The minutes to the most recent Federal Reserve Meeting, held on August 8th just came out and show that the Fed is deeply divided on economic policy. Below are the key parts of the participants’ views section of the minutes. I intersperse my commentary/translation from time to time. Some of that commentary will indicate where I come down on the debated issues and what I would do if I were on the committee. I bold face what I see are the key statements.
Participants’ Views on Current Conditions and the Economic Outlook
"In their discussion of the economic situation and outlook, meeting participants regarded the information received during the intermeeting period as indicating that economic growth so far this year was considerably slower than they had expected. Participants noted a deterioration in labor market conditions, slower household spending, a drop in consumer and business confidence, and continued weakness in the housing sector. Manufacturing activity was reported to be mixed.
"Participants judged that temporary factors affecting demand and production, including the damping effect of higher energy and other commodity prices and the supply disruptions from the Japanese earthquake, could account for only some of the weakness in economic growth over the first half of the year. While these effects appeared to be waning, the underlying strength of the economic recovery remained uncertain.
"In addition, many participants pointed to the recent downward revision to estimates of economic activity over the past three years, and some to the financial market strains seen during the intermeeting period, as contributing to a downgrade of the outlook for the economy. More-over, many participants saw increased downside risks to the outlook for economic growth."
The economy is weaker than expected, and could get weaker still. Yes, there were some temporary headwinds that are abating, but they don’t tell the full story. And there are new headwinds that are developing.
"Meeting participants generally noted that overall labor market conditions had deteriorated in recent months. While the employment report for July showed that hiring was somewhat better than in previous months, the release was still seen as indicating relatively weak conditions.
"A couple of participants commented that the exceptionally high level of long-term unemployment could lead to permanent negative effects on the skills and employment prospects of those affected. Another participant, however, noted that it could instead reflect a mismatch between the characteristics of the unemployed and the jobs currently available.
"Participants also discussed the labor force participation rate, and it was noted that extended unemployment benefits could be increasing the measured unemployment rate by encouraging some workers to remain in the labor force longer than they otherwise would have. Other participants remarked that the declines in the unemployment rate that have occurred over the past year appeared to reflect primarily declines in labor force participation rather than significant gains in employment.
"Reports from business contacts suggested that depressed business confidence as well as uncertainty regarding the economic outlook, regulatory policy, and fiscal policy continued to restrain hiring and also capital investment."
The labor force participation rate falls to its lowest level since 1983, and some clown on the committee is suggesting that extended unemployment benefits are artificially painting a picture of the unemployment situation that is artificially bleak?!?
The mismatch issue is an important one. If it is true, then there really isn’t much that the Fed — or Congress, for that matter — can do to fix the unemployment problem. It isn’t that aggregate demand it too low, but that those workers — who had perfectly good skills in 2007 and 2008 — are just dinosaurs. I find very little evidence for this point of view.
However, the longer people are out of work, the more true it becomes. Still, mostly it sounds like someone trying to make excuses for a total dereliction of duty on the full employment side of the dual mandate.
"Inflation had moderated in recent months after having been somewhat elevated earlier this year. Transitory factors, including supply chain disruptions from the earthquake in Japan and a surge in energy and other commodity prices, had pushed up both headline and core measures of inflation for a time.
"More recently, however, as prices of energy and some commodities have declined from their earlier peaks, headline inflation has moderated. Participants generally noted that, with apparently significant slack in labor and product markets, slow wage growth, and little evidence of pricing power among firms, inflation was likely to decline somewhat over time.
"Measures of inflation expectations had remained stable. Nevertheless, a number of participants noted that core inflation had moved up, on balance, since last fall. Some indicated that the rise in inflation from very low levels reflected the Committee’s accommodative stance of monetary policy, which had helped address the deflation risks of a year ago. A couple of others, however, suggested that the juxtaposition of higher core inflation and somewhat lower unemployment could imply that the level of potential output was lower than had been thought."
Gee, core inflation rises from a historic low to a level that is still far below the average of the last 10, 20, 30, 40 and 50 years, and unemployment declines ever-so-slightly but remains close to the highest levels seen since the Great Depression, and these guys want to throw in the towel and say, oops, the economy is no longer capable of growing.
The immediate threat of deflation was taken off the table by QE2. I see very little danger of runaway inflation in the near- or intermediate-term future. Those who do must think that virtually every participant in the bond market has a room-temperature IQ. Who in their right mind would be willing to lock up their money for 10 years at a yield of under 2.25% if they thought inflation was about to soar to say the levels of the late 1970’s, or for that matter the levels of the late 1980’s or late 1990’s?
"Most meeting participants indicated that the weakness in consumer spending in recent months was unexpected. The flattening out of consumer spending was seen as reflecting, in part, the modest pace of gains in employment and labor income. In addition, household spending on autos had been held back by low inventories, and participants generally expected a pickup in sales of motor vehicles in coming months as production rebounded.
"Nonetheless, low consumer confidence, efforts to rebuild balance sheets, and heightened caution on the part of households facing an uncertain economic environment were seen as factors likely to continue to weigh on household spending going forward. Several participants also pointed to financial constraints, particularly depressed home prices and still-tight credit conditions, as further restraining consumer spending for a time."
Given the impressive list of factors they cite, none of which exactly came out of the blue (with the exception of the supply chain disruptions in the auto sector), I have to say I’m a bit perplexed as to how it could have been all that unexpected.
The wealth of the middle class declined by about $7 Trillion due to the housing bust. That was not "funny money" wealth, used mostly for keeping score. For the most part it was the core of modest nest eggs that had a purpose. People had been counting on that housing equity wealth to finance retirements or help send kids to college.
Provided that people do not all of a sudden want to work until they drop dead in their late 80’s, or have decided that it no longer makes sense for their kids to get a college education, they have to rebuild their wealth the old-fashioned way — by spending less than they earn, and their earnings have not been going up very much.
"Business outlays on equipment and software continued to advance, although at a slower pace than earlier in the year. Business contacts in many parts of the country reported that uncertainty about the pace of growth in coming quarters and a general slump in business confidence had made some firms reluctant to expand capacity. With home prices depressed, housing construction was quite subdued and seen as likely to remain so, while investment in nonresidential structures remained low."
Housing construction is the traditional locomotive that pulls the economy out of a recession. The locomotive is still derailed. Non-residential investment will get even weaker late in the 4th quarter and into early 2012, based on architectural billings.
"The weakness in household and business spending was accompanied by fiscal consolidation at the state and local level. The shedding of state and local government jobs contributed to the deterioration in overall labor market conditions. Some policymakers noted that their outlooks for economic activity were shaped in part by an expectation of fiscal restraint at all levels of government."
Austerity is concretionary. To argue for immediate cuts in government spending is to argue that we need for the government to take steps to slow the economy. Private sector job growth has actually bee pretty solid over the last year or so — not great, but solid. The decline in employment at the State and Local levels is unprecedented coming out of a recession, and the magnitude of the declines is the largest on record.
"Participants generally saw the degree of uncertainty surrounding the outlook for economic growth as having risen appreciably. A couple noted that the cyclical impetus to economic expansion appeared to be weaker than it had been in past recoveries, but that the reasons for the weakness were unclear, contributing to greater uncertainty about the economic outlook.
"Many participants also saw an increase in the downside risks to economic growth. While participants did not anticipate a downturn in economic activity, several noted that, with the recovery still somewhat tentative, the economy was vulnerable to adverse shocks. Potential shocks included the possibility of a more protracted period of weakness in household financial conditions, the chance of a larger-than-expected near-term fiscal tightening, and potential financial and economic spillovers if the situation in Europe were to deteriorate."
I agree that the most likely case is that we will avoid a new recession, but the odds of a new recession are rising, and are far greater than the odds that we have an economic boom in 2012. The most likely case is a continuation of the current pseudo-recovery, where GDP growth stays slightly positive, but not positive enough to see the unemployment rate actually fall. It could even drift upwards in that case.
"Participants noted that financial markets were volatile over the intermeeting period, as investors responded to news on the European fiscal situation and the negotiations regarding the debt ceiling in the United States.
"However, the broad declines in stock prices and interest rates over the intermeeting period were seen as mostly reflecting the incoming data pointing to a weaker outlook for growth both in the United States and globally as well as a reduced willingness of investors to bear risk in light of the greater uncertainty about the outlook. While conditions in funding markets had tightened, it was noted that the condition of U.S. banks had strengthened in recent quarters and that the credit quality of both businesses and households had continued to improve."
It is not as if those things are not related. The outcome of the debt ceiling negotiations was that fiscal policy was going to become more concretionary, although fortunately in the first round most of the cuts are back-end loaded. However, it also took an expansionary fiscal policy totally off the table.
If we were to have one of the shocks listed above, there is nothing the government could really do about the situation. If the super committee ends up being deadlocked, which is the most likely case, then the automatic cuts are going to kick in and those will be front-end loaded and will kill economic growth.
"Participants discussed the range of policy tools available to promote a stronger economic recovery should the Committee judge that providing additional monetary accommodation was warranted. Reinforcing the Committee’s forward guidance about the likely path of monetary policy was seen as a possible way to reduce interest rates and provide greater support to the economic expansion; a few participants emphasized that guidance focusing solely on the state of the economy would be preferable to guidance that named specific spans of time or calendar dates.
"Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates. Others suggested that increasing the average maturity of the System’s portfolio–perhaps by selling securities with relatively short remaining maturities and purchasing securities with relatively long remaining maturities–could have a similar effect on longer-term interest rates. Such an approach would not boost the size of the Federal Reserve’s balance sheet and the quantity of reserve balances.
"A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions. In contrast, some participants judged that none of the tools available to the Committee would likely do much to promote a faster economic recovery, either because the headwinds that the economy faced would unwind only gradually and that process could not be accelerated with monetary policy or because recent events had significantly lowered the path of potential output.
"Consequently, these participants thought that providing additional stimulus at this time would risk boosting inflation without providing a significant gain in output or employment. Participants noted that devoting additional time to discussion of the possible costs and benefits of various potential tools would be useful, and they agreed that the September meeting should be extended to two days in order to provide more time."
Sounds like there was a real donnybrook of a discussion. It probably came as close as those meetings have ever come to a shouting match. The specific date of mid-2013 seems like a bit of a compromise.
In an interview on CNBC this morning, Chicago Fed President Charles Evans indicated he wanted to see the Fed say something like “we will keep rates near zero until unemployment hits 7.5%.” That is an interesting approach, but the date-specific one probably accomplishes most of the same objectives.
While I agree that additional monetary stimulus would not be as effective as some fiscal stimulus, I think the "sit here are wring our hands and do nothing" crowd is dead wrong. Inflation is not a serious risk at this point.
Of the policies discussed above for further help from the Fed, the first one I would do is the elimination of paying banks not to lend, aka paying interest on excess reserves. I think doing so is just plain STUPID under the current circumstances.
The again, the Fed is technically not owned by the U.S. government; it is owned by the major banks of the country like JPMorgan (JPM) and Bank of America (BAC), and I guess this is a policy that keeps their shareholders happy. A twist operation of extending the maturities of the current portfolio would be worth a try as well.
Clearly I am on the side of those who want the Fed to continue to try to help the economy. It is just a case of me wanting the Fed to do its job. That job, according to the law, is to keep both unemployment and inflation low.
Well inflation is low, and very likely to remain very low for the foreseeable future. The Fed target for inflation is generally thought to be 2% per year. They have missed it repeatedly to the downside recently.
The target for unemployment is probably about 5.5% to 6.0%. Clearly unemployment is missing far to the high side. The textbook prescription is for the Fed to ease up on monetary policy. If would be nice if the dissenters would look at the textbook.
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