Monday, January 27, 2014

The Fed's New Tool for Increasing the Short Term Interest Rate

As the U.S. economy starts to look better, the Fed eventually has to increase its federal funds rate. The Fed has stated that it is planning to keep the near zero federal funds rate until the unemployment reaches 6.5 % as long as the inflation rate and expected inflation remains low.
Now, the question is whether the Fed will be able to increase the short term rate in the economy as it desires when the correct time comes through changing its federal funds target rate. As the Fed has been conducting QEs since the recession ended, its balance sheet  reached  $4 trillion mark in last December and bank reserves at the Fed increased greatly.
To increase the short term interest rate in the future, under current system, the Fed has to sell government bonds to pull money out of the economy, therefore increases the interest rate. But since it has put in enormous amount of reserves for last few years, the Fed faces a problem of selling huge amount of asset to effectively increase the interest rate.
Since September 2013, the Fed has been experimenting a new tool to control the short term interest rate. This new tool called a reverse repurchase program works this way: the Fed sells its asset in the System Open Market Account to money-market mutual funds, banks, securities dealers, government-sponsored enterprises and others with a condition that it will buy back those assets in the future for higher price than it sold to them. In other words, the Fed, under this program, borrows from those institutions with collateral of Treasury Securities. The difference between the sale price and repurchase price along with a length of time between these indicate the interest rate the Fed pays.
When the Fed wants to increase short term rates, it can increase the reverse repurchase interest rate. When the financial institutions see this higher interest rate paid buy the Fed, they aren't willing to borrow reserves each other below this rate because they can make more buy purchasing assets from the Fed and selling back. Therefore, it can effectively put a floor for the short term interest rates that banks charge each other. Moreover, through raising this rate, the Fed can affect the overall short term interest rate in the economy. Also, using reverse repurchase program, the Fed doesn't have to shrink its balance sheet; therefore, it can use its assets when it faces a problem.
One counterproductive effect this program could have is that when the Fed shifts to this policy, the Fed will be expanding the monetary base through its payment to financial institutions. That is reverse of what the Fed tries to do when it needs to raise the interest rate in the economy.
Along with targeting reverse repurchase interest rate, the Fed has to increase the interest on reserves, which is currently 0.25%, when it raises the short term interest rate to prevent depository banks from lending too much credit and causing inflation.
This policy has been examined by the Fed since September, and there has been a research paper on its effectiveness. Whether the Fed will employ this policy in the future is interesting thing to put eye on.
Related article on the Wall Street Journal:

Rising Inequality Explains the Weak Recovery, Not Vice Versa

In this article, I will not passionately try to convince you of the post title. Instead, I will make points on how John B. Taylor's argument on the topic fails under more scrutiny. In his article in the Wall Street Journal, titled "The Weak Recovery Explains Rising Inequality, Not Vice Versa", John B. Taylor makes following use of data to make his point that today's inequality isn't a cause of the type of recovery we are witnessing. First, he explains what the people who he is arguing against say: the slow recovery has been a result of growing inequality. He writes down their argument as follows:
"The key causal factor of the middle-out view is that a wider income distribution slows economic growth by lowering consumption demand. Saving rates rise and consumption falls if the share of income shifts toward the top, according to middle-out reasoning, because people with higher incomes tend to save more than those with lower incomes."
And then he goes on to counteract this view by data he collected and put some make up on. He gives what his data shows:
"The data for the recovery since mid-2009 do not support this view. The 5.4% overall savings rate during this recovery is not high compared with the 8.4% average since 1960. It is relatively low compared to past recoveries, such as the 9.3% savings rate during a comparable period during the recovery in the early 1980s."
In my curiosity, I was able to look at the data he worked on. It is data on personal saving ratio-the ratio of personal saving to disposable personal income. The following graph shows what the saving rate has been.
PSAVERT_Max_630_378John Taylor is correct on that the saving rate has been averaging 5.4% since the end of the latest recession. However, when he tried to compare this rate to the 8.4% average rate since the 1960, he makes wrong comparison. Due to the general downward trend of this rate over the last decades, he shouldn't compare this 5.4% average rate of saving during the recovery to the all time average saving rate. But if we compare the 5.4% average rate during the recovery with the average saving rate between the end of 2001 and the start of the recession, which is 3.9%, we can see that the saving rate today is higher than its pre-recession level. Therefore, we have just disproved his claim by using the same argument he tried to use. In other words, with data on how the income inequality has grown, we have further see that the saving rate also increased after the recession.
10economix-sub-wealth-blog480Hence, we are able to claim that the increase in inequality indeed increased the saving rate; therefore, the total consumption demand has declined, which is exactly what the people he argued against said.
One could argue that  because people might be willing to save more than what it was saving before the crisis to use their saving when another crisis comes during the recovery and uncertainty, the higher saving rate doesn't say that inequality is hindering the recovery. But this surge in the saving rate after a recession has been witnessed only twice, after 2001 and 2007-2009 recessions. Prior recoveries experienced the saving rate which was actually lower than its level before the crises. If we look at the average saving rate between November 1970 and November 1973, it was 12.8% which is higher than the saving rate after the recession, between April 1975 to December 1979, which is 10.8%. The same decrease in the saving rate was seen also during the early 1980's recovery. We can see this trend of decrease in the saving rate following the recession in the above graph except during the latest two recoveries.
In my very first blog post, I compared the income inequality during the pre-recession periods for the Great Depression and the Great Recession and argued the recovery the economy is going through is unhealthy one. One could agree with John Taylor on that the weak recovery is causing the widening inequality and the first problem policymakers should tackle is to boost the recovery by any means. However, the increasing inequality could be the heart of the problem, and the policymakers should prioritize equality to change the speed of the recovery.

An Attack on the Austrian Business Cycle Theory

In my most recent post, I briefly explained what the Austrian Business Theory is. In this post, I will try to make some arguments against the Austrian Business Cycle Theory. The theory, in short, says that when the central bank extends the bank credit at an artificially low interest rate, this credit feeds a boom in the production sector, And once businesses realize that the higher demand wasn't relative rather overall caused by an expansionary policy, they try to re-adjust their capital. This re-adjustment process is, according to the ABCT, a recession.
Now, let's try to argue against one of the main assumptions on which the ABCT built on.
The first assumption or definition that was taken to build the foundation of the theory by Ludwig Von Mises is the notion of a natural rate of interest. The natural rate of interest, a defined by Swedish economist Knut WIcksell, is the rate that would balance the amount of capital demanded by the borrowers and the amount of capital saved by the savers in the economy. In other words, it is a market equilibrium price for the capital. F.A.Hayek explains the notion in Prices and Production (1935):
“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks."
The ABCT says that when the government or the central bank intervenes the market and controls the interest rate, the economy is distorted by this artificial interest rate.
However, the notion of the natural rate of interest could be attacked in a following way. This notion assumes that an equilibrium interest rate could be dictated by the market itself. If we want to see this natural rate of interest, we have to assume that savers and borrowers perfectly maximize the profit that can be made from the capital saved or borrowed. That perfect maximization, however, doesn't take a place in real world. When savers decide how much money to save for future, their decision depends on not only the prevailing interest rate but also how much money they have in their saving account or for how much time period they are saving etc. For the borrowers, they also don't react perfectly to the change in the interest rate. They might consider uncertainty in the economy or conditions on their borrowing. For these and many other factors that influence their saving and borrowing decisions, the definition of a natural rate of interest loses its assumption.
Therefore, from the very beginning of its story, which takes the notion of a natural rate of interest when it talks about how the central bank lowers the interest rate below a natural rate of interest, the Austrian explanation of business cycles is attacked by the other schools.

Meeting my own goal: A post on the Austrian Business Cycle Theory

Developed by Ludwig Von Mises and Friedrich Hayek, the Austrian Business Cycle Theory (ABCT) says that an artificially low interest rate, created by the government or a central bank, induces more investment in a production sector because investors now can find more money with an interest rate that is lower than a natural rate of interest. The artificially  low interest rate creates a production boom. Sooner or later, according to the theory, the investors realize the production is unsustainable and try to re-adjust the production and capital to other productions. At this moment, the economy is in a recessionary period.
When the interest rate is lower than a natural rate of interest, savers saves less and consumes more. At the same time, businesses borrow more money to invest in their projects. Businesses fail to see an increase in the demand for their products as an aggregate increase in the demand instead they think that the relative demand for their products has increased. To respond to the increase in the demand, businesses borrow more money and produce more. With a new cheaper money, investments that wouldn't have been done without an artificially low interest rate are made. These investments are called malinvestment by Austrian economists. When the businesses realize that this higher demand wasn't relative and the inflation is higher than they expected, they try to fix the mistake they made by changing the use of the capital and labor they have already obtained through the artificially low interest rate. Unfortunately, the process to make this adjustment takes some time because not all capital and labor can be used to produce a different product than the product they had been specified for. Therefore, this adjustment results in a period of unemployment and underemployment a.k.a a recession.
Moreover, the Austrian Business Cycle Theory explains one more thing that other business cycle theories don't explain. William J. Luther and Mark Cohen states this in their recent paper:
In particular, we have argued that the Austrian view is unique in suggesting that a monetary shock will distort the structure of production. An unexpected monetary expansion encourages early and late stage production relative to middle stage production. Hence, the Austrian theory claims that prices and production will increase in early and late stages relative to middle stages when the interest rate prevailing in the market falls below the natural rate.
In other words, the artificially low interest rate changes the structure of the production process.
According to the Austrians, the recent recession was the result of the Fed's low interest rate policy that followed 2001 recession.
Moreover, the theory has a implication on today's Fed's low interest policy. According to the Austrian Theory, the recession is a self-healing process of the economy after a boom and burst. Therefore, lowering the interest rate is seen as a problem by the Austrians. Here, WSJ covers some Austrian voices on the issue of the easy money policy in 2010:
Narayana Kocherlakota, president of the Minneapolis Fed, argued that a large part of today's unemployment problem is caused by issues the Fed can't solve, such as the mismatch between the skills of jobless workers and the skills that employers wanted.
The ABCT theory hasn't been prominent theory to explain the business cycles as others, such as Keynesian economics. Economists have done researches to study the empirical evidence of the theory, but most of them shows results against the ABCT explanation. (Here and here) But it is still important to look back at the ABCT theory and its ingredients to understand economy more and fix its errors, if there is, to solve the economics problems more successfully.

Does the recent low interest rate induce more investment?

 As Keynes argued that the solution to the Great Depression was to create more investment through a reduction in interest rates, one of the goals the Fed pursued through its near zero interest rate policy was to lower overall interest rate in the economy and create more investment. As we studied from IS-LM model, I(nvestment) part of the model is a decreasing function of the real interest rate. But, of course, IS-LM model is very simplified but useful to see effects of certain changes in the economy isolated from other factors. If we naively assume the model's argument and recent economic condition since the recession, we would expect total investments to be risen since the Fed has shifted to zero interest rate policy. As the monetary policy makers lowered the interest rate to near zero, the economy has been seeing the only period of below zero real interest rate which wasn't created by high inflation as it was in the 1970's.
Historical real interest rate ( 10 year rate minus personal consumption expenditure inflation rate)
Historical real interest rate ( 10-year rate minus personal consumption expenditure inflation rate)
We would expect businesses to borrow money with negative real interest rate and invest it to their businesses, right? Recent research done by by Federal Reserve staff economists Steve Sharpe and Gustavo Suarez showed that businesses investors were inelastic to low interest rates. According to the paper,
The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points.
Strikingly, 68% did not expect any decline in interest rates would induce more investment.
In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.
In other words, one of the goals, namely to increase investment, that the policy makers hoped to achieve through the low interest rate policy hasn't been achieved.
Private non-residential fixed investment, federal funds rate, and real interest rate
Private non-residential fixed investment, federal funds rate, and real interest rate
If we look at the above graph, business sector hasn't been really responding to the historically low real interest rate. It may be due to the uncertainty created by the Fed's policy tools.
Overall, total real private investment hasn't gotten back to a level it was at before the recession.
This slow increase in private investment has been one of the reasons the recovery has been slow since the recession. The Fed should increase the business and consumers confidence to increase investment.

The Fed and a Bubble: Flashback to 1927-1930

In recent discussions around effects and consequences of the Fed's monetary policy, a bubble in stock market has attracted attention. Even though the Fed's conventional and unconventional easy monetary policy, along with fiscal policies, has been keeping the U.S. economy from slipping into another Great Depression, unintended consequences of the Fed's recent policy, specially QE3, could be a big problem on its own as the policy sustains the recovery. The full effect of QE on the economy and the financial system isn't still fully known. Victoria McGrane quotes San Francisco Fed President John Williams from his recent paper on the zero lower bound:
Added to this uncertainty, the programs also raise “nagging concerns that large-scale asset purchases carry with them particular risks to the economy or the health of the financial system that we still don’t understand well,” he said.
Warning of a stock bubble has already been voiced by some of the Fed's policy makers. They argue that today's historically low federal funds rate has been fueling the stock prices. Therefore, they argue the Fed should pull back its bond-buying program to stop the potential stock bubble. However, the Fed shouldn't, in my opinion, tighten its monetary policy  so quick to just stop any potential bubble.
Here, Economist's 1998 article, "America's Bubble Economy", says:
In the late 1920s the Fed was also reluctant to raise interest rates in response to surging share prices, leaving rampant bank lending to push prices higher still. When the Fed did belatedly act, the bubble burst with a vengeance. The longer that asset prices continue to be pumped up by easy money, the more inflated the bubble will become and the more painful the economic after-effects when it bursts.
Now, let's try to see what was the Fed's action in the years prior to the Great Depression. In 1927, the Fed decreased its federal funds rate in the face of a mild recession in the U.S. and Britain's balance of payments crisis. Following this policy, the stock market prices gained 39% and the price-dividend ratio rose by 27% in 1928 (FYI: IN 2013, the Dow and S&P500 stock prices gained 26.5% and 29.6% respectively.) Worrying about a potential stock market bubble, the Fed raised the discount rate from 3.5% to 5% in the first half of 1928. The contractionary policy seemed to be working as the price-dividend ratio continuously fell until July 1929, when it started to increase again. Acting against this increase in the stock price, the Fed further increased the discount rate to 6% in August 1929. We know what happened next: the stock market crashed in late October of 1929. Here, we can see the Dow Jones Industrial Average price and price-dividend ratio in late 1920s.

As we briefly discussed the actions that the Fed took to cool down the stock market in the late 1920's, we should study further what this Fed's actions led to.
Today, the Fed faces the same problem even though Fed Chairman Ben Bernanke doesn't see an evidence of a bubble. Therefore, today's one of the biggest problems is whether the Fed can manage its bond-buying program in a way such that it's action doesn't burst or sustain any dangerous bubble.

Asset Boom vs Low Inflation

Since the Fed announced that it would start trimming it's bond buying program of $85 billion a month to $75 billion in the face of better economic outlook in December, the certain members of the FOMC have been open about their opinion on the Fed's recent QE program.
Being one of the strong critics of the program, Federal Reserve Bank of Dallas President Richard Fisher has been arguing against the whole bond buying program. In his opinion, the bond buying program does nothing much to the recovery, and the Fed should have cut back the amount of monthly bond purchase by $20 billion instead of $10 billion. Moreover, Fisher worries about increasing price of stocks and other assets. He isn't alone to warn about the bond buying programs push on asset price as stock prices are up 30% from a year ago. The worrisome result of the program is that "the boost to wealth and consumer confidence has accrued almost exclusively to the 52% of Americans who own stocks, based on a Gallup survey. It has not flowed through to jobs as the employment-to-population ratio has remained at 58.6% of the working-age population, within tenths of a percent of the recession low", according to RANDALL W. FORSYTH on Barron's. In other words, the bond buying program's main effect has been on the upward movement of the stock and asset prices but not much on the employment. The employment-to-population ratio has been lower than what it was at the "official" end of the recession, namely 59.4%, in June 2009, let alone before the recession ratio 62.7%. But we have to be careful here; to judge the QEs' effect on the economy, we should compare how the economy has been doing to how it would have done without the Fed's bond buying programs. Therefore, the judgement on the unemployment rate should be considered with a research on an "imaginary" economy without the QEs. However, the other point made in the above quote on the distribution of the Fed's high powered money and the beneficiaries of the FED's program, namely asset owners. The Fed's policy, therefore, could be a factor that is widening income inequality. Increasing income inequality should be tackled as soon as possible as it is growing as never before.
On the other hand, some members of FOMC have been big proponents of the Fed's bond buying program. Being one of them, Chicago Fed President Charles Evans has been taking strong stand on the continuation of the program to boost the recovery. He, among others, is worried by not-so-much inflation rate of 1.1% in the last year, which is well below the Fed's targeted level of 2%. To boost it to this targeted level, the Fed should pursue its near zero percent interest rate policy with its bond buying program, according to him. With low inflation, consumers and businesses have low incentive to borrow and spend their money. Therefore, the Fed is targeting high enough inflation to give confidence to consumers and businesses.
In other words, the Fed's policymakers have been divided between a policy against increasing asset prices and a policy against low inflation. Of course, it is not like "black vs white" argument. Fortunately, the monetary policymakers have been critical of each possible effect of the program.

The Income Inequality and the Economic Downturns

When we look at the similarities between the Great Depression and the Great Recession, one stark phenomenon that only these two economic downturns saw was the high income inequality in the U.S. that preceded these economic disasters. If we look at the graph showing the historical percent share of income of the top 10%t, this share was at the record high levels right before the Great Depression, in 1928, and the Great Recession, in In fact, during those times, the income share of the top 10% was almost 50%. As we look from the graph, this high level of income inequality was not seen during the time between the two great crises. This high level of inequality was seen first time at the onset of the Great Depression, and the next one coincided with the beginning of the Great Recession.
Could the increasing income inequality have been a root cause of the greatest economic panics the U.S. economy has faced in the 20th and 21st century? Let me try to see the potential link between the high level of inequality and the economic downturn. When people at top of the income ladder get bigger share of the total income, the folks at the bottom of the ladder would get less share of the total income. However, when, the top, let’s say, 10% get more income, their propensity to consume would decrease. In other words, the money that would have otherwise been spent for the consumption by the bottom 90% wouldn't be spent for the consumption by the top 10%. This leads to a decrease in total consumption in the economy which could have caused the downturns.
The most interesting data we can see is that since the official end of the Great Recession, the income share of the top 10% has only gone up until 2012, in which the latest data is available. Not only did the income share of top 10% go back to the pre-crisis level, but also it is now greater than 50%. In 2012, the top 10%t collected more than a half of the total income for the first time during the time of data. In other words, the income inequality in the U.S. is going to the same direction as it went to before the crisis. In that sense, I doubt the recovery that U.S economy is going through is healthy one. Not only has the income inequality in the U.S. been increasing, but also that in other countries has increased since the 2007-2009 recession. ( Harold James, Project Syndicate) This increase in income inequality in the U.S. has been facilitated by the Fed's non-conventional monetary policy, which has been potentially creating an asset price boom. The Great Recession challenged everyone in the U.S. in some ways, but the top 1% has already recovered what it has lost during the recession. Meanwhile, the increase in the income of the bottom 99% has been very low if there was any.  (Moran Zhang, IB Times)