Today's Moment Of Lunatic Insight Comes From Bill Dudley: "Fed Not To Blame For Emerging Market Inflation"

Tyler Durden's picture

Former Goldman managing director, and current uberhead of the Fed Ponzi extend and pretend efforts, Bill Dudley, gets the prize for today's moment of lunatic brilliance. Some choice quotes from a speech delivered to the NYU Stern Busines School:

  • Fed is not an exporter of inflation and not to blame for inflation in emerging markets
  • It would be unwise for the Fed to overreact to recent commodity price pressures
  • Current Fed policy is in the interest of the world's economy
  • Rates likely to stay low for extended period
  • Several areas of vulnerability for US economy, and sees need to be ever watchful for any price bubbles

Full deranged ramblings (link):

Remarks at New York University's Stern School of Business, New York City

It is a pleasure to have the opportunity to speak
here today. My remarks will focus primarily on two areas. First, what is
the outlook for economic activity, employment and inflation? In
particular, what are the areas of vulnerability that we should be most
concerned about? Second, what does the outlook imply for monetary
policy? As always, what I will say reflects my own views and opinions,
not necessarily those of the Federal Open Market Committee (FOMC) or the
Federal Reserve System.

In my talk, I'll argue that the economic outlook has improved
considerably. Despite this, we are still very far away from achieving
our dual mandate of maximum sustainable employment and price stability.
Faster progress toward these objectives would be very welcome and need
not require an early change in the stance of monetary policy.

However,
I'll also focus on some issues with respect to inflation that will
merit careful monitoring. In particular, we need to keep a close watch
on how households and businesses respond to commodity price pressures.
The key issue here is whether the rise in commodity prices will unduly
push up inflation expectations.

Inflation expectations are
well-anchored today and we intend to keep it that way. A sustained rise
in medium-term inflation expectations would represent a threat to our
price stability mandate and would not be tolerated.

Turning first
to the economic outlook, the situation looks considerably brighter than
six months ago. On the activity side, a wide range of indicators show a
broadening and strengthening of demand and production. For example, on
the demand side, real personal consumption expenditures rose at a 4.1
percent annual rate during the fourth quarter. This compares with only a
2.2 percent annual rate during the first three quarters of 2010
(Chart 1).
Orders and production are following suit. For example, the Institute of
Supply Management index of new orders for manufacturers climbed to 67.8
in January, the highest level since January of 2004 (Chart 2).

The
revival in activity, in turn, has been accompanied by improving
consumer and business confidence. For example, the University of
Michigan consumer sentiment index rose to 77.5 in February, up from 68.9
six months earlier (Chart 3).

Indeed,
the 2.8 percent annualized growth rate of real gross domestic product
(GDP) in the fourth quarter may understate the economy's forward
momentum. That is because real GDP growth in the quarter was held back
by a sharp slowing in the pace of inventory accumulation. The revival in
demand, production and confidence strongly suggests that we may be much
closer to establishing a virtuous circle in which rising demand
generates more rapid income and employment growth, which in turn
bolsters confidence and leads to further increases in spending. The only
major missing piece of the puzzle is the absence of strong payroll
employment growth. We will need to see sustained strong employment
growth in order to be certain that this virtuous circle has become
firmly established.

With respect to the labor market, there are
conflicting signals. On one hand, the unemployment rate has fallen
sharply over the past two months, dropping to 9.0 percent from 9.8
percent two months earlier (Chart 4).
This is the biggest two-month drop in the unemployment rate since
November of 1958. On the other hand, payroll employment gains have
remained very modest—rising by only 83,000 per month over the last three
months (Chart 5). Such modest payroll growth is not consistent with a sustained drop in the unemployment rate.

The
true story doubtless lies somewhere in between—but probably more on the
side of the household survey that tracks unemployment. That is because
measured payroll employment growth in January was probably temporarily
depressed by unusually bad winter weather. Although some of the recent
decline in unemployment is due to a drop in the number of people
actively seeking work, the household survey does show a pick-up in
hiring. Other labor market indicators, such as initial claims and the
employment components of the ISM surveys for manufacturing and
nonmanufacturing, have also shown improvement recently
(Chart 6 and Chart 7), which suggests that the weakness in payroll growth is the outlier.

Although
there is uncertainty over the timing and speed of the labor market
recovery, I do expect that payroll employment growth will increase
considerably more rapidly in the coming months. We should welcome this. A
substantial pickup is needed. Even if we were to generate growth of
300,000 jobs per month, we would still likely have considerable slack in
the labor market at the end of 2012.

In monitoring employment
trends, we also need to recognize that the data are likely to be quite
noisy on a month-to-month basis. This is particularly the case during
the winter months, when weather can play an important role. Recall, for
example, the aftermath of the blizzard of 1996 in the Northeast when the
February payroll employment count was originally reported as rising by
705,000 workers. It will be important not to overreact to monthly data
but to focus on the underlying trend.

So why is the economy
finally showing more signs of life? In my view, the improvement reflects
three developments. First, household and financial institution balance
sheets continue to improve. On the household side, the saving rate,
which moved up sharply in 2008 and 2009, appears to have stabilized in
the 5 percent to 6 percent range. Meanwhile, debt service burdens have
fallen sharply to levels that prevailed during the mid-1990s. Debt
service has been pushed lower by a combination of debt repayment,
refinancing at lower interest rates and debt write-offs (Chart 8).
Financial institutions have strengthened their balance sheets by
retaining earnings and by issuing equity. For many larger institutions, a
release of loan loss reserves has been important in supporting
earnings. Credit availability has improved somewhat as very tight
standards start to loosen (Chart 9). As a result, some measures of bank credit are beginning to expand again
(Chart 10).

Second,
monetary policy and fiscal policy have provided support to the
recovery. On the monetary policy side, the unusually low level of
short-term interest rates and the Federal Reserve's large-scale asset
purchase programs (LSAPs) have fostered a sharp improvement in financial
market conditions. Since August 2010, for example, when market
participants began to anticipate that the Federal Reserve would initiate
another LSAP, U.S. equity prices have risen sharply and credit spreads
have narrowed (Chart 11 and Chart 12).
Long-term interest rates have moved higher after initially declining,
but this does not appear troublesome as it primarily reflects the
brightening economic outlook.

On the fiscal side, the economy has
been supported by the shift in policy toward near-term accommodation. In
particular, the temporary reduction in payroll taxes is providing
substantial support to real disposable income and consumption. This
could have a particularly strong impact on growth during the first part
of the year.

Third, growth abroad—especially among emerging market
economies—has been strong and this has led to an increase in the demand
for U.S.-made goods and services. Over the four quarters of 2010 real
exports rose 9.2 percent (Chart 13). After a disappointing performance earlier in the year, U.S. net exports surged in the fourth quarter (Chart 14).

The firming in economic activity, in short, is due both to natural healing and past and present policy support.

In
this regard, it important to emphasize that we did expect growth to
strengthen. We provided additional monetary policy stimulus via the
asset purchase program in order to help ensure the recovery did regain
momentum. A stronger recovery with more rapid progress toward our dual
mandate objectives is what we have been seeking. This is welcome and not
a reason to reverse course.

We also have to be careful not to be
overly optimistic about the growth outlook. The coast is not completely
clear—the healing process in the aftermath of the crisis takes time and
there are still several areas of vulnerability and weakness. In
particular, housing activity remains unusually weak and home prices have
begun to soften again in many parts of the country (Chart 15 and
Chart 16).
State and local government finances remain under stress, and this is
likely to lead to further fiscal consolidation and job losses in this
sector that will offset at least a part of the federal fiscal stimulus (Chart 17).
And we cannot rule out the possibility of further shocks from abroad,
whether in the form of stress in sovereign debt markets or geopolitical
events. Higher oil prices act as a tax on disposable income, and the
situation in the Middle East remains uncertain and dynamic. Also, we
cannot ignore the risks stemming from the longer-term fiscal challenges
that we face in the United States.

But in the near-term, the most
immediate domestic problems may recede rather than become more
prevalent. On the housing side, stronger employment growth should lead
to increased household formation, which should provide more support to
housing demand. And anxieties about the large overhang of unsold homes
represented by the foreclosure pipeline may overstate the magnitude of
the excess supply of housing. Families that have lost their homes
through foreclosures are likely to seek new homes as their income
permits, even though many may re-enter the housing market as renters
rather than buyers. On the state and local side, a rising economy should
boost sales and income tax revenue and help narrow near-term fiscal
shortfalls.1

Moreover,
although we do need to remain ever-watchful for signs that low interest
rates could foster a buildup of financial excesses or bubbles that
might pose a medium-term risk to both full employment and price
stability, risk premia on U.S. financial assets do not appear unduly
compressed at this juncture.

On the inflation side of the ledger,
there are some signs that core inflation is now stabilizing. However,
both headline and core inflation remain below levels consistent with our
dual mandate objectives—which most members of the FOMC consider to be 2
percent or a bit less on the personal consumption expenditures (PCE)
measure.

Recent evidence shows that the large amount of slack in
the economy has contributed to disinflation over the past couple of
years. This can be seen in the steady decline in core inflation between
mid-2008 and the end of 2010. As shown in Chart 18,
core PCE inflation in December had risen at just 0.7 percent on a
year-over-year basis, down from 2.5 percent in mid-2008. Slack in our
economy is still very large, and this will continue to be a factor that
acts to dampen price pressures.

Nevertheless, there are several
reasons why we need to be careful about inflation even in an environment
of ample spare capacity. First, commodity prices have been rising
rapidly (Chart 19).
This has already increased headline inflation relative to core
inflation, and the commodity price changes that have already taken place
will almost certainly continue to push the headline rate on
year-over-year basis higher over the next few months. Second, some of
this pressure could feed into core inflation. Third, medium-term
inflation expectations have recently risen back to levels consistent
with our dual mandate objectives (Chart 20).
If medium-term inflation expectations were to move significantly higher
from here on a sustained basis, that would pose a risk to inflation
and, thus, would have important implications for monetary policy.

With respect to the inflation outlook, I think there are four important questions that deserve attention.

  1. How
    much slack is there in the economy? In other words, how fast can the
    economy grow for how long until the economy is close to full employment?
  2. Are
    there speed-limit effects on inflation? In other words, could inflation
    rise because the rate of economic growth was unusually high, even
    though plenty of slack remained in the economy?
  3. Given the
    emergence of such economies as China and India, can commodity price
    pressures be safely ignored as temporary “noise” in terms of the
    long-term inflation outlook or are these pressures likely to prove
    persistent? If commodity price pressures persisted, this could undercut
    one rationale for focusing on core measures of inflation—the argument
    that core measures are better predictors of future headline inflation
    than today's headline rate.
  4. What can the Federal Reserve do to ensure that inflation expectations stay well-anchored?

With
respect to the first question, the economy retains a very large amount
of slack by virtually all measures. For example, last month the
industrial capacity utilization rate was 76.1 percent. This compares
with a long-term average of 80.9 percent (Chart 21).
Similarly, the current unemployment rate of 9 percent is well above
most estimates of the non-accelerating inflation rate of unemployment
(NAIRU)—the lowest rate of unemployment consistent with sustained price
stability.

In the pre-crisis period, the NAIRU was likely in the
region of 4.5 percent to 5 percent. There are several reasons why the
NAIRU may now be higher. First, extended unemployment compensation
benefits create incentives for prospective workers to keep looking for
better jobs rather than accept less attractive positions. Empirical work
on this subject suggests that the NAIRU might currently be roughly 1
percentage point higher because of this factor. However, this effect
will only persist for as long as the extended benefits are in place.

Second,
the rise in unemployment has been associated with an increase in the
degree of mismatch between unemployed workers' job skills and available
job vacancies. Some cite the upward shift in the Beveridge curve, which
illustrates the relationship between unemployment and job vacancies (Chart 22), as evidence of this effect.

Third,
the longer that people are unemployed, the more their skills tend to
atrophy, which makes it harder for them to become employed in the
future. For unemployed workers, the median duration of unemployment has
climbed and a growing proportion of the unemployed has been jobless for
long periods (Chart 23).

In
my view, these last two factors have probably pushed up the NAIRU by
0.5 to 1 percentage point on top of the about 1 percentage point effect
of extended unemployment benefits, which is likely to be a temporary
effect. Taken together, this suggests that the current NAIRU might be
between 6 percent and 7 percent.

Although undesirable, this rise
should not create concern about the medium-term inflation outlook.
First, even the higher estimate of NAIRU is still far below the current
unemployment rate of 9 percent. Second, as discussed above, much of this
rise is likely to be temporary rather than permanent. As the labor
market improves, the extension of unemployment claims benefits will
almost certainly be allowed to lapse. When this occurs, the NAIRU is
likely to drop back to somewhere in the region of 5 percent to 6
percent.

Third, some of the evidence that the NAIRU has increased
is not particularly compelling. For example, the loop in the Beveridge
curve that is evident now has been seen in past business cycles—cycles
in which there was no persistent rise in the NAIRU. This strongly
suggests that the rise in job mismatch has a cyclical component. Fourth,
the 9 percent unemployment rate may understate the amount of labor
market slack. That is because the labor participation rate has fallen
sharply.

In my view, the large gap between the current
unemployment rate and the long-run NAIRU suggests there is little payoff
from investing much energy to more precisely estimate the NAIRU. As the
economy expands and the unemployment rate falls, we will have plenty of
time to be able to refine our estimates of NAIRU in light of what
happens to labor cost trends such as the employment cost index, and to
unit labor costs. Currently, all these measures are quiescent and
consistent with a large amount of labor market slack (Chart 24).

The
second question is whether the economy could grow so fast that
inflation pressures could rise even with an unemployment rate still well
above the NAIRU. The notion is that at very fast growth rates wages and
prices might have to rise in order to funnel labor and capital to those
areas where demand and output were rising particularly rapidly.

Although
this possibility shouldn't be ruled out, we should not be too worried
about this, particularly if growth is broadly based. In particular, the
economy is not growing quickly right now relative to past recoveries.
For example, in the rebound from the comparably deep early 1980s
recession, the annualized growth rate exceeded 7 percent for five
consecutive quarters. Moreover, empirically there is little historical
evidence that discontinuous “speed limit” effects play a significant
role in influencing inflation in the United States.

The third
issue is whether the rise in commodity prices will turn out to be
persistent and, if so, how this might impact the inflation outlook.
Recently, commodity prices have risen sharply. For example, the spot
GSCI—a broad measure of commodity prices—has risen more than 35 percent
over the past year. This was in train before the upheavals in the Middle
East raised market concerns about potential disruption to oil supplies,
pushing energy prices—though not other commodity prices—still higher.
Commodity price pressures are pushing measures of headline inflation
above measures of core inflation, which exclude food and energy prices.
How worried should policymakers be about this development?

Although
there have been commodity price cycles in the past, commodity prices
have not consistently increased relative to other prices, and indeed
have declined in relative terms over the very long term. Historically,
if commodity prices rose sharply in a given year, it has been reasonable
to expect that these prices would stabilize or fall within a year or
two. This property has been important because it has meant that measures
of current “core” inflation, rather than current headline inflation,
have been more reliable in predicting future headline inflation rates.

In contrast, over the past decade, commodity prices generally have been on an upward trend. For example, as shown in
Chart 25,
fuel prices have generally been in a rising trend since 1999 and
non-fuel prices since 2001—both trends interrupted temporarily by the
financial crisis.

Setting to one side the near-term effects of
geopolitical developments, the rapid urbanization and industrialization
of nations such as China and India could be generating an ongoing
secular rise in commodity prices that might not be fully captured in
today's spot and futures market prices. If so, this would undercut the
role of core inflation as a good predictor of future headline inflation.

Nevertheless,
there are important mitigating factors that suggest that it would be
unwise for the Federal Reserve to over-react to recent commodity price
pressures. First, despite the general uptrend, some of the recent
commodity price pressures are likely to be temporary. In particular,
much of the most recent rise in food prices is due to a sharp drop in
production caused by poor weather rather than a surge in consumption (Chart 26).
More typical weather and higher prices should generate a rise in
production that should push prices somewhat lower. This is certainly
what is anticipated by market participants, as shown in Chart 27.

Second,
even if commodity price pressures were to prove persistent, the U.S.
situation differs markedly from that of many other countries. Relative
to most other major economies, the U.S. inflation rate is lower and the
amount of slack much greater.

Moreover, for the United States, commodities represent a relatively small share of the consumption basket (Chart 28).
This small share helps to explain why the pass-through of commodity
prices into core measures of inflation has been very low in the United
States for several decades.

Third, the Federal Reserve's success
in anchoring inflation expectations has also been important in limiting
pass-through. Since 1984, for example, when the Federal Reserve began to
achieve success in driving down and then subsequently anchoring
long-term inflation expectations, there has been very little evidence of
commodity price pass-through into core inflation. In contrast, prior to
1984, when inflation expectations were much less well-anchored,
pass-through did occur and, at times, played an important role in
pushing underlying inflation higher.

This leads to our final issue—the importance of inflation expectations in shaping the inflation outlook.

Rising
inflation expectations tends to push up inflation in a number of
ways—by reducing the expected cost of borrowing at a given level of
interest rates, by pulling forward buying decisions to beat future
expected price increases, and by encouraging more aggressive price and
wage setting behavior. In a world of unanchored inflation expectations,
commodity price pressures would more easily be passed through into core
inflation.

Fortunately, inflation expectations remain
well-anchored. This can be seen in all three major measures of inflation
expectations. First, market-based measures of inflation expectations
are generally well-behaved. For example, the five-year forward measure
of breakeven inflation generated from differences in the nominal
Treasury yield curve and the TIPS yield curve has shown a modest rise
since mid-2010 back into the range that has generally been in place for
the past decade (Chart 29). Second, the long-term inflation expectations of professional forecasters have been very stable. As shown in Chart 30,
the median long-term inflation forecast in the Professional
Forecasters' survey remains around 2.1 percent for the PCE deflator. In
terms of household expectations, there has been an increase in
short-term expectations. This typically occurs when commodities such as
gasoline go up sharply in price. However, even here longer-term
expectations remain well-anchored. As shown in Chart 31,
the University of Michigan median five-year inflation expectations
measure remains around 2.9 percent—comfortably within its normal range
and historically consistent with slightly lower realized inflation.

To
summarize the main points, we have a considerable amount of slack,
little evidence of discontinuous speed limit effects, and little
inflation pass-through from commodities into core inflation when
inflation expectations are well-anchored, which is currently the case.
This suggests that the biggest risk in terms of higher underlying
inflation over the next year or two is that inflation expectations could
become unanchored. This might occur, for example, if there were a loss
of confidence in the ability and/or willingness of the Federal Reserve
to tighten monetary policy in a timely way in order to keep inflation in
check.

In this regard, the proof of the pudding will be in our
actions—talk is cheap. What is key—that the appropriate policy steps are
taken in a timely manner.

However, let me make two points. First,
I am very confident that the enlarged Federal Reserve balance sheet
will not compromise our ability to tighten monetary policy when needed
consistent with our dual mandate goals. Second, I am equally confident
that no one on the FOMC is willing to countenance a sustained rise in
either inflation expectations or inflation.

Let me explain why our
enlarged balance sheet does not compromise our ability to tighten
monetary policy. Although our enlarged balance sheet has led to a sharp
rise in excess reserves in the banking system, this has the potential to
spur inflation only if banks lend out these reserves in a manner that
generates a rapid expansion of credit and an associated sharp rise in
economic activity. The ability of the Federal Reserve to pay interest on
excess reserves (IOER) provides a means to prevent such excessive
credit growth.

Because the Federal Reserve is the safest of
counterparties, the IOER rate is effectively the risk-free rate. By
raising that rate, the Federal Reserve can raise the cost of credit more
generally. That is because banks will not lend at rates below the IOER
rate when they can instead hold their excess reserves on deposit with
the Fed and earn that risk-free rate. In this way, the Federal Reserve
can drive up the rate at which banks are willing to lend to more risky
borrowers, restraining the demand for credit and preventing credit from
growing sufficiently rapidly to fuel an inflationary spiral.

For
this dynamic to work correctly, the Federal Reserve needs to set an IOER
rate consistent with the amount of required reserves, money supply and
credit outstanding needed to achieve its dual mandate of full employment
and price stability. If the demand for credit were to exceed what was
appropriate, the Federal Reserve would raise the IOER rate—pushing up
the federal funds rate and other short term rates—to tighten broader
financial conditions and reduce demand.2
If the demand for credit were insufficient to push the economy to full
employment, then the Federal Reserve would reduce the IOER rate—pushing
down the fed funds rate and other short term rates—to ease financial
conditions and support demand, recognizing that the IOER rate cannot
fall below zero. While the mechanism is different, the basic approach is
very similar to the way the Federal Reserve has behaved historically.

Although
our ability to pay interest on excess reserves is sufficient to retain
control of monetary policy, it is not bad policy to have both a “belt
and suspenders” in place. As a result, we have developed means of
draining reserves to provide reassurance that we will not—under any
circumstance—lose control of monetary policy. These include reverse repo
transactions with dealers and other counterparties, auctions of term
deposits for banks, or securities sales from the Fed's portfolio.

A
related concern is whether the Federal Reserve will be able to act
sufficiently fast once it determines that it is time to raise the IOER.
This concern reflects the view that the excess reserves sitting on
banks' balance sheets are essentially “dry tinder” that could quickly
fuel excessive credit creation and put the Fed behind the curve in
tightening monetary policy.

In terms of imagery, this concern
seems compelling—the banks sitting on piles of money that could be used
to extend credit on a moment's notice. However, this reasoning ignores a
very important point. Banks have always had the ability to expand
credit whenever they like. They didn't need a pile of “dry tinder” in
the form of excess reserves to do so. That is because the Federal
Reserve's standard operating procedure for several decades has been a
commitment to supply sufficient reserves to keep the fed funds rate at
its target. If banks wanted to expand credit that would drive up the
demand for reserves, the Fed would automatically meet that demand by
supplying additional reserves as needed to maintain the fed funds rate
at its target rate. In terms of the ability to expand credit rapidly, it
makes no difference whether the banks have lots of excess reserves on
their own balance sheets or can source whatever reserves they need from
the fed funds market at the fed funds rate.3

So
we have the means to tighten monetary policy when the time comes, but
do we have the will? I think there should be no doubt about this. It is
well understood among all the members of the FOMC that allowing
inflation to gain a foothold is a losing game with large costs and few,
if any, benefits.

In this regard, some have argued that Fed
officials might be reluctant to raise short-term rates because such
increases would squeeze the net interest margin on the Fed's System Open
Market Account (SOMA) portfolio. Although it is true that a rise in
short-term interest rates would reduce the Fed's net income from the
extraordinary high levels seen in 2009 and 2010,4 this will not play a significant role in the Fed's monetary policy deliberations.

Fed
policy is driven by the objectives set out in the dual mandate, and the
net income earned by the Fed is the consequence of the policy choices
that advance those objectives. The Federal Reserve's net income
statement does not drive or constrain our policy actions. In short, we
act as a central bank, not an investment manager.

It is also worth
pointing out in passing that a failure to raise short-term interest
rates at the appropriate moment based on our dual mandate objectives
would also be a losing strategy with respect to net income. Inflation
would climb, bond yields would rise and the Fed would ultimately be
forced to raise short-term rates more aggressively, or to sell more
assets at lower prices to regain control of inflation. This would almost
certainly result in larger reductions in net income than a timelier
exit from the current stance of monetary policy. So what does this all
imply for monetary policy? First, barring a sustained period of economic
growth so strong that the economy's substantial excess slack is quickly
exhausted or a noteworthy rise in inflation expectations, the outlook
implies that short-term interest rates are likely to remain unusually
low for “an extended period.” The economy can be allowed to grow rapidly
for quite some time before there is a real risk that shrinking slack
will result in a rise in underlying inflation. We will learn more as we
go, and, as always, should be prepared to adjust course in a timely
manner if incoming information suggests a different strategy would
better promote our objectives.

Second, the Federal Reserve needs
to continue to communicate effectively about its objectives, the
efficacy of the tools it has at its disposal to achieve those
objectives, and the willingness to use these tools as necessary. This is
important in order to keep inflation expectations well-anchored. If
inflation expectations were to become unanchored because Federal Reserve
policymakers failed to communicate clearly, this would be a
self-inflicted wound that would make our pursuit of the dual mandate of
full employment and price stability more difficult. If we consistently
and effectively communicate our objectives and our strategies, we can
avoid this outcome.

Thank you for your kind attention. I would be happy to take a few questions.

And some lunatic charts