Archive for December 15th, 2011

Thinking of US as a giant CDO (collateralized debt obligation)…

December 15, 2011

This blog dreads this term CDO..

But anyways here is JR Varma with a nice analogy. He points top a new paper by Hyun Song Shin delivered as the Mundell-Fleming lecture. The paper shows how European banks essentially constitute the US shadow banking system.

The paper shows how Europe has financed the sub-prime bubble :

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Making Monetary Policy Using a Mandate Dashboard

December 15, 2011

Narayana Kocherlakota of Minneapolis Fed provides an interesting way to present monetary policy decisions and outcomes in this  speech.

He says we need to make policies based on the economic outlook. How do we simplify our economic outlook? He says we could use a dashboard:

What economic conditions are relevant? Again, I think that it’s useful to think of a car driver who is trying to maintain his speed. To know how much (or how little) acceleration to provide, the driver would certainly like to know his current speed. As well, he would like to know how future road conditions—like hills—are likely to affect his future speed. The FOMC’s problem is quite similar. Just like the driver needs to know his current speed, the FOMC needs an accurate measure of current inflation and unemployment. Just as the driver needs an estimate of his future speed, based on anticipated road conditions, the FOMC should have an assessment of the future levels of inflation and unemployment.

I find it helpful to summarize the relevant information in what I term a mandate dashboard. The dashboard provides real-time readings on current and expected inflation and unemployment. Here’s what the dashboard looked like in the FOMC meeting earlier this month.

Table 1: Mandate Dashboard

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I’ll explain the dashboard starting with the inflation side. The first cell from the left is current inflation. The second cell is what inflation is projected to be in one year’s time. Finally, the third cell contains a forecast for inflation in two years’ time. The unemployment side is similar. The first cell from the left represents current unemployment. The second cell represents a forecast for unemployment in one year’s time, and the third cell is a forecast for unemployment in two years’ time.

The dashboard is based on Fed’s dual mandate. Given this how do we form the policy outlook?

Given this mandate dashboard, how should the level of accommodation evolve over time in response to changes in dashboard readings? There are many subtleties associated with providing a general answer to this question, including the key trade-off that I mentioned earlier between the two mandates. But there are two relatively common and important instances in which the mandate dashboard becomes straightforward to use in a qualitative way. Suppose inflation and expected inflation rise and unemployment and expected unemployment fall, as is often true in a recovery. Then, regardless of how it weights the two mandates, the FOMC should reduce the level of accommodation. In contrast, suppose inflation and expected inflation go down and unemployment and expected unemployment go up, as is often true when the economy slows. Then, regardless of how it weights the two mandates, the FOMC should increase the level of accommodation. 

Based on this Fed’s policies are inconsistent. In Nov-2009, forecasts for 2012 were bleak. The actual numbers in 2012 are better than forecasts and instead of lowering accommodation, Fed has increased it:

I became president of the Federal Reserve Bank of Minneapolis in October 2009. I attended my first FOMC meeting in November 2009, as a nonvoter. So, when I think about current monetary policy, I find it natural to look back at the position of the mandate dashboard at my first meeting:

Table 4: Current and Past Dashboards

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The dashboard points out that economic conditions were quite grim at that meeting. The Committee expected low inflation, and ongoing disinflation, over 2010 and 2011. Unemployment was expected to average well above 9 percent over 2010 and 2011.

The situation two years later, while hardly ideal, has improved markedly. Hence, I would say that the evolution of the dashboard readings suggests that monetary policy should be less accommodative now than it was in November 2009. But in fact, through choices dating back to last November, the Committee has made monetary policy considerably more accommodative. 

Well, unemployment numbers are worse than expected. But he is looking more closely at the inflation outlook:

How should an outside observer interpret this inconsistency between the evolution of the mandate dashboard’s readings and the Committee’s actions? Earlier in my speech, I set forth what I see as a key trade-off involved in the making of monetary policy. There is a benefit to adding monetary accommodation: It reduces unemployment. There is a cost to adding monetary accommodation: It increases the risk of inflation running above the Committee’s objective of 2 percent for multiple years. The FOMC’s actions in 2011 suggest that the Committee is now more concerned about high unemployment, and correspondingly less concerned about the possibility of higher-than-target inflation. 

In particular, the Committee’s actions in 2011 suggest that it is now more willing to tolerate higher-than-target inflation than it was in 2009. If this possible drift in inflation tolerance were to persist, or were expected to persist, it could give rise to a damaging increase in inflationary expectations. Undoing such an increase in inflationary expectations, as Americans discovered in the early 1980s, requires drastic policy steps that have extremely painful consequences for employment. It is exactly in this sense that I have said in earlier speeches that the Committee’s actions in 2011 served to weaken the Committee’s credibility.

Well, depends on how you look at it. Chicago Fed chief Evans looks more closely at unemployment and has been dissenting lately asking Fed to ease policies further. He says if inflation around 5 is untolerable (as target is around 2%), so is unemployment at 9% where the normal rate should be around 6%.

However, this dashboard approach is useful way of looking at things. Could be tried to understand things..

Meanwhile Gulzar points to this NYT article which says Fed is looking at forecasting its interest rate outlook..

The European Debt Crisis – from a Danish Perspective

December 15, 2011

Title of a new speech from Denmark Central Bank chief. Before this some background.

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