:

And, despite the clever arguments that Dave brings up in the WIN button's favor, I think one great disservice of that campaign was to cultivate the misperception that inflation is somehow the responsibility of ordinary U.S. citizens. In my view, maintaining the purchasing power of a dollar is instead exclusively the responsibility of the people who control how many dollars get printed.

In the long run, yes. In the short run, other things do affect measured inflation, and WIN tried to affect some of these. I still think that it was ill-advised and a set up for failure because it created expectations that could never be fulfilled in the short run (because of politics and policy lags) or the long run (because of Hamilton's argument). Though you must admit that Ford was between a rock and a hard place on this, and although the buttons may have been overkill, some of the policies were worth a shot.

The ECB has raised their key interest rate from 3.25% to 3.5%.