Monday, June 18, 2012

Mike Konczal — What Constrains the Federal Reserve? An Interview with Joseph Gagnon

Mike Konczal interviews Joseph Gagnon, a former Fed insider now at the Peterson Institute for International Economics. Mike asks everything you would likely ask if you had the opportunity and the time limit.

Read it at the Next New Deal | RortyBomb
What Constrains the Federal Reserve? An Interview with Joseph Gagnon
by Mike Konczal
(h/t Miles Kimball, Professor of Economics and Survey Research at the University of Michigan, who blogs at Confessions of a Supply Side Liberal)

Of note:

1. Legal limits of Fed power
Basically, the Fed has run out of ammo in terms of language about future policy intentions because it cannot credibly signal its intentions for more than two to three years ahead. It can extend the “late 2014” horizon into 2015, but that is fairly minor.
In terms of the asset purchases, the Fed is limited by law to the Treasury, agency, and agency MBS markets plus foreign exchange. Buying foreign exchange would be viewed as economic warfare by many countries, so it is probably ruled out even though it reflects rank hypocrisy on the part of foreign governments that are massively buying dollars. In the Treasury market, yields on three-year notes are only 0.3 percent, so the Fed must buy five-year to 30-year bonds to have any effect. With the 10-year yield at 1.5 percent, the scope for further effects is modest. Even if the Fed bought every 10-year Treasury, it would be hard to get the yield much below 1 percent, because the risks on such a bond become tremendously skewed toward future losses. There is more scope to buy agency MBS to lower the mortgage rate, but already mortgage rates are at a record low of 3.75 percent. At some point between 2 and 3 percent we are likely to reach the limit. So, the Fed has quite a bit of ammo left, but we can see that it is not inexhaustible. 
 Research I am doing suggests that it would be much more attractive for the Fed to buy a broad basket of U.S. equities to support the stock market than to try to push down bond yields from these already low levels. Sadly, the Fed is not authorized to buy equities, even though other central banks are allowed to do so.....
I think the average economist outside the Fed thinks the Fed has less ammo than the average economist inside the Fed. I frequently hear people say the Fed has done all it can do. I do not agree, but I do see a limit approaching. Note that that limit arises from legal restrictions on the Fed. If the Fed were empowered to buy all assets, it would never run out of ammo....
2. Transmission mechanism needed to create credible expectations
...I fear that announcing a goal of higher inflation, either temporary or permanent, will not actually do anything unless it is backed by actions....
3. NGDP Targeting Problems
Some have argued for a price path target or a nominal GDP path target. In that case you do make up for past deviations in inflation. But I think it is difficult to explain to the public how the specific path is chosen. Why should the CPI be 105 in 2013, 107 in 2014, 109 in 2015, and so on indefinitely? People care about the inflation rate not, some arbitrary price level. And it means that after booms you must have deflation. Indeed, if one had started the path in the early 1990s, the late 1990s boom would have put us way above it. Then the Fed would have had to make the 2001 recession much more severe to get us back on the path. That would have been a tough sell politically.
 4. Expectations
I think it is sensible for the Fed to stick to statements about things it is confident it can achieve, provided that it feels it is doing enough to achieve its objectives. For example, it can talk about purchasing MBS and pushing down the mortgage rate, thus stimulating the economy. The problem is that it has not achieved its objectives over the past three years and its own forecast shows it does not expect to achieve its objectives over the next three years....  I would tend to favor those for which the Fed has direct tools, such as buying foreign exchange to push down the dollar, rather than trying to raise inflation expectations by verbal jawboning.....
5. Consolidation
...From the point of view of the United States, what matters is the consolidated government balance sheet (Fed + Treasury),...


Ryan Harris said...

Can the Fed take the proceeds from fx purchases and buy JGBs or EuroBonds or something similar?

STF said...

"But the Fed’s mandate does not include maximizing profits. From the point of view of the United States, what matters is the consolidated government balance sheet (Fed + Treasury), and there is no way that QE can do anything but reduce our national debt burden. Any future losses by the Fed would be more than matched by gains to the Treasury."

Yes, bond sales are more inflationary than "money," as we've said for years. Wonder if he understand that's the logical result of what he's saying there. But what do I know? I'm also one of those crazies who thinks considering a consolidated Tsy/Fed is actually relevant and not pure fantasy at least in certain contexts.

Matt Franko said...

"Even if the Fed bought every 10-year Treasury, it would be hard to get the yield much below 1 percent,"

Yeah, I'll say, especially with the people who work there "trying to get the best deal for the taxpayers" and DROPPING their bid.

A good question would be how come rates have only recently hit new all time lows now that the Fed is WINDING DOWN Operation Twist?

Once the Fed ends Operation Twist, whereby they have been holding up rates, then rates can really fall down towards Japan-like levels.

We'll see if there is any announcements from the Fed meeting this week wrt the end of Operation Twist....

Anonymous said...

What does he mean "more than matched by gains to the Tsy?"

Anonymous said...

Wait, Gagnon was the dummy in the MMT WaPo article who said QE would create a loan multiplier ripple. And THIS is a FED Insider???

Ryan Harris said...

"Any future losses by the Fed would be more than matched by gains to the Treasury."

Interest rate risk, I assume.

Matt Franko said...

The Fed can have the Treasury early redeem at face value of the USTs if need be, which doesnt look like it would even be needed as they have identified a 3-5 year exit which should be long enough for the securities which the Fed has to run off...

Tom Hickey said...

"What does he mean "more than matched by gains to the Tsy?""

I think that what he means is that the Fed would have paper losses on its book when yields rise and the value of Fed assets as bonds and MBS falls. But it's only an actual loss when realized by selling the asset (or default, which is not going to happen with govts). The Fed would be more likely to just hold the assets to maturity rather than take losses anyway.

The Treasury would gain in that yields rising would signal recovery and when the economy turns up (on his argument due to Fed action), then tax revenues increase quickly and substantially.

Dan Lynch said...

WSJ reports Fed is frustrated that monetary policy isn't working the way economics textbooks say it's supposed to work.

Anonymous said...

Ah, if only the Fed could buy all assets. Then we'd have the Fed picking winners, and fiscal policy without democratic accountability. Wouldn't that be wonderful, and so "free market".

Leverage said...

Thanks god they can't buy every asset in the world if we want to keep any sort of resemblance to a "free market" (LOL).

One thing they could do is buy MBS and regulatory authorities instance banks to cut principals. They buy at current market value so banks don't have loses and the FED takes the lose on these packages. It still is a moral hazard a free check for banks but at least it translates to fraudulent mortgages which have their financial costs reduced (along with low rates) and have wider disposable income.

The problem with all this as always is: it props an economy based on fraud, asset bubbles and moral hazard. That won't end well in the long term.

Matt Franko said...


"They buy at current market value so banks don't have loses and the FED takes the lose on these packages."

I believe the Treasury guarantees those MBS coupon payments so neither the banks that may hold them currently or the Fed if they buy them are at any risk. The Fed takes no losses as the Treasury pays the Fed the interest and the Fed just returns the interest back to the Treasury at the end of the year.

Mortgage rates here have fallen a bit since the Fed got out of the MBS market after the QE1. If they announce this week that they are going back into MBS, expect mortgage rates here in the US to rise again.

The people at the Fed who do the buying fancy themselves as hedge fund traders, rather than public servants. And want to pay the lowest price they can for any asset purchases. This depresses bond prices and hence raises interest rates else equal.

My take: If the Fed withdraws from any form of asset purchase/QE at the meeting this week, then bond rally continues. If they ramp up asset purchases then the bond rally gets stopped in its tracks for a while again....


Bob Roddis said...

Joseph Gagnon: Sadly, the Fed is not authorized to buy equities, even though other central banks are allowed to do so.

Do you guys have a tissue?

It’s just so terrible that the central bank can’t create some fiat funny-money for rich people who own worthless stocks and give it to them for their stock as a transfer of wealth and purchasing power from ordinary folks. That’s just terrible.

Hey, wait a minute. I thought prices were “caused” by costs. How can the stock price collapse if the underlying assets originally cost a lot?

Tom Hickey said...

Bob: "I thought prices were “caused” by costs. How can the stock price collapse if the underlying assets originally cost a lot?"

I explained previously that goods price are chiefly cost-determined while financial instrument prices are determined by a variety of more subjective factors, but chiefly expectation of a favorable risk/return ratio. Capital goods investment and replacement cost of underlying assets is usually a peripheral factor in trading decisions, although they do figure into fundamental analysis of nominal price wrt actual value of bricks and mortar, brains and brawn, i.e., how actual value is nominally priced (market cap).

If one looks chiefly at price in financial terms, then one gets a biased view. For instance, measures of price stability excludes changes in asset prices and includes only factor prices and final goods prices, because factor prices determine final goods prices and lead changes in them too.

Leverage said...

Matt as I said, it would have to be followed with a mandatory reduction on mortgage principals (which are under negative equity I add). if not it would only be an other futile attempt on market manipulation and wealthy welfare.

I don't agree with all this sort of measures (including buying equities, very retarded IMO), for all sort of problems. But if we live in dysfunctional plutocratic regimes measures which help everybody at least are better that these that are skewed towards wealthy people. "Innocent fraud" will implode at some point anyway, this may as well accelerate the process.

Leverage said...

What I mean is the buying of MBS is accessory (just to prevent bank loses and insolvency of the whole financial system), a form of insurance.

The real objective would be reducing principal repayment of mortgages (could be followed with a measure to index these packages to FFR so arbitrage wouldn't happen with interests rising again in the mortgage market).

Matt Franko said...

"Do you guys have a tissue?" LOL

Bob, that's actually a pretty funny one-liner!

imo Once the US Treasury starts to guarantee equity prices, the Fed will volunteer to buy equities, not sooner.

The Fed will take no risk.


Bob said...

I cant tell where the fed manipulation ends and the private sector (non financial takes over)
Bring back the ABE Lincoln greenback, with the treasury printing its own money with zero interest instead of the parasitic banksters getting the low interest income on money printed out of thin air and dumping the interest payments off on the sheeple.

Matt Franko said...

"dumping the interest payments off on the sheeple."

They cant dump this on the sheeple because the sheeple have no authority to create the currency balances required to pay the interest, and the loan at origination only provides the balances for the principle, this is Paul heres point in general... without the govt providing the balances to pay the interest thru ongoing deficit spending, the whole thing eventually shuts down .... yet these morons are advocating for a "balanced budget" >>> THEY... ARE.... MORONS.


Tom Hickey said...

@ Bob, at least the ratio of government money to credit money has to improve, or financial crisis will be endemic since the financial sector as become so large and financialization represents an increasing share of GDP. Of course a lot of other things need to be done as well.

beowulf said...

"In terms of the asset purchases, the Fed is limited by law to the Treasury, agency, and agency MBS markets plus foreign exchange."

This is just wrong, Tsy can order the Fed to buy and sell "instruments of credit and securities". Its irritating that Joe Gagnon would mislead people in this way. Let's look at the Gold Reserve Act:
"Consistent with the obligations of the Government in the International Monetary Fund... the Secretary or an agency designated by the Secretary, with the approval of the President, may deal in gold, foreign exchange, and other instruments of credit and securities the Secretary considers necessary."

Gosh, if only the word "securities" wasn't so nebulous and confusing... oh wait, its defined in the SEC act:

"The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”"

Tom Hickey said...

Thanks for the sleuthing, beowulf.

Don't forget to evernote that, y'all. I have a feeling it is going to be coming up more and more.

Tom Hickey said...

beowulf, thinking further about that, it seems that the Fed itself cannot purchase securities other than as provided in the FR Act unless directed to by Tsy.

So Gagnon is correct in stating the limitations of the Fed itself as far as Fed insiders are concerned? It doesn't seem that the Fed board would act in this regard without direction from Tsy, for several reasons, 1) dubiously legal, 2) CYA, and 3) fear of Congressional reaction that might hamper Fed independence in the future.

Matt Franko said...

With the direction to purchase, they would want Treasury guarantees Tom (probably in writing).

Remember how is was reported that Paulson wanted Bernanke to step in wrt the Oct 2008 crisis and Bernanke backed up on him and told Paulson to get with Pelosi and get an appropriation... I suppose at that point Paulson could have used the appropriation to guarantee any Fed losses and had the Fed purchase assets, but I believe Treasury just did it themselves (bought GM/bought FRE/bought FNMA, etc...)

I dont see the Fed doing anything where it could be looked at in hindsight that they "lost money". So you see the Fed even in the QEs trying to "get the best price for the taxpayer" (ie buy low/sell high which actually raises interest rates when the stated policy is to reduce interest rates).

I think Bob Roddis is correct here and 'smells a rat' whereby these elites wish the Fed would buy stocks... I dont see it happening without a Treasury guarantee so these elites should instead start to lobby Congress...


beowulf said...

Right, you notice that its not just Tsy that has to direct the trade, but the President himself. This is for the good (the Fed's status as the fourth branch of govt is rather dubious seeing as the Constitution stopped at three branches).

Even without the Gold Reserve Act, going to Congress for TARP was unnecessary since the President's war powers are vast indeed, the International Emergency Economic Act authorizes him to (among other things)..."regulate, direct and compel, nullify, void, prevent or prohibit, any acquisition, holding, withholding, use, transfer... any property in which any foreign country or a national thereof has any interest by any person, or with respect to any property, subject to the jurisdiction of the United States".

You will all remember, of course, when we declared war on the Japanese Yakuza. No? That didn't stop President Obama from dropping the IEEA on them.

If Obama had spent more time worrying about the Federal Reserve and less time worrying about the Crazy 88s, he might have had a shot at being re-elected. Oh well.

Tom Hickey said...

Now that is a fight scene. Great acrobatics.

But the fight scenes in Japanese movies are more realistic. I was fascinated with Japanese samurai movies, which I often watched many time, and I always wanted to learn kendo. But never had a teacher handy other than a friend who was a lot more experienced than I was. Fun.

I did study Taiji sword and Kung Fu broad sword, though. The Taiji sword is formidable in a practiced hand, and aristocratic women were experts both the sword, which is light and razor sharp on both sides with a sharp tip, and also the Taiji fan.

But there is something special about those samurai swords.