Chairman Bernanke has been pretty clear about his intentions regarding the overall size of the Fed's balance sheet

TO BE NOTED: From Macroblog:

"Debt and money

If you are hunkered down on inflation watch, yesterday's news offered some soothing words. From Reuters:

"Chinese officials have expressed concern that heavy deficit spending and an ultra-loose monetary policy could spark inflation, eroding the value of China's U.S. bond holdings.

"But [U.S. Treasury Secretary Timothy] Geithner said: 'We have a strong, independent Fed and I am completely confident they have the ability to do their job under the law, which is to keep inflation stable and low over time, and that they will be able to—and certainly intend to—unwind these exceptional measures as soon as they have served their purpose.' "

And from Bloomberg:

"He said that there was 'no risk' of the U.S. monetizing its debt, a response to a question about whether the government would seek to finance the national debt by expanding the money supply and thus trigger a rise in inflation."

Concerns about such monetization arose in the wake of the FOMC's decision at its March meeting to purchase up to $300 billion of longer-term Treasury securities and that decision's coincidence with the very large fiscal deficits contemplated in President Obama's budget proposals. Those concerns have accelerated as longer-term Treasury yields have moved higher since.

There will, I trust, be plenty of opportunity to expand on these concerns as things develop, but for now I will offer just a little perspective in the form of the chart below, which shows the recent and (near-term) prospective shares of federal debt held by the Federal Reserve. The red line represents the share of debt that will be held by the Fed at the end of fiscal year 2009 if the $300 billion Treasury purchase program is completed and the federal deficit emerges as currently predicted by the Congressional Budget Office.

The financial crisis has, of course, borne witness to the shift in the Fed's balance sheet from Treasuries (which have been much in demand by the private sector) to a variety of loans and mortgage-backed securities. The consequence has been a sharp fall in the fraction of government debt held by the central bank, a fact that will be little changed under the current trajectory of Fed purchases and projected deficit spending.

A large decline in Fed holdings of Treasury bills—securities that mature in one year or less—drives much of the pattern seen in the chart above. The drop-off in share is not as large for Treasury notes—securities in the two- to ten-year maturity range, and some assumptions have to be made to get a picture of how the Fed's share might evolve over the near term. Without knowing how this evolution will occur, I developed two general assumptions for argument sake. If net new issues of Treasury debt follow historical averages, meaning just over half of net new debt is in the form of notes, and if the central bank applies the remainder of the $300 billion of longer-term Treasury purchases (about $170 billion at the end May) to notes, then the Fed would hold roughly 13 percent of the outstanding stock by the end of the year. If the Treasury were to issue nothing but bills or bonds, a $170 billion purchase of notes by the Fed would bring its share up to the neighborhood of 17 percent. Though these numbers are not as unusually low in historical context as is the case for total outstanding debt, neither would they jump off the page as an extreme aberration in the other direction.

Some might argue that "monetization" these days involves a whole lot more than government debt, but Chairman Bernanke has been pretty clear about his intentions regarding the overall size of the Fed's balance sheet. And, as I see it, so far allegations that extraordinary steps are being taken specifically to accommodate fiscal deficits are properly characterized as risk rather than fact.

By David Altig, senior vice president and research director at the Atlanta Fed"

—is the central bank's lender-of-last-resort function meaningful if narrowly construed (that is, if it fails to reach the shadow banking system)?

TO BE NOTED: From Macroblog:

"A new accord?

As days go in the U.S. Treasury market, Wednesday was a rough one. Bloomberg News described the day's developments as follows:

"The difference in yields between Treasury two- and 10-year notes widened to a record on concern surging sales of U.S. debt will overwhelm the Federal Reserve's efforts to keep borrowing costs low. …

"The unprecedented government borrowing has created concern about a rise in consumer prices. Policy makers have expanded the Fed's balance sheet to $2.2 trillion while excess reserves at U.S. banks have increased to $896.3 billion.

" 'Inflation is in the headlight of many investors,' wrote Andrew Brenner, co-head of structured products and emerging markets in New York at MF Global Inc., in a note to clients today."

By cosmic coincidence, I was reading that story in Tokyo as I prepared to chair a session at the Bank of Japan's 2009 International Conference on Financial System and Monetary Policy Implementation in which Marvin Goodfriend (Carnegie-Mellon professor and former Richmond Fed policy adviser) presented his thinking on keeping the central bank's inflation objectives firmly in hand at a time of rapidly rising government debt and large increases in the Fed's balance sheet. Professor Goodfriend's case is laid out in a paper titled "Central Banking in the Credit Turmoil: An Assessment of Federal Reserve Practice" (which was also presented at a conference devoted to research on the interactions between monetary and fiscal policy—that is, government spending and tax—co-sponsored by Princeton University's Center for Economic Policy Studies and Indiana University's Center for Applied Economics and Policy Research). Goodfriend pulls no punches:

"The 1951 'Accord' between the United States Treasury and the Federal Reserve was one of the most dramatic events in U.S. financial history. The Accord ended an arrangement dating from World War II in which the Fed agreed to use its monetary policy powers to keep interest rates low to help finance the war effort. The Truman Treasury urged that the agreement be extended to keep interest rates low in order to hold down the cost of the huge Federal government debt accumulated during the war. Fed officials argued that keeping interest rates low would require inflationary money growth that would destabilize the economy and ultimately fail.

"The so-called Accord was only one paragraph, but it famously reasserted the principle of Fed independence so that monetary policy might serve exclusively to stabilize inflation and the macroeconomic activity. …

"The enormous expansion of Fed lending today—in scale, in reach beyond depository institutions, and in acceptable collateral—demands an accord for Fed credit policy to supplement the accord on monetary policy. A credit accord should set guidelines for Fed credit policy so that pressure to misuse Fed credit policy for fiscal purposes does not undermine the Fed's independence and impair the central bank's power to stabilize financial markets, inflation, and macroeconomic activity."

Goodfriend's "new accord" amounts to asserting a set of principles that would reinforce price stability as the central goal of monetary policy, set the Fed down the road of extricating itself from the extraordinary credit market interventions of the past year-and-a-half, and join the central bank and Treasury in common cause toward the goal of doing everything possible to make sure that the Fed and Treasury don't go there again.

The paper was provocative, but it also raised a couple of fundamental questions. In particular, what is the degree of autonomous fiscal risk-taking appropriate to allocate to a central bank? If such powers are granted, how often and under what conditions ought those powers be exercised? And how far should the powers reach? If, as Goodfriend states, "the central bank's power to stabilize financial markets, inflation, and macroeconomic activity" requires lender-of-last-resort interventions—and hence pure credit policy interventions—what does that imply about the appropriate scope of monetary and regulatory authorities going forward? If the "shadow banking system" is the de facto banking system of the modern era—as Yale University's Gary Gorton argued in a paper presented at the Atlanta Fed's annual Financial Markets Conference held earlier this month—is the central bank's lender-of-last-resort function meaningful if narrowly construed (that is, if it fails to reach the shadow banking system)?

These, really, are first-order questions. On to the debate.

By David Altig, senior vice president and research director of the Atlanta Fed"

Consumers are proving to be much more resilient than previously expected

TO BE NOTED: From News N Economics:

"Adding to Altig's consumer spending dispute

Saturday, April 18, 2009

David Altig, senior vice president and research director at the Atlanta Fed, argues (hat tip, Mark Thoma) that a piece written in Economix on Tuesday (NY Times economics blog) is not, as David calls it, "that tight". Specifically, the sole purpose of the article was to highlight that the sustained retrenchment in consumer spending is a "historical oddity". And as David argues, it is not an oddity at all.

I agree with David: this Economix piece has its flaws and is definitely outdated (see last paragraph). In contrast, I don't agree with David's measure of cumulative PCE loss, which understates the impact of the shocks to consumer spending in the current cycle. Each indicator has its own cycle within the overall economic cycle; and the best measure of cumulative PCE loss is using the peak to trough of PCE, rather than the economic peak (the NBER dated peak, which David uses) to the PCE trough.

The chart illustrates the cumulative PCE loss using monthly data, as measured by the economic peak to PCE trough (blue) and by the peak and trough of PCE itself (red) over the last eight cycles (including this one). Normally, the different measures present almost identical results. With the exception of the current cycle, the biggest difference occurred in the 73-75 recession, a -0.2% differential.

However, this time it matters by a -0.6% differential. The cumulative PCE loss using the peak to trough PCE measure is -2.5% compared to that using the economic peak to PCE trough measure, -1.9%. PCE was rising through May 2008, five months after the peak of economic activity as defined by the NBER.

The PCE peak to trough paints a darker picture; one that puts this cycle on par with one of the bigger recessions, 1973-1975 (Note: I disagree with David's calculation of the 73-75 PCE loss; it appears to be too little).

One last thing: the Economix article is behind the times, even in the comment that the "sustained" consumer spending decline is an oddity. Consumers are proving to be much more resilient than previously expected. Currently, this PCE cycle is unlikely to set any records, not even that of the first time that PCE contracted for three consecutive quarters since 1947. By my estimates, March real PCE (to be released on April 30) needs to fall by more than $74.6 billion in order to post a third consecutive quarterly decline; that is unlikely.

Rebecca Wilder

Posted by Rebecca Wilder

"In fact, the investment/net worth ratio is currently at a postwar low."

Bad news for another of my proposals. Namely, targeted tax cuts for investment. From Macroblog:

"Will tax stimulus stimulate investment?

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses(ODDLY, THAT'S THE SAME AMOUNT AS MY PROPOSAL FOR THESE TWO TAX CUTS ), a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs( I WANT TO USE IT AS AN INCENTIVE TO ATTACK THE FEAR AND AVERSION TO RISK, WHICH I BELIEVE TO BE THE MAIN PROBLEM NOW.).

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years( MY FIGURE IS $700 Billion )—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills( ISN'T THAT SPENDING? ) or saved the cash( I HOPE SOME PEOPLE DO. JUST NOT EVERYBODY. ) rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”( I THINK THAT THE TAX HAS TO BE PHASED OUT TO ENCOURAGE SPENDING SOONER RATHER THAN LATER.)

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment( THIS IS WHAT I WOULD FAVOR ). The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:

Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low. ( IS HOUSING INCLUDED? )

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds.( TRUE ) (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending.( TRUE ) (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding( TRUE ). ALL OF THESE ARE PROBABLY TRUE TO SOME EXTENT, BUT WHEN I LOOK AT THE GRAPH, IT SEEMS THAT INVESTMENT STARTED GOING DOWN DURING THE TECH BUBBLE YEARS AND CONTINUED IN THE HOUSING BUBBLE YEARS. I'M WONDERING IF THERE HASN'T BEEN A MASSIVE AMOUNT OF MONEY INVESTED IN STOCKS AND HOUSING AS OPPOSED TO, SAY, MANUFACTURING. SEE BELOW.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.( I STILL FAVOR MY IDEA. THE GRAPH ISN'T CONCLUSIVE. )

By David Altig, senior vice president and research director at the Atlanta Fed"

Here's Casey Mulligan:

"TESTING THE THEORY WITH DATA FROM 2008

Another application of this logic is to the residential sector: does residential spending increase or decrease nonresidential spending? Here it is easy to see the importance of supply -- see the figure below.

When housing boomed, nonresidential construction spending fell (despite the fact that the housing boom was increasing the prices of construction labor and materials) -- almost dollar for dollar!

When housing crashed, nonresidential construction spending ROSE (despite the fact that the housing crash was reducing the prices of construction labor and materials), about 15 cents on the dollar. Note that, according to the NBER, some of the nonresidential increase occur ed during a recession.

Another fascinating property of this episode is that the shocks to spending are on the order of magnitude (100s of billions of dollars) of the kinds of fiscal stimuli being recommended by some economists.

When interpreting what is above, we need to recognize that a large sector is omitted -- the non-construction sector. For this reason, the calculations above underestimate of the aggegate supply effect of housing spending on nonresidential spending (Take, for example, accountants. A housing boom pulls accountants into work for construction businesses, which leaves fewer accountants to work for non-construction businesses.). But they also underestimate the aggregate demand effect, because the housing construction workers are taking their paychecks and spending some of it on non-construction items. In any case, the supply effect is easy to see -- the housing construction boom did not take place with resources that would have otherwise been unemployed and the housing bust did not release resources entirely into unemployment."

So, I'm wondering if the Tech and Housing Bubbles diverted money away from other types of investment. If so, we might want to rethink subsidizing the purchases of houses ( I'm for a general housing subsidy for low-income people. ) It would seem to me, interpreting Mulligan's points for my own purposes, that now would be an especially felicitous time to encourage investment in sectors that have been recently shunned.

"Still, in current circumstances a glimmer of hope is better than nothing."

From Macroblog, some good news:

"Good news in income growth?

One of my New Year’s resolutions is to be more consistent in responding to questions and comments from the loyal readers of macroblog. Though it remains the case that time constraints prohibit a response to all worthy queries, we’re still listening. Next year we’ll endeavor to give a shout back just a little more often.

In that spirit, I received an interesting inquiry from reader Robert Schumacher:

A cursory examination of the monthly trends in real disposable income in light of the NBER official business cycles suggests to me that a sustained rise in disposable personal income (at least three if not four months) signals the end of the recession is at hand. In that real disposable income rose in October and November how are we to interpret this amidst the dire economic forecasts for the coming year?

It does seem, as Robert suggests, that a sustained rise in real disposable income is characteristic of a typical recession’s end. Using a graphical device from a few posts back, here’s a look at the trajectory of disposable income up to and after December 2007 (the start date of the current recession according to the NBER Business Cycle Dating Committee), compared with the average experience of the previous seven recessions dating from 1960:

As in the previous post, “time 0” represents the peak of a business cycle, or the month a recession begins. The average length of US recessions from 1960 through 2001 was 10.7 months, so the line indicating 10 months from the peak roughly coincides to the end of the average recession over this period.

On average, Robert’s conjecture looks right on track( I AGREE ). In the typical case, growth in real disposable income stalls and then begins to pick up three or four months before recession’s end. If you smooth through the spike associated with the stimulus package of late spring, income growth was roughly flat through August but has increased since (and at a reasonably good clip). That would seem to portend well for all of us—and I assume it is all of us—hoping for a sooner rather than later end to the current contraction.

The picture is equally encouraging if we look at the income series preferred by the Business Cycle Dating Committee, which subtracts out transfers (that is, payments made to the public by the government):

That’s all encouraging, but there is a caveat: Individual results may vary. Here are the comparisons for the long-lived (16-month) recessions of 1973–75 and 1981–82:

In these two recessions—which are arguably better benchmarks than the average at this point—income measures were not such reliable harbingers of expansion( NOTHING IS WRITTEN ).

Still, in current circumstances a glimmer of hope is better than nothing. ( I AGREE )

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

"But I see no signs that a recovery is about to begin."

James Hamilton with some similar graphs to the ones that we've already seen, but I want to feature this post and his blog because it's so good:

"Comparing recessions

Last week was a tough one for the optimists.

In addition to dreadful numbers for auto sales, last week the Institute for Supply Management reported that its manufacturing PMI index fell to 36.2 in November. A value below 50 indicates that more facilities are reporting deterioration rather than improvements in categories such as orders, production and employment. The index never fell below 39 in either of the previous 2 recessions.

Source: FRED.

ISM's related index of business activity constructed from a survey on nonmanufacturing establishments fell to 33.0 in November. We don't have a long enough track record of that index to know what it requires to get a reading that low.

Source: FRED.

But the real attention last week was on the loss of 533,000 jobs during the month of November reported by the Bureau of Labor Statistics on Friday. That's a 0.4% drop, the biggest percentage drop in 28 years, and part of broader employment picture that Ian Shepherdson called "almost indescribably terrible." Notwithstanding, Dave Altig did his best to describe it, perhaps as something not so terrible after all, by comparing the decline in employment since December with what was seen on average during previous postwar recessions.

Horizontal axis: months before or after the business cycle peak. Vertical axis: ratio of nonfarm employment to the value at the business cycle peak. Green line: average postwar recession. Blue line: 2007-2008. Source: Macroblog.

By that measure, this looks a little worse than the average postwar recession, in part, Dave notes, because it's already lasted one month longer than the postwar average. If you compare the current recession with the two longest and most severe postwar recessions (1973 and 1981), we're maybe not quite as badly off now as we were then, at least if you trust the preliminary data.

Horizontal axis: months before or after the business cycle peak. Vertical axis: ratio of nonfarm employment to the value at the business cycle peak, for the recessions beginning in November 1973 (green), July 1981 (red), and December 2007 (blue). Source: Macroblog.

But there's another comparison we can look at along these lines that's much less reassuring. One of the developments that helped get us out of previous downturns is that the Fed responded to the recession by lowering interest rates. The blue line in the graph below shows the average behavior of the fed funds rate in the months following the recessions of 1957, 1960, 1969, 1973, 1990, and 2001. I've left out the somewhat anomalous 1980 and 1981 recessions, in which rapidly changing inflation expectations played a key role. The red line shows the fed funds rate during the current recession. The Fed cut rates more quickly and farther this time around than in any of the other 6 comparison downturns.

Horizontal axis: months after the business cycle peak. Vertical axis: change in fed funds rate since the peak. Data source: FRED.

Why does that trouble me? It means that the Fed did everything it could from the very beginning this time, and it wasn't enough. The average fed funds rate in November was 0.39%, meaning that even if the Fed cuts its official "target" for that interest rate to 0.5% or even 0.25%, it's not going to do anything for anybody. The main weapon we've always used in the past in this kind of situation is now out of bullets.

If a recovery begins soon, Dave's diagrams indicate that this wouldn't be regarded as all that serious a recession. But I see no signs that a recovery is about to begin."

We've already looked at the comparison to other recessions and seen no clear evidence of where we're going in the near future. The Fed policies are a series of actions that need to be gone through to see if they can turn the tide. Some of their decisions have been poor, and some good. But they're currently fighting an incredible fear and aversion to risk and the accompanying flight to safety that might well be a terribly hard nut to crack. I'm surprised by its thickness myself. But we do have more nutcrackers to try, and always will. Of that I'm sure.

I see signs of recovery in the eyes of the people I encounter everyday. Thank God for them. As Jackson says:

The road is filled with homeless souls
Every woman, child and man
Who have no idea where they will go
But theyll help you if they can
Now everyone must have some thought
Thats going to pull them through somehow
Well the fires are raging hotter and hotter
But the sisters of the sun are going to rock me on the water now

"I’ll take the opportunity to step back and take in the current recession in a somewhat broader context"

Here's another take on the unemployment stats, from David Altiq on Macroblog:

"The recession in pictorial context

If your head had not yet been turned by economic events, today’s startlingly weak employment report probably did the trick. Rather than repeat all the negative superlatives you are likely to hear, I’ll take the opportunity to step back and take in the current recession in a somewhat broader context. One way to look at this is to examine the trajectory of employment relative to December 2007 levels (when this recession began) and compare it with the average trajectory of relative employment in other recessions:

In the graph above “time 0” represents the peak of a business cycle, or the month before a recession begins (December 2008 for the current recession). “Average” refers to the average experience in the seven previous recessions since 1960 (1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, and 2001). To facilitate comparison across recessions, I have normalized the level of employment at the peak of the business cycle to one. As noted, then, each point represents the level of employment relative to the peak: numbers below one indicate that the number of nonfarm jobs was below the number that existed as the economy entered recession.

Before the November job report, the overall employment picture had been fairly unexceptional compared to the average recessionary experience. That changed, as I guess will happen when a half-million job loss statistic arrives. As of today, a milder than average recession has turned into a somewhat deeper than average recession, at least in terms of employment."

Okay. We were in a fairly straightforward recession until now, when we've gone into a deeper recession than on average.

"Does this mean we are heading off the map in terms of past experience? It is hard to tell by just focusing on the average experience of the previous seven downturns. The previous two recessions—1990–91 and 2001—lasted only eight months. Assuming that we remained in recession through November—and I don’t think that conjecture will draw much debate—the current episode is already a year in duration. A more apt comparison might therefore be the “bad” recessions of recent memory, the 1973–75 and 1981–82 episodes, which both lasted sixteen months.

Here, for your viewing displeasure, are those comparisons:

Not surprisingly, in the last two recessions, which were relatively short-lived, the employment situation had already stabilized twelve months after the onset of the downturn. So there may not be much comfort in noting that the employment losses are not yet out of line with experiences of those episodes (especially the 1990-91 version). The trajectories suggested by the relatively long-lived, more severe recessions of 1973-75 and 1981-82 are almost certainly more sensible comparisons at this point. And, as bad as it is right now, we are still a fair distance from the pace of relative employment losses in those episodes.

Okay. And?

"The story is similar if we adopt the vantage point of the unemployment rate:

It is not yet clear whether the acceleration in job loss is a new trend or the lingering impact of a very bad few months, of which the worst is passing. It's always important to monitor new data and anecdotal reports to determine which way the wind is truly blowing. But today's report raised the stakes on that activity by a considerable amount."

It really does seem too soon to tell.