A Harbinger of Things to Come?

Tue, Jan 11, 2011 - 9:05am

The Federal Reserve’s Vice-Chair Janet Yellen provided a spirited defense of the Fed’s quantitative easing program at the American Economic Association annual meeting last week. She laid out what clearly seems to be the conventional wisdom inside the Fed as to the effects of its crisis programs, the results of the current additional $600 billion of additional asset purchases, and the hoped-for path of employment flowing from those policies. The claim is, among other things, that the Fed’s purchases were designed to lower longer-term interest rates. Furthermore, based upon model simulations, the $600 billion of additional securities purchases will create 700 thousand more jobs, and the full program will create an additional 3 million jobs.

Now, one can quibble with reliance upon models that in the past have had significant difficulties in capturing movements in the economy, especially since the forecasts and simulations are out-of-sample extrapolations. That is, the models were not estimated with data that include economic downturns like the one we are currently experiencing.

Additionally, to present point estimates with no indication of the confidence intervals around those estimates implies a degree of precision greater than is justified. In fact, in the main paper that Governor Yellen cites, the error bands are huge and are consistent with almost any result one might imagine. With everyone at the Fed looking at the same simulations, there is the danger of group-think and believing that models are in fact the real world. Keep in mind that these are 700 thousand and 3 million simulated job forecasts, not actual jobs to which policy makers can point.

As for QE2, while Governor Yellen provides evidence that interest rates did decline somewhat leading up to the Fed’s November QE2 decision, she fails to note that those declines were temporary. Within one to two weeks following the November decision, medium- and long-term rates not only erased all of their declines but increased substantially. The aftermath of the November QE2 is higher nominal rates, not the lower rates the models predicted.

Governor Yellen also repeated assertions made by Chairman Bernanke and other FOMC members that the Fed’s tool kit is adequate to reverse policy when the time comes. But she did not address how the Fed would deal with its potential market-value insolvency, how it could absorb the losses that would be associated with asset sales, or how it might deal with an abrupt shift in long-term rates that would surely accompany liquidation of private-sector bond positions, when a policy reversal commences as investors seek to avoid large capital losses. Repeating difficult-to-support assertions is not good communication.

One gets the impression that the scenario the FOMC envisions, when the time comes to change policy, is one in which the economy is growing above-trend, unemployment has dropped, slack in the economy has disappeared, wages are on the rise, inflation is somewhere in the 2% to 3% range, and the FOMC can gradually raise interest rates as needed. Indeed, this is essentially the scenario implied in the simulation results mentioned above, with policy tightening beginning in 2014.

This may not, however, be the policy problem the Fed will face. The scenario emerging in Europe may be equally or more likely.

Like the US, both the Bank of England and the ECB injected huge sums of liquidity into their financial markets. The Bank of England increased its balance sheet by about 2.5 times, and the ECB’s balance sheet has roughly doubled over the course of the crisis. However, despite this stimulus, unemployment remains distressingly high. UK unemployment is about 7.9% and rising, not falling. EU unemployment is in excess of 10% and it is not evenly distributed across countries. In some EU countries unemployment is extremely high. In Spain it is over 20% and in Ireland it has topped 14%. However, in other countries, like Germany, unemployment is at 6.7% and has been declining steadily.

At the same time, both central banks are charged with a single mandate that targets low inflation. In the UK, inflation is outside the officially acceptable upper bound of 3% relative to its 2% target, and the Bank of England has had to explain why it has continually missed its target for about a year. The ECB similarly is faced with the prospect that, at 2.3%, existing EU inflation is now above the ECB’s official target of 2% for the second month in a row. Inflation rates are also not evenly distributed across the EU, making it difficult for the ECB to infer the overall path for inflation. The lowest rate was in Ireland at -0.8%, but other countries have substantially higher rates (Romania 7.7%, Estonia 5.0%, and Greece 4.8%). Real GDP growth in the euro zone is less than 1%, and about 2.7% year-over-year in the UK.

The policy problem is that despite slow-growing economies and increasing unemployment rates, the inflation situation would call for monetary tightening by single-mandate central banks. But for either the ECB or Bank of England, to begin tightening risks choking off growth and exacerbating the unemployment situation. These central banks could act to tighten policy, but obviously have not, despite their single mandate. They are behaving as if they have a dual mandate, even though it isn’t explicit. Indeed, the ECB has embarked upon additional quantitative easing in announcing its intention to purchase the sovereign debt of Portugal in an attempt to preempt another financial crisis.

How would the Fed deal with policy choices if presented with the combination of growth, inflation, and unemployment facing the ECB and Bank of England, especially given its dual mandate? Would the FOMC be induced to expand its quantitative easing policy in the name of creating even more jobs, even if it meant tolerating higher and higher inflation rates? My guess is that it would. The simulations that Governor Yellen cites clearly suggest that core inflation will be 40 basis points higher down the road than it would without the extra $600 billion of QE2. But inflation could be much higher.

What the EU and UK experience tells us is that central bank mandates don’t really matter when economies are in extreme states. Changing the Fed’s mandate, as some in Congress are now suggesting, won’t likely impact the Fed’s behavior. What really matters – as the UK and EU experience demonstrates - are the preferences, insightfulness, and skills of the people in decision-making positions as they seek to do what is right for their countries.

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com. He may be reached at Bob.Eisenbeis @ cumber.com.

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Chief Monetary Economist
Bob [dot] Eisenbeis [at] cumber [dot] com ()