Recently in Federal Reserve Category

I am happy to report that macroblog is back. David Altig, who had been running the blog independently since 2004 when he was at the Cleveland Fed, has brought back the blog with a new look and some new co-authors. Altig, now research director at the Atlanta Fed, is bringing the other Atlanta economists into the blogosphere as co-authors on macroblog.

Welcome back, David, and thanks for making macroblog part of the research mission of the Atlanta Fed.

The Chicago Fed also has a blog (three, in fact). Are there others I'm not aware of? Are the other Feds listening?

It's probably a good thing that the determination of a recession is not subject to a majority vote.

Via Reuters:

NEW YORK (Reuters) - Just over two-thirds of Americans believe the country is either already in recession or headed for one over the coming year, according to a new poll conducted jointly by The Wall Street Journal and NBC.

Nearly half the survey respondents, 46 percent, believed a recession was already under way.

The conviction comes despite a 3.4 percent rebound in economic growth during the second quarter, according to Commerce Department data released last week.

A recession is generally defined as two consecutive quarters of declines in gross domestic product.

Turning points in the economy are notoriously difficult to predict. In 2001, many Wall Street and government forecasters waited until growth had already turned negative before acknowledging a period of contraction.

Can we lose the definition of "two consecutive quarters of declines in GDP"? By that definition, we didn't have one in 2001. What we had was three quarters of negative growth, but they were every other quarter. One down, one up... one down, one up.... one down, one up. Definitely a recession, there's no question about that. But the standard textbook definition is obsolete.

Likewise, even though the most recent quarter posted growth above 3% doesn't mean that this is a trouble-free economy. Just about everyone acknowledges that growth for the rest of 2007 will be weaker, perhaps significantly weaker. If we have two quarters of growth around 1%, will it feel like a recession? Perhaps in many ways, yes. Would it meet the textbook definition? No.

This is not your father's economy, and the textbook definitions that worked in the '70s and '80s to explain the malaise of the time are not applicable now. We need to get out there and educate the next generation as to the subtleties of economic statistics, lest they become disillusioned that economists and the media are out of touch with their textbook definitions from the '70s.

At least we don't wear bell-bottoms.

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.

That is to say, it's easy over very short time horizons and almost impossible over longer horizons. In Monday's Wall Street Journal, E.S. Browning continues the chronicle of the widening disconnect between the Fed and the market.

The Fed is expected to leave target interest rates unchanged, fueling hopes that it will start cutting rates some time next year, which would be good news for stocks and bonds.

But worries are spreading that, longer-term, investor hopes for interest rates may have gotten a little out of hand. If so, stocks and bonds both could be in for some rough waters in the coming months.

Later in the article, his interview subject expresses thoughts that should be familiar to any reader of this blog.

"Inflation is the key here," says Ethan Harris, chief U.S. economist at Lehman Brothers. "Inflation is the enemy of all markets. If you get serious inflation, if the Fed's fears materialize, then you will have the Fed hiking instead of cutting, pushing growth weaker. That is a lousy environment for both" the stock and bond markets.

Mr. Harris isn't forecasting a resurgence in inflation. He thinks it could remain more or less steady.

But, like the Fed, he doesn't think that is a sure thing, and he thinks investors could be making a mistake to assume that inflation is dying....

Sorry. No "one armed economists" here. On the one hand inflation could be under control. On the other hand the battle may not yet be over.

Some people find a certain irony in all this.

Now, Mr. [Jim] Bianco [of Bianco Research in Chicago] notes, "the guy that is holding the Fed back from easing is Helicopter Ben. We got him all wrong, at least for his first 10 months" in office.

It is really hard not to say, "I told you so."

Anyway, while we sit here and think about the implications of what the Fed may or may not do, Ed Prescott reminds us in a Wall Street Journal op-ed today that it may not matter all that much. The op-ed is titled "Five Macroeconomic Myths" and is sure to provoke a response from people who, for example, think that the national debt is too large (it's #4 on his list). Read the whole thing. Here's part of myth #1 that monetary policy causes booms and busts.

Between 1975 and 1980, the inflation-corrected federal funds rate was low; at the same time, output trended upward until late 1978. So far, things look somewhat promising for the mythmakers. But looking closer at the data we see that output began its downward trend in late 1979 while monetary policy was still easy through most of 1980. Also, output continued its decline through 1982, when it began to climb at a time when monetary policy remained tight.

These facts do not square with conventional wisdom. Our obsession with monetary policy in the conduct of the real economy is misplaced.

Where monetary policy's effect on output is concerned, expectations matter. That is a fact which is not lost on Mr. Bernanke, especially these days.

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

This time, it comes from Ed Leamer, who is worth listening to: (Reuters)

SAN FRANCISCO (Reuters) - The U.S. economy will expand at a weak pace next year, setting the stage for lower interest rates, according to a UCLA Anderson Forecast report released on Thursday.

The forecasting unit's latest report projected quarterly real gross domestic product growth no higher than 2.7 percent next year, reflecting the weak housing market.

...

As a result, the Federal Reserve will cut interest rates to stimulate business, said Edward Leamer, director of the UCLA Anderson Forecast.

"We think the Fed will shift from an inflation concern to a sluggishness concern so that we'll get some rate cuts," Leamer said, adding that he sees the Federal Funds rate falling to 4.5 percent by the fourth quarter of next year.

...

Manufacturing has already shed so many jobs it is in no position to produce the kind of massive layoffs that paired with a housing downturn would trigger recession, Leamer added.

"We've trimmed it to the bone," Leamer said, referring to factory work. "It's already lean and mean."

Additionally, the economy will avoid recession because credit is abundant and consumers will continue spending at a moderate pace, Leamer said.

Interesting. Their prediction of moderate growth (2.7%) is certainly less than average, but equally certainly not indicative of a recession. It is quite similar to the GDP growth in 1995 (a "soft landing" year). And while there were two rate cuts in 1995 (and one more in early 1996), those cuts were to bring the funds rate down to 5.25%. Ironically, that's where we are now. So, while I'm not ready to predict three rate cuts in 2007 to bring the funds rate down to 4.5%, I would say that the UCLA forecast is in the ballpark.

Given all that has transpired in recent days, I would regard a rate cut in the first six months of 2007 to be more likely than a rate increase in that same time frame. That said, I continue to hold to the view that a rate cut at this time would slow the return of core inflation to its comfort zone. The fact that productivity is not growing as fast as it was in the first half of the year and that Mr. Bernanke has suggested that potential output growth may be slowing only serve to reinforce that view. Unlike 1995 and 1996 when productivity was rising rather than falling, the Fed will not have the luxury of cutting rates while inflation trends down.

The part of me that wants to give a prediction that is right is turning to the view that there will be at least one rate cut in 2007.

The Cassandra in me is having a tough time with that.

UPDATE: Calculated Risk quotes the LA Times version of the story, which includes Leamer quotes such as:

"If you are a builder or a broker, it will feel like a deep depression," he said. "But the rest of us will hardly notice."

and...

His conclusion: "The models say 'recession'; the mind says 'no way.' I'm going with the mind."

UPDATE 2: Leamer isn't alone. At least some people's models agree with his mind.

NEW YORK (Reuters) - The economy will likely pick up in 2007 after output growth slows rapidly in late 2006, according to a survey conducted by the Philadelphia Federal Reserve Bank released on Thursday.

Economic growth for 2008, released for the first time in the survey, was forecast at 3.0 percent.

Economists lowered their forecasts for U.S. growth in the first half of 2007 to 2.8 percent from 3.0 percent when the previous survey was taken six months ago. They forecast growth at 3.1 percent for the second half of 2007.

Yesterday I wrote of the growing disconnect between the Fed and the financial markets:

Is it just me or are the markets trying like mad to find an argument for lower rates sooner? I think this would be a little frustrating for the Fed, which would like to bolster its inflation fighting credentials.

Now comes Greg Ip, writing in the Wall Street Journal:

WASHINGTON -- Federal Reserve officials -- unlike bond investors -- think the economy is a lot sounder today than at the end of 2000 and in early 2001, when the Fed abruptly reversed course and began a string of interest-rate cuts.

Yet Fed Chairman Ben Bernanke's effort to convey the message that today's conditions are different is hampered by the Fed's lack of candor back in 2000.

Fed officials, who have universally voiced concerns about inflation, are expected to keep short-term interest rates steady at 5.25% at their policy meeting next Tuesday. But bond markets have priced in a small chance of a rate cut next week and three one-quarter percentage-point cuts over the next 12 months.

Markets anticipate those cuts in part because they see parallels to 2000. A technology-stock and investment bust began to unfold in the summer of that year, yet in November the Fed still said its principal concern was inflation, not economic growth. Seven weeks later, with stock prices tumbling and businesses canceling investment plans, the Fed made the first of 13 interest-rate cuts.

Like stock prices then, housing prices today are turning down after a long run-up. But there is little sign the decline has spilled over into the rest of the economy. Stock prices are up, not down. Officials acknowledge recent data have been weak, especially for manufacturing and commercial construction, and they are expected to closely scrutinize the November jobs report, to be released Friday.

The weak data, however, haven't been corroborated by anecdotal evidence from the Fed's extensive business contacts. The Fed's recent "beige book" roundup of regional business conditions found "moderate growth" and "tight" labor markets.

In the comments to my post yesterday, spencer writes that he is more optimistic for lower inflation and interest rates and asks why he shouldn't be.

To which I would respond that I am also more optimistic for lower inflation than I was a month ago. That is, I am finding it easier to buy the story that the Fed has been giving us for the past few months that core inflation should be expected to moderate in 2007. Make no mistake, it is still above my comfort zone (and that of many of the FOMC members), but if the pressures that have been keeping it there are receding, I agree that the best thing to do is hold interest rates where they are now and allow the core inflation rate to fall back into the comfort zone and reassess things in a few months. Let bygones be bygones, as former Fed governor Laurence Meyer would say.

But I'm also still inclined to view today's short term rates as being pretty close to neutral--certainly more neutral than the 6.5% in place when the calendar turned from 2000 to 2001. The current rate is even a bit lower than it was in the 1995 "soft landing". The real interest rate was actually negative as recently as late as 2005--hard to argue that policy has been overly tight in recent months. The same cannot be said of 2000.

Most importantly, a rate cut here would not help long term inflation expectations. The longer that the core inflation rate remains out of the Fed's comfort zone, the more risky this becomes.

It's just hard to see a rate cut now (or in early 2007) as a risk that the Fed would want to take unless there was a pretty solid body of evidence pointing to a serious slowdown--more serious than most models are predicting. If it turns out that the forecast is wrong, then they will act. However I don't see them changing their course based on the bond market's comparison of 2006 to 2000. Indeed, I think it would damage their credibility to change course on that basis. Returning to the Wall Street Journal article, Ip interviews Edward Gramlich:

In late 2000, the Fed's business contacts were getting worried, and the stock market was crumpling as profit warnings proliferated. "Everything was pointing up and, all of a sudden, everything started pointing down," recalls Edward Gramlich, a Fed governor at the time. Today, "the key thing is whether the weakness in housing -- and now autos -- feeds over into consumption at large, and as I understand it, it really hasn't."

Trouble is, the bond market doesn't appear to share Gramlich's confidence that, as they say, this time it's different. And that has got to be frustrating for the folks at 20th and Constitution.

David Altig (macroblog) reads Ip's article as well.

Ip includes this comment:

"They're paid to worry about inflation, which means that until the slowdown is obvious and undeniable, they will stick to their forecasts," Ian Shepherdson, chief U.S. economist at High Frequency Economics, said in a report last week, citing the similarity to late 2000.

Altig responds:

... I'm not inclined to protest too much. I'll leave it to the sociologists and cognitive psychologists to figure out if being "paid to worry about inflation" somehow systematically biases the forecasts of policymakers. But just for the sake of argument, let's say it is so. Taking the long view, the not-so-arguable success of U.S. monetary policy over the past 25 years, and the memory that it wasn't always so, let me ask this: Would you really have it any other way?

No. And I wouldn't want to squander that success by allowing inflation expectations to creep up any further.

One more time over to Ip:

Transcripts of the Fed's November 2000 meeting offer grist for the skeptics. Fed officials at the time saw ample reason to shift from their assessment that higher inflation represented a greater risk to the economy than did weaker growth, to a view that the two risks were balanced. "The balance of risks has shifted quite noticeably," then-Vice Chairman Roger Ferguson said.

Mr. Kohn, then a staff adviser, said a balanced assessment of risks might well be merited, but could turn stock and bond markets frothy again. Then-Chairman Alan Greenspan agreed: "Were we to go to balance today we would almost surely end up tomorrow with financial conditions that would be too easy."

...

More so than Mr. Greenspan, Mr. Bernanke thinks it is dangerous for the Fed to slant its words to elicit a particular market reaction. Indeed, he was burned in April when markets misinterpreted his hints about a pause in interest-rate increases as complacency about inflation. That suggests he means his recent warnings on inflation to be taken at face value.

And so the problem boils down to this... Bernanke would probably rather not have to choose his words in such a way as to keep the bulls fenced in. But would you want to bet any amount of your paycheck that a more balanced assessment of risks would be interpreted correctly by the market? Ip is miles ahead of the bond market in understanding and interpreting Bernanke. That's great if you are a newspaper reader--not so great if you're a policymaker.

The Fed simply must continue to improve its communication strategy. This latest situation is the "measured pace" episode dressed up in different clothing. A change in language now will likely be interpreted as an announcement of a future policy change. That is not an ideal state of affairs, and I must say that I'm a bit more of an advocate of inflation targeting than I was when I got up this morning.

Maybe. (NY Times)

The Labor Department said that unit labor costs, a measure of what workers earn that takes into account their productivity, rose 2.3 percent in the third quarter, falling short of the preliminary estimate of 3.8 percent issued last month. Worker productivity increased 0.2 percent in the third quarter, more than the government’s first calculation of no change but far less than the productivity gains during the first half of the year.

Strong productivity is needed to help offset growing labor costs so they do not feed into inflation. In that sense, some economists noted that the 0.2 increase in productivity growth was troublesome.

A decline in productivity growth would mean somewhat tighter monetary policy would be warranted, all other things being equal. Let's go to Bernanke's speech from last week:

That said, longer-run trends in the growth of productivity are very difficult to predict. During the first half of the decade, productivity in the nonfarm business sector increased at an unusually high average annual rate of about 3 percent. However, according to current estimates, productivity growth slowed in the second quarter of this year and came to a halt in the third quarter. Moreover, the strength of recent hiring raises the possibility of subpar productivity growth in the fourth quarter as well. When all is said and done, however, I expect that the latest numbers will turn out to have been a reflection of the typical volatility in the data and some cyclical response to the slowing in economic activity, not a signal of a sea change in the longer-run outlook for productivity growth.

Even if productivity growth is sustained at a reasonably good rate, the slower expansion of the labor force will imply some moderation in the rate of growth of potential output over the next few years. In the very near term, that slower growth in the labor force needs to be taken into consideration when assessing the sustainability of given rates of expansion in economic activity. In the medium term, because the factors that affect potential output and thus aggregate supply also tend to affect aggregate demand, slower growth of potential output does not necessarily mean that inflation will be higher or that monetary policy will have to be tighter. Rather, the implications for monetary policy of a possible slowing in the growth of potential output depend on the extent to which such a slowing alters the balance of supply and demand in the economy. For example, as we saw in the second half of the 1990s, changes in expected productivity growth and potential output can significantly affect aggregate demand through their influences on income expectations and asset prices. The problem for policymakers is to identify, in real time, any changes in the prospective growth rate of potential output and to anticipate the accompanying effects on the balance of supply and demand.

Is it just me or are the markets trying like mad to find an argument for lower rates sooner? I think this would be a little frustrating for the Fed, which would like to bolster its inflation fighting credentials. Will next week's statement be more hawkish? Or will they admit that the slowing economy may necessitate easing? How would the latter be interpreted?

The October minutes are on the Fed's web site. Here's the first thing that caught my eye.

The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations and the Chairman asked Vincent Reinhart, Director of the Division of Monetary Affairs, to form a committee of Federal Reserve System staff to consider these issues.

They could learn from Canada, the UK, and New Zealand, as this publication by Sellon and Weiner from the Kansas City Fed explains. Let me know if you have other papers in this area to suggest.

On to the current outlook,

In their discussion of the economic situation and outlook, meeting participants noted that incoming data over the relatively brief intermeeting period had come in broadly as anticipated. The most recent indicators suggested that economic growth had probably slowed more sharply in the third quarter than had been expected at the time of the September meeting, but that appeared to largely reflect the impact of temporary influences. Participants continued to expect the economy to expand at a rate close to or a little below the economy's long-run sustainable pace over coming quarters. The ongoing adjustment in the housing market was likely to depress real activity in the near term, but this effect was expected to wane gradually; private final domestic purchases had held up well in recent months and looked set to expand at a reasonably good pace. Although recent monthly inflation readings indicated some slowing of core inflation from the very rapid rates of spring and early summer, many participants noted that current rates of core inflation remained undesirably high. Most participants expected core inflation to moderate gradually, but they were quite uncertain as to the likely pace and extent of that moderation.

There was some concern about consumer spending, especially if the housing market continues to falter.

To date, weakness in the housing market and the associated downshift in house price appreciation did not seem to be spilling over into consumer spending, which appeared to have grown at a steady pace in recent months. Retail activity in most Districts had been relatively robust and contacts in the retail sector were generally upbeat about the outlook. Several participants noted, however, that contacts within the transportation sector had reported that activity in anticipation of the holiday shopping season appeared to be softer than in previous years. Meeting participants judged that consumer expenditures going forward were likely to expand at a steady pace a little below the growth in disposable income, supported by favorable financial conditions, continued increases in employment and income, and the recent decline in energy prices. Nonetheless, many participants expressed concern that ongoing developments in the housing market could have a more pronounced impact on consumer and other spending, especially if house prices declined significantly.

Inflation, however, appeared to be more of a concern, even in light of lower energy prices recently. The main concern is that if core inflation is too high for too long it will cause expectations shift.

All meeting participants expressed concern about the outlook for inflation. Most participants expected core inflation to edge lower, in part as the effects of the run-up in energy prices in recent years waned. And shelter costs were not expected to add materially to inflation going forward. Moreover, moderate growth in aggregate demand and the associated modest easing of pressures on resource utilization should also contribute slightly to the slowing in core inflation. Recent changes in core prices had declined slightly from earlier in the year. Nonetheless, nearly all participants viewed the current rates of core inflation as uncomfortably high and stressed the importance of further moderation. The available measures suggested that medium- and long-term inflation expectations remained around the levels seen for the past several years, although in the view of some participants these expectations were probably higher than would be consistent with their assessment of long-run price stability. Participants were concerned that inflation expectations could begin to drift upwards if core inflation remained elevated for a protracted period. Any such rise in inflation expectations and associated upward pressure on inflation itself would likely prove costly to reverse. Although some participants noted that the recent slowing in core inflation had helped to allay their fears of a further sustained increase in inflation, all participants emphasized that the risks around the desired downward path to inflation remained to the upside.

In summary,

...Although substantial uncertainty continued to attend that outlook, most members judged that the downside risks to economic activity had diminished a little, and likewise, some members felt that the upside risks to inflation had declined, albeit only slightly. All members agreed that the risks to achieving the anticipated reduction in inflation remained of greatest concern. Members noted that a significant amount of data would be published before the next Committee meeting in December, giving the Committee ample scope to refine its assessment of the economic outlook before judging whether any additional firming was needed to address those risks.

Overall, the data coming in over the last few days has given me no reason to expect any additional firming is coming in December. Many have been speculating that the Fed may ease rather than tighten in early 2007. I'm not on that bandwagon yet, but I'm less dismissive of it than I would have been two months ago. It seems that staying the course is the best bet, probably for another meeting or two before we see where things are heading. I have been somewhat sympathetic with Mr. Lacker for worrying that core inflation has been too high for too long and thus additional firming will be necessary sooner or later. Depending on tomorrow's CPI, I maybe more or less so. I'm leaning toward the "less". If the core CPI (and then later the more important core PCE) are moderating, then it seems a good bet to hold things where they are. We shall see.

On communication, they had this to say...

The Committee then continued its discussion of communication issues and considered the advantages and disadvantages of quantifying an inflation objective. Participants stressed that any such step had to be consistent with the statutory objectives for monetary policy. In that regard, it was noted that over time price stability is a prerequisite for maximum employment and moderate long-term interest rates. However, the possible specification of a numerical price objective raised a number of complex and interrelated issues that required considerable further discussion. The Committee reached no decisions on these issues at this meeting, and participants agreed to continue the Committee's review of communication issues at its meeting in January 2007.

Check 21 is the name given to the law that allows banks to treat the image of a check as the real thing. Transmission of the images saves time and money, and it allows checks to clear even in the event of another 9/11 type of crisis that cripples the nation's transportation system (most checks travel in the bellies of airplanes).

Large banks started clearing checks electronically almost immediately after the law was passed. Now, as the NY Times reports, small businesses are able to take advantage of the efficiency improvement. The necessary hardware is available for about the price of a personal computer ($500-$1200).

Now banks are issuing miniature versions of those scanners to their small-business customers. The Stone Age, a 10-person company that sells stones, bricks, statues and tools to landscapers, started scanning its checks for deposit a few months ago. One of its owners, Jack Longo, estimates that it saves him five hours a week that used to be spent driving to and from the PNC branch about 10 miles away from his office in Totowa, N.J.

Mr. Longo had to go to the bank only twice in August: once because he had a check, for $50,000, that exceeded the dollar limit for remote deposit, and another time because he needed to initiate wire transfers that could be handled only at the branch.

Adding to the benefits, the device — a single-feed scanner made by the RDM Corporation — is connected to the company’s QuickBooks accounting software. After both sides of a check are scanned, the device’s software reads the routing number and dollar value and creates an electronic deposit slip. It also updates the company’s account balances and its accounts-receivable log.

“The computer automatically debits and credits the proper things, and all the bookkeeping is done at that time,” Mr. Longo said. That saves him money on the outside bookkeeper he pays by the hour. The scanner almost never reads the numbers wrong, he added, whereas “manually, you are prone to transposition or entering the wrong amount.”

Instructors who teach principles of macroeconomics are often discussing money and banking at about this time of the semester. This would be an interesting article for your classes and could be used as a starting point for a discussion of check clearing, the banking system, and the Fed.

3rd quarter real GDP grew at a 1.6% annualized growth rate. King asks how bad this really is and says that it's pretty bad, but not as bad as some will make it out to be. Brad DeLong says, "Gork!" Nouriel Roubini pats himself on the back for an excellent forecast. And he goes on to say:

What do these Q3 growth figures imply for Q4 and 2007 GDP growth? Expect today the usual spin with the soft-landing optimists – who were altogether wrong on Q2 growth and even more wrong on Q3 growth – having already started to spin the fairy tale of a Q4 rebound. This Q4 rebound has, so far, no base or data behind it: residential investment will be falling at a faster rate in Q4 than in Q3 given recent data on building permits and housing starts; non-residential investment that was, until now, growing very fast will sharply decelerate in Q4 and much more in 2007: see the lead story in the WSJ today referring to a McGraw Hill Construction study forecasting a rapid fall in construction spending in 2007 (including non residential construction and specifically stores and shopping centers), the first decline of construction spending since 1991.

No spin here. I do admit to being more optimistic than Roubini, but even so I am open to letting incoming data refine my position. I do not predict a 4th quarter rebound. Even if this is something approximating a soft landing, we're not out of the woods yet. Looking at the contributions of the different components of GDP to the overall growth rate, I cannot see any reason to expect anything much over 2% for the 4th quarter even under the best of circumstances. I would not be surprised with a number between 0.5 and 1.5%. Less than 0.5% would surprise me but not shock me. Residential investment will continue to be a drag on GDP, no argument there. However on the plus side, retail sales are continuing at a decent pace. Inventories are basically unchanged suggesting that firms still have some pricing power and consumers haven't yet let the housing slump get them down. Unless something suggests that the bottom is in the process of dropping out as we speak, I don't see 4th quarter GDP to be markedly worse than the 3rd.

Tim Duy makes the following observation:

Also, there is a reasonable chance that investment spending is held back by the delayed launch of Windows Vista. And note this from Bloomberg:

Norfolk Southern Corp., the fourth-largest U.S. railroad, boosted freight rates, helping third-quarter profit increase 38 percent. Sales rose 11 percent.

''Overall, we don't see any drastic slowing of the entire economy,'' Norfolk Southern Chief Executive Officer Charles ``Wick'' Moorman said in an interview. ``We think that pricing power will stay with us for a while.''

I pay attention to what the rail barons say – they generally have a good sense of economic activity.

Indeed. So while an actual prediction of a recession may be a bit premature, there are still many uncertainties that cloud the picture as we move from winter into spring. I will be paying close attention to the holiday spending figures. But interpret the early numbers with caution. The day after Thanksgiving isn't what it once was. Internet shopping peaks in mid-December. Some internet shoppers have already been at work (propping up 3rd quarter consumption?). This article on the subject is a year old, but probably still a good guide to what to expect.

The bottom line is that we are probably in for two or three quarters of below average growth. The 1995 soft landing was harder than what we have experienced so far--a fact that hasn't been mentioned much. By no means would I predict a reversal of the current trend and a return to 3+% growth yet. This report probably didn't surprise anyone at the Fed, nor would a slightly worse report in the 4th quarter. These figures support the position that pausing when they did was probably the right thing to do, but do not give any clarification about what is to come next (i.e. which will come first, a cut or an increase in rates). Staying the course still seems like the best option.

In closing, I point out a report that I have not seen getting a lot of play yet. From Bloomberg:

Oct. 27 (Bloomberg) -- An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist.

Last quarter's annualized 26 percent increase in motor vehicle production shocked Joe Carson, now director of economic research at AllianceBernstein LP in New York. Without the gain, the economy would have grown at an annual rate of 0.9 percent, not the 1.6 percent the Commerce Department reported today.

The reported increase in output came despite cutbacks announced by General Motors Corp., Ford Motor Co. and others. A drop in the wholesale price of SUVs and light trucks as the automakers cleared leftover 2006 models made production look stronger than it actually was, said Carson. The economic fallout from the auto-industry cutbacks will instead come this quarter, he said.

``Last quarter was weak even with the benefit of this mismatch and the fourth quarter will now also be weak because it's going the other way,'' Carson said. ``Whatever output you have this quarter, which will probably be down, will be discounted by a likely rebound in prices.''

Carson stressed that there wasn't an error in procedure requiring a correction from the government. It's the way the Commerce Department always computes the data and doesn't mean the statisticians committed any mistakes, he said.

Adjusting For Prices

The mismatch can be explained by looking at how the government adjusts the figures for price changes.

Commerce Department economists use wholesale light truck prices, from the Labor Department's producer price report, to eliminate the influence of inflation on investment and inventories for that category. A 5.5 percent drop in price of SUVs and other light trucks last quarter made output look stronger when adjusted for inflation, Carson said.

Declines in shipments of vehicles and parts from the Commerce Department's durable goods report over the last three months and in the Federal Reserve's output numbers in its industrial production figures, reinforce forecasts that the fourth-quarter growth numbers will show the auto cutbacks, Carson said.

Read the whole thing. Chain weighting looks at the percentage changes in constant dollar GDP for adjacent periods. So if firms cut prices to get rid of inventories, it would show up as higher growth in GDP from the production period to the sales period than if prices didn't fall. The size of the influence on overall GDP growth is larger than I would have thought, but I'll take their numbers at face value. How much it affects the 4th quarter depends on the slowdown in production. We shall see. But it's just one more thing to keep in mind going forward.

Link to the statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market. Going forward, the economy seems likely to expand at a moderate pace.

Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; William Poole; Kevin M. Warsh; and Janet L. Yellen. Voting against was Jeffrey M. Lacker, who preferred an increase of 25 basis points in the federal funds rate target at this meeting.

Differences between this statement and the last are actually very few, and do help clarify rather than obscure what the FOMC is and has been thinking.

Here is a link to the previous statement. Notice that the verb tense has changed in the paragraph on growth.

The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market.

Previously it was stated that the moderation in growth appears to be continuing. Now they say that growth "has slowed" and add a forward looking statement that growth is likely to expand at a moderate pace.

Soft landing, anyone?

The paragraph on inflation is revised and is more clear than in the previous statement. In September it read,

Readings on core inflation have been elevated, and the high levels of resource utilization and of the prices of energy and other commodities have the potential to sustain inflation pressures. However, inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations, and the cumulative effects of monetary policy actions and other factors restraining aggregate demand.

When the previous statement came out, Tim Duy was not impressed. To me it looked like they were hedging on energy prices--not yet ready to let go of the line about energy prices adding to inflation pressures. That part is now gone. As a result, the statement is a lot crisper. That is really the only substantive change. The focus now is on the possibility that resource utilization is the main worry for any further inflation going forward.

The statement about inflation risks remaining is identical to what we have seen before. The fact that Mr. Lacker dissented again indicates that among those who think inflation is already too high nothing has fundamentally changed. This is not the kind of statement that makes you think that a rate cut is around the corner. On the contrary, if this is a soft landing, some futher firming of policy will probably be needed to bring inflation down from its current level.

Today's statement is clearer than the last, and that is a good thing. The debate over whether or not we are in the midst of experiencing a soft landing will continue.

Via Reuters:

The Labor Department said a seasonally adjusted 299,000 workers filed new claims for state unemployment insurance benefits in the week ended October 14, down from 309,000 claims a week earlier.

Economists polled by Reuters were expecting a slight increase in jobless claims to 312,000 from an original reading of 308,000 in the week ended October 7.

Separately, the Conference Board released its index of leading economic indicators today. From their website:

The Conference Board announced today that the U.S. leading index increased 0.1 percent, the coincident index remained unchanged and the lagging index increased 0.2 percent in September.

and...

The leading index has fallen 1.0 percent below its most recent high reached in January. At the same time, real GDP growth slowed to a 2.6 percent (annual) rate in the second quarter, following a 5.6 percent gain in the first quarter. The behavior of the leading index so far suggests that economic growth should continue at the slow rate in the near term.

According to the Wall Street Journal, analysts had expected a 0.3% increase in the leading economic indicators. So once again the news is mixed. Overall, it appears that the economy is slowing a bit. Growth for the remainder of the year will probably remain below average, but there is no indication yet of a full-blown recession.

Taken as a whole, this week's data releases leave us pretty much where we started. If there were only a couple pieces of conflicting evidence, it would be more puzzling. The preponderance of conflicting signals reinforces what most of us have been thinking for a while. For the past few months, indeed most of this year, the economy has been slowly inching toward a critical point where either growth will slow (perhaps briefly turning negative) or resume at a more normal pace. That's a good argument for not doing anything to rock the boat at the moment.

UPDATE: On Tuesday, I admitted that the mixed bag of data makes it impossible for me to be Harry Truman's "one-armed economist". Today, James Hamilton also cannot avoid saying "on the other hand."

I'm wondering though whether "no change" might be the least likely outcome at this point. If we start to see some serious financial repercussions develop in housing, I'd look for a rate cut, and wouldn't worry in that event about commodity prices, since I would expect to see commodities fall sharply on news of a big downturn in economic activity. On the other hand, if instead we have seen the bottom for housing and the core inflation numbers remain this high, I'd look for the Fed to tighten further.

That is the direction the data has been pushing me as well. Unlike Kash, who seems more convinced than I that we've reached a peak (though he does leave some room for doubt), I see the upside and downside risks as roughly equal.

It might be that the upcoming 3rd quarter GDP data could be the news that gives us a clue as to which way this will break. It probably won't be the overall growth rate (which is likely to be positive but below everage), but the different subcategories of consumption and investment that will tell the story. At least until that point, I'm prepared to use both hands when explaining where the economy seems to be going, and what direction interest rates might take in 2007.

UPDATE 2: David Altig finds himself in general agreement and is almost ready to take the next step--but not quite.

But, for reasons I'll detail in a later post, I'm beginning to wonder about the reach of developments in [the housing] sector. I'm not quite ready to take the anti-Roubini bet with the degree of confidence that Nouriel himself puts on his recession call. But I'm getting there.

Absent any additional negative shocks, I would agree. I'm not quite ready to call it a soft landing yet, but I too am getting there.

A couple of dynamics seem to be at work in the CPI numbers released today. Obviously the fall in gas prices decreased the headline number which was down by 0.5%. That was no surprise. Yet the core rate continues to come in above the Fed's comfort zone. This months increase in the core was at 0.2%, the same as last months increase. Combined with previous increases, the core CPI has increased by 2.9% from a year ago.

Owners equivalent rent (OER) continues to push the core upward. This is due to two factors--the improvement in the rental market as housing slows, and the fall in energy prices since OER is computed net of utilities costs. See macroblog for an excellent discussion. Of course OER held the core low during the housing boom. (Ironic, isn't it?) If the rental market continues to improve and energy prices continue to fall, this effect could be with us well into 2007. Does the fact that the rise in the core can be partly explained by the rise in OER make it less troubling? Perhaps slightly, but be careful not to discount it too much. In the last couple years when OER was holding the core down, the core rate was already at the top end of the Fed's comfort zone. If the current rise in OER is the most important change to affect the core in recent months, then not much has changed. The core was rising at slightly more than a 2% rate for most of last year. If the current trend in OER continues, the core inflation rate could top out above 3%. If a simple back-of-the-envelope calculation suggests that after adjusting for OER's effect the core inflation rate has been up around 2.5% or higher for all of that time, that would still be too much for most.

In short, these numbers don't inspire me to call for a rate cut right now. However, there is an interesting question of whether the FOMC's assessment of risks has changed since the last meeting. Aside from the OER component of core inflation (which we can reasonably expect to rise a bit more--and which is somewhat more predictable), it does appear that the risk of additional inflation may have diminished. But the fact remains that the current level of inflation remains too high in the eyes of many. Facing this fact, will the Fed hold rates at this level for an extended period of time or begin raising them again? Given the suggest of "opportunistic disinflation" a decade ago, it is reasonable to expect that they might try that strategy again and hold steady for a while.

Today's CPI figures do not totally clear up the fog of uncertainties. They reinforce the fact that this is still a critical time for the economy. Given the "wait-and-see" stance of the Fed currently, I think it will take more than this to move them off of that position. Will core inflation rates on the wrong side of 3% be enough to effect a change in policy? We may find out.

(Archived BLS press release of today's CPI report)

Harry Truman wanted a one-armed economist. He didn't like our tendency to say, "on the other hand...".

These numbers make it hard to be one-armed. Let's turn it over to Reuters...

WASHINGTON (Reuters) - U.S. producer prices fell more than twice as much as expected last month on a record drop in gasoline prices, but core prices jumped amid a rebound in autos that may vex the Federal Reserve as it weighs inflation risks.

The Labor Department said on Tuesday that producer prices declined 1.3 percent in September, the steepest drop since April 2003. This came with a 22.2 percent fall in gasoline prices that broke the previous record of a 22.1 percent drop, set in March 1986.

It should be obvious that the decline in gas prices is responsible for most of the decrease. So we look at the core PPI. Brace yourself...

The core producer price index, which strips out volatile food and energy costs, advanced 0.6 percent after a 3.5 percent rebound in light motor truck prices, the largest increase since October 1985, following a 3.4 percent dip the previous month.

Passenger cars rose 2.8 percent -- the largest gain in 16 years -- after falling 2.6 percent in August.

Stripping out those sharp rises in truck and car prices, core producer prices would have risen 0.1 percent, a Labor Department official said.

So now the picture is either murkier or clearer depending on the importance you put on the core and various components of the core.

U.S. stock futures and Treasury bond prices lost ground on news of the advance in core prices, while the dollar was little changed.

"It's mostly a rebound in motor vehicle prices that exaggerated the jump in the core," said Mark Vitner, senior economist at Wachovia Securities in Charlotte, North Carolina.

"The trend is still one of moderation and with economic growth slowing, we should inflation moderating further later this year. This doesn't mean that we are not going to see a troubling number from time to time," he said.

Wall Street economists had expected the report, which comes a week ahead of a Federal Reserve meeting on interest rates, to show overall producer prices declining 0.6 percent last month while core prices were forecast to rise 0.2 percent.

So they didn't see the change in auto prices coming.

Financial markets believe the U.S. central bank will hold interest rates steady not just at its October 24-25 meeting, but through the end of the year. But the mixed signals from producer prices underline the tricky task facing policy-makers.

"I think the Fed will be confused on the number but I think the market is looking at the 0.6 (percent rise in core prices) and saying the Fed is less likely to cut," said Robert Macintosh, chief economist at Eaton Vance Management in Boston.

Wasn't the probability of a cut almost zero already? (Was that a Freudian slip revealing his wishful thinking?) This doesn't change much, and it is not going to "confuse" the Fed. The fact that gas prices dropped last month--something that all of us watched happen and so knew would be reflected in the data--certainly will not make them more likely to cut. Core PPI rose more than expected because of autos but without factoring in autos the increase was much more subdued. But when you look at the increase in the core over the last two months, you see that because of the drop in core prices (again due to autos) of -0.4% in August the total increase in the last two months is about +0.2%. That is certainly tolerable.

Far from making the Fed "confused", I think this is a reassurance that last months drop was the anomaly. The core PPI data hasn't changed dramatically since mid-summer. If anything, maybe it is a bit better. Steady as she goes. I can't see how this report is enough to swing the policy recommendation either way. So the stock market is probably overreacting a bit. They'll figure it out soon enough. They usually do. Of course there might be a little latent anxiety in the market in advance of the CPI data tomorrow. We shall see if the headline number and the core go off in opposite directions again. Given the fall in gas prices, I think it's a safe bet. The numbers will be mixed. What else is new?

Minutes of the September meeting are on the Federal Reserve website.

Highlights:

The decline in real state does not appear to be affecting spending, but it is still a concern.

Thus far, the drop in housing market activity appeared not to have spilled over significantly to other sectors of the economy. Indeed, consumer expenditures appeared to have been expanding moderately over the previous few months, buoyed by increases in employment, personal income, and household wealth. Contacts in some Districts reported that retail sales had picked up a little most recently. Meeting participants noted that consumer spending going forward would be supported by the higher levels of personal income indicated by recent revisions to the national income and product accounts, by further gains in employment, and by the decline in consumer energy prices over recent months. However, considerable uncertainty was expressed regarding the ultimate extent of the downturn in the housing sector and the degree to which the slowing in housing activity and the deceleration in home prices would affect consumption and other expenditures going forward.

Inflation seems to be weighing heavily on many of the FOMC members. Some even worry that the public could lose confidence in the Fed's commitment to fighting inflation if the core measure remains at current levels. This is a decidedly stronger statement than at the August meeting.

Many meeting participants emphasized that they continued to be quite concerned about the outlook for inflation. Recent rates of core inflation, if they persisted, were seen as higher than consistent with price stability, and participants underscored the importance of ensuring a moderation in inflation. To be sure, very recent data on inflation suggested some improvement from the situation in the late spring, partly reflecting slower increases in owners' equivalent rent. Also, the considerably lower level of energy prices of recent weeks, if sustained, would help reduce overall inflation and damp increases in core prices. Moreover, businesses would meet more resistance to attempts to pass through cost increases in the less robust economic circumstances that were likely to prevail at least for a time. However, energy prices remained quite sensitive to a wide range of forces, including geopolitical developments, and might well rebound. To date, the available evidence indicated that inflation expectations remained contained--indeed, expectations of price increases for the next few years had fallen some as energy prices declined. Nonetheless, several participants worried that inflation expectations could rise and the Federal Reserve's willingness to carry through on its intention to seek price stability could be called into question if cost and price pressures mounted or even if there was no moderation in core inflation. Looking forward, most participants thought that the most likely outcome was a reduction in inflation pressures, but the anticipated decline was only gradual and the uncertainties around that forecast were skewed toward higher rather than lower inflation rates.

Their decision in September was not as difficult as it was in August.

In the Committee's discussion of monetary policy for the intermeeting period, nearly all members favored keeping the target federal funds rate at 5-1/4 percent at this meeting. Members generally expected economic activity to expand at a pace below the rate of growth of potential output in the near term before strengthening some over time. Moreover, given the uncertainties in forecasting, significantly more sluggish performance than anticipated could not be entirely ruled out. Although the uncertainties were substantial, core inflation seemed most likely to ebb gradually from its elevated level, in part owing to the waning effects of past increases in energy prices. The anticipated expansion of economic activity at a pace slightly below the rate of growth of the economy's potential would likely also play a role by easing pressures on resources. Members noted that certain developments of late--appreciable declines in energy prices, some softer indicators of economic activity, and slightly lower readings on core inflation--pointed to a modestly better inflation outlook and hence made the policy decision today somewhat less difficult than it was in August, when it was seen as a particularly close call.

And yet they make it clear that inflation surprises will be dealt with.

In view of the most recent information on the economy, members agreed that it was appropriate for the post-meeting statement to characterize economic growth as apparently continuing to moderate. However, in view of still-high energy and other commodity prices and elevated rates of resource utilization as well as recent indications of a possible acceleration in labor costs, members continued to see a substantial risk that inflation would not decline as anticipated by the Committee. Consequently, the Committee agreed that the statement should again cite such risks to inflation and explicitly reference the possibility of additional policy firming.

Contrast this with the corresponding paragraph from the August minutes:

All members agreed that the statement to be released after the meeting should convey that inflation risks remained dominant and that consequently keeping policy unchanged at this meeting did not necessarily mark the end of the tightening cycle. They concurred that an indication that economic growth had moderated was appropriate, and a consensus favored citing the same reasons for that moderation as in the June statement. Members also agreed that the statement should both mention factors contributing to the likely moderation of inflation pressures over time and reiterate the forces that were seen as having the potential to sustain inflation pressures.

The last couple sentences of the are a little stronger in the current minutes than in the previous.

Mr. Lacker's reason for dissent remained essentially unchanged.

Mr. Lacker dissented because he believed that further tightening was needed to bring inflation down more rapidly than would be the case if the policy rate were kept unchanged. Recent data indicated that inflation remained above levels consistent with price stability. Moreover, the upswing in compensation and unit labor costs in the first half of the year indicated that inflation risks were tilted to the upside. Although real growth was likely to be moderate in coming quarters, in his view it was unlikely to be slow enough to bring core inflation down.

While it is somewhat ironic that some of the statements about inflation are stronger this time than six weeks ago, we must remember that the last minutes needed to make the case for changing the policy stance from tightening to neutral. Now that the Fed is in a more neutral stance, the communications groundwork needs to be laid for the more likely change in the policy stance. As such it would appear that the next meeting will likely yield no change, but if you were expecting a decrease in rates in the next few months you may be disappointed.

UPDATE: Wall Street Journal and Reuters have articles on the minutes. Reuters characterizes the minutes as hawkish.

UPDATE 2: The NY Times has a quote from Mr. Lacker:

In Washington today, Mr. Lacker expanded on the reasons for his dissent, saying in a speech to the District of Columbia Chamber of Commerce that he is worried that Americans will come to accept higher inflation as the rule rather than an exception, and would act accordingly, to ill effect on the economy.

“If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate,” he said. “We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. That is why I have argued for further policy actions to convincingly restore price stability.”

His entire speech can be found here, and this is the whole paragraph from which the Times quotes:

Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability.

In today's NY Times, Joseph Stiglitz takes on the topic of the hour. Most of it you have probably heard elsewhere. This part is not always mentioned:

Imagine that the Bush administration suddenly got religion (at least, the religion of fiscal responsibility) and cut expenditures. Assume that raising taxes is unlikely for an administration that has been arguing for further tax cuts. The expenditure cuts by themselves would lead to a weakening of the American and global economy. The Federal Reserve might try to offset this by lowering interest rates, and this might protect the American economy — by encouraging debt-ridden American households to try to take even more money out of their home-equity loans to pay for spending. But that would make America’s future even more precarious.

Yes, there is a tension between the fiscal and monetary authorities in cases like this. That is an important point to make, and is not always made. Stiglitz has a simple solution, however.

There is one way out of this seeming impasse: expenditure cuts combined with an increase in taxes on upper-income Americans and a reduction in taxes on lower-income Americans. The expenditure cuts would, of course, by themselves reduce spending, but because poor individuals consume a larger fraction of their income than the rich, the “switch” in taxes would, by itself, increase spending. If appropriately designed, such a combination could simultaneously sustain the American economy and reduce the deficit.

"If appropriately designed...," is a deus ex machina. This paragraph, I think even the most adamant proponents of tax increases would admit, makes a number of assumptions. One important one would be that the increase in taxes at the high end of the distribution does not reduce saving even further (since he laments our lack of savings earlier in the piece). It also assumes that the tax change would cause enough new spending by "poor individuals" to offset whatever change in consumption and savings occurs at the high end. I suppose one could postulate a Keynesian model and mathematically determine how to change taxes at different income levels--thus the phrase "if appropriately designed". I am understandably skeptical of either party's ability to do the math and appropriately design the new policy. I would also apply the Lucas Critique to any proposed model.

So the title of the piece, "How to Fix the Global Economy," is perhaps too ambitious. It's not that simple, even at the textbook level. Unfortunately, it is hard to fix the global economy in 1000 words--harder still when you have to expend half of your word budget rehashing the yuan issue. He makes an excellent point on the fiscal vs. monetary conflict but reduces the solution to one paragraph that raises more questions than it answers and makes some rather heroic assumptions about our ability to model the effects of these policies as well as our ability to design and implement them. The debate continues.

UPDATE: The debate does indeed continue. Mark Thoma, Greg Mankiw, and "knzn" all weigh in. Thoma notes that it is the difference in maginal propensities to consume (for individuals with different levels of income) that matters. True. Mankiw argues that average propensities differ, but that "...the evidence for substantially different marginal propensities is much weaker." Being charitable and granting the benefit of the doubt that there may be some difference in MPCs, I'm still left with the feeling that those MPCs (and the differences between them) are not policy-invariant (my original objection invoking the Lucas Critique). I would be very wary of attempts to fine tune progressivity to this objective. If you want to argue for more progressivity for other purposes, that's one thing. But this argument doesn't convince me. (Greg Mankiw makes a similar statement.)

Postscript: In this post, I referred to posulating a Keynesian model. That is not to say that I think that a Keynesian model would be the one I would opt for in addressing this issue, but because it seemed to best fit the argument that Stiglitz was making (the focus on the MPC in formulating tax policy). Just wanted to clarify that.

Tim Duy is not impressed.

OK, so they don’t completely know which way the economy is headed; not entirely unexpected, given that the US economy is almost certainly at an inflection point (although I like to see a bit more confidence from my central bankers, or at least another explanatory sentence). But I would expect the Fed to have a better handle on the inflation situation. Unfortunately, the third paragraph doesn’t leave me very confident on that front either. In the first sentence, energy prices have the “potential to sustain inflation pressures.” In the second sentence, inflation pressures are likely to moderate due to the “reduced impetus from energy prices.” What? WHAT!?! Are energy prices contributing to inflation or not? Shouldn’t the FOMC have an opinion on the impact of energy prices on inflation?

He's got a point. My reading of it was that they moved one of the statements about energy prices from the 2nd to the 3rd paragraph to reflect their thinking that energy prices are more likely to moderate and thus help us out on the inflation front rather than hurt us on the growth front. The line that energy prices have the potential to sustain inflationary pressures could be seen as a hedge. But that would beg the question of whether the press release is an appropriate place to hedge. I'm with Tim on that.

He also says,

In any event, this mixed message stuff is not exactly credibility enhancing.

I'll go so far as to say that the apparently contradictory statements on inflation are odd. However, divergent opinion (we know of one dissenting vote--we do not know the overall tone of the discussion) is not what could destroy their credibility. Of much greater long term consequence for their credibility is whether they follow through on what they say they will do--namely to address changes in the balance of risks according to new information.

As I wrote recently,

Everyone needs to remember that transparency in the process does not imply certainty over the outcome.

Or, in a similar vein, ambiguity does not automatically mean less credibility. So, taking Tim's comments as a jumping-off point, it's time for a discussion of how much transparency we want from the Fed and how much ambiguity we can tolerate.

Let's cut to the chase. The ultimate in transparency (short of televising the meeting, which is most assuredly not going to happen) would be for the FOMC to release the "Greenbook" along with the press release. The Greenbook is the document that contains the staff forecast and is made public with the transcripts after a five year delay. Now we could debate whether it would be a good idea to make this information public. The point is that if we had that information along with the outcome of the policy decision, we would know in real time whether they are behaving in a manner consistent with a given (forward looking) policy rule.

At that point, for the sake of credibility, you might as well go all the way and institute a policy rule.

The increased transparency of the last decade has been very welcome. It has focused the spotlight on the Fed in a way that has disciplined the organization. When I look at what I teach my classes about the Fed from principles through the graduate level, I am often amazed at how much more sophisticated it is than was even possible when I was an undergraduate. We simply have more information, and we have that information instantly at our fingertips. When William Greider's Secrets of the Temple was published almost 20 years ago, the Fed was not subject to the daily scrutiny of the 24 hour financial press, the bloggers, and so forth. Public awareness and interest in the Fed is running quite high these days. Perhaps we can thank Greider for shining the light on the Fed. Certainly the mystique of Chairman Greenspan, especially after his handling of the 1987 stock market crash, had a lot to do with it. But ultimately it was the institution, led by Greenspan, that took on the challenge of making its actions known for the benefit of all. Even though they knew it might restrict them in the future. These are small steps towards a commitment mechanism.

However, the job isn't done. As the minutes of the August meeting make clear, the Fed is taking a long look at its communication policy. The experience of the last decade suggests that the more we know about what goes into the decision (this we learn from "Fedspeak") and the faster we know the decision (press releases and minutes), the less latitude they have to do things that are out of line with our expectations. Transparency enhances credibility at the cost of tying your hands. ("Measured pace," anyone?) However, tying your hands without a clear objective in mind could lead to trouble.

And so they should review their communication policy. Today's press release was a little problematic in the ways that Tim Duy points out. But even so, today's press release was more enlightening than the months worth of "measured pace" statements that, as I have said before, painted them into a rhetorical corner, unable to raise rates faster or slower than 25 basis points per meeting for fear of spooking the markets. That was not their finest hour in terms of communication skills either.

Personally I'd prefer that they release the Greenbook right away, issue a longer press release detailing some of the discussion of the Greenbook and clearly define their objective function. But that isn't likely to happen soon, so we will have to settle for some occasional abiguity to make sure that they don't get tangled up in their own rhetoric as they navigate between their dual, and sometimes conflicting, objectives.

UPDATE: New Economist is also unimpressed with today's statement.

FOMC press release

Mark Thoma does the line-by-line comparison. The 30 second summary of which is that the housing slowdown is no longer regarded as "gradual" and that energy prices are not as much of a concern as they were previously. As a result, energy prices are now mentioned in the paragraph on factors moderating inflation (because they seem to have stabilized) rather than factors moderating growth (as when they were still climbing).

On a related note, oil was down again today.

And despite the fact that Jeffrey Lacker dissented again, preferring a 25 basis point increase, there is a growing chorus of those anticipating a rate decrease in the next few months.

PIMCO has heard both sides and takes the middle road. (Reuters)

CHICAGO (Reuters) - The Federal Reserve could keep benchmark interest rates steady for some time given its focus on pulling down inflation, said Paul McCulley, managing director of the bond fund PIMCO.

"The hurdle to starting an easing process is high, because the Fed actually does want to see softer employment growth," McCulley said in a research note released on Wednesday.

"A deceleration in growth is not necessarily sufficient on its own for the Fed to start easing, particularly when the Fed wants inflation to actually come down rather than just stop going up," he said.

For the easing cycle to start, McCulley said the risks of an economy-wide recession must be more apparent. "Those risks aren't there at the moment, and on our base case forecast, they won't get there over the cyclical horizon," he said.

I know some people who would disagree strongly. However, McCull