Tuesday, July 29, 2008

The Federal Reserve Bank’s policies are changing

Recent negative shocks to the housing, oil, and credit markets have forced the Fed’s hand, and in response, its policies are changing. The Fed developed three new policy tools that have curbed the financial crisis that peaked in March. The Fed will move toward an inflation target over the next five years. And finally, current and future policy will be based on headline, rather than core, inflation.

Ben Bernanke was sworn in as the Chairman of the Federal Reserve’s Board of Governors on February 1, 2006. One wonders whether he would have taken the job if he’d known the mayhem that would take over the U.S. economy in 2008. Over the year, the U.S. has been subject to the strong and negative forces of record oil prices, precipitously declining home values (wealth), spikes in gas prices, and a credit crisis that continues to elude stabilization. It is truly resilient to grow an expected 2.4% in the second quarter of 2008 (GDP growth in Q2 at an annualized rate) amid the turmoil that besets us.

Some say that the fiscal stimulus is the catalyst for the recent resilience. That is certainly true. Without the fiscal stimulus, Q2 growth may very well have been 1% (or worse, -1%) rather than the expected 2.4%. But that is not the whole story. The Fed has taken action to target the specific problems at hand. Because of innovative Fed policy, the U.S. economy has not suffered a deep and prolonged recession.

New and innovative Fed policies helped liquidity

Losses mounted from assets linked to bad mortgages, and banks needed to raise funds quickly. However, lack of transparency in bank balance sheets caused the flows of monies from lender to lender to halt and liquidity dried up. In response to the liquidity problems, the Fed doubled the number of policy tools available to it to aid the suffering banking sector directly.

The standard tool used by the Fed, Open Market Operations (lowering interest rates), would not have been effective in tackling the liquidity problem. The Fed saw this and changed its policy tools accordingly; it created 3 extra programs to allow a wide array of banks access to short-term funds at the Fed’s discount window (where banks borrow from the Fed). The new programs are:

Term Auction Facility (TAF) – allows lending using a wider range of collateral to banks; it is a substitute to interbank lending (federal funds market or the Libor market).

Primary Dealer Credit Facility (PDCF) – provides loans to primary dealers (investment banks that deal with the Fed on a regular basis), rather than just to the depository banks, with proper collateral.

Term Structures Lending Facility (TSLF) – provides loans to all financial entities (any bank, not just primary dealers and depository institutions) to access loans with proper collateral.

Since the peak of the credit crisis in mid-March 2008, these innovative programs have allowed for some general relief in the banking system. Liquidity is still dry, but flowing much more freely than it did in March.

Fed policy is changing to include explicit inflation targets

Inflation has been on the top of the Fed’s worry list, and I see the Fed’s objectives are changing in two ways:

1. The Fed will move toward an inflation target within the decade.
2. The Fed is likely to put more emphasis on headline inflation, rather than core, inflation when making policy decisions.

The inflation target

Globally, central banks are moving toward targeting inflation, or keeping inflation around 2%. Under an inflation target, a central bank will raise or lower interest rates if inflation moves away from the target. The Bank of Canada, Bank of England, European Central Bank, Reserve Bank of Australia, Bank of New Zealand, and other developed economy central banks, target inflation explicitly.

Inflation targeting is in stark contrast to Alan Greenspan’s era of discretionary policy: using policy to obtain stable prices and maximum sustainable growth, and whichever is currently at higher risk, the central bank will put emphasis on correcting that problem. Currently, inflation has accelerated to 5.2% (and is expected to continue) and growth is struggling; under these circumstances, discretionary policy can be a nightmare. The Fed must make a choice, and that choice has a price – the good-old Phillips Curve.

Ben Bernanke is a strong proponent of an inflation target. An inflation target is easy for the public to understand and sets a clear objective for the Fed. The Fed has already made efforts to become more “transparent” by offering its economic forecast at every other monetary policy meeting.

Members of the Fed have been outspoken in their support of an inflation target. Governor Frederic Mishkin http://federalreserve.gov/aboutthefed/bios/board/mishkin.htm, a voting member of the Fed’s monetary policy committee (at least until August), expressed his strong support of the inflation target:

“By establishing a transparent and credible commitment to a specific numerical inflation objective, monetary policy can provide a firm anchor for long-run inflation expectations, thereby directly contributing to the objective of low and stable inflation…. Thus, the establishment of an explicit numerical inflation objective [inflation target] can play an important role in promoting financial stability as well as the stability of employment and inflation….More broadly, it should be noted that central bank transparency contributes importantly to democratic accountability and economic prosperity.”

Point: an inflation target is the best method to anchor inflation expectations and find stability in current economic conditions (financial markets, employment, inflation, and growth).

Headline versus core inflation

As Gov. Mishkin indicated, a “firm anchor for long-run inflation expectations” is the key to maintaining low and stable current inflation. I have stated before my beliefs that energy price inflation will subside, and that core and headline inflation will converge. Thus, if the Fed tightened too much now, then the economy will suffer excessive unemployment and falling income.

However, if energy price inflation continues to rise, then headline inflation will further rise relative to core inflation (total inflation minus energy and food price inflation). Consumers will change their expectations over how future prices will change.

Governor Charles Plosser, President and CEO of the Federal Reserve Bank of Philadelphia and a voting member of the Fed’s monetary policy committee, argues that it is difficult to keep inflation expectations in check when consumers and firms are seeing energy and gas prices rise precipitously. If it were just the prices of, let’s say tractors that were rising quickly, then inflation expectations would not be in jeopardy. But it’s not. Energy is a key expenditure for most families, and surging energy prices can have a profound impact on inflation expectations – even while the prices of all other goods remain quite stable.

Governor Charles Plosser expressed his support for targeting headline, rather than core, inflation:

“Since energy price increases have been so persistent in recent years, I do believe more attention should now be paid to measures of headline inflation in setting monetary policy.” Note: This is a great speech to read for a nice introduction to core versus headline inflation.


The Fed: It is a changing.
Recent shocks to the housing, oil, and credit markets have forced the Fed’s hand. In response to these shocks, the Fed developed three new policy tools that have curbed the financial crisis that peaked in March.
The Fed will likely move toward an inflation target over the next five years.
Current and future policy will be based on headline, rather than core, inflation.
Please leave comments. Best, Nontruths


  1. Thank you to the person who sent an email correcting me on Charles Plosser's title. Charles Plosser is the President and CEO of the Federal Reserve Bank of Philadelphia and not a member of the Board of Governors.

    The Board of Governors includes the following members: Ben S. Bernanke (Chairman), Donald L. Kohn, Randall S. Kroszner, Frederic S. Mishkin (retiring next month), and Kevin M. Warsh. Normally, the Board consists of 7 members, but Congress has yet to approve a nomination.

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