Thursday, November 27, 2014

The Impotence of the Federal Reserve

CAMBRIDGE – The United States Federal Reserve’s recent announcement that it will extend its “Operation Twist” by buying an additional $267 billion of long-term Treasury bonds over the next six months - to reach a total of $667 billion this year - had virtually no impact on either interest rates or equity prices. The market’s lack of response was an important indicator that monetary easing is no longer a useful tool for increasing economic activity.

The Fed has repeatedly said that it will do whatever it can to stimulate growth. This led to a plan to keep short-term interest rates near zero until late 2014, as well as to massive quantitative easing, followed by Operation Twist, in which the Fed substitutes short-term Treasuries for long-term bonds.

These policies did succeed in lowering long-term interest rates. The yield on ten-year Treasuries is now 1.6%, down from 3.4% at the start of 2011. Although it is difficult to know how much of this decline reflected higher demand for Treasury bonds from risk-averse global investors, the Fed’s policies undoubtedly deserve some of the credit. The lower long-term interest rates contributed to the small 4% rise in the S&P 500 share-price index over the same period.

The Fed is unlikely to be able to reduce long-term rates any further. Their level is now so low that many investors rightly fear that we are looking at a bubble in bond and stock prices. The result could be a substantial market-driven rise in long-term rates that the Fed would be unable to prevent. A shift in foreign investors’ portfolio preferences away from long-term bonds could easily trigger such a run-up in rates.

Moreover, while the Fed’s actions have helped the owners of bonds and stocks, it is not clear that they have stimulated real economic activity. The US economy is still limping along with very slow growth and a high rate of unemployment. Although the economy has been expanding for three years, the level of GDP is still only 1% higher than it was nearly five years ago, when the recession began. The GDP growth rate was only 1.7% in 2011, and it is not significantly higher now. Indeed, recent data show falling real personal incomes, declining employment gains, and lower retail sales.

The primary impact of monetary easing is usually to stimulate demand for housing and thus the volume of construction. But this time, despite historically low mortgage interest rates, house prices have continued to fall and are now more than 10% lower in real terms than they were two years ago. The level of real residential investment is still less than half its level before the recession began. The Fed has noted that structural problems in the housing market have impaired its ability to stimulate the economy through this channel.

Business investment is also weak, even though large corporations have very high cash balances. With so much internal liquidity, these businesses are not sensitive to reductions in market interest rates. At the same time, many very small businesses cannot get credit, because the local banks on which they depend have inadequate capital, owing to accrued losses on commercial real-estate loans. These small businesses, too, are not helped by lower interest rates.

The Fed’s monetary easing did temporarily contribute to a weaker dollar, which boosted net exports. But the dollar’s decline has more recently been reversed by the global flight to safety by investors abandoning the euro.

Even if the US economy continues to stumble in the months ahead, the Fed is unlikely to do anything more before the end of the year. The next policy moves to help the economy must come from the US Congress and the administration after the November election.

Nonetheless, what needs to be done is already clear. The cloud of a sharp rise in personal and corporate income-tax rates, now scheduled to occur automatically at the start of 2013, must be removed. The projected increase in the long-term fiscal deficit must be reversed by stemming the growth in transfers to middle-class retirees. Fundamental tax reform must strengthen incentives, reduce distorting “tax expenditures,” and raise revenue. Finally, the relationship between government and business, now quite combative, must be improved.

If these things happen in 2013, the US economy can return to a more normal path of economic expansion and rising employment. At that point, the Fed can focus on its fundamental mandate of preventing a rise in the rate of inflation. Until then, it is powerless.

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    1. CommentedProcyon Mukherjee

      I would like to draw attention to Per Jacobsson Lecture by Dr. Reddy dated 24th June, Professor Levine’s seminal paper on lack of independence of the financial regulatory authority and Robert Schiller’s allusion to the Code of Ethics for financial innovation in providing stewardship to the society’s assets.

      That regulatory capture is pervasive and comprehensive, there is enough evidence both in the run up to the crisis as well as after it had mellowed and even in periods of tranquil. The financial markets helped by central bank advances have amassed assets that have compounded annual growth rate of 9% (even after the painful adjustments), whereas the world economy has not even grown by 3%. This apparent dysfunctional arrangement had raised the doubt that financial markets instead of propounding systemic stability, consumer protection and risk mitigation practices to benefit large sections of people may have actually not served the lofty goals of bringing financial service access to greater majority of people, who go through the pains of adjustment more than the larger institutions; in providing the balance between serving those sections who have less knowledge of the products on offer that could advance credit and could be actually used judiciously through a mode of smoothening consumption (not excessive leverage), the larger focus had shifted to misallocation of resources to housing and consumer credit at an alarming rate which is not sustainable. People who need to keep their financial savings in safe custody actually succumbed in this process with large scale erosion of their net worth. But more importantly the competitive efficiency of the global financial markets whose benefits should have flown unequivocally to the larger sections of the society actually petered to an excessive financialization that made some of the sovereign back-stops insufficient. The question of sovereign insolvency, which was never in doubt, has become a very common word and the moral hazard has multiplied its preponderance in recent times.
      The over-financialization has led to housing market crash and it is probably going to take a decade to even out the effects of excessive supply stemming from extreme leverage, but the effect of the same in the commodity markets needs a careful scrutiny. The over-financialization of the equity markets may be the next step in the making.
      Excessive financialization of the commodity markets as is evident in the component of money supply that moved to this segment had served the dual purpose of creating a virtual demand through credit conditions and therefore supporting a real supply that may not be actually consumed. The net impact of this has left a gaping hole in the balance sheet of large corporations operating in these markets, through erosion of equity and reserves, while the solvency could be maintained through financial instruments.

      We are living in times where regulatory capture is complete.

      Procyon Mukherjee

    2. CommentedDave Friedel

      While Bernanke has skillfully navigated the current environment with the monetary tools afforded to him with some creative liberty, he understands a centralized global solution must be arrived at sooner than later. Removing the uncertainty around the tax code for US businesses is only a small part of the problem and a more global approach to growth must be undertaken by rethinking the role of currency and nations as a whole.

      The fundamental basis of globalization and the mechanisms that govern the species must be addressed if meaningful, sustained advancement is to be achieved without the constant disruptive booms and busts which are becoming more common place. The base must be integrated, involved and a system of visibility and accountability needs to reach as far as the corporations themselves instead of archaic solutions to a problem which no longer is homogeneous in nature which may resonate with those of past generations and provide temporary relief but ultimately will result in greater dissonance. Soon we may reach the point where incremental advances from competitiveness no longer propels us meaningfully forward and only through cooperation will we reach the next level. Whether the base is ready for such innovation has yet to be seen without some sort of catastrophe to bring about change.

    3. CommentedDavid Doney

      I think the prescription merits some adjustments.

      An overly-indebted private sector is not spending as it should as it pays down debt and worries about the future. Corporations are sitting on this savings rather than investing it, not because of a bad relationship with government but because they worry about the solvency of their customers and face a shortfall in demand for their goods.

      Richard Koo explained this situation well when he discussed balance sheet recessions.

      GDP = C + I + G + NX

      With the C and I engines of GDP cavitating, G has to step up. Or we bring the jobs home to reduce a negative NX with a ban on offshoring and requirement for a 10 year plan to bring home the jobs.

      The key is eliminating the private debt albatross. To get consumers spending, let's write down their debt. The Fed can print money or the Federal government can borrow money at very low rates to pay down $1 trillion in student loans and $3 trillion in mortgage debt.

      Some wage driven inflation would help pay off debt in more plentiful dollars, as we did after WW2. If nominal wages are going up but debt is fixed, that is a good thing.

      Removing the cap on the payroll tax should cover the Social Security shortfall; we can also make some minor retirement age and cost of living adjustments.

      Letting the Bush income tax cuts expire for the wealthy now and others later would return us to Clinton tax rates, when the economy was fine.

      Yes, some tax expenditure reduction is a good idea, provided it is done progressively.

      Medicare is the big long-term concern and we'll need to go after the dozen or so cost drivers of private healthcare costs.

      But most importantly, in the short-run, government should step up demand and debt reduction. Infrastructure, clean energy, education reimbursement, etc.

      Once C is working, the rest follows.

    4. CommentedProcyon Mukherjee

      Monetary policy all along in times of crisis had been an approach towards experimenting with responses under different stimuli; it had never been a static continuation of instruments that have received the same set of responses, as in the present case, of heightened liquidity preference from corporates to the common man.

      I do not know how expansion of piles of cash in the balance sheet of S&P 500 and a market index that is buoyant by bond price escalation could be the primary indicator that reflect positivity of Fed actions while the real economic progress that comes from production and sales could be relegated to a tertiary activity in any economic analysis.

      The problem is too much liquidity chasing to few ideas in favor of economic progress.

      Procyon Mukherjee

    5. CommentedRichard Foosion

      >> The market’s lack of response was an important indicator that monetary easing is no longer a useful tool for increasing economic activity.>>

      That the Fed's inadequate actions did not do much does not mean that monetary easing is no longer a useful tool; it only means that inadequate actions are inadequate.

      >> The projected increase in the long-term fiscal deficit must be reversed by stemming the growth in transfers to middle-class retirees.>>

      The main issue here is healthcare costs. Transferring those costs from the government to retirees doesn't do anything for our overall economic health (govt plus citizenry). According to the CBO, costs would increase, mostly because Medicare has more buying power and lower overhead than alternatives.

      >> Fundamental tax reform must strengthen incentives, reduce distorting “tax expenditures,” and raise revenue. Finally, the relationship between government and business, now quite combative, must be improved.>>

      Business profits are at all time highs. That doesn't sound very combative to me.