Friday, January 4, 2013

Harvard Keynesian: The Fed's Dangerous Direction

I have always called Martin Feldstein my favorite mainstream Keynesian economist. Despite his mainstream Keynesian leanings, he watches money supply very closely and seems to understand monetary policy better then most Keynesians. Indeed, in 2008 at a conference in San Francisco, I tried to catch him off guard. I asked him if he knew at what rate M2 money supply was growing. He had to think for a few seconds, but then gave the correct answer to within a tenth of a basis point. This is very rare. In the middle of the crisis in 2008, when Bernanke slowed money supply growth to a standstill, Treasury Secretary Paulson's top economic advisor did not even know the slowdown in money growth was occurring.

When it comes to money (not business cycle theory), Feldstein knows what is going on. Amazingly (for a Keynesian), Feldstein warned way back in 1997 that the problems in the eurozone would occur because of the construction of the single currency that would be used in the EZ. He saw the problem in detail in 1997!

My introduction commentary here is because Feldstein is at it, again. In an op-ed in Thursday's WSJ, he outlined completely the problems the Federal Reserve is going to have because of its current monetary policy. Feldstein has nailed it and the below is must reading.-RW

The Fed's Dangerous Direction

By Martin Feldstein

The Federal Reserve is heading in the wrong direction. What the central bank describes as "unconventional monetary policy" is creating dangerous bubbles in asset markets that will lead to higher future inflation and is supporting the explosive growth of the national debt. Its new "communications strategy" will, moreover, only further confuse markets.

The Fed's recently announced plan to buy $85 billion a month of government bonds and mortgage-backed securities will keep long-term interest rates at historic lows, with a 1.6% yield on 10-year Treasurys and a negative yield on 10-year TIPS (Treasury Inflation-Protected Securities). The Fed sees its strategy as a way of boosting the prices of equities, real estate and other assets. It has indeed boosted asset prices, although the increase in individual balance sheets has had very little positive impact on real economic activity.

Once the Fed stops buying securities, however, interest rates will rise and asset prices, including stock prices, will fall. This will have serious adverse effects on investors, particularly highly leveraged institutions and pension funds.

Long-term interest rates are also likely to rise in the future because of the higher inflation induced by the Fed's current policy. Because of the Fed's purchases of bonds and mortgage-backed securities, commercial banks have $1.4 trillion more in reserves than is legally required by the size of their balance sheets. The banks can use these excess reserves to create loans and deposits, which will increase the money supply and fuel inflation.

For now, the banks are content to leave their excess reserves at the Fed in exchange for a low rate of interest. But the day will come when aggregate demand is increasing, companies want to borrow, and the banks are willing to lend aggressively. When the increase in money starts to cause a rapid increase in prices, the Fed will need to limit the banks' credit creation by raising the interest rate it pays for banks to keep their reserves at the central bank.

That is the "exit strategy" that Fed Chairman Ben Bernanke and others are counting on to prevent future inflation. Unfortunately, no one knows how high rates will have to go to restrain the commercial banks.

Moreover, because of the large number of very long-term unemployed, unemployment may remain high even as prices climb. And so, just when the Fed should act to tighten the money supply, there will be strong voices in the Federal Open Market Committee emphasizing the Fed's dual mandate to achieve "maximum employment" as well as price stability. Congressional leaders are also likely to warn that raising interest rates while unemployment is still high could cause Congress to punish the Fed with new restrictions. These pressures may cause the FOMC to delay in raising rates, allowing inflation to get out of hand.

Although Mr. Bernanke and others at the central bank declare their commitment to price stability, the Fed's new "communications strategy" runs the risk of undermining public confidence in the Fed's approach to policy. After its December meeting, the FOMC announced that it would keep the federal-funds rate at its current near-zero level until the unemployment rate is less than 6.5%—as long as the predicted inflation rate between one and two years ahead is no more than 2.5%.

The rationale for this radical announcement was discussed last month in a brilliant lecture by Janet Yellen, vice chair of the Fed, at the University of California, Berkeley. She explained that it approximates the optimal path for a dual-mandate monetary policy that is implied by simulations with the Fed's macroeconometric model of the U.S. economy.

This communications strategy may be persuasive to a small group of academic specialists and others versed in modern monetary theory. But the Fed's statement and the actions it implies will confuse the general public and undermine confidence in the bank's commitment to price stability.

In the first place, the Fed's new approach appears to raise the inflation threshold above 2%. Moreover, at his news conference after the December FOMC meeting, Mr. Bernanke made it clear that there is both flexibility and ambiguity in how the central bank will apply this new approach. It won't judge labor-market conditions by the unemployment rate alone, and its expectation of inflation will reflect a variety of indicators.

It will be difficult for the public to understand what the Fed is trying to do, and even technical monetary experts will be unable to anticipate when and by how much the Fed will change the federal-funds rate. The outlook for monetary policy is further confused by the Fed's comment that the new unemployment and inflation guideposts apply only to the fed-funds rate and not to the Fed's purchases of Treasury bonds and mortgage-backed securities.

Read the rest here.

Martin Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.


  1. What he doesn't seem to recognize is that the FED is doing this because they're in a no-win:

    If they keep printing money to buy US debit then they'll cause hyper-inflation.

    If they stop printing money to prevent hyper-inflation then the US will default because no one else is buying their debit.

    The FED is trying to have it both ways by printing for the Treasury but not anyone else in hopes that that will stop hyper-inflation.

    But of course it won't, because the money still gets into the system, it just has to go through the government first (thus slowing the multiplier effect of fractional reserve banking slightly)

    And of course it won't work because the banks are using the treasury notes that they're forced to buy as tier 1 capital and lending against those notes at 10 to 1. (it's actually 10 to 1 from the money provided by the fed to the Treasury notes, and then 10 to 1 against those treasury notes for a total of ~90 to 1 in many cases)

    Until and unless the FED deems Treasury notes to not be tier 1 capital this will continue. The problem is that to do so would mean that the FED didn't believe that US debit was AAA status which would cause a massive increase in treasury yields and compound the problem by increasing the cost to service the debit massively which would require more money printing.

    In short, there is no way out. They've screwed themselves into a corner and they know it. There is no gimmick in existence (or can be invented) that can save them from the reality of the math. They're dancing to try and hide it from the layperson, but there is going to be a crack-up boom and then as massive bust under hyper-inflation. It's just a matter of how long the bomb lasts.

    1. You nailed it. They are boxed in, with no hope of escape. It won't be pretty for any of us.

    2. There might be a way out without collapsing the currency or the economy . . if only the federal government would meaningfully cut federal spending and balance the budget. That should restore confidence in Treasury notes and bring back private/foreign sovereign buyers. (You're right, there's no way out.)

    3. There might be a way out without totally collapsing the currency or the economy . . if only the federal government would meaningfully cut spending and balance the budget. That might restore confidence in Treasury notes and bring back private/foreign sovereign buyers to roll over the existing debt. Although deflating the credit bubble would unavoidably cause a recession (if I understand AET correctly).

      More realpolitick-istically, couldn't the Fed just raise reserve requirements to lock up the excess reserves indefinitely? What would be the effect of doing that?

    4. The government can't balance the real budget which is ~8 trillion. 106% of all taxation goes out the door to SS, Medicare, Medicaid and servicing the debit before congress gets to vote on anything. Even if they cut the rest of the budget to 0 they'd still be losing money.

      Further no one else is buying US debit.

      If the Fed increases reserve requirements, then they'd have to print even more money to finance the treasury because the FED can't lend money directly to the government, they have to go through the major banks to do so, and they multiply the cash (as tier 1 capital) and then lend to the treasury. They then take the t-bills that they receive at about 1% interest and multiply that (because it's tier 1 capital) and then lend it to others.

      So while it might slightly slow the inflation increasing the reserve requirements doesn't solve the problem (and even at 100% of reserve requirement there would still be vastly more money in the system now than was in the system in 2008 so it still wouldn't matter and given $80 billion per month of new money to finance the treasury, it ain't going to work.)

      If they start charging interest to keep the reserves on hand, they'll push the money out into the system. Conversely if they start paying a higher interest rate to keep the money in the fed and not lend it after it's lent to the Treasury, they just create more money to pay the interest and sooner or later it's going to get out as inflation outruns the interest rate that the fed can pay. (because the money is already in the system as is clearly evident by high capital investment job growth in the last couple of months)

      If they prevent the banks from multiplying their government debit, that's the equivalent of the FED downgrading the US debit to junk status and would cause a run and the interest the treasury pays would skyrocket al la Greece which would quickly cause debit service to account for 100% of taxation (i.e. 4.75% interest rate on the debit would result in 100% of taxation on debit, we're not completely insolvent because interest on the debit is so low!)

      If the FED forces the banks to only lend outside of the US they cause hyper-inflation everywhere else just like they did in the middle east which is what caused the arab spring, just worse and eventually it will come back into the US as private investment and VC which will cause hyperinflation, to say nothing of the cost of commodities skyrocketing in the meantime.

      If the government actually cut Medicare, Medicaid and SS (about 60% of the mandatory spending, the rest being interest payments) you would have riots in the street, because to maintain military spending at even 40% of what it is now, and keep even 40% of the rest of the discretionary budget, you'd have to cut SS, MC, MCAid by 70-80%... basically shut them down AND keep the payroll taxes without providing service.

      And every day makes the problem much worse. SS is not taking in as much as it's spending, and there is no trust fund. It's empty.

      I'd love to hear from an economist some theory as to how we get out of this. Some gimmick that gets the money out of the system before they're faced with hyper-inflation or defaulting on the debit. Bernanke hasn't explained any system he just says he has one, but even his own staff have said there isn't a plan. So I'm all ears, I want to hear how this can be unwound. Cause from where I'm sitting the only thing to do is get the hell out of dodge before it blows up, and it could blow up within days depending upon events...

      Anyone have any solutions?

  2. "Once the Fed stops buying securities, however, interest rates will rise...."

    As if that's not bad enough, imagine if Bernanke tried to draw down the money supply by selling. All those traders who spend most of their time front-running the Fed would start trying to sell treasuries. It wouldn't be pretty.

    1. The fed can't stop buying treasuries... If they do, the government defaults.