Friday, December 6, 2013

Asset Markets See the Light: No Fed Taper on the (near) Horizon

It seems that financial asset markets have lost the jitters they've been feeling for the last several weeks based on the misguided fear of an imminent Fed "taper." The jobs report which came out today had unemployment at 7%, a half a percentage point above the metric Bernanke laid out as a parameter for the current bond-buying regimen of $85 billion per month. This return to complacency following the recent hand- wringing means one of two things: either I'm highly influential and my message has gotten through, or bond and equities traders have actually decided to take the explicit policy pronouncements of the FOMC at face value. I know which option I'd like to believe.

Like I've said, short-term interest rates are going to stay low as long as unemployment remains above at least 6.5%. Bond investors have nothing to fear but a strong labor market. When the FOMC meets on Dec. 18, lets hope they give me an early Christmas present in the form of a vindicated prognostication.

Tuesday, December 3, 2013

Sumner, Krugman, Williamson, and My Two Cents

There's been a recent row in the economics blogosphere over the nature of quantitative easing, and its long-term effects on the price level. FOMC member John Williamson recently implied that quantitative easing, instead of causing inflation, instead will exert deflationary pressures on the economy in the long-run. Here's a quote: "The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen. The observation of continued low, or falling, inflation will only confirm the Fed's belief that it is not doing enough, not committed to doing that for a long enough time, or not being convincing enough."

Paul Krugman, Scott Sumner, and Nick Rowe, among others, have already jumped into the fray, with predictably intriguing discourse ensuing. 

Here's my two cents: Williamson mixed up the difference between real and nominal. Its really as simple as that. Quantitative easing, i.e. dramatically increasing the supply of base money in an economy, doesn't by definition induce asset owners to increase their real holdings of money, i.e. a great amount of purchasing power over goods and services in the form of currency or demand deposits; it by definition induces them to increase holdings of nominal balances.

Lets investigate this using some preliminary algebra. The real money supply is equal to the nominal money supply divided by the price level so that we write:

mD = MS/P

This means the real purchasing power of the money supply is equal to total amount of base dollars in the economy, i.e. paper money plus bank reserves at the Fed, divided by the price level, which is the "average" price of all output in the economy. Quantitative easing means an increase in the nominal money supply, the MS term in the above equation. Williamson has in effect postulated that for an increase in MS, mD must rise by the same amount, which implies that P must correspondingly fall to maintain the equality. What he overlooked is that just because a central bank decides to increase the supply of nominal money, asset holders do not necessarily want to hold more purchasing power in the form of money base. Instead, it is the level of prices that rises via inflation so that the newly issued money is held as real balances to keep purchasing power constant.

Monday, December 2, 2013

Memo to Skittish Bond Holders: Remember the Dual Mandate

The Federal Open Market Committee is not going to "taper," or slow the rate of its bond-purchases, in the short or medium term. The Federal Reserve Act ultimately governs the policy goals of the FOMC, and the Act contains a dual mandate to "maintain long run growth of the monetary and credit aggregates .... so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

Under Bernanke's leadership, the Committee has made an explicit commitment to maintain the bond-purchases of $85 billion per month until unemployment falls below 6.5% or inflation rises above 2.5%. Unemployment is currently running at 7.3% while headline inflation is approximating 1%.

Even the 7.3% unemployment rate is a misleading indicator of conditions in the labor market. Only Americans who are actively seeking employment are counted- the official number excludes those who have become discouraged and dropped out of the labor force due to lack of job opportunities. A more representative measure of the condition of the labor market is the civilian employment - population ratio, which peaked at 63.3% in the third quarter of fiscal year 2007 but which was 58.3% in October.

The current population of the United States is 313.9 million. If the same proportion of the population was employed today as in the third quarter of 2007, it would take the creation of another 15.695 million jobs; with that kind of employment gap and inflation average less than 1%, securities markets shouldn't expect a hike in rates nor a "taper" in quantitative easing in the near future.