The Fed Ties Interest Rate Raise (*remotely) to the Tapering Instead of Unemployment Rate

Following today's Fed's meeting, the meeting statement has been scrutinized by every word to word. Of course, the biggest headline news was the Fed's move to drop the unemployment rate of 6.5% as a threshold rate for raising interest rate from its meeting statement. Not only are Fed watchers reading the statement literally word to word, but also some of the policymakers at the Fed worried that some paragraphs of the statement might stir the market to a wrong way. To be more precise, Minnesota Fed President Narayana Kocherlakota was the only voting member who voted against the Fed's decision to remove the key number of 6.5% from the statement. He says that the a paragraph in the statement may signal the Fed's weakness when it comes to reaching the long-term inflation rate of 2%. The paragraph he was referring to is following:

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored [emphasis added].

It seems like the last sentence could have caused Mr. Kocherlakota to vote against the action because of it's  possible inference of a lasting low inflationary period. As low inflation has continued since 2012, inflation expectation, also, hasn't been reaching the goal of 2%. The expected inflation in 10 years is still lower than 2%. The following graph provided by the Cleveland Fed shows the market's expectation of inflation in certain time horizons :

Considering the low expected inflation in next few years, Mr. Kocherlakota's worry of weakening the credibility of the Fed's commitment to the 2% inflation is indeed valid. The Fed's main goal thorough its forward guidance is to lower the expected interest rate for certain duration, but it's another goal from which the FED is quite away from reaching it is to raise the inflation expectation, which in turn lowers the real interest  rate and boost investment.

Now let me interpret the Fed's statement in my way. The WSJ posts an interesting post on how the latest Fed's statement changed from last month's. The following passage shows the change made in the statement from last month:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate
well past the time that the unemployment rate declines below 6-1/2 percentfor a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal
. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent, and provided that longer-term inflation expectations remain well anchored.

As we see from the change made in the statement, the Fed untied the possible date of raising interest rate from the unemployment rate and related it more to the Fed's tapering process and its ending. Now, the Fed watchers should be giving more weights to the tapering process than before since it is now more related to the raise in interest rate.

This change could be progress forward for the Fed because as the tapering continues for at least throughout 2014, the market will have stronger signal of the Fed's raising interest rate in near future. Even though then higher expected interest rate might seem worse for the economy, raised expected interest rate could actually induce more investment today, which is opposite to what one might assume. Because, the market will be surely knowing the coming of the raise in the interest rate in few months, firms should take advantage of the low interest rate today by borrowing and investing rather than postponing the investment project. This idea of surely known interest rate increase could create more investment is explained in my one of the previous posts.

*UPDATE: After posting this, I watched Mrs. Yellen's press conference following the FOMC meeting. When one of journalists asked exactly how much time the Fed will take to raise the interest rate after it completely stops its large-scale asset purchase aka QA, she answers (from the press conference transcript):

 So, the language that we use in this statement is considerable, period. So, I -- I, you know, this is the kind of term it's hard to define, but, you know, it probably means something on the order of around six months or that type of thing. But, you know, it depends -- what the statement is saying is it depends what conditions are like.

I don't want to make a big deal out of that "around six months" as some are doing. But it gives "considerable" idea of how long is that "considerable" 

Thought on Forward Guidance: Proposal for the Fed

The FED has been pursuing its so called "forward guidance" program hoping it could stimulate economy by convincing the persistence of low interest rate policy. It stated that it sees the current low interest rate appropriate as long as the unemployment rate remains above 6.5% and the expected inflation in one to two years is below 2.5%. According to the statement, it will consider the broader labor indicators and inflation expectations to decide how long it will continue the near zero interest rate policy once the unemployment rate drops to 6.5%. Therefore, it is very up in the air when the FED is increasing the federal funds rate.

We know that the latest report shows the unemployment rate is 6.6%.  This rate indicates that even though the monthly net number of jobs added hasn't been up to the projections for last two months, the FED will soon be deciding its future policy and writing up its well-into-future forward guidance once the unemployment rate hits 6.5%.

After all, the FED's low interest rate policy has been directed toward increasing investment. But there could be different type of "forward guidance" that could potentially create more investment as the FED wishes. My proposal to the FED is that:

a) It should forward guide the market by putting hard deadline on when it is increasing the federal funds rate and therefore the market interest rates. How this clear deadline for increase in federal funds rate works is following: If the FED successfully (!) convince the market that it will indeed push up the federal funds rate, the investors will have clear expectation of when the overall market interest rates are rising. Therefore, realizing the higher investment cost in the specific future, firms will have incentive to borrow and invest today before the FED raises the interest rate. Hence, the investment could increase as the FED has been wishing. This argument is analogical to the people's consumption when there is very high inflation expectation. If the expected inflation is very high, people would try to buy goods as soon as possible. But the one difference between these two analogies is we don't know what interest rate is very high to be analogy to the high inflation rate.

One might say that then if there is higher demand for loanable funds because of this policy, the interest rate will rise in the loanable funds market. But we have to remember, the FED has control over overall interest rate in the economy (or I believe so), it will pursue its current near zero interest rate policy until the date it forward guided comes.

b) Again, to succeed in increasing investment, the FED must be able convince the market that it is indeed increasing the federal funds rate at that certain date, To convince the market, the FED should set the date to be in near future and interest rate minimally higher in first few periods and commit to what it said.

According to latest report, the expectation of the FED's federal funds rate in June 2015 has lowered in a recent month. This might be showing that the FED's forward guidance indeed successfully convinced the market that the FED will be pursuing near zero interest rate policy. If current forward guidance is indeed somewhat successful, I believe the proposed forward guidance could be also successful.

Remember, at the time when the FED sets the specific date to increase the interest rate, the interest rate will be still zero percent, therefore there will be no negative shock to the total investment.

The problem to implement this forward guidance is that the FED cannot surely know how bad or good the economy will be performing at the time of its forward guided date. The FED could announce its first date to increase the interest rate once the unemployment rate reaches 6.5%. If the FED chooses 3 months to increase the federal funds rate after the unemployment reaches 6.5%, it can study how the investment behaved during this 3 months when the market believes the increase in the interest rate is coming. If the sign turns out to be good, the FED can further implement this "hard deadline for minimal increase in federal funds rate" forward guidance.

Change in Expected Inflation and Its Effect on Investment and Spending

Greg Mankiw explained a possible tool for the FED to stimulate the economy under zero lower bound. He says that even the FED has already lowered the federal funds rate to close to zero, the monetary policy that creates a higher expected inflation in the economy could boost the economy. Mankiw explains that if the expected inflation is increased due to the FED's policy or other reasons, the real interest rate can be lowered. According to this argument, this lower real interest rate induces more investment because of negative correlation between real interest rate and investment. In his words:

"Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the central bank could raise inflation expectations by committing itself to future monetary expansion. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending."

How I see this argument is this: since a firm expects that the overall price in the economy to increase by more than  what it expected before, the firm would invest more in new capital than it was planning to do for two reasons: first, it would try to take advantage of low price more than it was planning before. In other words, since the firm expects the general price to go higher than it expected before, it will increase its today's investment to avoid paying this higher price in the future to buy capital. It is shifting its investment from the future to today. Second, when the firm's expectation of inflation increases, it would seek to borrow more money than it planned to do because the real interest it will pay in the future decreases. In other words, they just cannot resist this lower real interest rate in the future; therefore, they will borrow money today and invest in whatever plan they could think good.

The part I don't understand in Mankiw's argument is how the change in expected inflation could affect the real interest rate today.

In his General Theory, Keynes writes:

"The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. (p.142)

Keynes says that any possible affect of the increase in expected inflation on the investment is through the higher schedule of the marginal efficiency of capital. What I am understanding as the schedule of the marginal efficiency of capital is the firms demand for investment.

Now on the effect of higher expected inflation on consumption spending, it seems to be reasonable to expect that people would spend more today if their expectation on the general price rises. Of course, whether it is true or not depends on in what time period we are talking about the inflation expectation. If people raises their expectation of inflation in the near future, they try to adjust their spending accordingly. Also, the effect on consumption differs for durable goods and non-durable goods since the absolute change in the prices of durable goods tend to be higher than that of non-durable goods. Because of this possible effect on the spending, there could be increase in overall prices today. In other words, a higher expected inflation could cause increase in prices today. However, this possible positive relation between the change in expected inflation and spending isn't clear. In their paper in 2012, Bachmann et al concludes following: 

"We find that the impact of inflation expectations on the reported readiness to spend on durable goods is statistically insignificant and small in absolute value when compared to other variables, such as household income or expected business conditions. Moreover, it appears that higher expected price changes have an adverse impact on the reported readiness to spend. A one percent increase in expected inflation reduces the probability that households have a positive attitude towards spending by about 0.1 percentage points. At the zero lower bound this small adverse effect remains, and is, if anything, slightly stronger."

We still lack empirical study on the effect of the change in expected inflation on the spending. In my curiosity, I looked over some data on the monthly change in the expected inflation, quarterly percent change in the investment and monthly percent change in consumption spending.  From this graph, we cannot tell whether the higher expected inflation induces more investment or higher consumption spending. Of course, we need to do empirical research to claim whether it is true or not. In conclusion, I don't see or understand the stimulating effect of the higher expected inflation on the economy as Mankiw and others see it. Therefore in my opinion,  the effect of raising inflation expectation by monetary policy, which is one of the two main tools that some people suggest in today's case of zero lower bound problem, isn't clear. The other tool, quantitative easing, seems to be more effective under zero lower bound.

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.

Source: http://www.piie.com/publications/pb/pb14-4.pdf

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:

Former Fed Economist Call For Central Bank to Scrap Fed Funds Rate Target

Fed Moves Toward New Tool for Setting Rates

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.

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.