Professor Paul Palley's
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Here are two links that argue that marginally higher inflation rates would be beneficial in two ways. The first is that it would justify higher wages, and second that because it would result in higher nominal interest rates. These higher nominal interest rates would allow for more flexibility by the Federal Reserve and other central banks to lower interest rates when necessary to fight recessions. This is a controversial proposal because over the course of the last three decades low inflation targets have been set by central banks, emphasizing the importance of low rates of inflation. As a result a change in policy would be required. Then again, very low inflation and interest rates are identified as factors contributing to the financial crisis that deepened dramatically in 2008. At the same time policy makers would need to make sure that inflation does not get to be too high due to the change in policy. Here are the links to the first article (http://www.imf.org/external/pubs/ft/survey/so/2010/INT021210A.htm) and the second article (http://elsa.berkeley.edu/~akerlof/docs/inflatn-employm.pdf).

What do you think?

The Federal Reserve (Fed) is a terrific source of economic data, forecasts, and perspectives on current economic conditions and policy making. The Fed has both regulatory and monetary responsibilities and its reports to Congress and cryptic public statements shape policy-making efforts and expectations related to the economy. Understanding these responsibilities and the Fed’s data sources and expectations facilitates long-term planning and decision-making. The following discusses these roles, sources of information, and perspectives on the economy.

The seven members of the Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/) are appointed by the President and approved by Congress. They are responsible for formulating policy and implementing these policies through the Federal Reserve Banks. See the following link for information related to frequently asked questions about the Board of Governors (http://www.federalreserve.gov/faqs.htm). The publication, The Federal Reserve System, Purposes & Functions (http://www.federalreserve.gov/pf/pf.htm) includes an overview, and sections on monetary policy and the economy, implementation of monetary policies (open market operations, and changing the discount rate and reserve requirements), and international perspective, and regulatory responsibilities. It also includes a section on the role of the Fed and payment systems in the United States. The website for the Board of Governors is also a very good resource for economic research and data. See this link for details: http://www.federalreserve.gov/econresdata/default.htm. Another excellent source of historical economic data and perhaps the best single site to go to in order to start a research effort is the Federal Reserve Bank of St. Louis. The link is:
http://research.stlouisfed.org/fred2/.

The Fed’s monetary policies capture a lot of the attention the public has on the Federal Reserve and the economy. This Board of Governors’ website includes details related to this (http://www.federalreserve.gov/monetarypolicy/default.htm), and this is a very good resource for details related to this issue. Monetary policy decisions are made by the Federal Open Market Committee (FOMC). The FOMC (http://www.federalreserve.gov/monetarypolicy/fomc.htm) includes the members of the Board of Governors and five Reserve Bank presidents. The FOMC meets eight times during the year, and will meet at other times if necessary. The main policy goals of the Fed include balance economic growth, stable prices, and full employment.

The Fed uses contractionary monetary policy tools at a time when the economy is in a period of very strong economic growth and inflation expectations are very high. When this occurs, the Fed will sell US Treasury bonds as they raise their target for the Federal Funds rate, increase the discount rate, and on very rare circumstances raise reserve requirements. The impact of this policy is to reduce the money supply and raise short-term interest rates. Higher interest rates will, everything else being equal, lead to decreases in household and business spending and lower the rate of growth of the economy.

The Fed employs expansionary monetary policy tools at a time when the economy is in a recession and inflation expectations are very low. In order to do this, the Fed buys US Treasury bonds as they lower their target for the Federal Funds rate, lower the discount rate, and on very rare circumstances lower reserve requirements. This increases the money supply and lowers short-term interest rates. At the same time long-term interest rates may or may not be impacted as these rates will be more dependent on inflation expectations and expectations related to economic conditions. Lower interest rates will, unless the economy is overcome with uncertainty, lead to increases in household and business spending and increase the rate of growth of the economy. As we have seen, during the very sever recession of 2007 to 2009, the twin problems of a serious decline in asset values combined with a financial crisis and uncertainty, make expansionary monetary policies more difficult to implement. Extraordinary efforts will be necessary.

The Monetary Policy Report to Congress dated July 21, 2009 also details the extraordinary efforts undertaken by the Fed to stabilize the economy, and this illustrates the vast array of tools at the Fed’s disposal to deal with the economy. The Fed reported the following in this report, “The Federal Reserve and other government entities continued to respond forcefully to these adverse financial market developments. The Federal Reserve kept its target for the federal funds rate at a range between 0 and 1/4 percent and purchased additional agency mortgage-backed securities (MBS) and agency debt. Throughout the first half of the year, the Federal Reserve also continued to provide funding to financial institutions and markets through a variety of credit and liquidity facilities. In February, the Treasury, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision announced the Financial Stability Plan. The plan included, among other elements, a Capital Assistance Program designed to assess the capital needs of banking institutions under a range of economic scenarios (through the Supervisory Capital Assessment Program (SCAP), or stress test) and, if necessary, to assist banking institutions in strengthening the amount and quality of their capital. In early March, the Federal Reserve and the Treasury launched the Term Asset-Backed Securities Loan Facility (TALF), an initiative designed to catalyze the securitization markets by providing financing to investors to support their purchases of certain AAA-rated asset-backed securities. At the March meeting of the Federal Open Market Committee (FOMC), the Committee decided to expand its purchases of agency MBS and agency debt and to begin buying longer-term Treasury securities to help improve conditions in private credit markets. In May, the Federal Reserve announced an expansion of eligible collateral under the TALF program. In the same month, the results of the SCAP were announced and were positively received in financial markets.” (http://www.federalreserve.gov/monetarypolicy/mpr_20090721_part1.htm).

Two reports produced by the Federal Reserve receive a lot of attention. The Beige Book (http://www.federalreserve.gov/fomc/beigebook/2009/default.htm) reports details related to current economic conditions in the districts of each of the twelve Fed banks. As a result it offers information that is useful for those who want to understand current economic conditions. The Monetary Policy Report to Congress (http://www.federalreserve.gov/monetarypolicy/mpr_default.htm) is an excellent resource for those interested in a current overview of the Fed’s monetary policies and economic conditions. It is also one of two resources I suggest for economic forecasts produced by the Federal Reserve System. The second is the Livingston Survey (http://www.philadelphiafed.org/research-and-data/real-time-center/livingston-survey/). This is compiled and produced by the Federal Reserve Bank of Philadelphia and is forecast reflecting the opinions of a large group of economists.

For example, the Monetary Policy Report to Congress dated July 21, 2009 indicated the following related to the future direction of the economy The Fed marginally raised its projections for the economy. They expect the economy to demonstrate sluggish economic growth during the second half of 2009 versus the serious decline prior to this. Moderate economic growth is expected for 2010, and stronger growth is predicted for 2011. The unemployment rate is expected to exceed 9% through 2010, before declining to less than 9% in 2011. Long-run projections are that the unemployment rate will be in the range of 4.8% to 5.0%. The inflation rate is expected to remain relatively low, and this indicates continued relatively low interest rates. This will be a necessary condition for a recovery of the housing market to take place.

The following details are reported in the June 2009 Livingston Survey. The participants in the survey expect very low levels of economic growth during the second half of this year, 1.1% growth, and then a 2.6% rate of growth of real GDP in 2010. The unemployment rate is expected to remain very high (9.1% in 2009 and 9.7% in 2010). This reflects the expectation by the economists that recovery in the labor market will trail the recovery of the economy from this exceptionally bad recession. The economists expect that the inflation rate and interest rates will remain relatively low throughout 2009 and 2010. These low interest rates reflect the expectation that the economy will be relatively weak and that inflation will remain in check.

Here is a link to a column by Professor Nouriel Roubini, a very bright economist who predicted much of the crises related to the recession that started in December 2007. He supports the reappointment of Ben Bernanke as Chairman of the Board of Governors of the Federal Reserve, and does a good job of explaining why he helped prevent the recession from potentially becoming a depression. Dr. Roubini also describes some mistake that were made in the past. The link is: http://www.nytimes.com/2009/07/26/opinion/26roubini.html?ref=opinion

Here is a link to an interesting column in the New York Times about China’s dollar denominated assets that have been the result of trade surpluses accumulated by China over the years: http://www.nytimes.com/2009/05/14/opinion/14Gao.html?ref=opinion

Over the years the dollar has been the primary reserve currency held by many central banks around the world. Will this continue? Here is a link to a column written by an economist who is well known for anticipating the financial crisis that took hold in 2008:

http://www.nytimes.com/2009/05/14/opinion/14Roubini.html?ref=opinion

Here is a link to a terrific article in the New Yorker about Ben Bernanke and the financial crisis in 2008: http://www.newyorker.com/reporting/2008/12/01/081201fa_fact_cassidy

The Federal Open Market Committee (FOMC) decided on June 25, 2008 to leave its target for the federal funds rate at 2%. The Federal Reserve has incrementally dropped its target for the federal funds rate from the 5.25% it was in the middle of 2007 to its current level. In its statement, the FOMC indicated that it sees the economy growing primarily due to small increases in household spending. On the other hand, the labor market remains weak, the housing market continues to contract, energy prices are high, and the financial markets are stressed. The FOMC further reported that uncertainty about the inflation outlook remains high because of high energy and commodities prices even as they expect that inflation will moderate later this year and next year.

The Federal Reserve’s statement raised the issue of its focus on inflation, and particularly inflation expectations. This is important because it is generally believed that their policy goal of stable prices is, over time, the primary focus of the policy makers. Supporting the expectation that at some point in the near future the Fed will start raising their target for the federal funds rate in response to inflation is the statement issued by the FOMC, and Dallas Federal Reserve Bank president Richard Fisher’s vote for a rate hike (the other members of the FOMC voted to leave rates unchanged). With the Federal Reserve indicating that the risk for higher inflation expectations is higher, it is highly probable that more members of the FOMC will vote for rate increases later this year or early next year.

In a sense, the Federal Reserve is stuck in a very uncomfortable position. The weak economy tends to argue for relatively low interest rates in order to spur economic growth. On the other hand, higher inflation rates demand higher interest rates for two very practical reasons. The first is that lenders demand higher interest rates in order to produce a justified real rate of return on their investment. This point indicates that short and long-term market rates will remain relatively high in comparison with the federal funds rate or rise, and as a result the Federal Reserve can find itself behind the curve, and this is a condition many argue already exists. The second reason for the FOMC to raise its target for the federal funds rate is the fact that higher rates tend to restrain economic growth and as a result lead to a lower inflation rate. On the other hand, if energy and commodity price inflation does not spread to the rest of the economy in a significant way then the FOMC can wait to raise rates.

The point I made about short and long-term market rates remaining relatively high compared to the federal funds rate is evident in the financial markets. Consumer and mortgage lending rates have not followed the federal funds rate down, and in fact have increased. Mortgage rates and the yield on 10-year Treasury note have increased in response to higher inflation expectations even as the housing market has weakened. I must add though, on the other hand, that from a historical perspective these rates are still historically low. If the FOMC raises its target for the federal funds rate, the prime interest rate will increase, and credit card rates will also increase, and this will further stress households.

With the economy as weak as it is, and possibly in recession, it might seem to be counterintuitive at this time to be thinking about the prospect of the Federal Reserve raising interest rates. However, given higher oil prices, higher food prices, and a generally higher inflation rate, it is logical to think about higher interest rates. Adding to the pressure in this direction is the weaker dollar, something that contributes to higher commodities prices in general, and in particular higher oil prices. While the Federal Reserve’s policy goals are balanced economic growth, full employment, and stable prices, it is thought that the primary goal is stable prices or low rates of inflation. Given this, and the price pressures we are witnessing in our daily lives, we can easily understand the focus on a change in the Federal Reserve’s monetary policies.

The press has picked up on this. On June 10, 2008 on CNNMoney.com (see the link below), there was a story about possible Fed rate hikes. Fed Chairman, Ben Bernanke, explicitly made a statement supporting a stronger dollar on Monday, June 9. The Federal Reserve Bank of New York president, Timothy Geithner, expressed similar sentiments. A contributing factor to the weaker dollar is the difference between lending rates in the U.S. and Europe. Lower interest rates in the U.S. tend to lead to a weaker dollar. The Federal Reserve’s target for the federal funds rate is 2%, but the European Central Bank’s target rate is 4%. This differential combined with large trade deficits will only contribute to a weaker dollar against the Euro and higher commodities prices including higher oil prices. The New York Times (see the link below) covered this issue the next day, reporting that in part due to Ben Bernanke’s statements, the yield on the 2-year Treasury Bill rose sharply on June 10. The value of the dollar rose in response to this.

These facts are increasingly leading to the conclusion that the Fed is finished with rate cuts, and that if their next move will not be higher interest rates then it will be a signal that this is coming. Another contributing factor is statements made by the president of European Central Bank, Jean-Claude Trichet, indicating that interest rates are likely to rise in Europe between now and July. These moves would weaken the economy further, but are designed to strengthen efforts to fight inflation.

Finally, on June 11, 2008 in Bloomberg.com (see the link below) it was reported that a survey of Bloomberg users indicated the forecast that the price of government bonds will fall in the Americas, Asia, and Europe over the next six months. It is higher inflation expectations that lead to the forecast of lower bond prices and the resulting higher interest rates. In addition, the survey showed a greater concern about inflation rather than the mortgage crisis. Another troubling factor is higher household inflation expectations over the next five years. It was reported that these inflation expectations have reached a thirteen year high. It is the increase in these inflation expectations that more than any other factor may lead the Fed to raise interest rates as the Fed does not want to see inflation expectations take hold.

See the links below.

CNNMoney.com: http://money.cnn.com/2008/06/10/markets/thebuzz/index.htm?postversion=2008061010

The New York Times:

http://www.nytimes.com/2008/06/11/business/worldbusiness/11stox.html?ref=business

Bloomberg.com:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aFhSf54NDYxk&refer=home

Since September 2007, the Federal Reserve has cut the federal funds target rate a full percentage point from 5.25% to 4.25%, but the immediate results for the economy have not been perceived to be positive. The problem is the Federal Reserve’s inability to unfreeze debt markets, especially the markets in which large financial institutions lend money to each other. The source of this problem is a lack of confidence in the balance sheets of lending institutions, and the genesis for this is the breakdown of the mortgage markets and the complex securities constructed from these mortgage loans. The result is that some are predicting that a recession is set to happen; others argue that the economy is in recession; and there are analysts who are predicting only slow and sputtering economic growth for this year. Either way, the economy will be at best weak during the first half of this year and this has raised questions about the effectiveness of the Federal Reserve, but the better questions are related to how the macroeconomy and financial markets in the world today affect the Federal Reserve’s ability to successfully implement its monetary policies.

It is not surprising that the cuts in the target for the federal funds rate detailed above have not had immediately positive impacts on the economy as it is well known that there are lags between changes in monetary policies and responses by the economy. What is interesting is that the Federal Reserve’s use of its discount window hasn’t been effective either. Finally, the effectiveness of the “term auction facility” recently implemented by the Federal Reserve and foreign central banks remains to be evaluated. Two auctions are planned for January and further auctions in February have not been announced at the time that this article was written (see http://www.federalreserve.gov/ for further details).

The problem with the Federal Reserve’s discount window it that it is not used. It is generally perceived to be the place desperate banks go to borrow, and as a result healthy banks do not use it and instead they borrow money from other banks to meet short-term liquidity needs and pay the federal funds rate rather than the discount rate. This negative perception of the discount window may also carryover to the “term auction facility” limiting its effectiveness. On the other hand, it has been suggested that coordinating this effort with other central banks may lead to the success of the “term auction facility”, but that will have to be evaluated over time. This also illustrates a point, as seen with this case and the Federal Reserve’s coordination of monetary policies with foreign central banks in the past, the Federal Reserve does not act in a vacuum and it increasingly must consider the actions of other central banks when it implements its policies.

The fact of the matter is that the Federal Reserve is not the all powerful fixer it has been advertised to be and this is due to a number of important developments; financial markets are really very complex interrelated global markets that are transnational rather than simple markets open for central bank intervention; the United States is not as dominant financially as it used to be and more coordinated central bank policy moves are now required; the Federal Reserve has also been criticized for not acting to “pop” the stock market bubble of the 1990s and real estate market bubble of the recent memory. The mortgage market breakdowns that resulted from “liars’ loans”, teaser-rate mortgages, and poor lender and borrower due diligence, indicated a need for the Federal Reserve to step up its regulation of the lenders it can regulate but it did not, and holes in its regulatory authority indicated a need for further statutorily approved regulatory authority were not filled.

It must be further noted, though, that to a great extent the Federal Reserve is a victim of its own prior success, especially when combined with the successful inflation fighting of foreign central banks. In part, the lower inflation rates seen in recent memory is the product of successful inflation fighting monetary policies. These policies reinforced with the understanding of the meaning of monetary policy rules geared around the relationship of short-term interest rates with the inflation rate and economic growth, or on the other hand inflation targeting policies, carried out by foreign central banks are also very important. The result is lower inflation rates and lower long-term interest rates. This success, combined with the way globalization has increased world wide competition and facilitated more efficient supply chains. Plus, technological developments have increased productivity and as a result lowered the cost of doing business. These and other developments lead to lower current and expected inflation rates and as a result lower long-term inflation rates. Further contributing to lower long-term interest rates is the availability of funds held by societies that save a much larger percentage of its income than the United States and nationally controlled funds supported by oil and other resource sales. These factors, combined with the large amount of United States Treasury securities held by foreign investors has reduced the impact of independent Federal Reserve policy initiatives when it seeks to raise market interest rates through its policies.

There have been a number of changes in commercial banking that have also reduced the effectiveness of the Federal Reserve in its efforts to successfully implement its monetary policies. These include deregulation; the fewer number of commercial banks that exist today; technology; complex financial modeling; and asset securitization. Bank deposits are relatively small today and this makes changes in reserve requirements by the Federal Reserve as a monetary policy tool largely ineffectual. The cumulative impact of this is that banks are more likely to facilitate credit rather than hold onto loan assets. The mutual fund or another institutional investor, investment bank, corporation, or large foreign investment interest can often be the real provider of credit. This fact requires a much broader focus on an array of sources of funds in order to understand why the financial markets function as they do, and how the Federal Reserve’s monetary policies impact the economy.

It is well understood that the effectiveness of the Federal Reserve’s monetary policies can be undermined by two facts; the Federal Reserve does not control the willingness of people to borrow money and it does not control the willingness of banks to lend money. That being said, the above points in this piece raise a list of changes in the financial markets that all need to be considered when we try to understand the impact of Federal Reserve policies on short-term and long-term interest rates, and the economy. The complexity of the financial markets indicate that the Federal Reserve will increasingly face new and more complex challenges, and the public and financial markets will need to adapt to this new understanding of the Federal Reserve’s place in the equation.

Biography:

Paul Palley manages Palley Economics Seminars and is a practitioner faculty member for the University of Phoenix where he teaches graduate and undergraduate economics and statistics courses.