Finance Basic To Advance Level Knowledge

Martin Wolf says its time to unload both barrels of the gun and resort to true helicopter drop-types stimulus.  He has the right idea, but it could be better implemented through an explicit price level or nominal GDP level target.  Doing so is important because as Josh Hendrickson notes no one at the Fed or the ECB knows exactly how much to print. What the central banks can do, though, is properly shape expectations about future nominal spending and price growth.  Doing so would cause the markets themselves to do much of the heavy lifting (through expectation-induced portfolio rebalancings) and in the process ensure the Fed's goals are realized. Josh Hendrickson sums it up this point nicely: The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the ma...

Following a speech on Wednesday, Fed Chairman Ben Bernanke had this to say in a Q&A: "If inflation itself falls too low or inflation expectations fall too low, that would be something we'd have to respond to because we don't want deflation[.]" At first glance this statement seems reasonable, but upon further reflection there is something troubling about it.  It is the monetary policy equivalent of locking the barn door after the horse is already out.  Bernanke is saying here the Fed will respond after inflation falls too low.  Why not lock the barn door up front by explicitly targeting inflation expectations so that the public's expectations about future spending and price growth are anchored and not likely fall in the first place?   If this were the way monetary policy were conducted the Fed would be a little more concerned right now about the now 6-month downward trend in inflation expectations.   If there is one lesson the Fed sho...

Scott Sumner once compared arm wrestling with his daughter to the relationship between monetary and fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how hard fiscal policy may attempt to stimulate aggregate spending the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  In other words, the size of the fiscal multiplier ultimately depends on the stance of monetary policy. Recent studies by Eric Leeper, Nora Traum and Todd Walker , Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo , and Michael Woodford all lend support to this understanding.  They show using formal models that in a world where nominal and real rigidities exist the impact of fiscal policy on economic activity is muted when the central bank follows something like a Taylor Rule. 1 ...

Stephen Colbert invokes his inner Keynesian spirit to propose a plan to end the Eurozone crisis and and revive the U.S. economy at the same time. The Colbert Report Get More: Colbert Report Full Episodes , Political Humor & Satire Blog , Video Archive

The latest initiative to save the Eurozone is the " Geithner Plan ." It would have the Eurozone leverage up the EU's €440 billion bailout fund to €1 trillion by making it act as an insurance fund for investors buying up debt of the troubled Eurozone countries.  Though big, this plan would only address the current debt problems.  It would not solve the large real exchange rate misalignment--30% according to Ambrose Evans-Pritchard--between the core countries and the the troubled periphery. The ECB, on the other hand, could address fix this problem. Here is how.  If the ECB were to sufficiently ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity and nominal spending is more robust.  Currently, that would be the core countries, particularly Germany.  Consequently, the price level would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods...

What explains the big sell off in markets today? As Ezra Klein notes , many observers are attributing it to the FOMC saying it sees "significant downside risk" to the economy.  Felix Salmon, however, objects to this line of reasoning: It’s silly to think that the decline in stock-market prices was a rational reaction to the FOMC statement. If the FOMC is more pessimistic than the market expected, that’s normally a good sign for markets, since it implies that monetary policy will remain looser for longer. The market cares about the Fed because the Fed controls monetary policy. And so Fed forecasts are important because they help drive that policy. No one revised down their growth expectations as a result of the FOMC statement. Actually Felix, the decline in equity markets, the drop in treasury yields, and fall in expected inflation all indicate the public has revised down its growth expectations and the most likely reason is Fed policy.  Over the past three y...

The Fed decided today it would lower the average maturity of publicly-held treasuries by selling $400 billion of shorter-term treasuries and buying the same amount of longer-term treasuries.  In addition, the Fed also reconfirmed its commitment to maintain the size of its mortgage holdings and anticipated its targeted interest rate would remain low through mid-2013.  The burning question now is how big of an impact will the Fed's new treasury maturity transformation or "operation twist" program have on the economy?  Not much in my view.  It should add some monetary stimulus, but like the original operation twist its effects will probably be modest and do little to spark a robust recovery.   So how would it add monetary stimulus?  The standard story is that it would transfer duration and other risks from the private sector's balance sheet to the public sector and thus add to the private sector's ability to take on more risk.  Other riskie...

That additional monetary stimulus would help the economy.  That is the only sense I can make of the letter from Republican leaders in Congress sent to Federal Reserve Chairman Ben Bernanke asking him to refrain from further monetary stimulus.  They may realize that a truly bold monetary stimulus program like FDR's original quantitative easing program of 1933-1936 can turn a depressed economy around and affect political outcomes.  If so, this understanding would also explain Governor Rick Perry's comments about Bernanke committing treason if he printed more money before the election.  It would be truly tragic if in fact these politicians were making this tradeoff between political gain and economic gain.  There is, though, a silver lining to these developments. Marcus Nunes notes that the congressional letter actually opens the door for the Fed to do something bold if they can justify it: But you don´t have to read far [in the letter] to see the mess...

Back in April 2010 when it first seemed the Eurozone was about to crack up, I did a post on the lessons of the Eurozone crisis.  I argued then that the main lessons were, one, countries joining a currency union should take seriously the optimal area criteria and the real exchange rate and, two, central banks should take seriously the task of stabilizing the growth of nominal spending.  I still think these points are valid,  but I now see a more important lesson from this ongoing crisis: avoid relationships where one party to the relationship is domineering and has a history of abuse.  In short, avoid bad relationships. In the case of the Eurozone relationship the dominant party is Germany.  Its desires have largely shaped the direction of the Eurozone and continue to do so today, even though it only has historically made up at most about 30% of the Eurozone economy.  This uneven relationship has been very apparent lately as the future of the Eurozone se...

I recently argued that the Fed and the ECB were passively tightening monetary policy and thus responsible, in part, for the increasing economic stress in their regions.  Michael T. Darda makes the same argument today for the Eurozone in his note titled " Anatomy of a Deflationary Debt Collapse ": As the ECB fiddles with its forecast, European inflation-indexed bond spreads have plunged to record lows, while eurozone corporate bond spreads continue to hit new highs for the year. Inflation breakeven spreads in the indexed swap market in Europe have tumbled to the lowest level on record (i.e., below both the 2008 and 2010 lows). With corporate bond spreads at new 2011 highs this morning, the European Central Bank can now be blamed for a passive tightening of monetary policy. Why? Central banks are responsible for responding to velocity shocks by adjusting the supply of money to offset changes in the demand for money. If there is a spike in the demand for money and a central...

Via Jon Hilsenrath we learn this about the FOMC members: Fed Chairman Ben Bernanke has asked Philadelphia Fed President Charles Plosser and Chicago Fed President Charles Evans, two intellectual adversaries, to work with Vice Chairwoman Janet Yellen on how the Fed can better explain its economic goals to the public. One issue high on the agenda: Detail what changes in unemployment and inflation it would take to make the central bank veer from its low interest rate target... Mr. Bernanke and many other officials dismiss the idea that he’s confronting a rebellion inside the Fed. They argue that internal disagreement is a sign of strength because it shows officials are wrestling earnestly with hard questions and have their eyes wide open to the challenges they face. “My attitude has always been: if two people always agree, one of them is redundant,” Mr. Bernanke said earlier this month in Minneapolis. This would be fun to watch if the Fed's internal divisions were...

I have mentioned many times here how the decision of FDR and his Treasury to devalue the dollar and not sterilize gold inflows sparked a robust recovery from 1933-1936.  This development can be called the original QE program and it worked wonders despite the fact that the private sector was still deleveraging through at least 1935.   The recovery fell apart when the recession of 1937-1936 hit.  The standard story for this recession has been that some fiscal policy tightening and a lot of monetary policy tightening caused it.  On the latter point, the conventional view is that monetary policy tightened when the Fed raised reserve requirements on banks.  Douglass Irwin, however, has a new paper that calls into question this conventional wisdom.  He says it was largely a tightening of monetary policy that caused the recession, but it was not because the Fed raised reserve requirements.  Rather, it was because the Treasury started sterilizing gol...

Yesterday we learned that despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now.  In the Eurozone, ECB president Jean acknowledged the Eurozone economy faces "particularly high uncertainty and intensified downside risks" yet chose, along with the rest of the ECB authorities, not to further loosen monetary policy.  Across the Atlantic, Fed Chairman Ben Benarnke gave a speech where he too acknowledged the economy was surprisingly weak. He then noted that the "Federal Reserve has a range of tools that could be used to provide additional monetary stimulus" that he and other Fed offiicials "will continue to consider... at our meeting in September..."  In short, both central banks have decided to sit on the sidelines for now despite the ability and need to do more. There is a term for this. It is called a passive tightening of monetary policy. ...

I have continually stressed the need for the Fed to (1) publicly and forcefully announce a level target and to (2) back up such an announcement with a commitment to buy up as many assets as needed so that the target is hit.  Well, the Swiss National Bank has amazingly just done that in a way that would make Lars E. O. Svensson proud .  Below is the press release (my bold): The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities. Even at a rate of CHF 1.20 per euro, the Swiss franc is still high and should continue to weaken o...