Monetary Policy

Argentina is known for its populists leaders, as well as spectacular economic booms and busts. Yet looking at the economic data of the last fifty years, successive governments have, perhaps somewhat surprisingly, run fairly traditional countercyclical public policies. Government spending generally increased during downturns and slowed during spurts of economic growth. As you can see in the graph below, this trend was more noticeable in the 1960s and 1970s, but continued (if somewhat lessened) throughout the 1990s and early 2000s. World Bank Data This approach though has changed since the Kirchners (first Néstor, now Cristina) took office. Since 2003, and despite mostly good economic times, government spending has just grown,  rising by almost 500 percent in absolute terms. In relative terms, the 2011 levels of 15 percent of GDP are the highest recorded over the past fifty years. World Bank Data The government widely touts its new economic third way. But Argentina is also experiencing dollar shortages, capital flight, and rising inflation (at least unofficially). The question that remains is whether this government will be able to forge a new political path as well, and not be voted out when the coming rainy day hits.

Last week’s Bank of England (BoE) poll of UK lenders turned up some good news: credit “availability” for both households and companies is on the rise – as we document in the upper right figure of today’s Geo-Graphic.  The Old Lady of Threadneedle Street was quick to take credit for the credit: “Lenders noted,” crowed the BoE, “that the Funding for Lending Scheme,” through which the BoE and UK Treasury have since August provided banks with cheap funds to boost their lending, “had been an important factor behind this increase.” The survey the BoE referred to should be considered about as reliable as LIBOR, which, as we know, has been subject to systematic manipulation by major international banks over recent years.  The indexes of credit availability the BoE has manufactured from its surveys are similarly unreliable, as the banks have every incentive to convince the BoE that FLS is working, and that cheap government funds should keep flowing to them.  Actual UK lending, however, as our bottom two figures show, remains depressed. Not surprisingly, given tight lending conditions in the U.S (see the upper left figure), Fed Chairman Ben Bernanke has said that he is “very interested” in the scheme.  This has stimulated market expectations that the Fed might try to launch something similar in the United States.  The Fed should hold its fire. Bank of England: Credit Conditions Survey 2012 Q4 Fed: October 2012 Senior Loan Officer Opinion Survey on Bank Lending Practices Bernanke: June 20, 2012 Press Conference Financial Times: Credit Conditions Ease "Significantly"

Back in March, we showed that the $1.4 trillion in U.S. direct federal student loans that will be outstanding by 2020 will amount to roughly 7.7% of the country’s gross debt. This is 6.3 percentage points higher than it would have been had the scheme not been nationalized in President Obama’s first term. The government’s net debt was not directly affected by the move, as the government acquires assets when it issues student loans. The problem is that projected default rates on such loans have been climbing as the volume issued has increased, as shown in the graphic above. If we apply the projected default rate on loans originated in 2009 to the amount of student loans outstanding in 2012, we find that defaults on federal student loans currently outstanding are likely to cost taxpayers almost $80 billion. And the cost is projected to increase rapidly over the next decade as default rates continue to rise and the amount of student debt the federal government owns soars. There is more than a whiff of resemblance between the rise of the federal government’s student debt liability and the mortgage bubble – the detritus debt of which wound up nationalized. There is little in the way of credit checks carried out, and no evaluation of future earnings prospects. In the ten years to 2008, the amount of mortgage debt tripled: $3.2 trillion to $9.3 trillion. The CBO projects that student loans on the government’s balance sheet will rise just as fast: $453 billion in 2011 to $1.4 trillion in 2020. A 17.3% default rate on $1.4 trillion in loans would cost taxpayers about $240 billion. This is equivalent to 1% of the CBO’s GDP projection for 2020. It is also more than three times the 2013 federal funding level for the Department of Education, and just slightly less than ten times the amount the president requested for science, technology, engineering, and mathematics (STEM) programs in his most recent budget. It is surely worth asking, therefore, whether this $240 billion could be used more effectively than it will be in writing off defaulted student loans. Department of Education: Default Rates Bloomberg.com: Student Loans Go Unpaid, Burden U.S. Economy Wall Street Journal: Federal Student Lending Swells Geo-Graphics: Will Student Debt Add to America’s Fiscal Woes?

One interesting footnote to the Fed’s decision today to introduce quantitative thresholds--that it expects to keep rates low at least as long as unemployment exceeds 6.5%, their inflation forecast doesn’t exceed 2.5%, and long term inflation expectations are well anchored--relates to the fiscal cliff. The fiscal cliff creates a risk to the outlook that is unusually sizeable in a short timeframe.  First, while some of the cliff is phased in over time (a “fiscal glide”), there are significant upfront effects that will be reinforced by potentially sharp moves in financial markets.  This suggests the pass-through to the real economy would be rapid.  Also, whatever the eventual outcome, uncertainty due to the fiscal cliff is highest over the next few weeks or months.  This is not a combination that monetary policy is well designed to address.  With interest rates at the lower bound, evidence that successive rounds of quantitative easing are having a diminishing impact on the economy, and the long lags through which monetary policy feeds through to the economy, the Fed has limited short-term ability to buffer the economy if we go off the cliff.  But there will still be a monetary policy offset through changing expectations of future policy.  If we go fully off the cliff, and growth plunges, the yield curve should flatten (bond prices rise) on revised expectations of easy-for-longer monetary policy and safe-haven flows, providing a brake against the worsening of financial conditions that would result.  Conversely, a good deal brings forward expectations of the timing of the recovery. What’s different now?  The new approach creates automatic adjustment by markets.  Now when a shock hits the economy, we change our forecast and reset expectations accordingly; we don’t need a confirming change in guidance from the Fed.  Chairman Bernanke emphasized this point in today’s press conference. Yesterday I blogged about the seeming disconnect between how NY and DC look at the fiscal cliff.  My bottom line was that while there was an upside to markets if a comprehensive deal was agreed that included the debt limit, the markets may be underestimating the risk of outcomes that leave the debt limit unaddressed and cause substantial uncertainty to persist into 2013.  This is still the case, but if the Fed’s new approach and the clarity it provides results in a stronger or quicker market response, then monetary policy may be a more effective buffer against a negative cliff shock.  In any event, it will be an early test of the new approach.

The United States marches solemnly towards its fiscal cliff, awaiting only the command from the Goddess of Reason to halt. Unfortunately for Greece, that country plugged its ears back in March. Like the United States, Greece made prior commitments on spending and taxation in order to bind itself to the mission of deficit reduction. Unlike the United States, Greece left itself little means to unbind itself. As shown in the graphic above, its massive debt restructuring in March only reduced its debt-to-GDP ratio from 170% to 150%, but in the process made further significant restructuring much more difficult. Before the March restructuring, Greece owed private sector creditors €177 billion in obligations governed by Greek law and only €30 worth governed by international law, the latter being vastly more difficult to walk away from. After the restructuring, Greece owed private sector creditors only €86 billion, but all of it was now governed by international law (31.5%*177 + 30). And it also added €75 billion to its €124 billion stock of official sector (EU and IMF) obligations, bringing that total to a whopping €200 billion. Though Greece desperately needs to shed more debt, it faces the problem that its private sector creditors are now all shielded by international law, and its public sector creditors are protected by the power to hurl it into unsplendid economic and political isolation. This suggests strongly that Greece should simply have repudiated all its Greek-law private sector debt back in March, when it had the chance. Why didn’t it? Many reasons, some of which flimsy – such as fears of triggering credit default swaps if the restructuring were “involuntary.” But the most pressing reason was to avoid crushing the Greek banking sector, which was exposed to Greek sovereign debt to the tune of about €50 billion. The €25 billion lent to Greece by the so-called European Financial Stability Facility (EFSF) in order to recapitalize its banks would then have to have been a much higher €50 billion. Still, Greece would be at considerably less risk of hurtling over the fiscal cliff today had it avoided taking on the additional €56 billion worth of nonrepudiable private sector IOUs in March. In contrast, the United States can avoid its looming cliff by Congress and the president agreeing just to keep on adding to the prodigious national tab. It’s good to be the king of reserve-currency issuers - at least until the market cuts your head off. European Financial Stability Fund: Questions and Answers IMF: Greece's Financial Position in the Fund as of Sept. 30 BIS: Consolidated Banking Statistics Geo-Graphics: The IMF Is Shocked, Shocked at Greece's Fiscal Failure. Should It Be?

In last week’s vice-presidential debate, Republican Paul Ryan defended the fiscal prudence of lowering top marginal income tax rates by arguing that it would be accompanied by “forego[ing] about $1.1 trillion in loopholes and deductions . . . deny[ing] those loopholes and deductions to higher-income taxpayers.” The $1.1 trillion he refers to is actually an amalgam of specific “tax expenditures” – benefits distributed through reductions in taxes otherwise owed – identified by the Joint Committee on Taxation.  We break out the largest 10 of these graphically in the figure above. The full list is available here: http://subsidyscope.org/data/ The red bars indicate items that Romney and Ryan had previously promised not to touch: exclusion of employer contributions for health care, deductions for mortgage interest, reduced tax rates on dividends and long-term capital gains, and deductions for charitable giving.  These four items constitute a massive 30% of the $1.1 trillion.  Therefore the Ryan pledge to cut loopholes and deductions cannot, mathematically, be worth more than $770 billion. And note some of the other big-ticket “loopholes and deductions” on the list.  Social security and other retirement income constitute three of the top ten items, together making up 13% of the total, and the earned income credit, which benefits the poor, represents another 5% of the total.  Would Romney and Ryan eliminate those deductions?  We’ll speculate here: no.  A quick skim of the remainder shows that few of these items constitute “loopholes” in the public’s mind – they are items few imagine could or should be taxed. In short, Romney and Ryan cannot, logically, keep the pledge to cut $1.1 trillion in tax shields for the rich, because (1) they have already ruled out eliminating the biggest of such shields, and (2) much of the $1.1 trillion is actually derived from tax expenditures targeted at lower and middle income taxpayers – not tax shields for the rich.  This almost surely means that only a small fraction of the $1.1 trillion is actually in play. Sensitive to the charge that his numbers are not adding up, Romney proposed at Tuesday night’s presidential debate capping deductions at $25,000.  This would raise $1.3 trillion in revenues over the next ten years, according to the Tax Policy Center.  But that figure is only slightly above what Ryan said they would raise each year.  A $1 trillion a year hole remains in their budget math. Transcript: The 2012 Vice Presidential Debate Pew: Subsidyscope Tax Expenditure Database Romney: Tax Plan Ryan: Sept. 30 Appearance on Fox News Sunday

Back in February, Benn argued that the Fed’s three-year zero-rate pledge, combined with a 2% long-run inflation target, may have been a pledge too far, given the Fed’s poor forecasting record going back decades.  The Board of Governors’ and Reserve Banks’ first three-year forecasts in October 2007, for example, were wildly off the mark: actual 2010 GDP, unemployment, and inflation were all outside the range of the 17 forecasts.  Yet at its September meeting, the Fed’s Open Market Committee extended its zero-rate pledge into 2015, on the basis of its forecast that unemployment would still be significantly above their “longer run” expectation at that time—as shown in the figure above.  But last week’s September payrolls report revealed that the unemployment rate had dropped more than anticipated, to 7.8%, putting the 6-month trend line into 2015 well within the Fed’s comfort zone.  This implies that interest rates, by the Fed’s own reasoning, may well need to rise sooner.  We think it’s time that the Fed pledged to stop pledging for a while. FOMC: September 2012 Statement FOMC: Economic Projections of Fed Board Members and Reserve Bank Presidents, September 2012 BLS: The Employment Situation—September 2012 CNBC: Fed Often Gets It Wrong In Its Forecasts on U.S. Economy

The IMF last week told the Greek government to get with the program—specifically, the economic adjustment program that Greece agreed to as a condition for receiving loans from the Fund.  Greece is indeed way off target, but that’s apparently par for the course with such programs.  In 2003, the IMF’s own independent evaluation office looked at the difference between actual and projected changes in fiscal balances in countries receiving funds from its Extended Fund Facilities (EFF) and so-called Stand-By Arrangements (SBA).  As shown in the graphic above, nearly ¾ of market-based countries (that is, countries not in transition from central planning) receiving funds from the EFF or SBA underperformed their targets in the second year of their program.  By this standard, Greece looks like a normal ward of the IMF. However, Der Spiegel reported on Monday that the Troika of official Greek lenders (the European Commission, ECB, and IMF) was now pegging Greece’s budget deficit at €20 billion.  If accurate, that would put Greece on track to miss its IMF fiscal deficit target by €13 billion, or a whopping 6 percent of GDP – making it an extreme target-underperformer even by the standards of the many past underperformers. Der Spiegel: Troika Nearly Doubles Estimate of Greek Shortfall IMF: Statement on Mission to Greece Geo-Graphics: Does “More Europe” Mean More Pro-Cyclical Fiscal Policy? IMF Evaluation Report: Fiscal Adjustment in IMF-Supported Programs

Two of Mexico’s leading think tanks—Mexico Evalúa and IMCO—launched a new website this week, titled Mexico ¿cómo vamos? It lays out a perhaps surprising vision for Mexico: as a leading global economy. The website brings together some sixty economic and public policy experts from varying backgrounds to focus on where Mexico’s economy stands today and what it needs to do to achieve this ambitious future. Providing both raw data and expert analysis, the website identifies attainable goals in six critical areas (investment, competition, competitiveness, well-being, productivity, and exports), with the aim of expanding the middle class, reducing inequality, and promoting social inclusion. While much of the information is available through different sources around the internet, Mexico cómo vamos brings it all together in one place, and uses effective easy-to-read graphics to illustrate its goals. My current favorite is its “Economic Stoplight,” which will be updated every three months. In this graphic, Mexico cómo vamos explains where Mexico should be on various measure to reach a better future, and then compares these numbers to where it currently stands—color coding by just how close Mexico is to its target. As seen below (translated to English), Mexico is right on track for private investment and exports, but far below where it needs to be regarding productivity and competition. From Mexico cómo vamos wesbite http://www.mexicocomovamos.mx/semaforo-economico To move from red and yellow toward green will require a collective push from many different sectors of Mexican society and especially from the incoming government (whose transition team was invited to México cómo vamos’s launch). There are real challenges that will require significant political capital to overcome. But by breaking down the information and factors into this set of indicators, Mexico cómo vamos is helping provide a means for monitoring Mexico’s successes and failures, and hopefully influencing policy. While still in its website infancy, Mexico cómo vamos looks to be a valuable resource for Mexico watchers, informing citizens and hopefully provoking the broader discussions necessary to move the country forward.

Fed Chairman Ben Bernanke defended QE3 at his September 13 press conference by arguing that it would lower mortgage rates and increase home prices.  Over 80% of U.S. household debt is mortgage debt, so the extent to which he is right could be of considerable consequence to the future path of economic recovery.  Among the skeptics is the Financial Times, whose lead story on September 17 emphasized processing backlogs at major mortgage originators, which would block the transmission mechanism from Fed mortgage-backed securities (MBS) purchases through to lower mortgage rates. Yet just after the announcement of QE1 in November 2008, which committed the Fed to buying $500 billion in MBS (expanded to $1.25 trillion the following March), mortgage and refinancing applications spiked to much higher levels than they’re at today – and the spread between 10-year Treasurys and 30-year mortgages still fell rapidly and massively, as the graphic above shows.  Bernanke has history on his side here. Financial Times: QE3 Hit by Mortgage Processing Delays Video: Ben Bernanke's September 13 Press Conference Steil and Walker: Bernanke's "Risk-On, Risk-Off" Monetary Policy Eavis: An Enigma in the Mortgage Markets That Elevates Rates

The Fed has a dual mandate to pursue price stability and maximum employment.  How should these be defined?  In January, the Fed set itself a long-run inflation target of 2%, while in June the midpoint of Fed board members’ and Reserve Bank presidents’ long-run unemployment predictions was 5.6%.  Our figure above shows actual inflation and unemployment performance relative to these targets going back to 2002.  What stands out is the divergence that opens up, particularly on the unemployment front, after Lehman Brothers failed in September 2008.  The sum of the deviations reached its peak in July 2009, as shown in the small box in the upper left of the figure.  Though it has since declined fairly steadily, it is still well above zero – zero being a benchmark for fulfilling the combined mandate.  This suggests that the Fed’s doves should continue to hold the upper hand. Federal Reserve: Objectives in Conducting Monetary Policy Federal Reserve: Longer-Run Goals and Policy Strategy Hilsenrath: Gauging the Triggers to Fed Action Mallaby: Show Some Real Audacity at the Fed

Central bankers necessarily spend a great deal of time studying economic and market data that they believe to be forward-looking indicators of the economy’s health.  One such is the so-called “LIBOR-OIS spread” – the spread between the London Interbank Offered Rate (the rate at which major banks can supposedly borrow from each other, unsecured by collateral, for three months) and the Overnight Indexed Swap rate (which reflects market expectations of the overnight unsecured rate over a three-month period).  LIBOR is generally higher than OIS because of liquidity and credit risk (the risk that the borrowing bank will default on a loan).  European Central bank (ECB) board member Benoît Cœuré, echoing thoughts expressed by Alan Greenspan and others in the past, recently referred to the LIBOR-OIS spread as “a standard measure of tensions in unsecured markets.” It goes up when such tensions go up, and down when such tensions go down. The LIBOR-OIS spread can be low, however, even when banks are in appalling financial health.  How is this possible? The problem starts when the government begins tracking such a measure to determine whether it needs to do something.  The reason is that when statistical measures are targeted for policy purposes they tend to lose the information content that recommended them for that role in the first place.  This common pitfall in economic policymaking has been termed “Goodhart’s Law,” having been first articulated by British economist and former Bank of England Monetary Policy Committee member Charles Goodhart back in 1975. Could Goodhart’s Law be at work with the LIBOR-OIS spread?  We believe so.  In March, after the ECB ended its Long-Term Refinancing Operations (LTRO), which provided banks with over €1 trillion in 3-year 1%-interest loans, the LIBOR-OIS spread continued the downward trend it started on after the program was launched last December – as shown in the main graphic above.  By Cœuré’s logic, this indicated that LTRO had succeeded in addressing earlier worries about the ability of major European banks to attract vital funding. But look what happens to the price of 5-year credit default swaps (CDS) on the members of the LIBOR bank panel after LTRO ends – it soars.  A huge, and highly unusual, gap opens up between the CDS price and the LIBOR-OIS spread.  The small box in the upper left of the graphic shows that CDS prices and the LIBOR-OIS spread were highly correlated over the two years to the start of LTRO, but that this relationship collapses thereafter.  This indicates that whereas banks are happy to lend to each other for three months, given that they’re now awash with ECB cash, the end of LTRO combined with a renewed deterioration of Spanish and Italian sovereign bond prices led to rapidly revived fears of bank defaults within 5 years. In other words, the LTRO policy intervention significantly reduced the information content of the LIBOR-OIS spread.  CDS prices are now a more valid indicator of the health of the eurozone banking system – which is poor and deteriorating. Cœuré: The Importance of Money Markets St. Louis Fed: The LIBOR-OIS Spread as a Summary Indicator Financial Times: ECB Emergency Aid Is"No Silver Bullet" Chrystal and Mizen: Goodhart's Law—Its Origins, Meaning and Implications for Monetary Policy

When the Federal Reserve’s Open Markets Committee (FOMC) last met in April, the unemployment rate was on a declining path – having fallen to 8.2% in March from 9.1% the previous August.  Against this backdrop, the Committee was modestly sanguine on prospects for job growth going forward.  “The unemployment rate will decline gradually,” it predicted, “towards levels that it judges to be consistent with its dual mandate,” without need for new monetary stimulus measures. The two broken lines in the figure above show the upper and lower bounds of the “central tendency” of the Fed’s April unemployment forecasts – that is, the range of forecasts excluding the top and bottom three.  The three dotted lines show the trend of the unemployment rate if the pace of the decline in the number of unemployed people in the three months prior to March, April, and May, respectively, were to continue.  As can be seen by the May trend line at the top, the employment picture has clearly deteriorated since the FOMC met in April, and is above the most pessimistic of its “central tendency” forecasts.  This suggests that there will be significant pressure from within the Committee for further easing when it meets this Tuesday and Wednesday, June 19 and 20.  We believe this will take the form of extending “Operation Twist,” its program launched last September to push down long-term interest rates by buying long-term bonds using the proceeds of shorter-term bond sales. FOMC: April 2012 Meeting Statement Bloomberg: Fed Seen Twisting to Risk Management to Spur U.S. Growth The Economist: Shiny, New, Unopened & Unused Mallaby: The Fed and the ECB Should Be Trading Places

The so-called Taylor Rule in monetary policy suggests how the Federal Reserve should adjust interest rates based on movements in inflation and economic output.  Although the Fed has never explicitly followed such a rule, it described fairly well the path of interest rate policy under much of Alan Greenspan’s tenure as chairman. Our own primitive “Geo-Graphics Rule” suggests that from 2000 to 2008 the Fed also tended to move rates in line with household (and nonprofit) risk aversion, which we define in terms of the ratio of their currency, deposits (mostly insured), and money market fund holdings to their total financial assets.  The predictive power of our “rule” was strong (with an R² of 0.77, meaning that it was able to predict 77% of the variation in the Fed Funds rate), even measured against Taylor (with an R² of 0.69 from 1987 to 1999, and 0.51 from 1987 to 2006, using John Taylor’s 1993 formula and CBO measures of potential GDP). Household risk aversion soared as the financial crisis unfurled in 2008 and 2009, at which point our Geo-Graphics Rule suggests that the Fed Funds rate should have gone deeply negative.  In its stead, the Fed cut the rate to near-zero and engaged in “quantitative easing” (QE) to expand its balance sheet, mimicking the effect of negative interest rates. Household risk aversion has bounced around since 2011, as has the Fed Funds rate predicted by our rule.  Actual Fed policy has generally been more accommodative than predicted over the past 18 months.  Today’s Fed Funds rate should, on past experience, be near 1%. What does the Geo-Graphics Rule say about prospects for more QE going forward?  The Fed’s Flow of Funds data are released with a three month lag, so we won’t know where today’s risk-aversion measure stands until late September.  Given recent market volatility, it is likely back on the rise.  A modest one percentage point move upward would suggest another round of QE before the end of the year. We thank our former colleague Neil Bouhan for his contribution to this post. Taylor: Discretion Versus Policy Rules in Practice Chart Book: Economic Recovery Video: Conducting Monetary Policy at the Zero Bound Kansas City Fed: Taylor Rule Deviations and Financial Imbalances