What Next for Monetary and Fiscal Policy?

It is now pretty obvious that government policymakers are in a quandary. The economy is not growing the way they had hoped; criticism abounds as does confusion; and usable policy instruments are in short supply. Alan Blinder, a former vice chairman of the Federal Reserve Board, wrote an interesting op-ed for the August 26 Wall Street Journal on the dwindling options the Fed has to deal with the current situation ("The Fed is Running Low on Ammo", subscription required). He states that there are four additional measures available to the Fed.

1. The Fed could adopt a quantitative easing policy of buying private securities rather than Treasuries. 
2. The FOMC could change its wording to say that its commitment to a near-zero fed funds rate is even longer than the "an extended period," as it now says.
3. The Fed could lower the interest rate the Fed pays on bank reserves. It is currently set at 25 basis points.  Blinder suggest that it could be lowered to below zero -- a minus 25 basis points, in order to induce banks not to hold idle reserves. 
4. Fed bank examiners could ease up on questioning bank loans and indicate "that some modest loan losses are not sinful, but rather a normal part of the lending business."

Blinder concludes: "So that's the menu. The Fed had better study it carefully, for if the economy doesn't perk up, it will soon be time to fire the weak ammunition."

There are obvious problems with these tools. Buying private securities needs to be done carefully to avoid charges of favoritism. Changes in the wording of FOMC statements can have a transitory effect on markets but it is a rather weak tool. Blinder is "dubious that there is much mileage here." A negative rate of interest on reserves or excess reserves is an intriguing idea, but the Fed appears to be leery of what this would do to money markets. Finally, using bank examiners for macroeconomic goals establishes a bad precedent and may not work in any case. (I wrote a post related to this suggestion in February 2009 -- "The Regulators' Dilemma.")

Given the limited ability of the Fed to do much in addition to flooding the economy with money, which may not work and would cause great anxiety in any case, which would not be helpful for either consumer or investor confidence, one presumes that Administration policymakers are considering what fiscal policies they might take. One school of thought is that increased government spending, for example on repairing and improving infrastructure such as water and sewer systems, bridges, roads, and public transportation systems, should be undertaken. According to this school, the current deficit should not be a concern in an economy with unused resources, but the increased spending in the near-term should be coupled with a long-term plan to reduce the budget deficit once the economy recovers. Others argue that tax incentives are a better way to go than than increased government spending.

The fear of deficits and its use in political arguments (by conservatives against increased spending initiatives and by liberals against tax cuts) have appeared to make any changes in fiscal policy for the time being impossible. I do not know if the economy will continue to be weak or deteriorate, but, if the economy does get noticeably worse, the Administration and Congress, regardless of the outcome of the November elections, will face deafening calls to take action. Already, the Tea Party movement, which has no discernible economic prescription to current problems except perhaps to think that reduced taxes and reduces government spending should be the goal, is holding large rallies as the growing economic unease serves to swell its ranks. That must worry politicians, even though it is hard to know how to assuage the Tea Party movement. Most will probably eventually conclude that the best response is to take measures they hope will improve the economy, even if this meets with political criticism from Tea Party activists and others. 

The Administration likely believes that it has no ability to address the current bad economy in any meaningful way before the November elections. They must be hoping that the pessimists are wrong and that the economy will improve, if only slowly. However, if that does not happen and the economy worsens, some sort of fiscal stimulus (by a different name, no doubt) will be enacted. If the Administration and Congress do not do this in response to a bad economy, then U.S. politics has fundamentally changed more than I think it has. 

Some Comments on the FOMC Statement

The FOMC statement on Tuesday indicated that the Fed now thinks the economy is weaker than previously thought. In view of this, the Fed has committed to keeping its balance sheet roughly the same size by reinvesting the proceeds of principal payments of the securities it acquired during the financial crisis in Treasuries, mainly those with a maturities ranging from two to ten years.

Given the uncertainty about the outlook for the economy and prices, it is no surprise that the Fed decided to take this middle course. Those who think the risk of deflation and another recession (or worse) is serious, such as Paul Krugman, argue that the Fed should expand its balance sheet. There is, however, no consensus about this among economists, and some are worried if the Fed acts too aggressively to forestall potential deflation, we will get unacceptable rates of inflation instead. While many commenters on this sound awfully sure of themselves, the fact is that no one really knows what the Fed should do.

The stock market fell significantly on Wednesday, the day after the FOMC announcement. The common explanation is that this was in reaction to the Fed’s more pessimistic outlook on the economy. Well maybe, but I am skeptical of most explanations of daily stock market moves. You can always find some news item to “explain” the move after the fact. No one does a comprehensive survey asking the sellers of securities why they sold or the buyers why they bought on a particular day.  

For anyone paying attention, there was no need for the Fed to verify that the economy was stalling, nor was it any surprise that that the Fed was concerned about it. If the market had gone up, the explanation would likely have been that the Fed was optimistic enough about the economy that it considered it unnecessary to increase the size of its balance sheet at this time. As a thought experiment, one might consider what the likely market reaction would have been if the Fed had decided not to reinvest principal payments or had decided to increase the monetary base by expanding its balance sheet.  It is not so easy before the fact.

As to how the FOMC announcement may affect the Treasury, the Fed’s purchases will affect the maturity structure of marketable Treasury securities held by the public (excluding the Federal Reserve Banks). My guess is that Treasury will not alter its current debt management strategy in light of this, but, at some point, maybe Treasury debt managers need to think about this, since the Fed’s holdings of private securities are quite large.

Also, the Treasury should consider why it is issuing Treasury bills and depositing the proceeds into the supplementary financing program account at the Fed. As of Wednesday, there was almost $200 billion in this Treasury account at the Fed. The reason for this program was to help the Fed reduce the amount of reserves held by the banks at a time when the Fed’s holdings of Treasury securities that it could sell had declined. But with the Fed’s holdings of Treasuries increasing as the principal balance of the private securities it holds decreases, the question arises why this program is still necessary. (I have expressed concerns about this program on this blog.)

  

Deflation and Treasury Inflation-Protected Securities ("TIPS")

Unlike the inflation-indexed securities of some other countries, U.S. Treasury TIPS have a minimum guarantee. In the event of deflation over the life of a particular inflation-indexed security, an additional amount will be paid to the holder of the principal at maturity which will be equal to the difference between the original par value of the bond and the inflation-adjusted principal. (In this case, inflation is negative.) Note that this does not affect the semiannual coupon payments, which are always based on the inflation-adjusted principal value.

What this means is that the real yield on a TIPS held from issuance to maturity will be higher if there is deflation than if there is inflation over the life of the security. However, this possibility is reduced from the point of view of the investor for acquisitions of outstanding TIPS and those bought at reopenings, if the principal has had a positive inflation-adjustment. In other words, if there is the prospect of deflation going forward, the minimum guarantee is more valuable for newly issued TIPS which have not had any positive inflation-adjustment to the principal.

The reason TIPS have this feature is tax considerations. When I was working on the design of TIPS, I was informed by Treasury tax staff that they needed to qualify as a debt instrument. This is a bit of a murky area, but in order to satisfy this tax concern, I was told that the sum of all the payments on the bonds (interest and principal) had to equal the original par amount. Accordingly, the original proposal for inflation-indexed securities published in the Federal Register (May 20, 1996) included the following provision: "If the sum of all the interest payments and the inflation-adjusted principal is less than the par value of the security at time of issuance, the Treasury will pay an additional sum at maturity equal to the difference." This was the minimum necessary to satisfy the tax concern.

During the comment period, some market participants argued that the minimum guarantee should be made simpler and not include the interest payments. That is what was eventually decided that Treasury would do. At the time, it was thought deflation would never happen, and perhaps it is still not likely over a five-year period (the shortest maturity of TIPS). But it is not impossible.

The tax considerations in the event of deflation are complicated, and there may be questions raised by taxpayers if it occurs. In general, during a year in which there is deflation, the taxpayer holding a TIPS can use the decline in the inflation-adjusted value of the principal to offset coupon payments received that year on the security. If there is still an excess after that has been done, the taxpayer can take an ordinary deduction to the extent interest on the security has been included in the taxpayer's income for prior years.  If there is still an excess, it is carried forward. The minimum guarantee payment is included in income as interest in the year it is received. Tax considerations get more complicated if the security is sold. For those interested in tax issues (or interested to check if my general description is right), one place to start researching this is IRS regulation 1.1275-7.  IRS Publication 1212 ("Guide to Original Issue Discount (OID) Instruments") also provides some information on the taxation of TIPS. (It should go without saying that anyone faced with a particular tax issue in regard to TIPS should not rely on what I have written here.)

Note:  The link to the Federal Register may not work.  If it doesn't and you are interested in the document, go to this web page, remove the check mark for 2010, and search for "inflation-indexed" on May 20, 1996.

Uncertainty Over the Correct Policy Response to the Increasing Risk of Deflation

After the Fed had enormously expanded its balance sheet in response to the financial crisis, there was growing worry about the eventual potential inflationary impact of this. Currently, in what one might characterize as a paradigm shift, there is a growing chorus expressing worry about potential deflation. While there are different evaluations as to the probability of this occurring, it is no longer considered as a near impossibility. There is, however, no consensus as to what should be done to ward it off.

This shift in thinking is significant. A mistake often made in thinking about the economy is to assume that whatever has been occurring will continue indefinitely. When inflation was in double digits, many assumed this would continue. When tech stocks had their amazing rise, many assumed this would continue as the information age took hold. And, of course, it was near impossible for housing prices ever to decline -- they're not making any more land and people have to live somewhere. Projecting current conditions into the future is almost always wrong and demonstrates both a failure of imagination and an ignorance of history.

In the previous post, I mentioned that the M1 money multiplier was less than one, implying that monetary policy might not currently be the most effective tool in getting the economy going again. An interesting analysis presenting the reasons the banking system is holding excess reserves (and hence a low money multiplier) was published by the Federal Reserve Bank of New York in December 2009 ("Why are Banks Holding So Many Excess Reserves?" by Todd Keister and James J. McAndrews). At the end of the article, the authors discuss whether the excess reserves might be inflationary. They argue no, since the Fed can raise the interest rate it pays on reserves. (The Fed was granted the authority to pay interest on reserves in the TARP legislation.) By doing this, "the central bank can increase market rates and slow the growth of of bank lending and economic activity without changing the quantity of reserves." Since this was written before the paradigm shift, there is no discussion of how to deal with the opposite problem -- deflation.  Given that market rates cannot be pushed below zero, would increasing bank reserves spur lending, or would that be the equivalent of "pushing on a string"?

Some economists recommend lowering the interest rate on reserves to zero or even charging banks for excess reserves. Those opposed to this argue that it would have bad implications for the market for short-term money market instruments and for money market mutual funds. It is hard to know, since no one in the financial markets has seen rates this low.

The article does state that excess reserves do not imply that banks are not lending. If banks receive loans from the Fed to make loans rather than borrowing from banks holding excess reserves, then excess reserves go up but Fed's loan has facilitated increased lending. But it seems that direct Fed lending to banks would be a difficult policy to implement on a scale sufficient to jump start the economy.

Amazingly, some economists, recognizing that the Fed may have difficulty jump starting the economy by increasing the monetary base (which can be done by buying securities or direct loans), argue that the Fed should announce a target rate for inflation, perhaps 2%. It is hard to see how that would work. It could have a transitory announcement effect in credit markets, but talk not backed up by action will inevitably fail. The Fed saying it has a target does not mean it will be achieved any time soon nor will it prevent deflation from occurring.

Of course, others, recognizing that monetary policy has its limits, argue that the federal government should supply more stimulus. Those opposed to this state that the fiscal stimulus already supplied has not kept the unemployment rate from increasing; the counterargument is that, if not for the original stimulus, the economy would be in more dire straits and that we now know it should have been greater. A better argument against additional stimulus, though not one I find convincing, is that more stimulus would not work since it would increase the deficit and hence the stock of government debt. People would therefore not respond to the stimulus because of fear of higher taxes in the future because of this greater debt burden.

While there certainly is a risk of deflation, it is impossible to know how high that risk is.  Economists differ on what the policy response to the increasing perceived risk of deflation.  It is, though, generally conceded that once a country has entered into deflation, it is extraordinarily difficult to get out of it. One of the problems is that holding cash rather than investing it provides the equivalent of interest in real terms without risk.

While the degree of risk of deflation is unknown, there is reason to be concerned about the ability of policymakers to take measures to ward it off. The Fed appears to be unsure about what to do and what the consequences of using its monetary tools would be. Getting significant additional fiscal stimulus now is a near impossibility politically; the economic conditions that make it politically possible may necessitate an enormous amount of stimulus.

Finally, there are economists of a classical bent who seem to think, given enough time, the economy will self correct. Those with a Keynesian bent might dispute that, but, even if the classical economists are theoretically right, they ignore the political consequences of deflation and high unemployment. General economic distress could unleash highly unattractive social forces and political movements, including, perhaps, an assignment of blame to particular societal groups. The demands on the government to do something would be deafening. The hope we can have is that, if this happens, we will have enlightened and skilled political leadership that can navigate the social tumult.

The other hope we can have, of course, is that the fear of deflation is overblown. But it would be irresponsible for policymakers to ignore the risk.

St. Louis Fed President James Bullard on Deflation

The President of the Federal Reserve Bank of St. Louis, James Bullard, has put out on the web a "preprint" of an article for the September-October issue of the FRBSTL Review entitled "Seven Faces of 'The Peril."   That Bullard, who has been known as an inflation hawk, now expresses concern about deflation seems to signal that the Fed is ready to do something if it materializes, though there does not appear to be any unanimity among Fed officials that this is likely to happen.

The article, though, is a bit perplexing.  Bullard points out the obvious; there is a zero-bound limiting what the Fed can do with interest rate targeting to combat deflation.  He also says that the Federal Open Market Committee, of which he is currently a voting member, may be making things worse by saying that the Fed is likely to keep interest rates very low for an extended period.  This may, he says, move the U.S. economy to an equilibium point of low nominal interest rates and deflation. He apparently thinks that the Fed's statement may cause the private sector to form expectations that this will happen which will be self-fulfilling.  I do not find this reasoning persuasive.  If Bullard wants to make this case, he needs to expand his discussion of this point.

Obviously, though, Bullard is right that the Fed can still expand the monetary base even if it is not targeting nominal rates.  This is called "quantitative easing," a term which serves to obscure the fact that the Fed uses its ability to create money and to extinguish it when it is targeting interest rates.  If the Fed wants to lower the fed funds rate or to increase the monetary base in a situation where the fed funds rate cannot go lower, it will expand its balance sheet, usually by buying securities.  (It can also make loans, but this has not been a major tool of monetary policy, though the discount window is used to help out commercial banks, and, in some cases, other financial institutions which face liquidity problems.)

Mr. Bullard does not go into the relative merits of  what maturity of Treasury securities the Fed should consider buying when trying to expand the monetary base.  For example, if the Fed were to buy more long-term Treasuries, this would have implications for Treasury debt management, since it would affect the maturity structure of outstanding marketable Treasury securities held by the public (not including the Federal Reserve Banks).  It is conceivable that the Treasury would consider issuing a greater proportion of its debt at the longer end in response to such a policy.  Mr. Bullard does not address this issue, nor does he discuss whether the Fed would be trying to flatten the yield curve through a quantitative easing policy.  (Whether or not the Fed, or the Fed and the Treasury acting in concert, can affect the shape of the yield curve is an unsettled issue.  The evidence from an attempt to do this, "Operation Twist" of the 1960s, is inconclusive because Treasury debt management worked at cross purposes to the Fed's open market operations.)

Bullard also does not discuss the decline in the M1 money multiplier, which compares the monetary base and the M1 measure of the money supply.  The St. Louis Fed has a chart of this decline and a table of the data on its website.  The multiplier is now a bit over 0.8, which means that the monetary base is larger than the M1 measure of money held by the public.  Prior to the last quarter of calendar year 2008, the multiplier had been in the 1.6 to 1.7 range for a number of years.  This decline in the multiplier has implications for the effectiveness of monetary policy that Bullard could have discussed.

Also, Bullard too easily dismisses fiscal expansion as a policy tool in the U.S. context.  He looks at the sovereign debt problems in Europe and concludes:  "The history of economic performance for nations actually teetering on the brink of insolvency is terrible.  This does not seem like a good tool to use to combat the possibility of a low nominal interest rate steady state."  He also goes on to state that Japan's "aggressive fiscal expansion" has not worked.  The U.S. is not on the brink of insolvency, and he should have discussed what he thinks are the reasons fiscal policy has not worked in Japan and how these are relevant to the U.S.

It is significant that a member of the FOMC is thinking about deflation and what the Fed can do about it should it occur.  If deflation does happen, I suspect that the Fed will do what it can through quantitative easing.  I also suspect that, if the deflation seems to be locked into place, the politics of deficit spending will radically change and there will be fiscal expansion, probably through some combination of increased spending and tax cuts.  The deficit hawks need to know that the only way their concerns about long-term fiscal issues can be addressed is by getting the economy to grow again.  A sustained deflationary period would be a disaster.

OFAC, Cuba, and the United Nations Federal Credit Union

In a development that did not get very much attention, the Treasury's Office of Foreign Assets Control ("OFAC") announced on July 15 that the United Nations Federal Credit Union ("UNFCU") had paid $500,000 to the U.S. government to settle charges that it had violated the Cuban Assets Control Regulations ("CACR").

OFAC's description of its allegations is quite cryptic: "OFAC alleged that UNFCU dealt in property in which Cuba or a Cuban national had an interest in violation of the CACR by engaging in certain unauthorized financial transactions on behalf of its members/accountholders who were blocked Cuban nationals pursuant to the CACR. The transactions involved financial services that were routinely provided by UNFCU to its members."

Clif Burns, a Washington, DC lawyer, criticizes OFAC in his ExportLaw blog for not providing more detail.  He says that the lack of details "makes OFAC look foolish by suggesting the possibility that OFAC is penalizing the UNFCU for providing banking services to Cuban diplomats posted to the U.N."  He claims that, if this were the case, it would violate the U.N. Headquarters Agreement.

Mr. Burns speculates that the allegations may refer to banking services the UNFCU may be providing to Cuban nationals at U.N. facilities outside the United States.  If that is what the OFAC allegations concern, though, Burns argues that "the UNFCU’s extra-territorial application of U.S. sanctions could create a new problem for itself because these sanctions could well violate local laws that prohibit discrimination based on national origin."

Because OFAC did not provide much in the way of explanation, what exactly going on here is a bit of a puzzle.  Even though the Obama administration is inclined to be more flexible about the Cuban sanction regime than the Bush Administration, OFAC seems to be doing what it thinks it must, enforce the existing sanctions until such time as they are changed.

John Walsh to be Acting Comptroller

On Friday the Treasury issued a press release announcing that Secretary Geithner has chosen John Walsh,Chief of Staff and Public Affairs at the OCC, to be Acting Comptroller when John Dugan leaves the agency on August 14.  This was a surprise.  I had thought that Julie Williams, the OCC's First Senior Deputy Comptroller and Chief Counsel, would take on that role, as she did when Dugan's predecessor, John D. Hawke, Jr., left the OCC.

John Walsh was brought into the OCC by Dugan and has worked closely with him.  Dugan clearly thinks highly of him.  However, it is not clear why Geithner chose to bypass Williams.

Since it may take some time to get a new Comptroller in place and financial regulatory reform legislation has just been recently enacted, the role of acting Comptroller will entail more than a caretaker role.  Among other tasks, the OCC has to administer taking over much of the Office of Thrift Supervision, and it needs to define its role among other regulators under the changes made by the new law.  Geithner obviously has made the judgement that Walsh, who has an impressive résumé, has the necessary political skills as well  as substantive knowledge to lead the OCC during this transitional period.