Is the Fed fighting an old war?

June 15th, 2017 at 12:18 am

As expected, as their meeting concluded yesterday, Federal Reserve Chair Janet Yellen and company decided to raise the benchmark interest rate they control by one-quarter of a percentage point. The question is: why?

She was, of course, asked about this in lots of different ways in her press conference. [Pause here for a moment and consider the substantive difference between a Yellen press conference and a Spicer press conference. Kinda makes you shudder.] Specifically, journalists reasonably wanted to know what was up with the rate hikes given how low inflation has been. Sure, we’re closing in on full employment, but the Fed’s preferred inflation gauge, the core PCE, is below their 2 percent inflation target and slowing. It’s decelerated from 1.8 percent in the first two months of this year to 1.6 percent in the last two months. Expectations remain low–under 2 percent–as well. That’s the opposite of what you’d expect if tight labor markets were juicing price growth, and a legitimate reason not to tap the growth brakes with another rate bump.

Chair Yellen, as you’d expect, made a coherent case about not getting “behind the curve” and thus tapping the brakes now to avoid slamming them later. She talked about one-time factors dampening price growth, predicting that as soon as these faded, inflation would firm up and begin to reflect the tight labor market.

Coherent, but not very convincing. Economist Joe Gagnon, though he considers the rate hike to be “reasonable” based on other indicators he cites, bemoaned the ad-hockery of the Fed’s inflation analysis:

Is the FOMC revisiting the bad old days of the 1970s, when it tried to explain away inflation that was too high by pointing to a seemingly endless stream of one-off factors? The [core PCE] already excludes volatile food and energy prices. We certainly do not want to get on the slippery slope of excluding ever more categories with price movements the FOMC does not like.

A bit of ad-hockery and one-offery might be okay but for the following picture. The black line is the Q4/Q4 change in the core PCE, and the dotted lines are the Fed’s projections of future inflation with each projection labeled by its date of publication (I left a few out for clarity, but they followed the same pattern). It’s a pretty clear picture of hope over experience. The Fed keeps projecting that inflation will climb to their 2 percent target, while actual inflation keeps ignoring their predictions.

Sources: BEA, Fed

This suggests a problem with the model. One theory is that big, structural changes in trade and technology have permanently lowered the rate of price growth. But economist David Mericle from Goldman Sachs (no link) looks at trade, the internet, and productivity growth and finds they fail to explain much of the “hope-over-experience” pattern above. Import penetration from countries that export relatively cheap goods to us remains high compared to where it was 20 years ago, but it has actually come down in the past few years. Yes, we’re buying a ton more stuff online, but online prices don’t diverge that much from other prices, at least as measured by our deflators (Mericle cites “outlet bias,” meaning the indexes don’t always record when consumers switch to cheaper online sellers). Finally, it’s awfully hard to tell an accelerating productivity story when productivity growth has slowed over the very period wherein the Fed’s been consistently missing their target to the downside.

So, what’s going on with inflation? If the Fed can’t figure it out, I doubt I’ll be able to do so. Gagnon points out that the recent decline in the dollar should nudge inflation up a bit. Mericle’s points are all well taken, but perhaps when you add structural changes together, their whole is bigger than the sum of their parts.

Another thing to consider is that while we’re surely closing in on full employment, there are signs that we’re not there yet. Pockets of weakness persist for some less advantaged groups and in some parts of the country, a point Chair Yellen herself recently made, and even nationally, there’s not all that much wage pressure. Worker bargaining power looks lower than I might have expected at 4.3 percent unemployment. Empirically, the links in the chain between tight labor markets, wage pressure, and price pressure appear much weaker than they were decades ago, a point Ben Spielberg underscores in the recent podcast we did on the Federal Reserve (which some have found surprisingly entertaining!). It’s very important not to fight old wars.

For the record, Janet Yellen has long been a stalwart slack fighter, at least before she and most of the others decided: “enough already with the data-driven thing—it’s time to get rates back up to normal levels.” The problem is that figure above suggests there may well be a new normal, one to which the old benchmarks don’t apply. On the basis of that possibility, I’d urge the members of the committee to put down the old maps and look out the window. It’s a different world out there.

What’s the Fed Up to? Podcast version.

June 13th, 2017 at 2:59 pm

Sure, you can read the posts here at OTE, and be [choose as many as apply: better informed, entertained, annoyed, put to sleep]. And/or, you can listen to the latest episode of OTE podcast while you’re exercising, cooking, chilling, etc. Get it on SoundCloudiTunesStitchrGoogle Play, or TuneIn.

This episode is all about the Federal Reserve, which is meeting as we speak, and will almost certainly decide to bump up the interest rate they control. Ben and I talk to Kate Davidson (from the Wall Street Journal) about the Fed’s rationale for its interest-rate-raising campaign and to Ady Barkan (from the Fed Up Campaign) about what the Fed should do to up-weight the interests of those who’ve been left behind, even as we close in on full employment.

Given how obscure this sort of conversation can get, I was struck by the clarity and demystification of both Kate and Ady’s responses to our queries.

If I say so myself, our musical interlude for this episode is particularly enlightened.

And finally, the joke at the end of the episode is original! I’ve told it to lots of people and everyone under 15 thinks it’s hilarious.

All that in 25 minutes!


One more point about the KS legislature’s KO (Kansas Override) of supply-side tax cuts

June 12th, 2017 at 9:24 am

I’ve been citing the KO–the Kansas legislature’s override of Gov. Brownback’s veto, thus pulling the plug on the state’s failed experiment with supply-side tax cuts–ever since I heard about it, as have many others. The story raises welcome hopes that moderate R’s might be waking up to the fiscal reality that many constituents value public goods more than regressive tax cuts.

Not to be a downer, but I’ve been pessimistic that DC R’s will learn from KS R’s. That’s partly because facts clearly can’t kill trickle-down mythology. The party’s donors want their tax cuts, and they’ll continue to sell snake oil to get them, facts and KS be damned.

But there’s another dynamic in play here which I haven’t seen mentioned: states have to balance their budgets while the federal government does not. So, if they’re willing to accept larger budget deficits, DC R’s can pass all the tax cuts they want and not worry about the consequences.

But R’s wouldn’t go that route because they disdain deficits and debt, right?

You’re kidding, right? Have you seen budget proposals from Ryan or Trump? Though they claim to be revenue or deficit neutral through magic asterisks referencing cuts and loophole closures to be named later, and/or phony, inflated growth rates, the reality is that they load their tax cuts on the debt.

“We just don’t think tax cuts add to the debt” was how one high-ranking Republican put it to me once, which is equivalent to “we just don’t think 5-3=2. We think it still equals 5.”

To be clear, I’ve underscored that conservatives are pushing hard to cut anti-poverty programs to reduce the red-ink generated by their tax cut proposals. But my point here is that if they can’t get those offsets, and I and my colleagues are working to ensure that outcome, they won’t emulate the KS legislature and give up on the tax cuts.

They’ll put them on the deficit, because they can. And that’s an important difference between state and federal fiscal policy which folks should know about.

Recycling an oldie/goodie: You wanna whack this and future recoveries? Get rid of Dodd-Frank

June 8th, 2017 at 3:22 pm

Sorry to recycle, but with the Comey hearings sucking up all the air, folks may have missed that today the House today passed that fahrblunget bit of chazari known as the Choice Act, which largely repeals Dodd-Frank financial reform (it requires D votes in the Senate, so a much heavier lift over there, thankfully). Back in February, I wrote this defense of “finreg” (for WaPo) and while I insert a few updates [in brackets], I think I was as right then as now on this.

[From Feb 2, 2017]

There are two important pieces of economic news out this morning, and while it might not seem so, they’re intimately connected.

First, we got another in a stream of solid reports on the U.S. job market. Payrolls were up 227,000, and while the jobless rate ticked up to 4.8 percent, that was for a good reason: more people entering the labor market. Hourly pay is up 2.5 percent over the past year, ahead of inflation, meaning real paychecks have more buying power. There’s still some slack in the job market — too many underemployed folks, for example (part-timers who want to work full-time) — but if we stick on this path, we’ll squeeze out the remaining slack within the year or so.

[Of course, since last Feb, unemployment has fallen further, to 4.3 percent, though hourly pay is still growing at around 2.5% and inflation has picked up (that’s overall inflation, due to higher gas prices; core inflation has decelerated!]

That’s the good news.

The bad news is that the Trump administration is threatening to blow up the job market recovery by rolling back financial market oversight. It’s repeal-without-replace all over again, invoking the feared economic shampoo cycle: bubble, bust, repeat.

If you think I’m being alarmist, let me explain. The economic recovery of the 2000s was unquestionably ended by the bursting of the housing bubble, which in turn was inflated by underpriced risk. Financial “innovations,” often poorly understood by even those selling them (you saw “The Big Short,” right?), securitization (bundling loans into opaque packages), and sloppy underwriting of mortgage loans led to a housing boom that fed on itself. Brokers explained to home buyers that their obviously unsustainable loans would be absolutely fine, as long as home prices kept defying gravity.

But gravity has a way of reasserting itself, which is exactly what it did, and, as I explained above, eight years into this expansion, we’re still not fully recovered.

The thing is, while this round of the shampoo cycle was uniquely damaging, it was anything but unique (ergo, the “cycle”). We saw a mini-version of the same dynamics in the bubble that ended the previous expansion. Economic historians have unearthed countless such examples, and the economist Hy Minsky documented the process. The bust and the losses it generates realign the price of risk with reality. But as the recovery proceeds, the memory of the bust fades and lenders begin to “get their risk on,” often through clever new instruments, and not just exotic loans, but derivatives that take out bets on how those loans will perform.

As the cycle proceeds, the onset of econo-amnesia is sharply goosed by the fact that everybody’s making stupid money (i.e., everybody in the top few percent). Even the “risk-assessors” are in on the deal, as loan quality analysis is beset with grade inflation.

Then it ends, and guess who gets screwed? Yes, there are big financial losses, but in a scheme that would make Bernie Madoff blush, the banks that inflated the bubble point out that because they’re now sitting on bundles of nonperforming loans, we either bail them out or the ensuing credit freeze blocks the recovery.

As a member of the Obama administration when Dodd-Frank was devised and passed, I assure you that the legislation was motivated by our desire to break this cycle. I’m not claiming it’s perfect by a long shot. It’s super complicated, but then again, so are these markets. And we left a lot of the regulatory details to be completed post-legislation, which meant we allowed the deep-pocketed bank lobbyists to get into the fray, and that never ends well.

But somewhat to my surprise, many aspects of the law are working. As Dennis Kelleher, president of Better Marketstold me before the election:

“Financial regulation is much better today than it has been in decades. However, there is still a long way to go before the unique risks from this handful of very dangerous too-big-to-fail firms are either eliminated or reduced to the lowest levels possible. No question a number of key Dodd-Frank provisions are working, but many still have to be finalized, implemented and, importantly, enforced. It is a comprehensive, integrated law and it all must be enacted to effectively rein in Wall Street’s riskiest activities.”

[See also this short post I put up this AM on ways in which DF is making markets safer/less bubbly.]

One thing we recognized back when crafting Dodd-Frank (with heavy prompting from now-Sen. Elizabeth Warren) was that, given the evolution of the shampoo cycle and the complexity of modern credit markets, financial reform needed to set up a Consumer Financial Protection Bureau. Here’s what Kelleher said about this:

“The CFPB had to be started from scratch just five years ago but has already made consumer protection a priority in our financial markets, as proved by an impressive record of returning more than $10 billion to 27 million ripped off American consumers. One of the key accelerants of the 2008 crash was widespread predatory, illegal and, too often, criminal conduct where consumers were routinely ripped off and fraud was a frequently a business model. That was due to very little consumer protection pre-crash, which was also highly fragmented and mostly ineffective. The CFPB was a solution to that gaping regulatory hole and it is proving itself to be an invaluable protector of financial consumers across the country.”

[The Choice Act cuts CFPB off at the knees.]

Today I read that team Trump is going after Dodd-Frank, the CFPB, and another, similarly oriented Obama-era initiative, the “fiduciary rule” designed to diminish conflicts of interest between financial advisers and people saving for retirement by requiring such advisers to adopt a standard to act in their clients’ best interests, not their own.


Now, check out this poll result from a recent survey of Trump voters by the respected pollster Morning Consult. Strikingly, 65 percent say that Obama-era regulations “requir[ing] financial advisors to put their clients’ interests ahead of their own when providing retirement and investment advice” should be kept in place, while only 17 percent support repeal.

Dismantling consumer protections, restoring conflicts of interest and cranking up the economic shampoo cycle are all absolutely fantastic ways to kill the expansion, end the job and wage gains finally starting to reach low- and moderate-income households, exacerbate the income and wealth inequality still very much embedded in our economy, and stick it to some of the very people that helped elect this administration.

Or, as team Trump calls it, the end of week two.

[Updated: end of day 139…]

This word “deregulation.” I don’t think it does what you think it does.

June 8th, 2017 at 8:43 am

A quick note on “deregulation,” which is the other half of the mantra, i.e., the phony growth recipe–“tax cuts and deregulation”–you hear endlessly repeated in uninformed DC conversations.

I’ve been in these conversations for decades and I have no idea what these people are talking about and neither do they. What, specifically, do they want to “deregulate?” What evidence do they have that to do so would be pro-growth? Obviously, they’re just hand waving.

To take a timely example, the House is about to vote on the “Choice Act” today, designed to repeal most of the regs in Dodd-Frank. The bill will likely clear the House but needs D votes in the Senate where, hopefully, it is likely to come up short.

Now, consider this, from yesterday’s WSJ, touting favorable conditions in financial and credit markets:

The banking system is more resilient because of the regulations since 2008, as firms shifted away from short-term borrowings without collateral…Instead, banks are issuing longer-term debt in the low-yield environment as a way to reduce rollover risk, the risk from having to replace maturing debt.

 “The risk is that funding would run away for the banks in time of market stress,’’ said Steve Kang, interest rate strategist at Citigroup who specializes in money markets. ”Less reliance on short-term funding means more stable funding for banks and there is still lots of liquidity in the system.”

It’s one example of a regulation having its intended impact–I was there at the creation of Dodd-Frank, and I assure you, this was one of its targets–one that in this case, is boosting market stability and pushing back of the Minsky’esque risk underpricing that regularly occurs around this time in the cycle.

One could surely find counterexamples, and believe me, I’m sure there is brush to be cleared in our regulatory system. I’ll even go so far as to admit that Trump has a point re how long it takes to get infrastructure builds underway.

But sweeping allegations are meaningless. You’ve got to get down to cases, and when you do, you will find that many regulations are there for a good reason and they’re working as intended.