Author: WSJ.com: Real Time Economics

There’s no mistaking the brogue of Edmund “Ted” Kelly, the Irish-born chief executive of Liberty Mutual Group — or his views on politics and economics. The head of the Boston-based insurer has a PhD in mathematics from Massachusetts Institute of Technology and colorful ways of expressing his opinions. He talked with The Wall Street Journal about Washington’s efforts to remake financial regulation after the worst financial crisis since the Depression. An edited transcript:

What’s your main hope for financial regulation legislation?

Our hope is that they will leave us alone, particularly the property and casualty industry. We don’t create systemic risk (that can take down the financial industry). With us, if you want our money, you have to burn your house down.

But didn’t the meltdown of AIG show that insurance companies can help produce global panics?

AIG is everyone’s favorite whipping boy. But it was a remarkably well managed company, except for one unit (that mishandled derivatives). It was much better managed than many banking behemoths that were at the heart of crisis.

The bill that passed the House would ding large financial institutions to create a pool to pay for the dissolution of those financial firms whose failure would threaten the economy. Your view?

Under the House bill, we would be subject to an assessment because we are a financial services organization with more than $50 billion in assets. We have more than $100 billion.

We’re being tagged because of our size (not riskiness). There is religious theory of risk — if you have a concentration of wealth, God will find it and punish it.

Among insurers, Hartford, AIG and others received bailout funds. Should any insurer be bailed out?

I don’t think any company needs to be saved. But there has to be a way to put a company out of its misery without destroying everyone around it. Saving AIG and Hartford distorted the market. Why should someone be protected if they made a financial mistake?

It wasn’t a mistake to protect the problems AIG had with derivatives. That created a big crisis. But you could have protected that part of the business and liquidated the insurance companies to pay back (claimants).  The argument they needed to be saved it was totally specious.

Most regulatory reform plans would require systemically important financial institutions to hold much more capital. What’s your view?

Capital is not a protection against risk. It’s a way of curbing growth.

Look at Lehman Brothers. It  was well capitalized (before it collapsed).  It ran out of liquidity. In the end financial storms are caused by liquidity crises. You run out of money.

But if you’re worried about institutions being too big during crisis, constrain growth when there isn’t a crisis.

The U.S. economy will continue to recover at a healthy pace in 2010, led by strength in the business sector, helping jobs to be created from the first quarter, a panel of economists said in a report out Monday.

The National Association for Business Economics, or NABE, survey predicts the world’s largest economy will expand by 3.1% this year, close to November’s prediction that U.S. gross domestic product would rise by 3.2%. The economy is seen growing by 3.1% also in 2011.

Companies are seen playing a key role in the early part of the recovery, with higher spending on software and equipment, the survey of 48 professional forecasters showed. After the sharp drop of the last two years, business’ inventory rebuilding is also expected to lift the economy.

“We see a healthy expansion under way, although it will take time to reduce economic slack and repair damaged balance sheets,” said NABE President Lynn Reaser, chief economist at Point Loma Nazarene University. The predictions of the survey, which was carried out from Jan. 22 to Feb. 4, are in line with last month’s forecasts from the Federal Reserve and a group of banking economists. At its last meeting Jan. 26-27, the Fed projected that U.S. GDP would this year rise in a range between 2.8% and 3.5%.

The U.S. economy is recovering from its worst downturn since the Second World War. Although the nation’s output began to rise again in the second half of 2009, boosted by inventories, nearly one in 10 Americans are still without a job and prices in some sectors of the economy continued to fall in January due to low demand.

Despite scant evidence so far, NABE panelists are more optimistic in predicting the economy is already strong enough to begin creating jobs in the first quarter, compared to November’s forecast of no net change in employment. The median forecast of the survey is for an average monthly increase of 50,000 jobs in the January through March period.

January’s nonfarm payrolls fell 20,000 after a 150,000 drop in December 2009, a government report showed earlier this month. The unemployment rate, which is calculated using a separate government survey, fell to 9.7% in January from 10% the previous month.

The NABE survey expects the jobless rate to be at a still high 9.6% in the final three months of 2010, even as around 100,000 jobs are created on average each month this year.

Persistently high unemployment and recent household wealth losses should keep consumer spending sluggish, the panel of economists predicts, in line with recent NABE survey results. The savings rate, on the other hand, is likely approaching its peak. The median prediction was that it would rise to 4.8% for 2010, compared to 4.6% in the last quarter of 2009.

In a positive sign for Americans’ wealth, the panelists forecast that the stock market would continue to improve: They expect the S&P 500 Index to increase 23% overall. “Not a single forecaster is predicting a decline in stock market values,” the report notes.

Coupled with subdued inflation, weak consumer spending should give the Fed room to keep its key short-term interest rate at a record low near zero until late in the third quarter. The Fed funds target rate at which banks lend to each other overnight is seen rising to 0.75% in the final quarter of 2010, according to the NABE panelists.

Following continued improvements in financial markets, the Fed on Friday raised the rate it charges banks on emergency loans. But the central bank stressed that short-term rates on business and consumer loans are expected to stay close to zero for several more months at least to bolster the recovery.

Despite a considerable amount of slack still present in the economy, about 60% of NABE respondents said they were concerned the Fed could move “too slowly” in raising rates to keep inflation under wraps.

Turning to the housing market, the economists agreed “the housing market rebound is considered ongoing and sustainable.” They expect home prices to increase 1.6% in 2010 and 2.6% in 2011, which would mean they’d hardly keep up with inflation. The economists also expect gains in housing starts and residential investment.

The vast majority of panelists said the Fed would end its purchase of mortgage-backed securities, as scheduled, in March. They expect that winding down the program will have a “moderate effect” on mortgage rates: Three-quarters said rates will rise by half a percentage point or less.

There could be a better alternative to inflation targeting, which became all the vogue among central bankers in the last two decades but now has doubters.  Rather than target a rate of inflation, as is now custom, target a level of prices.

Price level targeting, its proponents say, would give central banks more flexibility to respond aggressively to downturns and crises without sacrificing their inflation fighting credibility. When inflation undershoots during a recession, it would allow the central bank to run the economy hot and allow inflation to overshoot for a while in a recovery.

First a little background. Many central banks now target a rate of inflation. The Federal Reserve, for instance, has an informal goal of 1.5% to 2% inflation over the long run. Targeting became popular in the 1990s and 2000s because central bankers felt it helped build their inflation fighting credibility, which anchored expectations for future inflation, kept interest rates low and helped to keep the economy robust and stable.

But there are problems with this approach. One is that it forces central bankers to lose their memory. Say inflation falls short of a 2% target one year — as it did in many places last year. A strict adherent to an inflation rate target would let bygones be bygones and continue to target 2% inflation in year two, even though the economy is coming out of recession with slack and excess capacity.

One problem with this approach is what happens to real interest rates – meaning interest rates adjusted for inflation — in a severe downturn. Say the Fed has pushed interest rates to zero and inflation goes negative in a downturn. Real interest rates – which play an important role in driving business and household decisions about spending and investing – would actually be higher. One solution to the problem would be to promise higher inflation in the future, but with a 2% inflation rate target, there’s only so much a central bank can promise without sacrificing its credibility.

Now imagine a world with the price level targeting twist. In this world, the central banker still wants inflation to average 2% over the long run. But his target isn’t the rate of inflatoin, it’s a price index, like the consumer price index.

Let’s say in year one the index is 100. Then say a shock hits in year two and inflation undershoots the target of 102 and instead comes in at 101. In year three, the target is 104 and change (in other words, it’s 102 plus a 2% inflation rate.) To get there, the central banker has to make up for the previous year’s underperformance, and has to instead deliver 3% inflation, running the economy a little hotter than normal as it comes out of recession. In this world, real interest rates would be a little bit lower than they are in the world in which inflation rates are targeted. But if the public believes the central bank is committed to its goals, the central bank doesn’t get punished for running too hot for a little while.

Kenneth Kuttner, a Williams College economist, says he used to be skeptical of the idea. But it’s starting to win him over. If you’re hit by a really bad shock, he says, “you want to get inflation expectations up” to avoid a deflationary spiral. This kind of approach, which promises more inflation after a big economic shock and less when an economy is running hot, helps to do that.

One problem with the idea is that central banks don’t have experience with it. Besides an experiment by Sweden in the 1930s, it is untested. Another is that it would be hard to explain. Bond investors are used to watching monthly readings of inflation rates and the public is used to headlines that focus on rates. Convincing the public to start focusing on some obscure index level [Trivia question: Where is the CPI index today?] would be a communications challenge for central bankers.

George Kahn, a researcher at the Federal Reserve Bank, looked at the idea and concluded central banks aren’t likely to adopt the idea “without considerable further research or a dramatic deterioration in economic performance.” http://www.kc.frb.org/PUBLICAT/ECONREV/pdf/09q3kahn.pdf

But don’t be surprised if you haven’t heard the end of this idea as the economics profession rethinks what went wrong in the great economic crackup of 2008 and 2009.

Here’s some more reading on the subject, courtesy of Professor Kuttner:

• On Sweden’s experience in the 1930s with price level targeting: www2.riksbank.com/upload/1015/98nr63.pdf
• On Canada’s flirtation with the idea: bankofcanada.ca/en/press/background_nov06.pdf
• On Wall Street’s flirtation with the idea [scroll down]: http://www.msdwd.com/views/gef/archive/2009/20090716-Thu.html
• Scholarly work on the issue: http://people.su.se/~leosven/papers/PTAR808.pdf

[ANSWER TO TRIVIA QUESTION: The price level of the consumer price index was 216.687 in January 2010, with the index set at 100 in the 1982-1984 period. That means inflation has averaged around 3% in the last quarter century.]

The February jobs report may look worse than is actually the case thanks to foul winter weather, according to a report from forecasting firm Macroeconomic Advisers.

That’s because the February blizzard, which laid feet of snow across the country and brought business to a virtual standstill across the Midwest and Northeast, kept many workers from getting to the office and likely pushed new hiring into the following month. The blizzard occurred during the periods when both the Household and Establishment Surveys were conducted, meaning it could affect both the jobs tally and the unemployment rate. Of course, those jobs would resurface in the March jobs report.

Using the January 1996 blizzard as a benchmark, Macroeconomic Advisers’ estimates that the March 5th jobs report would have 66,000 fewer jobs than it would otherwise have. However, because there was a lot more snow this month than in January 1996 – and because snow delays lasted almost an entire week in some places and occurred precisely at the time when Labor Department is taking measurements – the effect could be much bigger.

“I think it could be big – it could be 100,000″ jobs, says Joel Prakken, chairman of Macroeconomic Advisers.

Federal Reserve Bank of New York President William Dudley said Friday the increase in the discount rate done by the central bank late Thursday was “technical” in nature.

“We made a very small technical change” by raising the discount rate, Dudley said. “The action yesterday was really an action about the improvement in banks,” and reflected the fact these institutions no longer need this emergency source of cheap funding the way they did during the depths of the financial crisis, the official said.

The discount rate increase “is not at all a signal of any imminent tightening” in monetary policy, and the Fed’s commitment to keep rates very low for an extended period “is still very much in place,” Dudley said.

The central banker’s comments came in response to audience questions followed a speech he gave before the Center for the New Economy 2010 Economic Conference, in San Juan, Puerto Rico. He is the vice chairman of the interest-rate setting Federal Open Market Committee.

Dudley’s speech comes a day after the Federal Reserve boosted modestly its discount rate, which determines the cost of emergency loans made to deposit taking banks.

The action was largely symbolic in the view of economists and central bankers had suggested in advance the move was coming, framing it as a further normalization of policy.

Don’t mistake a jump in Friday’s consumer-price data as the start of an inflationary episode.

The Commerce Department is expected to say that its consumer-price index rose 0.3% in January, according to forecasters surveyed by Dow Jones Newswires, adding up to a gain of 2.8% over the past year. January’s rise would represent another modest gain from the 0.2% increase in December.

Consumer prices have staged a remarkable turnaround in the past six months after falling as much as 2% on a yearly basis last July. The increase has been largely driven by a rebound in oil prices, which cratered during the recession to around $40 a barrel. They have doubled since then, pushing gasoline prices up 54% last year and nudging up prices of other goods as well.

Those rising prices haven’t led to much inflation elsewhere. High unemployment means workers don’t have much bargaining power for wage hikes to cover rising costs — a hallmark of inflationary periods.

“If this were happening and we had a 5% unemployment rate, then I think most economists would be very worried,” says Jay Bryson, Wells Fargo Securities global economist. “Today, you just don’t have that.”

He notes that, excluding gasoline and other goods, the consumer-price index for services like rent, education and health care — which make up 60% of the total index — has fallen sharply from a recent high of 4% in mid-2008 to 0.9% as of December.

Meanwhile, even those who worry inflation could eventually take hold if the Federal Reserve doesn’t act aggressively enough to drain the system of liquidity injected during the credit crisis — its discount-rate rise notwithstanding — see little sign of that happening right away.

“That’s more an issue as we get to 2011 and beyond,”says Conrad DeQuadros, an economist with RDQ Economics. “I wouldn’t say we have a short-term fear of an inflation problem.”

If anything, the recent firming of consumer prices has helped soothe fears that the recession would lead to Japanese-style deflation in the U.S., a cycle of falling prices and wages that can be much tougher for policy makers to combat.

For now, rising prices look to be the lesser of two evils.

Economists react to the Federal Reserve’s announcement that it will raise the discount rate:

• To normalize capital markets, the Fed has to eliminate the distortions quantitative ease create and, to this end, raising the discount rate is the first of many necessary steps. The last step will be directly raising short-term markets rates, be it the Fed funds rate or the IOER [interest rate on excess reserves]. We still don’t know what will guide the Fed to do how much and when, and that is a problem. Today’s move was designed to take free arbitrage off the table rather than be any statement about the state of the economy other than that the financial system is stable enough to begin standing on its own. A stable financial system is necessary for the economy to grow but not sufficient. The minutes of the January FOMC meeting were a sober assessment of the economy giving little sense that prospects are for anything more than stable growth around 2% to 3% despite record monetary and fiscal stimulus. Given this outlook, a pace of unwind as accelerated as some FOMC members seem to want is very much unlikely. – Steve Blitz, Majestic Research

• While the increase in the discount rate came a bit earlier than we thought, it was clearly heralded by Chairman Bernanke in his testimony on February 10. … This step, in combination with the closure of most short-term liquidity programs earlier this month “is intended as a further normalization of the Fed’s lending facilities” in light of continued improvement in financial market conditions. We too would like to emphasize that the discount rate is a tool for addressing financial system stress, while the fed funds rate is a tool for addressing macroeconomic stability. … Just like easing the terms for discount window lending programs was the first response of the Fed to the crisis (in August 2007), its removal is now the first part of the exit strategy. – Harm Bandholz, UniCredit Research

• The Federal Reserve Board’s hike in the discount rate Thursday signifies a separation between credit easing and traditional monetary policy. However, it does not alter our forecast for the central bank to leave both the interest paid on reserves and the fed funds rate target unchanged until the fourth quarter of 2010. A higher discount rate makes sense, particularly since the Fed has closed many of its emergency lending facilities and demand for funding has slowed substantially. … The central bank is attempting to wean banks off government sources of liquidity. The Fed wants depository institutions to rely more on private funding markets and banks to shore up their capital the old fashioned way—by borrowing short and lending long. The recent widening of the yield curve, which reached a record earlier Thursday, should help in that regard. – Ryan Sweet, Moody’s Economy.com

• Along with the recent closure of most of the emergency liquidity facilities set up during the financial crisis, the widening of the spread between the discount rate and the upper bound of the fed funds target rate is another step in the normalisation of the Fed’s lending role. Before the crisis began, borrowers at the discount window were charged a [one percentage point] premium over the fed funds rate and could only borrow overnight. The day after Bear Stearns collapsed, that premium was slashed to [0.25 percentage point] and the maximum duration of loans was extended to 90 days. This rate hike takes the premium back up to [0.5 percentage point] and the Fed also announced that only overnight loans will be available from mid-March onwards.  – Paul Ashworth, Capital Economics

• This move is part of the removal of unconventional measures and should not be seen as a signal of a change in the Fed’s monetary policy stance. The timing of the announcement — away from an FOMC meeting and alongside the H.4.1 release of factors affecting reserve balances — was designed to reinforce this separation of the discount rate spread normalization and monetary policy. This move does not alter our view that the Fed’s first policy rate hike will come in [the first half of 2011]. – Bruce Kasman, J.P. Morgan Chase

A newly announced increase in the rate the Federal Reserve charges on emergency loans to banks does not signal any change in monetary policy but shows the central bank is moving to reverse the exceptional aid it provided amid the global financial crisis, Federal Reserve Board Governor Elizabeth Duke said Thursday.

In remarks prepared for delivery to the Economics Club of Hampton Roads in Norfolk, Va., Duke said the 0.25 percentage point increase in the discount rate isn’t expected to lead to tighter financial conditions for U.S. consumers or businesses.

The discount rate is what the Fed charges banks that need emergency cash, and that borrowing inevitably carries a stigma for the banks that need such loans.  After U.S. stock markets closed Thursday, the Fed announced it was raising the rate by a quarter-percentage point, to 0.75%.

“I’d emphasize that the changes are simply a reversal of the spread reduction we made to combat stigma and like the closure of a number of extraordinary credit programs earlier this month, represent further normalization of the Federal Reserve’s lending facilities; they do not signal any change in the outlook for monetary policy and are not expected to lead to tighter financial conditions for households and businesses,” Duke said in her prepared remarks.

Duke, a voting member of the Fed’s policy-making board, defended the Fed’s aggressive actions in the face of a financial meltdown in 2008, including its decision to lower rates to between zero and 0.25%.

In addition, Duke said she believes the Fed was right to extend emergency help to other distressed financial institutions, including insurance giant AIG and brokerage firm Bear Stearns & Co.

She said the Fed expects ” we will ultimately incur no losses on the credit we extended to support Bear Stearns and AIG.”

As Congress debates financial regulatory changes, Duke said she hopes that lawmakers ensure the Fed or some government entity “has all the tools and capabilities necessary” to meet any future crisis head-on.

More than a quarter of Americans say they are worried about losing their jobs in the next year, a new poll shows.

Some 26% of people surveyed in a February Marist Poll said they were somewhat or very concerned about losing their jobs, compared to 74% who said they were only a little or not at all worried about it.

Those who do have jobs said they were pleased with them, though. An overwhelming 88% said they were satisfied with their jobs, compared to just 12% who are dissatisfied.

On a counterintuitive note, the survey also found that more lower-paid employees were content with their jobs than higher-paid workers. Some 48% of people making less than $50,000 were very satisfied in their jobs compared to the 42% who said the same and were making $50,000 or more.

In a sign of labor market shake-ups that are still to come, 22% of employed people said they’re likely to look for a new job when the economy improves – a trend that’s likely fueled by workers who have opted for lower-skilled or lower-paying jobs to make ends-meet. People under 45 years old were about twice as likely as their older counterparts to say they’d begin job hunting when the economy starts looking better. Men were also more inclined to search for a new position.

The survey covered 1,072 Americans and has a margin of error of plus or minus three percentage points. It was conducted from Feb. 1-3.

The minutes of the January meeting of Federal Reserve policymakers, released this week, give a synopsis of what the Fed staff had to say about the gyrations in European markets over Greece and about the impact of the Chinese central bank’s efforts to restrain lending there.

On Greece: “Mounting fiscal concerns made investors more reluctant to hold debt issued by the Greek government; sovereign yields rose in Greece and, to a lesser extent, in several other countries where fiscal issues have raised concerns among investors.”

On European banks: “European financial stocks declined substantially, as early profit reports for the fourth quarter from a few banks rekindled some concerns about the health of the banking system.”

On the dollar: “The broad nominal index of the foreign exchange value of the dollar rose reportedly reflecting a growing perception that U.S. growth prospects were better than those in Europe and Japan.”

On China: “Concerns that policy tightening by China might restrain the global recovery also may have contributed to the dollar’s appreciation against many currencies late in the period.”

A roundup of economic news from around the Web.

• Should the Deficit Commission Succeed? Greg Mankiw, the Harvard economist who did a turn as George W. Bush’s economic adviser, say liberals want the new Obama commission to justify tax increases, but conservatives have a tougher choice. “You can try to stick to your no-tax-increase position. The problem is that doing so would require spending cuts larger than are politically realistic,” he notes. He offers things Republicans ought to get in exchange for giving Democrats cover on tax increase: Raise the retirement age, eliminate estate tax, impose a carbon tax, cut personal and corporate income tax rates, impose a value-added tax to shift taxation to consumption from income taxes.

• Interpreting the Baltic Dry Index: In the Financial Times, Javier Blas writes that the weakness in the Baltic Dry Index, long seen as an indicator of global economic activity, does not reflect a downturn in global trade. Instead, the measure of freight costs is showing a strong supply of new vessels that helps explain the 40% drop in three months. “New supply is astonishingly high and it is overwhelming the otherwise robust demand for bulk commodities from China,” he writes. “On the other hand, bullish investors should be cautious of any near-term turnround. Rather than a sign of stronger economic activity and commodities demand, it is likely to reflect cancelled orders, scrappage and port congestion.”

• Tracking Labor Costs: Richard McCormack, editor of a widely read manufacturing newsletter, says the Obama administration’s fiscal 2011 budget includes a seemingly small trim that would make it tougher to figure out how U.S. productivity and labor costs stack up against foreign competitors. The budget targets for elimination the $2 million International Labor Comparison program, run by the Bureau of Labor Statistics. The program, the only one of its kind in the world, according to McCormack, tracks and compares hourly compensation costs, productivity and unit labor costs, unemployment rates and consumer prices. He says the administration has decided the data doesn’t get enough use and it wants to redirect the spending to other data-collection programs.

Economists have used all manner of phrases to describe the likely economic path in 2010, predicting V, U, W or VW shaped recessions. However, an analyst at RBC Capital Markets has come up with a quintessentially British metaphor – the ‘Eddie the Eagle’ recession.

Speaking at a credit briefing this week, Simon Ballard, senior credit strategist at RBC Capital Markets, said he could see an “Eddie the Eagle type-recession” playing out, with a sharp fall, then a gentle rise, before flatlining.

Ballard isn’t the first to liken the economy to a ski jump, with short term stimulus aiding lift off. The difference with Eddie the Eagle is that there was no lift off.

For the uninitiated, Michael Edwards, better known as Eddie ‘The Eagle’ Edwards, is a former GB ski jumper who valiantly tried, and failed, in the 1988 Calgary Winter Olympics, finishing last in the two competitions he entered.

The International Olympic Committee later introduced rules which regulated who could take part in the event, so as not to have ‘The Eagle’ bring the sport into disrepute. Parallels with banking regulation, perhaps?

From Financial Muse, the new Financial News blog (www.efinancialnews.com/blog)

Most private analysts who study China think its economic recovery lost some momentum in the fourth quarter of 2009, a new poll by The Wall Street Journal shows. The finding runs counter to official statistics that indicate a recent acceleration in growth, and highlights the conflicting signals China’s economy is sending at a time when the leadership is trying to contain potential bubbles without derailing the expansion.

Read full post at China Real Time Report

The top 400 U.S. individual taxpayers got 1.59% of the nation’s household income in 2007, according to their tax returns, three times the slice they got in the 1990s, according to the Internal Revenue Service.  They paid 2.05% of all individual income taxes in that year.

In its annual update of the taxes paid by the 400 best-off taxpayers, who aren’t identified, the IRS also said that only 220 of the top 400 were in the top marginal tax bracket. The 400 best-off taxpayers paid an average tax rate of 16.6%, lower than in any year since the IRS began making the reports in 1992.

To make the top 400, a taxpayer had to have income of more than $138.8 million. As a group, the top 400 reported $137.9 billion in income, and paid $22.9 billion in federal income taxes.

About 81.3% of the income of the top 400 households came in the form of capital gains, dividends or interest, the IRS data show. Only 6.5% came in the form of salaries and wages.

Over the  past 16 tax years 3,472 different taxpayers showed up in the top 400 at least once. Of these taxpayers, a little
more than 27% appear more than once. In any given year,  about 40% percent of the top-400 returns were filed by taxpayers who weren’t in that exclusive club in any of the 15 years .

In all, the IRS received nearly 143 million individual tax returns for 2007, the year that ended with the onset of the worst recession in decades.

Federal Reserve Bank of Philadelphia President Charles Plosser said Wednesday he is uncomfortable with the central bank’s current pledge to keep rates low for an “extended period,” saying what happens with the monetary policy outlook depends on the economy’s path.

“I am not a big fan of that language,” Plosser said. The words “confine us in some ways,” he said. That’s not because the Fed won’t act if conditions change, but because language like that conditions financial markets to hold an interest-rate outlook that may not come to pass, the official said.

Plosser is not currently a voting member of the interest-rate-setting Federal Open Market Committee. When that body last met in January, it pledged to keep something like its current near-zero interest-rate policy in place for an “extended period.” One Fed official voted against that decision then, believing the language was incompatible with a recovering economy.

Plosser said whatever the Fed does with policy, “it’s all going to depend on economic conditions.”

The central banker also argued in favor of the Fed moving toward sales of mortgage assets bought under a $1.25 trillion program that ends in March. The effort was designed to keep borrowing costs low and help support both the housing sector and a broader economic recovery. But it’s also left the Fed’s balance sheet swollen at over $2 trillion. Policy makers are now contemplating how they will unwind this program at some point in the future.

“As the economic recovery gains strength and monetary policy begins to normalize, I would favor our beginning to sell some of the agency mortgage-backed securities from our portfolio rather than relying only on redemptions of these assets,” he said. “It will take some time for the Fed’s portfolio to return to its precrisis composition, but we should begin taking steps in that direction sooner rather than later.”

While he did not put a time frame on the sales, the policy maker said it needs to happen eventually. Plosser said he imagines sales of mortgages will start off at “modest” levels, with the Fed laying out some sort of formal plan for the selling, similar to how it laid out the buying agenda.

“We have no desire to disrupt the mortgage market and tank the economy,” so whatever happens will be done “delicately,” he said, adding he does not expect to see much of a rise in mortgage rates as the Fed exits the market.

The official said it is “an open question” what the Fed’s tightening cycle will look like. “I am not opposed and I might even favor beginning to shrink the balance sheet before we raised rates…because ultimately, the balance sheet has got to get down,” Plosser said. In part, that’s because the effectiveness of some of the other ways the Fed can tighten financial conditions is uncertain
right now, he said.

Minutes of the FOMC meeting released Wednesday show a growing desire on the part of some central bankers to do asset sales. That said, most Fed officials appear confident the balance sheet will not create an inflationary threat because the central bank has the ability to pay interest on the reserves.

Plosser also offered brief comments on the state of the economy. “Although we have yet to see robust employment growth, there are signs that labor market conditions are starting to slowly improve and it appears that a modest economic recovery has begun,” Plosser said. “Financial market conditions are considerably better than they were a year ago, and the worst of the financial crisis now appears to be behind us.”

Plosser’s remarks came from a speech in Philadelphia, where he spoke before the World Affairs Council, taking questions from both the audience and the press.

In other comments, the central banker said he believes the legal authority that gives the Fed its emergency lending power “should be either eliminated or severely curtailed,” with this sort of lending done only by the government.

If the Treasury requests the Fed to take part in a market intervention or bailout, “any non-Treasury securities or collateral acquired by the Fed under such lending should be promptly swapped for Treasury securities,” Plosser said. That way, “it is clear that the responsibility and accountability for such lending rests explicitly with the fiscal authorities, not the Federal Reserve,” the official said.

Plosser also said that the dollar’s strength depends on sound U.S. economic policy and low inflation. He said that the current government deficit is unsustainable and warned that it may become more difficult to sell Treasury securities, which could drive up borrowing rates in the economy.

The latest issue of The Onion, the parody news outlet, offers an item the Ron Paul crowd can rally around:

WASHINGTON—The U.S. economy ceased to function this week after unexpected existential remarks by Federal Reserve chairman Ben Bernanke shocked Americans into realizing that money is, in fact, just a meaningless and intangible social construct.

What began as a routine report before the Senate Finance Committee Tuesday ended with Bernanke passionately disavowing the entire concept of currency, and negating in an instant the very foundation of the world’s largest economy.

“Though raising interest rates is unlikely at the moment, the Fed will of course act appropriately if we…if we…” said Bernanke, who then paused for a moment, looked down at his prepared statement, and shook his head in utter disbelief. “You know what? It doesn’t matter. None of this—this so-called ‘money’—really matters at all.”

“It’s just an illusion,” a wide-eyed Bernanke added as he removed bills from his wallet and slowly spread them out before him. “Just look at it: Meaningless pieces of paper with numbers printed on them. Worthless.”

A roundup of economic news from around the Web.

• Defending Financial Innovation: The Brookings Institution’s Robert Litan warns against reacting to the financial crisis by stifling financial innovation. While Paul Volcker dismisses the value of financial innovation since the ATM, Litan offers a long list of developments — from indexed mutual funds to asset-backed securities to futures exchanges — that “are a net positive for the nation.” He writes: “Society would benefit from even more financial innovation in the future that would help cushion individuals or firms from certain financial risks to which they are now exposed but can do little or nothing about. … At the same, however, policymakers must do a much better job than they have in the past of stopping destructive innovation and the misuse of constructive innovation, either or both of which can lead to future financial bubbles that expose the economy to financial crises.”

• Trojan Horse? Writing for Project Syndicate, Barry Eichengreen looks at the troubles in Greece (along with Spain, Portugal and Italy) and what European leaders must do to address longer-term risks. “Creating the euro was not a mistake, but it could still be a mistake in the making,” he says. “The Greek crisis shows that Europe is still only halfway toward creating a viable monetary union. If it stays put, the next crisis will make this one look like a walk in the park.” Eichengreen says Europe needs “a proper emergency financing mechanism” that allows other member states to offer assistance with conditions and temporary control of the national budget by special masters appointed by the European Union. “The Greek crisis could be the Trojan horse that leads Europe toward deeper political integration. One can only hope.”

• The Murky Science: The British Ambassador to the U.S., Sir Nigel Sheinwald, uses the recent blizzard to look at weather forecasting and economic forecasting. “Weathermen and weatherwomen have the luxury of knowing exactly what the weather is doing right now and enjoy pretty accurate surveillance mechanisms to enhance their short-term forecasting,” he writes. “Economic forecasting is way murkier.” Improving international coordination and cooperation in economic monitoring and policymaking can mitigate the challenge, he says.

Originally posted on China Real Time blog

With China’s economy surging and flirting with a property bubble, most analysts are prescribing the same remedy: a stronger Chinese currency that would help contain inflation.

A few economists are now turning that argument on its head, and proposing that China allow inflation to do the work of currency appreciation. Rather than adjusting the currency upward to make Chinese goods more expensive abroad, authorities should just allow rising wages and other costs to make Chinese goods more expensive, they say. To put it in the language of economists, they think China can get the needed adjustment in the real exchange rate without actually moving the nominal exchange rate.

China is under tremendous pressure from the U.S., Europe and other nations to shrink its huge trade surplus, which some blame for contributing to the financial crisis. A stronger currency could do that by making Chinese goods less competitive. But Premier Wen Jiabao and other government officials have pushed back against outside pressure on the currency. They have kept the yuan, or renminbi, fixed against the dollar since mid-2008, and a big, rapid move is widely seen as unlikely.

Higher inflation could have the same effect—albeit indirectly—and be less contentious politically within China. If average prices in China rise 5% more than in the U.S., and the currency doesn’t move against the U.S. dollar at all, the result is effectively the same as if China revalued the yuan by 5% and the two countries had the same inflation rate. In both cases, Chinese goods have gotten 5% more expensive in U.S. dollar terms, or to put it another way, the real exchange rate has increased 5%.

“It is not clear that nominal renminbi appreciation is necessary,” Xiao Geng, director of the Brookings-Tsinghua Center for Public Policy in Beijing, writes in a recent article. The key, he argues, is to understand that some kinds of inflation are actually desirable.

As a developing country, China is on the road from being a poor nation to being a richer one. As part of that process, everything in China will get more expensive over time: as Chinese incomes and wages rise closer to global levels, it becomes more expensive to produce goods and services, and their price also rises. In other words, some inflation is unavoidable if China is to become more prosperous and its consumers are to spend more.

“Many formerly fast-growing industrializing economies, such as Japan, South Korea, Taiwan, and Hong Kong, kept inflation around 5% to 8% during their fast-growth phases as a way to make nominal wages and general price levels converge towards global standards,” Xiao says.

Arthur Kroeber, managing director of the economic research firm Dragonomics, also thinks the kind of inflation China faces is not fundamentally worrisome. “If inflation arises from rapid wage growth generated by big productivity gains in a flexible labor market, then it amounts to a perfectly normal and healthy adjustment of the real exchange rate,” he writes in a recent article.

“In our opinion allowing more domestic inflation is a better policy than an aggressive exchange-rate adjustment,” Kroeber writes. “Higher inflation is understandably a bit scary, but it is probably the best choice for China in the coming decade.”

Accepting a persistently higher level of inflation in the economy goes against decades of Western central-bank orthodoxy – not to mention the fear, deeply rooted in Chinese political culture, that soaring consumer prices could produce social unrest.

“We tend to see inflation as bad, though in fact the convergence of wages is good. We have to tolerate a reasonable amount of inflation, and learn how to operate in this environment,” Xiao says.

There’s no sign that the Chinese government is convinced by Xiao and Kroeber’s advice. Still, authorities have been adjusting key prices in the economy in recent months: the regulated prices of key inputs like water, electricity and crude oil are going up, and local governments are raising minimum wages.

And heterodox ideas about inflation are getting a broader hearing these days, as the financial crisis pushes many thinkers to re-examine conventional practices. Oliver Blanchard, chief economist of the International Monetary Fund, now thinks that even developed economies probably can tolerate a higher level of inflation they have in the past – with central banks perhaps targeting 4% a year instead of 2%.

–Andrew Batson

The Federal Reserve’s newest official sounded a bearish note on the economy today and offered a novel case for preserving the Fed’s role as a bank regulator.

Narayana Kocherlakota became president of the Federal Reserve Bank of Minneapolis in October. He’s mostly been keeping his head down since then as he settled into his seat at the table with other policy makers. His speech today to the Minneapolis Bankers Association was his first public speech on the economy since taking the new job. It merits extra attention, because he spent much of his career as an economic theorist and when he took the job it was hard to know how the brainy former University of Minnesota professor would apply his ideas in the real world.

Though he does see a recovery, he’s not terribly optimistic about the economy outlook. Here are a few key points:

• He is below the consensus forecast among Fed officials for around 3.5% annual economic growth for the next two years, projecting gross domestic product to expand at an annual rate of 3%. He’s got three reasons for the pessimism: 1) The Minneapolis Fed’s internal forecasting computer model is below consensus, with a 2.5% forecast; 2) He believes Washington is creating uncertainty for businessmen with ever-changing proposals for financial and health care regulation. “I see this kind of political uncertainty as problematic for the prospects of rapid recovery;” and 3) The banking sector faces ongoing problems, including commercial real estate.

• The job outlook is bleak. “I would be highly surprised if unemployment were below 9 percent by the end of 2010 or below 8 percent by the end of 2011 … to get a true expansion in employment and in the economy, the hiring rate has to pick up—and we have yet to see evidence that it will do so in the immediate future.”

• He’s not worried about inflation, where the news is “mostly good.” That’s not sure to last, he says. The combination of money pumped into the financial system by the Fed and big deficits run by the federal government could cause inflation to get unanchored, but he thinks that’s unlikely.

In all, in his first public comments, Mr. Kocherlakota doesn’t sound like he’s going to veer very far from the consensus at the Fed to keep interest rates near zero for at least several more months.

He also offers up an articulate defense of the Fed as a regulator. Mr. Kocherlakota argues that because the Fed is lender of last resort to banks when they face a cash crunch, it needs to know the health of firms to which it might be lending in a crisis. If Congress strips it of the power to supervise banks, it loses its ability to distinguish between healthy banks it ought to save and doomed banks that don’t deserve a loan.

Instead, it would have to depend on some other regulator for information, and the other regulator might not have an incentive to give the Fed a clear picture. “This other agency is not going to suffer a loss for making a bad loan—the Federal Reserve is.” In other words, stripping the Fed of its ability to regulate banks would set up bad incentives among regulators when the next crisis hits.

The U.S. economy is on the road to recovery, but healing will be slow as the outlook for the labor market remains troubling, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said on Tuesday in his first public speech as a central banker.

Kocherlakota pointed to a “nascent” recovery that he believes will continue as the economy bounces back from the worst downturn since the Great Depression. He believes, however, that the recovery in gross domestic product, or GDP, and especially in unemployment, will be slow due to uncertainties surrounding various legislative initiatives and to ongoing problems in the banking sector.

“I do think that the economy is on the mend, and should continue to recover over the next two years in terms of both GDP and unemployment,” Kocherlakota said, “but at slower rates than we would like.”

Fueling his belief that the economy is healing is that real GDP began to grow again in the third quarter of 2009, with the growth rate accelerating to a seasonally adjusted annualized rate of 5.7% in the fourth quarter. He predicts that the National Bureau of Economic Research will declare the recession to have ended sometime in the second half of last year.

Kocherlakota was delivering prepared remarks about the economic outlook and the Fed’s role as a bank supervisor before members of the Minnesota Bankers Association. The central banker said that with the challenges that still face the economy, he believes the economy will grow only by around a 3% per year rate over the next two years as opposed to 3.5%. In November, the minutes of the Fed meeting included a summary of central bank president and Fed governor forecasts for real GDP for 2010 and 2011; their predictions are roughly around 3% growth for 2010 and around 4% growth in 2011, an average of 3.5%.

Kocherlakota is more pessimistic about GDP for two reasons, he said: One, due to the great deal of uncertainty surrounding Congress’ proposals for changes in health care and financial regulation; and two, because of the risk that the commercial real estate market poses.

Banks with large amounts of commercial real estate risk exposure “face a correspondingly elevated risk of failure,” he said. “This threat could well lead to continued declines in bank lending, which would curtail the recovery.” Even worse, banks’ near-failure have strong incentives to make poor loans, he said. “This outcome would be even worse for the economy.”

The central banker called the outlook for the labor market “not comforting.” The jobless rate is currently at 9.7%. In the 25-year span between January 1984 and January 2009, unemployment never topped 8%, although it reached 10.8% in the
autumn of 1982.

“Though unemployment has fallen somewhat, forecasts remain uniformly troubling,” Kocherlakota said, adding that unemployment is notoriously slow to recover. He would be “highly surprised,” he said, to see a sub-9% jobless rate by the end of 2010 or a sub-8% unemployment rate by the end of 2011.

The central banker was positive on inflation, noting that inflation has been relatively tame and the outlook is “basically promising.” However, he noted, the  excess reserves of over a trillion dollars held by deposit institutions create the potential for high inflation. The Fed, therefore, must take care with its policy moves to keep inflation at bay.

In other remarks, the central banker stressed the importance of the Fed maintaining its supervisory power, noting that a healthy economy requires a Fed that actively engages banks. Without that power, it would have been more difficult for the Fed to have employed the extraordinary policy measures it did over the last few years to stabilize the financial system, he said, such as the
Term Auction Facility, which allowed depository institutions to bid on loans from the Federal Reserve.

Under the existing system, the Federal Reserve can turn to its own supervisors for detailed information about a financial institution to help it evaluate how to best help financial markets in the case of an upset. That ability needs to be preserved, he said.

“My conclusion is that stripping the Federal Reserve of its supervisory role would needlessly put a Great Depression on the menu of possibilities for our country,” Kocherlakota said.

Kocherlakota became the twelfth president of the Minneapolis Fed on October 8, 2009. Before that he was a professor of economics at the University of Minnesota, where he chaired the economics department. He also served as a consultant to the Federal Reserve Bank of Minneapolis and from 1996 to 1998 he worked as a research staff member at the Minneapolis Fed.