The Fed and the Feds

Add an “s” to a word and it becomes plural. Simple. One JD tastes good. Two JDs taste even better. There is no real confusion. The meaning of “s” is pretty clear. The same goes for the possessive “s”. That one is Larry’s JD. The “apostrophe s” is pretty clear. That is my JD and not yours.

But add an “s” to the word Fed and you get chaos. The Fed is the Federal Reserve, the central bank of the USA. The Fed is not your typical branch of government. For years, I taught that the US Fed is independent of the US government. It is not a part of the administrative, legislative, or judicial elements of the government. Ms. Yellen and the board of the Fed make important decisions about monetary policy without approval from any of those branches. It is true that the Fed itself and its administrators are created/confirmed by the government, but once in office they pretty much do what they want to do.

If you add an "s" to Fed you get the Feds. The Feds are the government, or in this discussion today, the US Treasury Department. The Treasury carries out the financial aims of the President and Congress. When government spends more than it receives in revenues, the Treasury sells government bonds or borrows from the public. That government budget deficit is what accumulates into a large national debt when the government continually spends more than it takes in. 

The confusion between the Fed and the Feds arises because they both play in a sandbox called the bond market. The Fed buys and sells already outstanding government bonds (and a few other things) as a means to carry out its monetary policy. The Feds (the Treasury) sell brand-spanking new bonds to finance the government's annual deficits. 

There was a time when the Fed was required to buy government bonds from the Feds. But in March 1951 an agreement between the Fed and the Treasury called “The Accord” let the Fed buy Hondas. Just kidding. The Accord said the Fed could no longer buy bonds from the US government. This freed the Fed from being a lap dog to the Treasury and gave it more independence to pursue its preferred monetary policies. 1951 is also known by some as the day rock 'n' roll was born. 

What a relief to not have to buy all those government bonds. Life would be easier for the government if the Fed just printed money and gave it to the government to spend willy nilly. But the Accord said no way. The government would have to find real suckers to buy all those bonds.

Are you art history majors keeping up? Great! This story has an ending. Ms. Yellen and Treasury Secretary Mnuchin run away to Ukraine together and lived happily ever after. Just fooling with you again. But there is a conclusion here about interest rates.

While the Accord agreement prevents the Fed from buying bonds from the Treasury, it does let them buy them from Pete and Charlie. You might have read that the Fed has a ton of government bonds. Experts use fancy phrases like the “Fed’s balance sheet” but those of us who got Cs in accounting know that means the Fed owns enough bonds to paper the entire Great Wall of China. They bought those bonds because the government sold them to the public and this flood of bonds caused interest rates to rise. Since the Fed hates it when interest rates rise, they bought these bonds from the market (not from the Treasury). The Fed's intent was to stabilize the government bond market and keep interest rates lower than a limbo stick at a Gary Coleman convention. 

Thus, the Fed has a lot of government bonds despite the Accord.

What the Fed does with this gargantuan pile of bonds in weeks ahead is why I wrote all that stuff above. The Fed could simply sell the bonds. Just as you advertise that you have a rusted patio chair to sell, the Fed can let the world know it wants to sell its government bonds. Since the Fed has a lot of bonds, this announcement would send bond prices plummeting and interest rates soaring. While the Fed is looking to normalize interest rates, they don’t want them soaring. So selling a bunch of their bonds too quickly is not in the cards. 

Even if the Fed sells them gradually, markets are not stupid. There are a lot of bonds.

One smart cookie noticed that many of these bonds are maturing. That is, the Fed will receive a final payment from the government and the bonds will disappear. But that is not the whole story. Where does the Treasury get the money to pay off these maturing bonds? Since the government has a whopping deficit, it can only get the money by selling even more bonds. As they do that action, interest rates would  rise and the Fed would buy more bonds from Charlie and Pete. Hmmm – an action by the Fed to reduce its bond holding causes the Fed to hold more bonds. Dern. No cigar here.

So for sure the impact of the Fed reducing its balance sheet will be upward pressure on interest rates. Whether the Fed sells its portfolio tomorrow or the next day, whether they sell the bonds or simply not renew them, the result is the same. Higher interest rates! What is the moral of the story?

A doughnut store opened across the street, and you gained 100 pounds. Despite your protestation and decision to drink one less JD per day, you are in for quite a challenge to restore normalcy.

You can swear off doughnuts but that just makes you hungrier. So long as the store is there and you don’t like hunger, you will not lose much weight.

The government has huge deficits and debt. That’s the candy store. The Fed hates 
owning all that debt but it also hates what happens when they sell it or don’t buy more of it. That's the Fed getting fat. 

The process of returning to financial normalcy starts with a government that balances its budget. It also goes with a Fed that attends to its monetary policy goals and adheres to both the wording and spirit of the Accord. The Fed is not the problem. The Feds are the problem. If government stops having large deficits then monetary policy is easier. It won't matter if the government sells short-term bonds or long term bonds. A balanced budget means they won't be selling much of either. Ms Yellen can then go fishing. 

2% Inflation -- A Fool's Quest

I wrote a piece on January 19^th about the Fed’s 2% inflation goal mostly saying that the 2% was a ruse – a way to take your eye off the ball. The Fed wants the unemployment rate lower and the economy stronger and the low recent inflation gives them the excuse to keep their pedal to the metal.

But there is more to the story. So let’s beat on the inflation goal again but in a different way. It seems clear why the Fed might want to adjust policy so as to reduce the unemployment rate. Higher unemployment hurts people. Lower unemployment is a sign of a healthier economy. I am not saying that the Fed is good at lowering the unemployment rate, but it seems to make sense that lower unemployment might be a desirable end.

During much of my lifetime, the Fed’s main goal was to reduce pesky inflation. That seemed reasonable too. Inflation is annoying. Ask folks who lived in any country ravaged by 100% inflation. Inflation hurts. Even when inflation hits 5-10% per year few of us like that. But the Fed tossed all that out lately. Their goal is to raise inflation. What? Why would they want to do that?

The answer has nothing to do with inflation or prices. The answer is that low prices might be an indicator of flagging or deficient national demand for goods and services. Influencing sagging spending makes sense but if you are concerned about low aggregate demand then why doesn’t the Fed come clean and say it is trying to raise AD? The answer is that AD is like love. Love is not directly measurable. Does she love me or does she not? We are always guessing about such things. If you want to know if someone loves you then you look at behavior. Apparently the Fed thinks it can look at measured prices to know what is happening to AD.

The problem with looking at inflation to gauge AD is that it simply is not very good for that purpose. For one thing, inflation reflects aggregate supply (AS) as well as AD.  When inflation falls because of increases in AS – then the Fed should not be reacting to that. So if the Fed has no direct measures of love or AD or AS, then inflation can be a dangerous and misleading indicator. When inflation falls is it because AD went down or because AS went up?  It is hard to know and reflexively presuming AD and inflation are the same thing has frequently led to grave policy errors and unnecessary economic suffering.

A second important problem with using inflation as a measure of AD is that inflation is like Steve Martin – wild and crazy. Inflation measures jump around like a kid on a red ant hill. Below I use some inflation data to make my point. The Fed might as well use lighting strikes to measure AD…it is a fool’s game to use inflation numbers.

My measures of inflation today are called implicit price deflators for GDP.  They are published by the Bureau of Economic Analysis and found at bea.gov with the various GDP statistics. Notice in the detailed table below there are inflation numbers for 2014 and 2015 for every component of GDP. This is a very comprehensive measure. It is broader than the consumer price index since it includes inflation rates of prices for things like plant, equipment, and exports. The closest thing to the CPI in this group is the deflator for personal consumption expenditures. 

I said above that inflation numbers are wild and crazy and could not possibly be good proxies for what is happening to AD or anything else. The overall index for inflation (for GDP) was 1.6% in 2014 and then 1.0% in 2015. The Fed would say that the national inflation rate fell and might be a problem if AD fell in 2015 and worsens in 2016. So far so good. But let’s look inside the wrapping of that sausage.

While the prices of consumer goods were falling by 2.9% in 2015 notice that the prices of consumer services rose by 1.9% after increasing by 2.3% in the year before. Note that the inflation of consumer services averaged those two years around 2%. Thus consumer services prices are at the Fed’s spoken limit. By the way, consumer services were approximately 65% of all consumer spending and 45% of GDP. In contrast, wild and crazy durable goods are only 13% of consumer spending and 9 % of GDP.  The durability of future inflation rates are much more associated with the heavyweight consumer services and much less influenced by wildly gyrating prices of consumer durable goods.

The GDP component we call investment includes purchases of capital goods – plant, equipment, software, buildings, and more. While consumers buy residential investment, the rest of these items are generally purchased by businesses. Notice the behavior of prices in this category. While the prices of the nonresidential portion of investment goods barely budged in 2015 (0.2%), prices of newly produced residences rose by 2% after rising by 6% the year before. Finally look at the behavior of both import and export goods.  Prices fell in those categories by 7-8% in 2015 after being pretty flat in 2014.

When you read the first line of the table and see that the US inflation rate fell to 1% in 2015 one might get the impression that the prices of most or all goods and services followed in lock step and somehow national AD must be on the decline. But this could be very misleading since the average masks a lot of different and conflicting changes – each one having a very different implication for AD or AS. Clearly spending on the biggest part of GDP, consumer services, was strong enough to put inflation of consumer prices at the Fed’s goal value. If you add prices of new residences, you get the same result – healthy enough spending to put inflation at 2%.

So what causes the impression that inflation is falling? Clearly sectoral issues that may or may not be AD in origin make the results very muddy. For example, prices of consumer nondurable goods retreated because of gasoline prices. Lower gasoline prices, however, should give consumers more money to spend on other items. Prices of imports and exports figured into much lower prices of those categories. Again, how much do these international changes reflect ongoing AD issues that our within our sphere of influence?

A closer look at inflation numbers suggests a mixture of temporary changes in highly volatile sectors and a mixture of AD and AS impacts. They paint a very unclear picture of how national AD is changing and a poor clue as to what will happen to inflation and AD in the future. The Fed should stop talking about inflation and be more honest about its true goal. The Fed has become Supergirl of modern times. Even the tiniest worry about unemployment or economic weakness sends the Fed into action. This was never the intention of the framers of the Federal Reserve Act and ignores all of the unintended negative impacts and imbalances that such policies have shown time and again.

Table. Inflation as measured by changes in

implicit price deflators of GDP

                                     2014  2015

Gross domestic product	1.6	1.0
Personal consumption	1.4	0.3
Goods	-0.4	-2.9
Durable goods	-2.3	-2.1
Nondurable goods	0.6	-3.3
Services	2.3	1.9
Investment	1.8	0.6
Fixed investment	1.9	0.6
Nonresidential	1.0	0.2
Structures	1.5	-0.5
Equipment	0.7	0.7
IP products	0.9	0.0
Residential	6.1	2.0
Net exports	na	na
Exports	0.1	-4.9
Goods	-0.7	-6.8
Services	1.9	-0.6
Imports	-0.2	-7.7
Goods	-0.5	-8.9
Services	1.2	-1.7
Government	1.8	0.2
Federal	1.6	0.7
National defense	1.4	0.2
Nondefense	2.0	1.4
State and local	1.9	0.0