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Did the Markets Overlook Fed Bullishness in the March 16 FOMC Statement?

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Financial markets reacted to the outcome of the Federal Open Market Committee meeting on Wednesday, March 16, as if what the Fed had revealed was highly dovish, that is, diminishing expectations regarding future interest rates.   Dollar down, stocks and bonds up…  According to Goldman Sachs, the markets reacted as if this were among the top 4 surprises in Fed dovishness since the turn of the century (not counting reactions to the GFC).

The markets were looking at a shift in the “dots plot.”  The shift formally rescinds the Fed members’ previous forecast that supposedly they would raise interest rates four times in 2016.  (Now it says twice.)  Furthermore, Chair Yellen in her press conference said, “Most Committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.”

But this is old news. It reflects developments at the start of the year, such as the Commerce Department report that GDP growth had been weak in the 4th quarter and the global financial market volatility in January and early February (especially related to China).  Everyone knew all this a month ago.

The new news pertains to what has happened since mid-February.  A lot of trends that had appeared to be negative have reversed in the last month.  Statistics on US domestic final sales in January suggest that GDP will likely be stronger in the first quarter. Meanwhile, job gains were back up to 242,000 in February, reaching a record six-year-long streak of private employment growth.  And globally, downward pressure on the renminbi, the US stock market, and commodity prices — which had so worried investors – all abated in February-March.

So did the Fed recognize these signs of economic strength in its statement Wednesday?  Yes, it did.   Gone was the January sentence “…economic growth slowed late last year.”   In its place was a note that “economic activity has been expanding at a moderate pace…”   (Also “Inflation picked up in recent months.”)  Unless I am mistaken that language wasn’t there before, only the longstanding positive language about employment.  It seems to me that the markets this week may have missed an acknowledgement from the Fed that things have turned around since the first six weeks of the year.

[Comments can be posted at the Econbrowser version.]

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8 Policy Recommendations for Newly Elected Members of Congress

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On December 3, 2014, I participated in a panel of Harvard University’s Bipartisan  Program  for  Newly Elected Members of Congress.   After establishing that the median US household has not shared in recent strong economic gains, I went on to consider policy remedies.

I offered the Congressmen eight policy recommendations.  Some will sound popular, some very unpopular; some associated with “liberals”, some with “conservatives.”   I would claim that they all have in common heavy support from economists, regardless of party – even the very unpopular ones.

  • Enable universal pre-school education
  • Spend on infra-structure
    o   For now, the spending could be financed by Treasury borrowing: 1% is a very attractive interest rate!
    o   For the longer term:  Finance roads and bridges by putting the Federal Highway Trust Fund on a sound footing.
    o   That means restoring real gas taxes to their past levels and putting the tax rate on an upward path over time.  Very unpopular of course.  But the best time to start this process is now, when gas prices are falling and inflation is low.
  • Take steps today to put social security on a sound footing for the long term
    o   We spent the last three years getting fiscal policy exactly backwards
    o  The US fiscal problem, measured for example by the path of the federal debt, is in future decades, not today.
    o  We hurt the economy during 2011-2013 by cutting spending and raising taxes and have done nothing to address the big future deficits in social security and medicare, exactly the opposite of what we should have been doing: allowing deficits while the economy has been weak, while taking steps to address entitlements on a long-term basis.
    o   Specific policies to put social security on sound footing:
    * Raise the retirement age (while accommodating blue collar workers);
    * and slow the rate of growth of dollar benefits for future retirees.
    *  At the same time, make payroll taxes less regressive:
    * Exempt low-income workers.
    * Raise the maximum-income threshold (from $118,500).
  • Reverse the long-term rise in household debt: housing, auto, and student loans
    o  Reduce especially the heavy policy tilt toward getting American families up to their eyeballs in mortgage debt that they can’t afford (which mainly drives up housing prices, without much raising home ownership rates for the middle class).
    o  Require a serious minimum down payment
    o  Require that mortgage-originators keep “skin in the game.”
    o Curtail tax deductibility of mortgage interest, which benefits the well-off (the deduction generally gives households earning $65,000 a year less than $200 in tax savings.
        * Reduce deductions at upper end (like Rep. Dave Camp’s proposal to cut from $1m to $500k)
         * Especially stop subsidizing mortgages that are used for something other than purchase of residence (i.e., second home or “cash out” home equity line of credit).
    o  Car-dealers should not have been exempted from the Consumer Finance Protection Bureau.
    o   Most college educations are still a good deal, and worth going into debt for if that is the only way a student can go.
    * But some enterprises are bad deals.
    * Government should expand student grants and loans, but require that the college or university have a decent record regarding rates of graduation and employment.
  • Tax reform
    o   We can’t afford to cut tax revenues.
    o   But we can reduce the most distortionary tax polices (those that most discourage work or encourage harmful activities) and raise a given amount of revenue in a less distortionary way.
    o   For the corporate tax system, that means cutting the overall tax rate some, but making up the lost revenue by eliminating wasteful exemptions, like oil subsidies.
    o   For household taxes, I have in mind:
    * Expanding the Earned Income Tax Credit, especially for young single workers who miss out;
         * and eliminating the payroll tax on lower-income working Americans (currently their marginal tax rate is often higher than anybody’s; currently 63% of taxpayers pay more in payroll taxes than income taxes);
        * but making up lost revenue by curtailing distortionary deductions (e.g., mortgage debt).
  • Allow fracking
    o   in every state, while allowing individual communities to opt out.
    o  Actually encourage it by expediting LNG export facilities.
    o  But regulate fracking carefully, e.g., to prevent methane leaks.
    o  It is good for jobs, manufacturing, national security and even — if carefully done — the environment (because natural gas is cleaner than coal).
  • Resume US global economic leadership:
    o   Pass Trade Promotion Authority (for WTO, TPP & TTIP)
    o   Pass IMF quota reform
  • Do No Harm:   Avoid going back to the dysfunctional fiscal policy of the past.  The uncertainty created by the morass of cliffs, shutdowns, debt-ceiling standoffs (Figure 5) together with the reality of the sequesters, held back growth by at least 1 per cent per annum during 2011-13.  (“The Cost of Crisis-Driven Fiscal Policy”  MacroAdvisers, Oct. 15, 2013.)  One reason growth has been stronger lately is that 2014 is the first year in the last four when Congress has not impeded growth very actively.
    o Dysfunctional fiscal politics hurt the economy in 2011-2013, not just directly (e.g., through the sequester), but also indirectly through the risks for business created by policy uncertainty.  (See Figure 5.)

Figure 5: Economic Policy Uncertainty

Picture5_dysfunctionalfiscalpoliticshurteconomy2011to2013

 

 

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How Europe Should Treat Sovereign Debt in the Future

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My preceding blogpost identified three mistakes made by leaders of the European Economic and Monetary Union in dealing with Greece.   But what is done is done.  The mistakes now lie in the past.  How can Europe’s fiscal regime be reformed to avoid future repeats of this crisis?  

The reforms that are now underway are not credible.  (“We are going to make the fiscal rules more explicit and make sure to monitor them more tightly next time.”)    Similarly, most proposals for how to put teeth into the rules are not credible — penalties such as monetary fines or loss of voting privileges. 

It is too late for Greece. But it is not too late for a euroland reform that would help avoid the re-emergence of unsustainable sovereign debt levels next time around by applying the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral.  This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.  

My proposal:   The eurozone should in the future adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral.  This system would achieve the elusive objective of true automaticity.   If a country exceeded the threshold for justifiable reasons, such as natural disaster, the private markets could perceive that and impose little or no default risk premium.   No judgment of the merits by bureaucrats or politicians would be required.   More likely, for periphery countries, the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart).  The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.  

This is how it works among the U.S. states and municipalities.  Despite the absence of their own currencies, the recurrence of dysfunctional local politics and excessive deficits, and even a history of state defaults in the 19th century, federal bailouts are not delivered and are not expected.   Without some such device, the new European Stability Mechanism is in danger of becoming a mechanism for instability.

[Niels Thygesen made the case in favor of the current reform track in “Governance in the Euro Area” at the Challenge of Europe session of INET‘s Annual Conference, Bretton Woods, NH, April 10, 2011. I gave my comment there as well. (Video)]

[Comments can be posted on the Vox.eu site (which has the copyright.)]

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