Put on Your Economic Thinking Caps

[Phrak]

CBS New, Los Angeles, 4:20 AM 1/7/09: "The Federal Reserve announces, the rate of inflation is uncomfortably low."

What does this mean? Why was this announced--what is the intent? How does this relate to the last 14 years of economic changes?

For those interested in future economic devolopments, I think this is a good place to both ask the relevant questions (For this rather interesting statement, did I ask them all?) and answer them too.

Please, please, no politics!

Any ideas?

 

[Astronuc]

I think the low inflation implies a concern over deflation, i.e. capital (investments, home/real estate) actually loses value.

If this also coincides with lower wages, there will be less consumption, which is about 2/3's of the US economy. One could ask, is an economy based on consumption and heavily weighted to services inherently sound?

There is also tighter credit, which will dissuade consumption.

Deflation can lead to a spiral downward in economic activity.

What is the incentive to invest now and in the future?

In what should investors be investing? Energy? Renewable energy (e.g. wind, solar, geothermal, biomass, . . . )?

I can think of lots of questions based depending on how general or specific the criterion.

 

[TheStatutoryApe]

In what should investors be investing? Energy? Renewable energy (e.g. wind, solar, geothermal, biomass, . . . )?

The current trend seems to be debt management. Wether or not one can invest in this I have no idea. :-/

 

[DrClapeyron]

It may mean many things. As pointed out it may indicate a coming period of deflation. It may also indicate a lower than projected income level which alters fiscal policy (lack of tax $) which will increase the debt to equity ratio as prices and income do not rise faster than accumalting debt and may result in decrease investment.

 

[russ_watters]

What is the incentive to invest now and in the future?

In what should investors be investing? Energy? Renewable energy (e.g. wind, solar, geothermal, biomass, . . . )?

Given the performance of the stock market over the past six months, I think a generic stock-based mutual fund (say, an S&P index fund) would be the obvious choice.

 

[russ_watters]

CBS New, Los Angeles, 4:20 AM 1/7/09: "The Federal Reserve announces, the rate of inflation is uncomfortably low."

Could you provide a link so we can read the quote in context? It's tough to respond to your questions without it. And pasting that quote into google yields only this thread.

 

[mheslep]

CBS New, Los Angeles, 4:20 AM 1/7/09: "The Federal Reserve announces, the rate of inflation is uncomfortably low."

What does this mean? Why was this announced--what is the intent? How does this relate to the last 14 years of economic changes?...

The Federal Reserve chairman thought the topic of deflation worthy of an entire speech back in 2002, which included the consequences of deflation and his recommended actions should it ever occur. That would tend to explain the Fed's specific mention of it recently.
http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

Consequences:

...First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be.3 To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. ..

Japan's deflation is treated, to contrast why it wouldn't happen here. Oops.

...
Japan
The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems,

Edit: an especially relevant blurb in that speech for those watching the mortgage rates drop since October and looking to refi or buy a home:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.
...
A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Sure enough, the rates for all long term mortgages fell today, after starting to level off or even creep back up before today.

 

[mheslep]

Could you provide a link so we can read the quote in context? It's tough to respond to your questions without it. And pasting that quote into google yields only this thread.

http://www.federalreserve.gov/monetarypolicy/fomcminutes20081216.htm

...indeed some members saw significant risks that inflation could decline and persist for a time at uncomfortably low levels.

 

[Phrak]

Thank you for the exact quote mheslep! and the link, good work. I rolled out of bed open the thread, so I was a bit concerned.

"Moreover, inflation would continue to fall, reflecting both the drop in commodity prices that had already occurred and the buildup of economic slack; indeed some [FOMC] members saw significant risks that inflation could decline and persist for a time at uncomfortably low levels."

(The Federal Reserve Bank's Federal Open Market Committee (FOMC) are the boy, who by buying end selling interest rate instruments such as Treasury Bills, manipulate the interest rates which FRB member banks lend money overnight to other member banks. This has a far reaching effect on lending rates overall. The quoted "prime rate", that has more than often lately meant the interest rate quoted in the WSJ, is the ~average overnight rate that member banks are currently charging, plus 3%. "Members" refers to representatives of FRB branch banks, whether the branch is currently represented on the committee or not. They serve in rotation, but all attend.)

The contex insisted by Watter becomes an issue. This wasn't a banner item, but buried in a report. And some suprizingly cognant reporter at CBS managed to fish it out. So it's hard to read: Was it in there to create an effect, or was it there because it's true, both, or neither?

 

[Phrak]

..."suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally."[\quote]

The current FRD inter-member bank rate stands at 0.25% according Wikipedia. When Japan hit zero they legislated forced lending, didn't they?

With this quote you've identify the crux of the problem. I ask around at work today, "What's economically wrong with deflation; how is that a bad thing?" No one knew. Your quote makes it apparent.

Given the 10% deflation senario, I could choose to ether lend someone money at 0%, with the associated risks, and obtain an effective 10% real value increase in returned funds. Or I could choose to stuff it in a matress, with less risk, and still get an effective 10%. So I have to charge more to overcome risk. So, deflation has the effect of increasing effective interest rates. The lending market, and those in need of it, crap out. This seems to generate a positive feedback--do you think?

 

[misgfool]

Any ideas?

Printing money solves the deflation issue.

 

[mheslep]

Printing money solves the deflation issue.

That is the first step for the Fed but it is not guaranteed to work, as seen when you read Benanke's 2002 speech. Look at the details of what happens when the Fed 'prints money'. Ok they print it (or more accurately, their computer credits the computer in some bank that agrees to take money from the fed). Then what? To raise prices, they have to get the money into people's hands that can spend or invest it. The fed has only indirect means to 'drop money from a helicopter', they can not directly put in into individual hands. Mostly, they rely on commercial banks to do that, and at the moment the banks are not all that cooperative, thus the additional steps described by Bernanke.

 

[misgfool]

That is the first step for the Fed but it is not guaranteed to work, as seen when you read Benanke's 2002 speech. Look at the details of what happens when the Fed 'prints money'. Ok they print it (or more accurately, their computer credits the computer in some bank that agrees to take money from the fed). Then what? To raise prices, they have to get the money into people's hands that can spend or invest it. The fed has only indirect means to 'drop money from a helicopter', they can not directly put in into individual hands.

That's were Obama's public spending plan comes in. Government buys goods and services from the private sector so the money goes directly to the economy. However, I'm concerned of the plan to give money as tax cuts, if all that money isn't spent.

Mostly, they rely on commercial banks to do that, and at the moment the banks are not all that cooperative, thus the additional steps described by Bernanke.

Don't forget that banks have to make a profit for the shareholders. They can't do that by sitting on the money.

 

[DrClapeyron]

Government buys goods and services from the private sector so the money goes directly to the economy.

That system has been running for a very long time.


http://www.henryckliu.com/page162.html

By law, the Secretary of the Treasury is the chief international monetary policy official of the United States. The Federal Reserve has separate legal authority to engage in foreign exchange operations. Federal Reserve foreign exchange operations are conducted in close and continuous consultation and cooperation with the Treasury Secretary to ensure consistency with US international monetary and financial policy.

The key to walk away from here is that monetary policy of the United States is dependent upon internation policy: who do we like and who likes us?

 

[mheslep]

That's were Obama's public spending plan comes in. Government buys goods and services from the private sector so the money goes directly to the economy. However, I'm concerned of the plan to give money as tax cuts, if all that money isn't spent.

I have been referring to monetary policy under control of the fed, not fiscal policy,

Don't forget that banks have to make a profit for the shareholders. They can't do that by sitting on the money.

They don't 'have to' make a profit, they want to do the best they can. If they decide that loaning money will lose money, then they may decide that buying up market share (other banks) and sitting on money now and then lending later is the smart move - not that the government wants the TARP money used that way.

 

[Phrak]

In what should investors be investing? Energy? Renewable energy (e.g. wind, solar, geothermal, biomass, . . . )?

If history is an example, and the last decade has tracked the 1930's very well, I don' think the FRB is going to let the stock market wip-saw the economy anytime soon in wild speculation and dramatic price changes. It was one of the reasons the FRB bank was established. I guess they needed a second lesson.

 

[misgfool]

I have been referring to monetary policy under control of the fed, not fiscal policy,

I think that the FED is able to cooperate with the government.