We’ve heard from a number of Fed officials over the last few weeks. Three that stand out for the color they provide are the statements from Bernanke, Pianalto, and Kocherlakota.
Pianalto describes why she voted the way she did on QE2. Her speech was given in the aftermath of a blistering round of criticism levied against the Fed for their QE2 plans. Kocherlakota provides some insight into the “communication value” of QE2 and what it is really telling us. Finally, Bernanke gives a broad overview of where the economy is currently, and then spends a significant amount of time taking academic shots at other countries.
Pianalto
She begins by providing the standard boiler-plate that everyone gives at the start of a big picture economic address…we avoided the next great depression…financial collapse…world-wide apocalypse…cats sleeping with dogs…yada yada yada.
Any time you read a statement from a Fed member it’s important to keep in mind that they have the dual mandate of full employment and price stability. That’s academic talk for keep everyone employed and don’t let prices get out of hand. Now let’s move on to the important stuff.
She voted for QE2 over her concern about our “uncomfortably low” rate of inflation and the high rate of unemployment. She notes that over 15 million Americans are unemployed. In October the economy added 150,000 jobs...this number forms the basis for an interesting point. In normal times we have 150,000 NEW workers entering the job market each month (as people graduate from high school or college and look for jobs). So to maintain a given level of unemployment you need to add at least that many jobs on a monthly basis. The October number is barely enough to get those people to work…much less to start making any progress at putting the other 15 million back to work. This gives some shape to the number of jobs we will have to start posting on a monthly basis to start making a dent in the unemployment rate. Whatever the number is…it will have to be way higher than 150,000.
Cyclical or Structural?
Another fact that the Fed wrestles with is the nature of our unemployment. Cyclical unemployment is your run of the mill stuff…people lose jobs, they are out of work for some period of time and then they go back to work in roughly the same capacity.
Structural unemployment is far more sinister. This is where the job goes away and it doesn’t come back. Workers stay unemployed for a much longer time period and ultimately many of them will take jobs for which they have no skills. This leads to lower productivity, lower pay, and a lower standard of living. If you multiply this phenomenon across millions of workers you can begin to grasp the magnitude of the problem.
Is our unemployment problem cyclical or structural? Pianalto says that their studies at the Cleveland Fed show that our current situation (while very worrisome) is still a cyclical problem.
While the good news is that we have a cyclical problem vs. the more sinister structural problem, the fact remains that the longer the unemployment rate stays elevated the worse the potential damage is to the economy. With regard to the Unemployment Rate she doesn’t expect it “to fall below 8.00% before 2013.” That is an important figure…the Cleveland Fed President…a voting member…expects the unemployment rate to remain above 8.00% for at least two more years. In my view forecasting the unemployment rate two years from now is like Ray Charles shooting skeet…good luck getting anywhere close to the target. The fact that her best guess is “it won’t be below 8.00% before 2013” is kind of scary.
With the unemployment piece out of the way let’s move on to her thoughts on inflation. The Fed’s comfort level on inflation is 2.00%. As a rule of thumb if inflation is higher than 2.00% they will tighten monetary policy, if it is below 2.00% they will loosen monetary policy. What could be easier? They could do that and be having hot wings by noon.
When considering inflation, Pianalto prefers to use “core” measures rather than CPI as she believes they provide a truer picture than CPI alone. Her measures show inflation falling to levels that are unacceptable. An example she gives is from the October CPI data. When they drilled down into the data they found that 40% of the items in the basket witnessed price declines while only 12% saw increases of more than 3%.
Inflation expectations are another important consideration. The most recent analytics from the Cleveland Fed showed that inflation expectations remain “below 1.50% for 10 years and below 2.00% as far as the eye can see”. Given that their preferred range is 2.00% you start to see why she voted for QE2. Keep these figures in mind as you formulate your own expectations for how long Fed Funds will remain at zero. A voting member that uses Fed Funds to influence inflation trends is saying that without QE2 she was seeing at least 10-years of no-reason-to-raise-rates.
She points out that while she doesn’t expect outright deflation, she understands that our current scenario of high unemployment and very low inflation are risk factors for deflation. Additionally she’d be happy to see positive surprises…but there is very little room for any negative surprises in the data. For these reasons she voted in support of QE2.
It is also important to point out that most Fed members seem to support the idea that QE2 will have a modest impact at best…but the alternative is bad enough that it’s not worth the risk of inaction. Additionally I pick up a rock solid belief from almost every Fed speech I read that they believe they will have no problem at all in pulling back the various stimulus measures if inflation becomes an issue. They simply have no doubt about their ability to fight inflation if and when the need should arise.
In summarizing Pianalto’s views on QE2 I’d have to say it feels like a Hail Mary pass…it’s not something you throw when you’re ahead. You’ve got little to lose and something to gain so why not throw it? She saw 10-years of below target inflation (i.e. no reason to raise fed funds) without QE2…so we can reasonably expect that with QE2 she expects inflation to pick up sometime before 10 years…at the same time she expects QE2 results to be modest and unemployment to remain above 8% through 2013. This doesn’t paint a picture of someone that expects to raise fed funds in the next few years.
And now a more difficult name to pronounce than my own
Minneapolis Fed President Narayana Kocherlakota also spoke recently. He will become a voting member in 2011 and he provided his thoughts on QE2 as well.
Kocherlakota provides us with a target inflation range of 1.50% to 2.50%. He uses PCE (personal consumption expenditures) as his benchmark for inflation. Over the first three quarters of 2010 this measure has averaged “roughly 1.00% at an annualized rate…and is drifting downward.” Over the prior two years this measure averaged 1.6%. So this inflation measure is also at the low end of their acceptable range and is moving lower.
Two other factors Kocherlakota points out are that over the last 5 quarters since we “recovered” from the recession the Unemployment Rate has risen slightly; and that GDP has run at only 3.00% and is falling…averaging only 2.00% over the last two quarters. Some recovery, huh?
So he essentially echoes’s the same sentiments as Pianalto: high unemployment, and alarmingly low inflation are on his mind.
Actions speak louder than words
Over this business cycle the Fed has told us that one way they can manage market expectations is through communication. Kocherlakota tells us that QE2 can be viewed as a non-verbal communication. What is it that we should take away from this non-verbal message from the Fed? Let’s hear it straight from the horse’s mouth:
“The November FOMC statement says that the committee will keep the fed funds target range exceptionally low for as long as conditions warrant. The statement also predicts that exceptionally low fed funds rates are likely to be warranted for an “extended period” of time. In this way the statement provides explicit communication about the FOMC’s future plans for short-term rates and also shapes the level of current longer-term interest rates.
QE provides a significant supplement to this explicit verbal communication. The use of QE indicates that the FOMC is likely to keep its target interest rate lower for an even longer period of time. Indeed, one could readily argue that buying $600 billion of Treasuries is a much more convincing form of communication of the FOMC’s plans than any words could ever be.”
Sparking runaway inflation?
Kocherlakota addresses criticism that QE2 will spark a wildfire of inflation. There are two parts to his argument that QE2 won’t serve as “kindling” for a future inflation fire.
First, his basic premise is that there are already over $1 Trillion in excess bank reserves sitting on balance sheets currently…and those trillion dollars have not sparked runaway inflation because they aren’t being lent out. So his question for the inflation folks is: how will another $600 billion of un-lent excess reserves do something that the first trillion didn’t do?
Secondly he points out that the Fed has the tools to fight inflation and that they have the political will to fight it as well. There is no doubt in his mind that they can and will contain inflation if it starts getting out of hand.
He also states that he expects any results of QE2 to be modest.
Bernanke is last at bat
Chairman Bernanke also spoke…a lot. Much of his speaking was directed at the differences between established and emerging market economies. Things like exchange rates and international capital flows dominated much of his discussion. One could boil this section down to “emerging market countries that blame U.S. monetary policy for their problems need to realize that their problems are their own big-fat-fault because they won’t allow their currencies to float like everybody else does. If they’d drop or alter their export led growth models things would be better for everyone”. I’ve taken some liberties there but I think my synopsis conveys the underlying tone of the argument, and I think it is far more interesting to read than the original as well.
The statements he made on the domestic situation run parallel to those made by Pianalto and Kocherlakota. I could summarize Bernanke’s position by saying the unemployment situation is unacceptable, monetary policy can do only so much but we have to do everything we can within this framework to support the economy, the Fed has the ability to drain the swamp of liquidity when they need to, and that someone needs to balance the budget or this is all for naught.
With regard to his global view one could probably sum it up with the old argument that Americans need to save more and spend less and the Chinese need to save less and spend more.
In the end
Ultimately the Fed came out of their corner defending their QE2 votes. They clearly view QE2 as a necessary project that will provide marginal improvement to the economy. This is done to stave off the potential negatives associated with a further deterioration of the economic data…notably higher unemployment and low inflation. You wrap all of this up with assurances that the Fed absolutely can and will put the brakes on inflation when it comes back and you get a big expensive program that everyone agrees will have marginal results at best. What’s not to love?
If you have any questions on this material just let me know.
Steve Scaramastro, SVP
800-311-0707
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