The Fed finds religion

Has the Federal Reserve found religion? Yesterday's verbal barrage from a host of Fed speakers, both voters and non-voters, suggested that the FOMC has started to notice that the cost of living is going up. A lot. It is probably through that prism that yesterday's strong US retail sales report should be viewed; it is hard to credit that spending growth has encompassed much beyond basic necessities. Such a conclusion, at least, is the least that can be reached on the basis of a chart posted on The Big Picture yesterday.

Now, central banks are in a tough spot here. One might (and indeed, Macro Man would) argue that the Fed has found religion after the inflationary horse has already bolted. Still, perhaps it's better to see straight late than never; less clear is what to do about. An obvious starting point is to quit inviting financial markets to shag the dollar, and it is through that prism that the Treasury's recent volte face should be viewed. It seems as if US officials have connected the dots and realized that the dollar down bubble might have at least a little to do with import prices rising 15.4%, and moreover that this imported inflation is being passed through domestically.

The Bank of England is in a similar boat. The macro data has deteriorated markedly; today saw the first rise in unemployment claims in more than eighteen months; meanwhile, the news from the housing market remains nothing short of execrable. Yet inflation remains persistently high; for an inflation targeting central banks, this makes aggressive easing on the back of weak activity data difficult, unless one assumes an endogenous disinflationary impact from lower growth.

And throughout the history of inflation targeting, that's been a reasonable assumption. Yet one could plausibly argue that for the first time since the 1970's, global inflation is largely exogenous for most countries, a product of the three axioms and prior underinvestment. In such a case, it's unclear that high rates will do much to ease headline inflation. On the other hand, tight policy can, on the margin help prevent the second round effects that helped to endogenize the external inflationary shocks of the 1970's.

Macro Man is starting to wonder if we're aren't seeing the beginning of the end of inflation targeting as we know it, much as the 1980's spelled the doom for monetarists. Targeting inflation is great in a world an endogenously-generated price rises when core and headline converge over time; in a world of exogenous inflation pressure and divergent core and headline, focusing on one inflation measure is likely to generate suboptimal policy.

Macro Man wonders if we won't move towards a a world where central banks begin to target nominal GDP growth, rather than simply inflation. In a world of exogenous inflation, high frequency tradeoffs between growth and inflation are, to a degree, out of the central bank's control; if those shocks feed through into domestic prices, this will be reflected in nominal output growth.

What's interesting is to look at a chart of nominal GDP growth in the US and three other inflation-targeting central banks. In New Zealand, nominal GDP growth is just north of 8% y/y...close to the level of the RBNZ's OCR. In the Eurozone, nominal GDP growth is just over 4% y/y....again, close to the ECB's refi rate. Interestingly, nominal GDP growth in both the UK and US are well above the respective central bank policy rates. Small wonder, then, that the dollar and sterling are two of the three worst performing G10 currencies this year (the third, the Canadian dollar, also has a central bank policy rate well below the level of nominal GDP growth.)

So if central banks do find a new religion, it looks like the conversion may be easier for some than for others.

(And yes, I know that trailing y/y nominal GDP growth rates are not optimal policy targets; in an actual nominal GDP target regime, forward-looking indicators would be used.)
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vlade
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May 14, 2008 at 12:52 PM ×

I was wondering who would be the first to point out that the "growing" retail sales were growing because people simply had to spend on petrol and food, so if the prices of these two were growing dramatically, of course the retail sales would grow...
Agree on the exo/endo genous sources of inflation, another of my long-term pet peeves :)

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Dom
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May 14, 2008 at 1:06 PM ×

A nominal GDP target? Imagine this scenario.

An economy is growing at a decent rate, but domestic capacity can't keep up with demand. So demand spills over into imports rather than domestic production. GDP growth declines. Should the central bank cut interest rates? I don't think so...

A nominal domestic demand target makes more sense. What doesn't make sense is ditching a policy framework the minute it becomes problematic. Surely that negates any benefit from having a framework in the first place?

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spagetti
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May 14, 2008 at 1:25 PM ×

retail sales my also have been helped by the tax rebates. whether people actually got it or not, they may have decided to spend some of it already.

i can only assume US retailers were trying to lure customers to spend money ahead of the tax cheques actually getting to their destinations

im just speculating, i guess in a few months we will see how much the tax rebates helped, but i doubt it will be much beyond a few tenths of % points of retail sales growth

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Macro Man
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May 14, 2008 at 1:36 PM ×

Amusingly, I heard that Grand Theft AUto added 0.2% to retail sales all by itself. One would presume that thateffect would fade.

And Dom, in your scenario I would expect domestic price inflation caused by shortages to more than offset any hit to real activity coming from rising imports...so in that scenario, the central bank would be putting rates up!

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Anonymous
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May 14, 2008 at 1:52 PM ×

humm post cpi maybe fed has it right--course my own personal CPI is running at about 10% y/y--i understand the maths behind the calc but still think its just not based in the real world

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Macro Man
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May 14, 2008 at 1:57 PM ×

Amen, Anon. Here's one for the conspiracy theorists: headline seasonally adjusted CPI was lower than expected....yet the headline non-seaasonally adjusted CPI index was marginally higher than expected! Is someone playing silly buggers with the seasonal adjustment factors, perchance? Tin foil hats at the ready!

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t
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May 14, 2008 at 3:08 PM ×

People do not give up fundamental articles of faith until they are untenable in the face of overwhelming evidence.
I don't know which path the Fed is walking, but it ain't the road to Damascus.
They are deliberately pursuing dollar depreciation via a negative real interest rate policy and achieving that by lying about inflation. How else can the debt be managed?

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May 14, 2008 at 3:37 PM ×

An interesting target would be the household savings rate, directly influenced by IR and an excellent indicator of people's dumb expectations of the future.

CB

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Linda P.
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May 14, 2008 at 3:59 PM ×

As long as boosts in Social Security are tied to the CPI numbers, you have to wonder...

I can barely afford my tin foil hat with aluminum prices rising

:)

And if Dennis Hopper is supposed to represent "my generation, the baby boomers" I want to see him leading a bunch of us on choppers to Washington for a meeting with the CPI number crunchers....

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May 14, 2008 at 5:53 PM ×

About retail sales, it's a dollar value, inflation adjusted in not so good (negative..) and then consider energy and food.. but it's too complex to see, it's better to buy equity...
also today, PPI and import prices less cpi, is it real so equity bullish??
Have anyone seen short-sterling??a carnage!!!

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Macro Man
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May 14, 2008 at 6:49 PM ×

"Carnage in short sterling." I'm not sure if I can remember a day when there wasn't carnage in that market.

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Mr. Prop
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May 14, 2008 at 8:34 PM ×

Is the Fed throwing markets a trial balloon? The idea is that negative real rates has helped but a floor under housing collateral and is making the the masses ($4trillion in money markets) feel a bit uneasy holding cash. The net effect is that the insurance policy against the nasty tail risk on the growth side has worked. They now are suggesting that the inflationary policy of benign neglect on the dollar is something they can at least jawbone against to the great relief of thier irate G7 partners. But, I call it a trial balloon, because make no mistake about it, if the Ponzi scheme that is "working" now fails, then make no mistake about it, it will be back to more monetary heroin and a weaker dollar. They are hoping markets take this shift positively - the dollar stabilizes or even rises to reflect a grater sense of confidence. Credit spreads and equities are judge and jury. If today is anything to go by, the "bluff" is working. Ben is walking a dangerous tightrope. As we all remember the attempt to go to neutrality last October was a disaster. Rates are so priced for the Raging Bull now that I really wonder if it makes any sense at all to position in reflation mode. November Fed Funds price a 60% chance of hike. Markets seem to forget Bernanke is at the helm, not Volker.

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Macro Man
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May 14, 2008 at 8:48 PM ×

Well, what's curious is that on a day when the Argentine statistician in charge of CPI calculation delivers a benign print, it looks like we're going to get a flat-to-lower close in stocks and a lower close in bonds.

WTF?

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David Pearson
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May 14, 2008 at 9:18 PM ×

Macroman,

One thing to consider: for all their rate cuts, and contrary to popular perception, the Fed has not coaxed the monetary base upwards. It seems at 2% Fed Funds there is no (net) demand from the banking system for funds.

What to do? Well, they could cut further, but previous cuts have had no impact on demand for Fed Funds. Their next choice is to simply wait. With time, the banking system may heal enough to demand funds. But what if it doesn't? Bernanke made a name for himself arguing that both the 1930's Fed and the 90's BOJ allowed the base to stagnate or contract. Would he commit the same error? If he wants to avoid that fate, his next choice is quantitative easing.

So maybe the question is not, "will the Fed abandon inflation targeting?" Maybe instead its, "will the Fed adopt a base money growth target?"

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Macro Man
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May 14, 2008 at 9:31 PM ×

David, I think ultimately the lack of monetary base growth is down to the structure of the Fed's policymaking. The Fed's provided funds to dealers and banks via the alphabet soup of programs, and funded those programs by selling off Treasuries rather than printing money. No increase in the Fed's balance sheet, no increase in the monetary base.

What's interesting is that other monetary aggregates- M2 and MZM, for example- have skyrocketed, though to a degree that's not a surprise; you often see this when securities are being sold.

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David Pearson
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May 14, 2008 at 10:52 PM ×

Macroman,

My basic point is that the Fed Funds rate of 2% is not accommodative. If it were, there would be higher demand for funds by the system, and the Fed would have to inject funds to keep the FF rate from rising.

So leaving aside the TAF (which is sterilized), we need a lower FF rate in order to see base growth, or the Fed has to resort to "force feeding" -- targeting base growth instead of the Fed Funds rate.

Its possible the Fed doesn't care about base growth and is satisfied with providing liquidity to the mortgage market. Perhaps. But its one thing to give banks liquidity, is another to motivate them to increase lending. I don't think the Fed considers their deflation-fighting job complete until credit growth resumes, and the best indicator of that is growth in the monetary base.

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D
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May 15, 2008 at 12:11 AM ×

The employment target will come back...

Nominal GDP targeting, aka the "dual mandate" or "new monetary consensus," are failing in the test.

James K Gailbraith

http://www.google.com/url?sa=t&ct=res&cd=3&url=http%3A%2F%2Futip.gov.utexas.edu%2Fpapers%2FCollapseofMonetarismdelivered.pdf&ei=JHErSJnsNZy-iAHtm-nFBg&usg=AFQjCNEhQ3g2tveNCK7a0uA5Zn3WxzXTtg&sig2=iHYba3AclXHQaZzxnbRX-A

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D
admin
May 15, 2008 at 12:20 AM ×

Reality: The Greatest Debt Deflation Show

Pearson nailed it. Aside from the I-banks borrowing against debt to buy more debt (ponzi) there is little demand for credit origination. Have you all noticed the trend of growing Level 3 assets on the balance sheets of banks and i-banks?

The income (productivity) is not there to service the current asset prices and debt pool. Debts have to be repaid and we have front row seats in what is to be the greatest cascading debt default show ever.

This can only end one way.

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D
admin
May 15, 2008 at 12:24 AM ×

Macro -

The Fed can only issue new currency by pledging assets first...have you noticed the correlation between assets and outstanding federal reserve notes?

In the near future expect the Fed to begin paying interest on Fed deposits to grow its balance sheet. This was previously expected to come in 2012, but is being rushed to the table out of necessity.

The smart money will hang on to their Federal Reserve Notes when we come to that moment.

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Anonymous
admin
May 15, 2008 at 3:52 AM ×

Dear MM,

Do you have any link/article where it teaches how to maintain a P&L ?

I have trouble mainting it and I am not an accountant but a trader

any help would be appreciated.

Cheers

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