Tag Archives: TIPS

The FOMC is Right to Stay the Course on QE2

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            The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2.  Ben Bernanke and his colleagues are right not to give in to these attacks.

            Critiques seem to be of four sorts. (Some are mutually exclusive.)

            1)  “QE is weird.”    Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations.    This has been a bold strategy, which nobody would have predicted 3 or 4 years ago.   But it has been appropriate to the equally unexpected financial crisis and recession.    Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past.    It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.”  The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s.  But as an economic historian, Bernanke had just the broader perspective that was needed.   Thank heaven he did.

            2)   “Monetary easing under current circumstances has no effect.”  It is true that, with short-term interest rates already near zero for the last two years, further monetary expansion is likely to be of less help than in a normal recession.  (The classic “liquidity trap” has been re-born as the “zero lower bound.”)    But monetary policy can work through other channels besides short-term interest rates.  Seven such mechanisms are: long-term interest rates, expected inflation, the exchange rate, equity prices, real estate prices, commodity prices, and the credit channel.   QE is worth a try, given that the economy is still weak and given the constraints that keep fiscal policy sub-optimal.

            3)  “Monetary ease will lead to inflation.   What we need now, if anything, is monetary tightening.”   This is the view, for example, expressed recently by some conservative economists, including John Taylor.   It seems to me way off base.  With unemployment far above the natural rate, GDP well below potential, and inflation (slightly) below target, it is clear that the Fed’s November 3 decision to ease further  was appropriate.

            4)  “The Fed is firing a volley in a destructive international currency war.”   This is the criticism that has come from some of our trading partners:  in particular, China, Germany and Brazil.   I don’t generally do “My country, right or wrong.”   But my country is right on this one.    Monetary easing is not a beggar-thy-neighbor policy.  The colorful phrase “currency wars” seems to have confused some people.  The current situation is precisely the point of floating exchange rates:    when some countries feel that their high unemployment calls for monetary expansion (US) at the same time that others feel that their overheating calls for monetary tightening (Brazil, India, Korea, China…), an appreciation of the latter currencies against the former is precisely the way that floating rates accommodate the differences.    This is why Milton Friedman favored floating rates, so that each country could pursue its own desired policies independently.   I realize that the pressure which US monetary easing puts on countries like China to allow appreciation is unwelcome. China is finding it increasingly difficult to cling to its exchange rate target by means of controls on capital inflows and sterilized foreign exchange intervention.   But capital flows are a far more legitimate way to let China feel the pressure than the alternative:  Congressional threats to impose WTO-inconsistent tariffs on Chinese imports if it won’t allow faster appreciation of the yuan.

            I was glad to see that today’s decision by the Federal Open Market Committee to stay the course was unanimous.   The Fed is right not to give in to misguided criticisms.   This is what we have central bank independence for.

Click here for a TV interview on today’s FOMC decision, and inflation & TIPs.

[Comments can be posted on the Belfer site.]

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A Review of Predictions of the Last Decade

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         December 31 is technically the end of the first decade of the 21st century.  It is perhaps an appropriate time to review one’s predictions.    It seems to me that I got some things right over the last decade.  Indulge me while I review the predictions that came true, before turning to those that did not work out as well.

Stock market peak     At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market”  (Nov. 20, 1999).   This was four months before the bubble burst in 2000.  So far so good.

The Euro        Also at the start of the decade, I thought the european currency was undervalued.   My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000).  Over the next eight years the euro in fact rose 60% in value.    (But, incidentally, “I don’t mean to express an optimistic forecast regarding European economics or governance…. Europeans have made many mistakes, the leaders and public alike.” 2006.)

The Yen       In January 2008, I wrote about “…the carry from the yen to the euro:  it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”  (“Getting Carried Away: How the Carry Trade and Its Potential Unwinding Can Explain Movements in International Financial Markets,”  Milken Institute Review 10, no.1, pp.38-45)   By November 2008 the yen had sharply reversed, precisely in the way predicted.

TIPS           I recommended Treasury Inflation-Protected Securities to my blog readers, early in what turned out to be a period of steep rise in their value.  (Feb. 2009.)

            The big economic story  of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it.    A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right).   I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini.  A 2009 paper identifies 12 commentators as having warned that the US housing market would end in a serious recession.

What parts of the crisis did I get right?

Severity of 2008-09 recession             After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:

 “Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…”  (Oct. 30, 2003.  Also Dec.2003 and Nov.2004).    

I said it again as the downturn began:”… if the economy does go into a recession, Mr. Frankel says, “it is likely to be worse than the last one” (WSJ, 1/21/2008).

That seems to me precisely what happened.

Budget deficits   At the start of the decade:  “We need to think about using our budget surplus to provide for the retirement of the baby boom generation, not to blow it on a big tax cut” (May 16, 2001).  But of course the Administration chose the latter policy.   Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible.  The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.”  (May 24, 2006.)   Indeed.

Market underestimation of risk        I was dubious of the “Great Moderation.”   By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high.  (May 24, 2006.)  The markets were underestimating this risk:
 “How can the implied volatility in options prices be so low?  Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.”  (Nov. 2006.)    “The implicit volatilities in options prices are substantially too low, and will rise.  … market estimates of risk are lower than they should be.  … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies.    Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.”   (Jan.12, 2007. And again, May 14, 2007.)     
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written.  It was to go as high as 80 when the full financial crisis hit in 2008.

The carry trade “should be reversing.” (Jan.12, 2007.)    Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)   

International crises    When asked Have financial developments made the International Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.”    (March 1, 2007)   I identified Hungary and other Eastern European countries as particularly vulnerable.  (Jan. 2008.)

The coming financial crash       The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look good now:

 “The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…”     (In Responding to Crises, Cato Journal, Spring 2007.)

Housing          Of the various asset markets, housing was the area where policy had most clearly gone awry.    I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.”   (March 26, 2007.)    “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.”  (April 28, 2007.)     

The start of the recession     “[A]t the time of writing [Jan. 2008], the United States appeared to be poised on the brink of recession….A coming recession may be more severe and long-lasting than the last one in 2001….”   By May 2008 I had figured out that a recession was indeed probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.   

Banking crisis resolution       When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work.  (March 23, 2009.)  I felt pretty isolated.  Others attacked the plan, from both left and right.  They expected Tim Geithner’s stress tests to be phony.  The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks.  They wanted either to nationalize the banks or leave everything to the free market.  As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.   

The trough      Financial markets stabilized in the first half of 2009.  Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then.   This turns out in fact to have been the case: The record shows that the recession ended that June.

Predictions gone wrong          Needless to say, I got plenty wrong in the decade as well.   For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came.   For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar in international currency use by 2015 or 2022.    It now seems unlikely.   I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar.  Yet flows into the U.S. showed that the dollar is still a safe haven.  For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.

My most spectacularly wrong predictions were all in the area of politics.  I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College.   (This did not happen after January 2001.)   I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise.  (Not!)   In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president.   (Wrong again.)  

In the coming decade, I resolve to eschew political forecasts, and stick to economics.

[Comments can be posted on the Belfer site.]

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TIPS tips

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Everyone asks for tips: Where can I put my money?   Stocks or bonds have done very badly over the last  year, needless to say, and one cannot be confident that they have hit bottom.  Should one just leave everything in banks and money market funds?   Surely there must be something else worth buying?
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