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Vince Foster: Has the Fed Changed Its Economic Assessment From a Liquidity Trap to a Structural Trap?


In the coming months, expect policymakers to map out the method for raising policy rates while at the same time adjusting lower their economic forecasts that reflect this assessment.

The relentless rally in the long end of the curve continued this past week with both the 10-year and 30-year Treasury yields making new lows. There have been a lot of colorful stories floating around that attempt to explain a move ex post that virtually no one saw coming ex ante. Many assume it must be a short squeeze. Some have attributed it to pension fund rebalancing. There is always the Asian buying conspiracy. And a few have even offered the ridiculous proclamation that there is a scarcity of safe assets relative to the demand.

On Thursday Bloomberg quoted Fortress Investments' Mike Novagratz, who at the SALT conference in Las Vegas complained that former Fed chairman Ben Bernanke tipped off some hedge fund managers at paid dinner engagements that the Fed was internally operating under lower growth rate assumptions. There are even rumors floating around that Bernanke gave these managers a 2.0% terminal Fed funds rate, much lower than the 4.0% that is offered by FOMC members.

"Bernanke did a dinner circuit and in dinners gave credence to the idea the Fed believed in lower potential GDP and inflation," Novogratz said. "That got through the market and that was the giant trade in fixed income that happened." 
This revelation had been in the market and it posed the question, was the Fed operating with a different internal economic assessment than what was being communicated to the market?
Friday I attended a bank conference where St. Louis Fed president James Bullard was the headline speaker and was expected to give an update on the efficacy of monetary policy. On the undercard was St. Louis Fed economist William Emmons who gave a presentation titled Slow and Low, referencing growth and interest rates. Emmons was quick to assure the audience that his views did not represent those of the St. Louis Fed, and it soon became obvious as to why. This proved to be a very interesting presentation considering it was coming from a Fed official. Emmons was not toeing the party line.
Emmons Presentation Slide 11

On slide 11 titled "Fed Research in Late 2013: Crisis Severely Damaged US Economy; Harm is Continuing," he showed a chart from a working paper authored by Fed economists Dave Reifschneider, William Wascher, and David Wilcox, the Director of Research and Statistics, titled Aggregate Supply in the United States; Recent Developments and Implications for the Conduct of Monetary Policy of the potential GDP output gap. On slide 12 titled "US Economy's Potential Growth Rate Now Only About 1% (Temporarily)" he showed a chart from the same working paper of potential GDP growth.

Emmons Presentation Slide 12

Emmons noted that because Wilcox authored the report, it was likely the prevailing economic assessment of US economic conditions among Fed staffers. I believed this to be an important revelation because of the implications for the path of monetary policy. This was not just an economic update; this was a shift in the Fed's operating framework. The report is long, but I cite the abstract below (emphasis mine):

Using a version of an unobserved components model introduced by Fleischman and Roberts (2011), we estimate that potential GDP is currently about 7 percent below the trajectory it appeared to be on prior to 2007. We also examine the recent performance of the labor market. While the available evidence is still inconclusive, some indicators suggest that hysteresis should be a more present concern now than it has been during previous periods of economic recovery in the United States. We go on to argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand -- contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand, and we present optimal-control simulations showing how monetary policy might respond to such endogeneity in the absence of other considerations.
Hysteresis? This is not the cyclical weakening of employment, as policymakers are telling us. This sounds structural.
The authors conclude the following (emphasis mine):
In the labor market, matching efficiency seems to have been somewhat impaired, the natural rate of unemployment appears to have risen somewhat, and trend labor force participation appears to have moved noticeably lower relative to what would have been expected based on pre-crisis trends. In addition, the capital stock and trend multifactor productivity are appreciably lower than what would have been predicted in 2007.
Despite this supply-side damage, our point estimates also suggest that the level of economic slack has been and remains substantial. As has been noted by a number of observers, this factor by itself would argue for a highly accommodative monetary policy, particularly in an environment of what appears to be quite well-anchored inflation expectations. We have argued that the case for aggressive policy is strengthened further by the likelihood that much of the supply-side damage is an endogenous response to weak aggregate demand.
I don't know or care if the Fed's models are correct, but if this report is driving its monetary operating framework, then this is a major difference. It's almost as if the Fed is abandoning the liquidity trap thesis and adopting the structural trap thesis that I have discussed in past articles.
In Forget the Shutdown! US Economy About to Hit the Vortex of a Structural Trap I cited Robert Dugger's 2004 paper, Structural Traps, Politics, and Monetary Policy, which describes the Japanese situation:
In this paper we develop the concept of structural trap, where the interplay of long-term economic development incentives, politics, and demographics results in economies being unable to efficiently reallocate capital from low- to high-return uses. The resulting macroeconomic picture looks like a liquidity trap - low GDP growth and deflation despite extreme monetary easing. But the optimal policy responses are very different and mistaking them could lead to perverse results.
The Fed's research is shifting attention from an employment-driven response to one that targets the capital stock and productivity, which is much more aligned with Dugger's structural trap. Mr. Emmons picked up on the capital stock and multifactor productivity deficits, citing work done by Stanford Professor Robert Hall, who offers an even bleaker assessment. In an April 2014 working paper titled Quantifying the Lasting Harm to the US Economy From the Financial Crisis, Hall writes:
Here I take for granted that the financial crisis was the cause of the collapse in product and labor demand and that expansionary policy was unable to offset the collapse. I offer a complementary analysis of other aspects of the post-crisis economy, focusing on the durable effects of the crisis that a boost in product demand would not correct quickly. These effects are
  • Lost total factor productivity
  • Lost investment resulting in a lower capital stock
  • Unemployment and short weekly hours of work lingering after job-creation incentives have returned to normal
  • A persistent decline in labor-force participation
Hall estimates that the economy is actually operating at nearly 12% below the pre-crisis trend. He claims that the capital stock and productivity shortfalls account for 71% of the deficit with unemployment and labor force participation only 29%.
The QE program was targeting product and labor demand, but the "quantity" of money remained in the financial system that was structurally trapped with massive excess capacity. Instead of stimulating the capital stock through increased private investment, QE stimulated capital structure arbitrage, stock buybacks, and dividend recaptures. As Dugger points out, the misappropriated stimulus led to perverse results. The reduction in capital investment in favor of financial engineering has sowed the seeds of below-trend growth in aggregate supply far into the future.
The long end of the curve is not rallying because of a short squeeze, a pension rebalancing, a scarcity of safe assets, or because Bernanke gave hedge fund managers some secret scoop. The long end is rallying for the same reason I described ex ante in Why Tapering QE Is Bullish for Treasuries on April 15 2013 -- because the Fed is reducing stimulus, which is removing the inflation premium in the yield curve. The Fed is exiting QE stimulus and it wants off the zero-bound, both of which should anchor the long end of the curve around the structural growth rate in aggregate demand, which remains weak.
Where there is smoke there is fire. Between the Bernanke dinner, the Wilcox paper, and the Emmons presentation, there is too much discussion of the Fed's internal downgrade of US economic conditions.  The Fed seems to be re-calibrating its assessment of the structural damage in the US economy and thus its policy response. In the coming months, expect policymakers to map out the method for raising policy rates while at the same time adjusting lower their economic forecasts that reflect this assessment. All else being equal, this should continue to provide support for the yield curve and long-term interest rates.
Twitter: @exantefactor
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