If Americans were convinced of the Fed’s commitment, they’d buy and borrow more now, he says.

TO BE NOTED: From Bloomberg:

"U.S. Needs More Inflation to Speed Recovery, Say Mankiw, Rogoff

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By Rich Miller

May 19 (Bloomberg) -- What the U.S. economy may need is a dose of good old-fashioned inflation.

So say economists including Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the International Monetary Fund. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up.

“I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.”

Such a strategy would be risky. An outlook for higher prices could spook foreign investors and send the dollar careening lower. The challenge would be to prevent inflation from returning to the above-10-percent levels that prevailed in the 1970s and took almost a decade and a recession to cure.

“Anybody who has been a central banker wouldn’t want to see inflation expectations become unhinged,” says Marvin Goodfriend, a former official at the Federal Reserve Bank of Richmond. “The Fed would have to create a recession to get its credibility back,” adds Goodfriend, now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh.

Preventing Deflation

For the moment, the Fed’s focus is on preventing deflation -- a potentially debilitating drop in prices and wages that makes debts harder to repay and encourages the postponement of purchases. The Labor Department reported May 15 that consumer prices were unchanged in April from the previous month and were down 0.7 percent from a year earlier.

“We are currently being very aggressive because we are trying to avoid” deflation, Fed Chairman Ben S. Bernanke told an Atlanta Fed conference on May 11.

The central bank has cut short-term interest rates effectively to zero and engaged in what Bernanke calls “credit easing” to spur lending to consumers, small businesses and homebuyers.

Bernanke, 55, said the risk of deflation was receding and that the Fed was ready to reverse course when needed to maintain stable prices and prevent an outbreak of undesired inflation. The Fed has implicitly defined price stability as annual inflation of 1.5 percent to 2 percent, as measured by a price index based on personal consumption expenditures.

Lifting Prices, Wages

Even after all the Fed has done to stimulate the economy, some economists argue that it needs to do more and deliberately aim for much faster inflation that would also lift wages.

With unemployment at a 25-year high of 8.9 percent, workers are being squeezed. Wages and salaries rose 0.3 percent in the first quarter, the least on record, according to the Labor Department, as companies including Memphis, Tennessee-based based package-delivery company FedEx Corp. and newspaper publisher Gannett Co. of McLean, Virginia slashed pay.

Given the Fed’s inability to cut rates further, Mankiw says the central bank should pledge to produce “significant” inflation. That would put the real, inflation-adjusted interest rate -- the cost of borrowing minus the rate of inflation -- deep into negative territory, even though the nominal rate would still be zero.

If Americans were convinced of the Fed’s commitment, they’d buy and borrow more now, he says.

Mankiw, currently a Harvard professor, declines to put a number on what inflation rate the Fed should shoot for, saying that the central bank has computer models that would be useful for determining that.

Gold Standard

In advocating that the Fed commit itself to generating some inflation, Mankiw, 51, likens such a step to the U.S. decision to abandon the gold standard in 1933, which freed policy makers to fight the Depression.

Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt, says Mankiw, who was chairman of the Council of Economic Advisors under President George W. Bush.

The White House has forecast that the budget deficit will hit $1.84 trillion this fiscal year, or 12.9 percent of gross domestic product. Rogoff doubts that politicians will be willing to reduce that shortfall by raising taxes as much as needed. Instead, he sees them pressing the Fed to accept faster inflation as a way of easing the burden of reducing the deficit.

Easier Debt Repayment

Inflationary increases in wages -- and the higher income taxes they generate -- would make it easier to pay off debt at all levels.

“There’s trillions of dollars of debt, in mortgage debt, consumer debt, government debt,” says Rogoff, who was chief economist at the Washington-based IMF from 2001 to 2003. “It’s a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?”

Laurence Ball, a professor at Johns Hopkins University in Baltimore, says it’s risky to try to engineer a temporary surge in inflation because it might spark a spiral of rising prices.

Even so, he sees good reasons for the Fed to lift its implicit, medium-term inflation target to 3 percent to 4 percent from 1.5 percent to 2 percent now.

To battle recession, the Fed had to cut interest rates to 1 percent in 2003 and zero in the current period. That implies its inflation target has been too low because it’s left the Fed running up against the zero bound on nominal interest rates.

Inflation Advantage

“The basic advantage of pushing inflation a little higher is that it would make it less likely that we run into the problem of the interest rate hitting zero and the Fed not being able to stimulate the economy if necessary,” Ball says.

John Makin, a principal at hedge fund Caxton Associates in New York, wants the Fed to go further and target the level of prices instead of simply a rate of inflation. Such a policy would mean that if inflation fell short of 2 percent over a period of time, the Fed would have to push inflation above that rate subsequently to make up for the shortfall and keep prices rising on the desired trajectory.

While that might sound radical, it’s the same sort of policy that Bernanke advocated Japan follow in 2003 to fight deflation. In a speech in Tokyo that year, then-Fed Governor Bernanke called on the Bank of Japan to adopt “a publicly announced, gradually rising price-level target.”

‘Bad for Creditors’

Some investors are already worried that Bernanke will go too far. “We’re on the path of longer-term, higher inflation,” says Axel Merk, president of Merk Investments LLC in Palo Alto, California. “It’s good for debtors but it’s bad for creditors. It’s dangerous and irresponsible.”

Billionaire investor Warren Buffett, chairman of Berkshire Hathaway Inc. in Omaha, Nebraska, suggested that faster inflation was all but inevitable.

“A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, it’s going to inflate its way out of the burden of that debt,” he told the CNBC financial news television channel on May 4, adding, “That becomes a tax on everybody that has fixed- dollar investments.”

To contact the reporter on this story: Rich Miller in Washington rmiller28@bloomberg.net"

I think the Fed knows this; hence, they avoid the loaded term quantitative easing in favor of credit easing.

TO BE NOTED: From Tim Duy's Fed Watch

"More on Inflation Expectations

Thinking about the issues raised in my piece last week, it is worthwhile to spend more time on actual inflation and inflation expectations within the context of the Fed's policy of "credit easing." Consider as a starting point the recent work by John Williamson at the San Francisco Fed who concludes:

This analysis highlights the central roles of economic slack and inflation expectations in the risk of deflation over the next several years. The evidence indicates that a substantial increase in slack can lead to deflation, but the depth and duration of the deflation depends on how well anchored inflation expectations are. Two policy implications can be drawn from this and other research on deflation. First, a central bank should take appropriate actions to stem the emergence of substantial slack in the economy and thereby reduce the risk of deflation. Second, it should clearly communicate its commitment to low positive rates of inflation. An example of such communication is the Federal Open Market Committee's recently released long-run inflation forecasts. Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral.

Conventional wisdom of the Fed's policy describes quantitative easing as an effort to boost inflation expectations. This flows from the fact that the Fed Funds rates is at zero, therefore further decrease in the real rate can only be achieved by boosting inflation expectations. To me, however, the Fed has not committed to a program of raising inflation expectations. Instead, they are reiterating their existing commitment to a low, stable rate of inflation. Consider the most recent FOMC statement:

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.

There is some risk of suboptimal inflation rates, and therefore they will conduct policy conducive to raising inflation. But what rate of inflation? Is there any sense that the Fed is actually trying to change the expectations of their policy goals? Not in the minutes from the previous meeting, where they clearly define their expectations for inflation under appropriate monetary policy:

It would appear that the Fed is attempting to anchor inflationary expectations in a range consistent with conventional understanding of the Fed's implicit inflation target of 1.7-2% (note that this implied the Fed see a floor on the real rate of -2%). If actual inflation is substantially less than this target, the Fed would be expected to ease policy accordingly. Otherwise, they would be accommodating declining inflation, which would challenge their commitment to their target. Their commitment to stable inflation would not be credible, and expectations would become unanchored in a deflationary direction.

Consider this commitment further via the Fed minutes:

Many participants noted some risk of a protracted period of excessively low inflation, especially if inflation expectations were to move down in response to lower actual inflation and increasing economic slack, and a few even saw some risk of deflation. Several others, however, anticipated that longer-run inflation expectations would remain well anchored, supported in part by the Federal Reserve's aggressive expansion of its balance sheet and the resulting growth of the monetary base, and therefore thought it unlikely that inflation would decline below levels they saw as consistent with the dual goals of price stability and maximum employment.

Yes, there is a risk of deflation, so policymakers will expand the balance sheet accordingly to prove their commitment to low and stable inflation. Notice the theme - to maintain credibility, the monetary authority needs to behave consistent with their commitments. In this framework, the Fed had little other choice but to expand the balance sheet aggressively if they want to avoid expectations of deflation.

Has the Fed been successful in anchoring expectations? Deflation concerns stem in part from the sharp drop in year-over-year inflation:

The TIPS market, however, is now waiving off deflation concerns:

In the context of the above discussion, the widening of the 10 TIPS breakeven looks consistent with a successful Fed policy to anchor expectations, which, again, differs from changing where that anchor lays. Likewise, the public perception does not appear to be tilted toward deflation:

Interestingly, the public's near term inflation expectation is well above the drop experienced in the wake of 9/11. It is worth noting that the rapid disinflation of late last year has somewhat reversed in recent months:

It is also worth thinking about what would have happened if the Fed did not do this:

Given that the velocity of the monetary base did this:

Now, credibility cuts both ways. The above analysis suggests that the Fed has so far staved off deflationary expectations by acting in a manner consistent with its inflation target. But suppose inflation rises above that target - perhaps velocity explodes, so that inflation rises even if output remains at suboptimal levels (something akin to Johnson and Kwak's emerging market scenario). Then the Fed would need to maintain its commitment to the inflation target by contracting the balance sheet. From the minutes:

Moreover, some noted a risk that expected inflation might actually increase to an undesirably high level if the public does not understand that the Federal Reserve's liquidity facilities will be wound down and its balance sheet will shrink as economic and financial conditions improve.

Policymakers are already considering the removal of their liquidity injections. In other words, they have not committed to a permanent increase in the money supply. Indeed, I believe this is why Fed Chairman Ben Bernanke describes policy as credit easing not quantitative easing. The latter implies permanence. From the minutes:

Several participants indicated that they thought the FOMC should explore establishing quantitative guidelines or targets for a monetary aggregate, perhaps the growth rate of the monetary base or M2; in their view such guidelines would provide useful information to the public and help anchor inflation expectations. Others were skeptical that a single quantitative measure could adequately convey the Federal Reserve's current approach to monetary policy because the stimulative effect of the Federal Reserve's liquidity-providing and asset-purchase programs depends not only on the scale but also on the mix of lending programs and securities purchases. In addition, a few participants noted that the sizes of some Federal Reserve liquidity programs are determined by banks' and market participants' need to use those programs and thus will tend to increase when financial conditions worsen and shrink when financial conditions improve; the size and composition of the Federal Reserve's balance sheet needs to be able to adjust in response.

Again, the Fed has committed to nothing other than to maintain a balance sheet consistent with well-anchored inflation expectations. Note too that this does not imply a complete reversal of the balance sheet expansion; if the velocity of money remains low, then some part of the balance sheet expansion can be permanent and not lead to an increase in expectations of the Fed's inflation target.

The risk is that the Fed commits a policy error by not allowing the balance sheet to contract sufficiently to offset any increase in inflationary pressures. There is a reasonable risk of such an outcome. Consider the first half of 2008, when the Fed continued to ease policy even as inflation, and inflation expectations, was rising dramatically. Had that situation continued, the Fed would have been accommodating increased inflation expectations, thereby threatening their perceived commitment to low and stable inflation. Instead, the Fed got "lucky" and the global economy collapsed, sending inflation downward as commodity prices collapsed. Would the Fed get so "lucky" again?

I think, however, the more likely risk is that the Fed's independence is compromised and they politically cannot shrink the balance sheet in a timely fashion. As I have argued, policymakers understand this risk, and are vociferously reiterating their independence. This too helps keep expectations in check.

Another risk is that policymakers deliberately attempt to reset the inflation target to a higher rate. This may become the policy choice if policymakers believe they need to reduce real rates below the -2% floor implied by the current target (effectively, the Fed chooses the inflation solution to the debt overhang). Resetting the inflation target, I believe, would amount to a commitment by the Fed to a permanent increase in the money supply growth rate. But I doubt it would be easy - how could a new target be credible if the Fed abandons the current target? An attempt to set a new target, I fear, would lead inflation expectations to become fully unanchored. I think the Fed knows this; hence, they avoid the loaded term quantitative easing in favor of credit easing.

Bottom line: The conduct of Fed policy is consistent with a commitment to the existing inflation target. The increase in the monetary base, in this framework, was necessary to prevent expecatations from shifting in the direction of deflation. But credibility works both ways; they need to remain ready to withdraw liquidity should inflation pressures emerge. The repeated claims that the expansion of the balance sheet is not permament is consistent with credibly committing to the existing target. There remains, however, plenty of room for policy error, and not to mention the now omnipresent fear that the Fed has sacrificed its independence."

Although the bank is considering quantitative and credit easing policies, “their use is not preordained,”

TO BE NOTED: From Bloomberg:

Loonie Loses 3% as Carney Pushes Quantitative Ease (Update1)

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By Chris Fournier

April 6 (Bloomberg) -- Foreign-exchange traders are stepping up bets Bank of Canada Governor Mark Carney will join Japanese, Swiss, U.K. and U.S. central bankers and dilute the nation’s currency by embracing quantitative easing.

Among the world’s most traded currencies, only the yen, pound and U.S. dollar performed worse in March than Canada’s dollar as central bankers began printing money last month to buy debt assets after exhausting other monetary-policy tools. The New Zealand dollar, which like Canada’s tends to track fluctuations in prices of raw materials, had its best month in at least 20 years in March, according to data compiled by Bloomberg.

Strategists at BNP Paribas, Bank of America-Merrill Lynch and Morgan Stanley advise investors to sell the so-called loonie before the central bank’s policy report on April 23. Carney has pledged to lay out a plan that would flood banks with cash to halt the hoarding of capital and expand lending. The greenback, pound and Swiss franc plunged as much as 3.4 percent on the announcement of similar steps to ignite growth.

“The precedent is a haircut right off the currency,” said David Watt, senior currency strategist in Toronto at RBC Capital Markets, Canada’s largest foreign-exchange trader by volume. “As we get through this month, we’re leaning toward Canadian dollar short positions.” A short position is a bet a currency will depreciate.

Worst Performers

Canada’s currency will fall 3.4 percent to C$1.27 to the U.S. dollar by July, from C$1.2286 today, according to the median forecast in a Bloomberg News survey of 40 economists and analysts. The loonie, so called for the aquatic bird on the one- dollar coin, rose 1 percent last week to 81.31 U.S. cents.

The franc plunged the most ever against the euro on March 12, tumbling 3.3 percent, when the Swiss National Bank began intervening to weaken the currency and outlined plans to buy corporate bonds. On March 4, the Bank of Japan offered to buy 150 billion yen ($1.5 billion) in company debt from lenders, its first ever such operation. The yen has since lagged behind all of the 16 most traded currencies.

The Bank of England cut its key rate on March 5 to 0.5 percent, the lowest level since the bank was founded in 1694, and said it will print money to buy as much as 150 billion pounds ($222.6 billion) in government and corporate bonds. The pound fell 4.6 percent against the euro last month, after losing 23 percent in 2008.

‘On The Table’

Federal Reserve officials on March 18 unveiled plans to buy $300 billion in government securities, sending the U.S. dollar 3.4 percent lower against the euro, a record one-day decline.

“Anytime quantitative easing is even entertained, markets react negatively to the currency,” said Sacha Tihanyi, a strategist in Toronto at Scotia Capital Inc., a unit of Canada’s third-largest bank. “The threat of QE as a policy option may keep the market a little less bullish on the Canadian dollar as long as it is still on the table.”

The Canadian currency plummeted a record 18 percent last year as the global financial crisis reduced demand for raw materials. Export revenue from energy products including crude oil, natural gas and coal plummeted in January by 30 percent to C$6.54 billion from the same month a year earlier, according to Statistics Canada. Energy exports comprise about a quarter of the total.

Oil has rebounded since reaching $32.40 a barrel in December, the lowest in almost five years, reaching $52.51 on April 3.

Kiwi Correlation

“I’m absolutely not concerned” about the effect of quantitative easing, said Francois Barriere, vice president business development for international markets at Laurentian Bank of Canada in Montreal. “It’s never going to be as much as they’re doing in the U.S. and it won’t be enough to justify a weaker Canadian dollar.” He predicts the loonie will strengthen to at least C$1.20 in three months.

The currency climbed 11 percent against the New Zealand currency from the September collapse of Lehman Brothers Holdings Inc. until the Bank of Canada cut its key overnight rate to a record low 0.5 percent on March 3. The central bank also said while cutting rates that it was considering using quantitative easing. The loonie has since given up its gains, falling 11 percent against the kiwi.

The correlation coefficient between the kiwi, as the New Zealand dollar is known, and the loonie has dropped to 0.88 when measured against the yen from 0.92 before the decision, according to Bloomberg data. A coefficient of one would indicate the currencies move in lock step. Both currencies track movements in commodity prices and equities, proxies for investors’ appetite for risk.

Oil Sands

Oil prices have dropped almost $100 a barrel since reaching a record $147.27 in July, prompting companies such as Royal Dutch Shell Plc, based in The Hague, and StatoilHydro ASA, Norway’s biggest oil producer, to defer or cancel at least 14 projects this year in Alberta’s oil sands.

Canada’s dollar reached parity with its U.S. counterpart for the first time in three decades in September 2007 following a 60 percent climb in the preceding five years that was fueled by rising prices for commodities, which account for 56 percent of Canada’s export revenue.

Canada has 179 billion barrels of oil reserves, the most in the world outside Saudi Arabia. All but six billion are locked in Alberta’s oil sands, a mixture of sand, water, clay and bitumen that’s too heavy to use without being heated. Oil must be at $65 a barrel for new oil sands projects to be viable, according to estimates by the Canadian Association of Petroleum Producers.

‘Biased Toward Weakness’

Hans-Guenter Redeker, the London-based global head of currency strategy BNP Paribas recommends selling the Canadian dollar against the Australian dollar, citing Canada’s exposure to the U.S. economy, the shrinking automobile industry and “pressure” on the price of gold.

“The Canadian currency for the time being is going to stay biased toward weakness,” said Ron Leven, an executive vice president and senior currency strategist at Morgan Stanley in New York. “The market is expecting quantitative easing. We’re thinking about going short the Canadian dollar.”

Bank of Canada’s Carney said in a March 14 interview in Horsham, England, where he attended a meeting of Group of 20 officials, that moves such as the purchase of assets from investors are an option for the central bank and may be part of a proposed framework to combat a deepening recession.

‘Not Preordained’

Although the bank is considering quantitative and credit easing policies, “their use is not preordained,” Carney said in an April 1 speech in Yellowknife, Northwest Territories.

Record job losses and trade deficits this year signal Canada’s recession is deepening. Exports to the U.S., destination of 76 percent of the total last year, are slumping as Americans cut home and car purchases. Canada’s economy shrank 0.7 percent in January, the sixth straight contraction.

Plummeting car sales at General Motors Corp. and Chrysler LLC and speculation the companies may file for bankruptcy may also weigh on the Canadian dollar.

Car and truck manufacturing provides 440,000 direct and indirect jobs in Canada, according to the Web site of the industry’s largest labor union. Revenue from Canada’s automotive exports, 13 percent of the total, dropped more than a fifth last year to C$61.1 billion, from C$77.3 billion in 2007, Statistics Canada said in its latest Annual Review.

“Car sales are a disaster,‘‘ said Daniel Tenengauzer head of global foreign exchange strategy in New York at Bank of America-Merrill Lynch. ‘‘It’s a combination of commodities and cars. We recommend selling the Canadian dollar.’’