Cowen on Finance and Inequality

In his American Interest essay, "The Inequality That Matters," Tyler Cowen offers a number of reasons not to be too troubled by the general rise in income inequality over the last 30 years (not surprising given his generally libertarian-ish outlook).  As he notes, much of the increase in inequality is really occuring within the top 1% of incomes, and much of that is driven by the financial sector.  That, according to Cowen, is where the real problem lies. Along the way he also offers one of the best nutshell explanations for why financial sector incomes exploded to such monsterous proportions:

The first factor driving high returns is sometimes called by practitioners “going short on volatility.” Sometimes it is called “negative skewness.” In plain English, this means that some investors opt for a strategy of betting against big, unexpected moves in market prices. Most of the time investors will do well by this strategy, since big, unexpected moves are outliers by definition. Traders will earn above-average returns in good times. In bad times they won’t suffer fully when catastrophic returns come in, as sooner or later is bound to happen, because the downside of these bets is partly socialized onto the Treasury, the Federal Reserve and, of course, the taxpayers and the unemployed. 

Furthermore,

To this mix we can add the fact that many money managers are investing other people’s money. If you plan to stay with an investment bank for ten years or less, most of the people playing this investing strategy will make out very well most of the time. Everyone’s time horizon is a bit limited and you will bring in some nice years of extra returns and reap nice bonuses. And let’s say the whole thing does blow up in your face? What’s the worst that can happen? Your bosses fire you, but you will still have millions in the bank and that MBA from Harvard or Wharton. For the people actually investing the money, there’s barely any downside risk other than having to quit the party early. Furthermore, if everyone else made more or less the same mistake (very surprising major events, such as a busted housing market, affect virtually everybody), you’re hardly disgraced. You might even get rehired at another investment bank, or maybe a hedge fund, within months or even weeks. 

Like Keynes said:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

Back to Cowen:

In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.

Run-RMB

Taiwan's next media animation illustrates Sino-American tensions over currency policy with a rap video:

The Failure of Say's Law

as illustrated by the Washington Post's Tom Toles:

A Semi-Defense of the Textbook Money Multiplier

John Taylor approvingly cites a JPMorgan note criticizing economics textbooks' treatment of the money multiplier.  The money multiplier relates the monetary base, which is directly manipulated by the Fed's open market operations, to the money supply, which is what actually affects the economy in most economic models.  The very simple version of the calculation is that the money multiplier is 1/rr where rr is the "reserve ratio" of bank reserves to deposits.

If one assumes a constant money multiplier, then the dramatic increase in the monetary base since mid-2008 implies a huge (and frighteningly inflationary) increase in the money supply.

According to JP Morgan:

The growth of the Fed’s balance sheet, which has been funded by an increase in commercial banks’ reserve balances at the Fed, has sparked fears that the “money multiplier” mechanism would translate those reserves into an explosion in bank lending, bank deposits, and inflation. None of these things has happened, because the money multiplier no longer makes sense given the institutional framework of the contemporary banking system. In spite of being almost totally divorced from reality, the money multiplier is still taught in undergraduate economics textbooks, with much resulting confusion.

While there have been quite a number of changes in the "institutional framework," which textbooks (and professors) may not want to treat in detail, the most basic flaw in the analysis which is being attributed to "undergraduate economics textbooks" is naively assuming a constant money multiplier.

I don't think that is a fair accusation.  Indeed, the only reason why money multipliers are interesting to talk about in class is that they can change.  In normal times, it makes sense for banks to hold as few reserves as they can get away with (they can lend excess reserves on the "interbank" loan market, and if they're short, they can borrow them, too).  But in unusual times, the calculation changes and banks respond to a riskier environment by holding more reserves, which reduces the money multiplier.

This issue normally enters an undergraduate economics course in a discussion of the Great Depression.  Milton Friedman and Anna Schwartz showed that the money multiplier fell during the banking panics of the early 1930's.  Because of the fall in the money multiplier, the money supply actually was decreasing even as the Fed increased the monetary base. This example has become part of the case the Fed bungled the depression. Both the Mankiw and Abel and Bernanke intermediate macroeconomics textbooks discuss this case immediately after algebraically deriving the money multiplier.

The sudden increase in the monetary base (blue line) occurred in late 2008.  In the same period, deposits (red) also rose, but much less dramatically, which means there was a large increase in the reserve ratio.

The Fed announced on October 6, 2008 that it would begin paying interest on reserves.  This is is the dominant factor in the increase in both the quantity of reserves and the reserve ratio.  Interest on reserves does indeed represent a significant change in the institutional framework which isn't included in traditional textbook treatments.

However, looking a little more closely at the graph one can see that reserves began to increase in September.  Reserves rose from $9bn on Sept. 10, to $47bn on Sept. 17 and $104bn on Sept. 24 - a more than tenfold increase over two weeks.  Those two weeks, of course, were the absolute worst days of the financial panic of 2008 (Lehman declared bankruptcy on Sept. 15).  At a time when the interbank lending market suddenly appeared risky, it is not surprising that banks would exercise more caution and increase reserves, thereby reducing the money multiplier.  And that is likely quite consistent with what students read in their undergraduate economics textbooks.

Stimulus III: Return of the EGTRRA

Not surprisingly, our political discourse has a hard time wrapping its head around the fiscal policy conundrum that we currently face, which is that we need more stimulus (bigger deficits) now, but long-run budget projections imply that we need to make future deficits smaller, because we are likely to still have a deficit when the economy returns to full employment and it may balloon further in the future mainly because of rising healthcare costs.

There is a valid concern that, when the economy recovers, the federal government's large borrowing needs could "crowd out" investment.  While there is absolutely no evidence that this is a problem now or in the immediate future (as evidenced by continued low Treasury yields), the scheduled reversion of the tax code to the status quo ante-Bushum does create a unique opportunity to deal with the long run problem.

As it happens, the projected level of revenue if the tax cuts expire looks close to about right in the long run (see the "extended baseline" in the CBO's long-run outlook).  While the Clinton-era tax code isn't ideal in terms of equity or efficiency, clearly we didn't do too badly when it was in effect.  The beauty of "current law" is that it makes Washington's natural tendency towards gridlock work for, rather than against, a solution.  All we need is for any of (i) congress to not agree, (ii) a Senate filibuster not to be overcome, or (iii) the president not to sign, and our deficit problem is largely solved.

If unemployment wasn't 9.8%, I might therefore be in the "let them expire" camp (even the "middle class" parts), but, as things stand, the economy urgently needs more fiscal policy support now.  A tax increase is the exact opposite of what we need in the short run.

Before this week's deal between the administration and Republican leadership, my preferred outcomes, in order of preference, would have been:

1. The expiration of the tax cuts is used to force a tax reform that simplifies the tax code and eliminates tax expenditures (i.e., closes loopholes).  This broadening of the tax base could raise revenue, and maintain progressivity (since it is high incomes that benefit most from loopholes), while keeping marginal rates low.  The Bowles-Simpson proposal did move in this direction - on progressivity, it landed between the Clinton and Bush tax codes (according to the TPC) - but it had an arbitrary cap on revenue at a too-low level.  At full employment, the ideal reform would be revenue neutral compared to a "current law" baseline (i.e., it would bring in the same revenues as the Clinton tax code over the long-run).  The short-run negative effect of the resulting tax increase would be offset (and thensome) with explicitly temporary fiscal stimulus, perhaps with a built-in trigger mechanism to unwind it automatically as the economy recovers, which would serve to minimize the inevitable push for extensions.
2. The tax cuts are allowed to expire, reverting to the Clinton-era tax code, but accompanied by the same type of stimulus described above.
3. The original Obama-Democratic policy of making the "middle class" tax cuts permanent while reinstating the Clinton-era rates for income above $250K.  Raising taxes on the rich is anti-stimulative, but not very (the multiplier is low), so the long-run deficit reducing benefit outweighs the short-term cyclical cost.
4. The whole thing expires (which may still happen - its not clear the deal will get through Congress), which solves our long run problem, but leaves us hoping even more fervently that Fed gets enough traction to keep the recovery going, even as the tax increase makes the headwinds stronger.
5. The preferred Republican policy of making all the tax cuts permanent, which has the virtue of not making things worse in the short run, but will eventually lead us back to the low-investment economy of the late 1980's and have us talking about cutting social security and medicare.

I'd put this week's deal somewhere between #2 and #3, and given that #3, 4 and 5 seemed to be what was realistically on the table, I can't be too disappointed (even if I sympathize with the widespread concern that President Obama's poker skills seem to have mysteriously diminished).  One concern is that extending the Bush tax cuts entrenches them further and increases the risk that they become one of those features like the alternative minimum tax "patch" that we expect to be perenially "fixed." But the two-year extension does leave open the possibility of something like #1 or #2 happening in 2012, and at least we haven't decisively dug the long-term hole deeper as #5 (and, to be honest, #3) would.  We have also averted the short-run damage that would result from #4 (and to a much lesser extent, #3).  Not only have we avoided that anti-stimulus, but the deal includes other demand-enhancing provisions, like the one-year payroll tax cut (which replaces the expiring "making work pay" credit from the 2009 stimulus bill, but is bigger, though less progressive).

David Leonhardt calls it a "second stimulus" (third, if you count the spring 2008 tax rebate).  The Center for American Progress applied existing multiplier estimates to the deal's provisions to estimate that it would increase employment by about 2.2 million (relative to unemployment of 15 million). Macroeconomic Advisors estimates a GDP growth bump of 0.5-0.75 percentage points.  (Both of these come to my attention via the invaluable Ezra Klein).

Of course, it would be better still if the unemployment insurance extension was for two years (even if the recovery gathers steam, there will still be many people unemployed in 2012), and included something for the "'99ers" who have hit the 99-week limit on benefits (recall that the recession began at the end of 2007).  They also should have raised the debt ceiling, so it doesn't become the next "hostage".  One might hope the outrage of Congressional Democrats gives them some leverage to make improvements (indeed, if the Democrats were an organized political party, I might think there was a clever "good cop, bad cop" routine being employed here).

Note: the title of the post refers to the official name of the 2001 tax cut, the Economic Growth and Tax Relief Reconciliation Act.

Barack Obama's Time Consistency Problem?

When I explain the time-consistency problem to my students, I begin by asking them what the stated position of the government is about negotiating with hostage takers.  They know, of course, that the official line is that the government will not negotiate.

The reason why governments always say they will not negotiate with hostage takers is that, if they won't negotiate, there is no incentive to take them in the first place.  But, once hostages have been taken, the government has a strong incentive to negotiate because they don't want to be responsible for the hostages getting killed.  And the problem is that the would-be hostage takers understand this, and therefore do not believe the government will follow its announced policy of not negotiating.

That example may not work next semester, if my future students saw President Obama's press conference:

I’ve said before that I felt that the middle-class tax cuts were being held hostage to the high-end tax cuts.  I think it’s tempting not to negotiate with hostage-takers, unless the hostage gets harmed.  Then people will question the wisdom of that strategy.  In this case, the hostage was the American people and I was not willing to see them get harmed.  

One of the implications of the time consistency problem is that a better outcome would be achieved if the government didn't have discretion to negotiate with the hostage takers.  In the real world, no perfect "commitment technology" exists so, in practice, we think about "credibility".  That is, how can the government behave so that the prospective hostage takers believe the authorities really mean it when they say they won't negotiate?

So, the question is: did President Obama diminish his credibility, thereby increasing the likelihood of future political "hostage" situations, or did he just say what everyone already knows?  And was the Republican threat credible to kill the hostages let the tax code revert to its 2000 levels if the tax cut extension for incomes over $250,000 wasn't included?  (John Boehner's slip in September notwithstanding).

For background on time consistency and more examples, see Greg Mankiw, this speech by Charles Plosser, and the Nobel Prize information about Kydland and Prescott. 

Bernanke on 60 Minutes

Euro Trouble

Another sign the euro is in trouble: this week's Economist has an article on how a member country might leave the currency union.  It concludes:

The cost of breaking up the single currency would be enormous. In the ensuing chaos and recrimination, the survival of the EU and its single market would be in jeopardy. But by believing that a break-up cannot happen, the euro zone’s authorities will always tend to stop short of the radical measures needed to hold the project together. Given the likely and devastating chaos, it would be a mistake for a country to choose to leave. But mistakes occur in times of stress. That is why some are beginning to contemplate the unthinkable.

Germany may be the country that walks - the Guardian reports:

At the Brussels dinner on 28 October attended by 27 EU heads of government or state, the presidents of the European commission and council, and the head of the European Central Bank, witnesses said Papandreou accused Merkel of tabling proposals that were "undemocratic".

"If this is the sort of club the euro is becoming, perhaps Germany should leave," Merkel replied, according to non-German government figures at the dinner. It was the first time in the 10 months since the euro was plunged into a fight for its survival that Germany, the EU's economic powerhouse and the lynchpin of the euro's viability, had suggested that quitting the currency is an option, however unlikely.

Much of the difficulty in Europe stems from German attitudes on monetary policy (though their deeply ingrained aversion to inflation is understandable) and their influence on the ECB.  Ryan Avent put it well last week:

A demonstration of commitment to Europe requires a little bit from everyone, and what it requires from the ECB is that it act like the European Central Bank, rather than just a Bundesbank that gets to impose unreasonably hard money on everyone in the single currency. Mr Trichet, who has had to earn his post by acting as German as a Frenchman can possibly be expected to act, seems to be realising that that's not actually what's required of the ECB.

The recent "bailout" of Ireland does not impress Barry Eichengreen:

The Irish “programme” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130% of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan.

According to the deal, not just interest but also principal is supposed to begin to be repaid after a couple of years. At that point, Ireland will be transferring nearly 10% of its national income as “reparations” to the bondholders, year after painful year.

This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. The Commission, the ECB, and the German Government have set the stage for a situation where Ireland’s new government, once formed early next year, rejects the budget negotiated by its predecessor.

Even measures like this, which fall far short of what would be necessary to end the crisis, are tough to get the Germans to sign off on.  Though its not surprising that loans to Greece and Ireland are bad politics in Germany, it needs to be remembered that the problems of some of the peripheral countries are due, in part, to the fact that ECB policy, which placed more weight on Germany (because its bigger) was too loose for them. This helped create the bubbles that have now burst.  Moreover, much of the debt involved is owed to German (and other European) financial institutions, so this is really a "bailout" of Germany's banks.

Europe faces both sovereign debt and monetary policy problems.  Some of the countries have too much debt, and a restructuring is probably in order.  But if they're going to avoid that - and they seem determined to (though don't they always?) - a more expansionary monetary policy would help them grow (and inflate) their way out of trouble.  Without more inflation, the peripheral countries really need not just loans, but fiscal transfers from those that are in better shape (i.e., some kind of fiscal union is needed - on this, see Gavyn Davies).

Neither way out seems palatable to Germany.  The Economist's article argued that the disruption of leaving the euro would be considerably lower for Germany than for the peripheral countries, since the likely appreciation of the Mark would ease some of the tangles associated with re-denominating debt.  Perhaps the rest of the eurozone should consider taking Chancellor Merkel up on her offer...

Now, That's an Economic Message

When I read the "Economic View" column in today's NY Times:

Uncertainty is likely holding back the recovery. But its sources are far more fundamental than the tax and environmental issues that typically top the list of complaints. And the solution is certainly not for the government to do less. Rather, it needs to do much more...

Wall Street analysts often cite possible government regulations on the environment as another source of damaging uncertainty. But as with the deficit, inaction could be far more damaging than action. Climate change and dependence on foreign oil are problems that won’t go away on their own. Tabling plans to deal with them doesn’t make it easier for companies to plan and invest; it makes it harder.

Until businesses and communities know the costs and incentives for developing renewable energy, nuclear power and natural gas — and whether we will address climate change through prices or direct regulation — it will be very hard to invest in new power sources and related industrial technologies.

The deepest and most destructive uncertainty we face centers on the overall health of the economy and its prospects for growth. Unlike other postwar recessions that were caused by tight monetary policy and high interest rates, the recent downturn resulted from the bursting of a housing bubble and a financial crisis. Because we are in largely uncharted territory, figuring out how and when the economy will recover is much harder than usual...

How do we resolve uncertainty about future growth? The Federal Reserve, Congress and the president need to reaffirm that they will do whatever it takes to restore the economy to full health. They could take a lesson from President Franklin D. Roosevelt, who declared in his 1933 inaugural address that he would treat the task of putting people back to work “as we would treat the emergency of a war.” 

I think: now that is exactly the kind of message we need to hear from the White House.  And then I see that the column was written by Christina Romer, who was, until very recently, chair of the Council of Economic Advisors....

What We Believe and the Tools We Use

At Worthwhile Canadian Initiative, Nick Rowe writes:

What we research, and what we believe, aren't necessarily the same thing. What gets published in the journals is a survey of what we are currently researching. It isn't an accurate survey of what we currently believe. The whole point of a journal is not to publish what everybody already believes. The journals are a map of where we are currently exploring for gold. They are not a map of existing gold deposits. They are not a map of where we think gold might be found in places we can't currently explore.

To which I might add, economic models can be thought of as tools.  Using a particular tool (model) to do a job (normal science) shouldn't be taken to imply a belief that the model is the right one for all economic phenomena.  In many cases, its much easier to make progress (and get papers accepted) if one uses existing tools.  For instance, I've used a real business cycle model in my own research - it turned out to be an effective device to implement an idea I had about real exchange rate volatility.  But it does not mean that I believe that real business cycle theory is a correct explanation of economic fluctuations.

Its Hard to Hold a Candle

in the cold November rain....

The BLS November employment report is a bummer, especially in the wake of mostly improving economic reports (e.g., consumer confidence, unemployment insurance claims, regional manufacturing surveys, etc).

According to the BLS, employment increased by a mere 39,000 and the unemployment rate rose from 9.6 to 9.8%.

The rise in the unemployment rate was not, alas, due to people re-entering the labor force - the participation rate was unchanged at a (depressed) 64.5%.  According to the household survey, 173,000 fewer people were employed in November (recall that the headline employment number comes from the separate survey of businesses, while the unemployment rate is calculated using the household survey).

If the other, positive, economic reports are ultimately reflected in strong fourth quarter GDP, the employment numbers would be an indication of rising productivity (for the third quarter, the BLS reported 2.3% labor productivity growth).

Out of the 15.1 million unemployed (!!!!), 6.3 million have been unemployed for more than 27 weeks.  There was a good article yesterday in the Times on how long-term employment can have persistent effects, as people who have been unemployed for a long time become less employable (a form of what is sometimes called "hysteresis" in the economics literature).

Hopefully the report will concentrate some minds in Washington (but don't hold your breath).  It should strengthen the President's attempt to salvage an extension of unemployment benefits from the negotiations with the Republicans on extending the Bush tax cuts.

November is one of the months when the seasonal adjustment makes things look worse - on an unadjusted basis, the unemployment rate was 9.3% (up from 9% in October), and payroll employment increased by 217,000.

For more on the employment report, see Calculated Risk, David Leonhardt, Free Exchange, and Real Time Economics' roundup.

Update: Mark Thoma is critical of the White House response.  Floyd Norris has a reason to hope for an upward revision.

The Counterfactual

"It could have been worse" isn't a winning political argument (and probably wouldn't have been even if the White House managed to consistently make it), but its probably true.  Compared to a counter-factual of no stimulus, real GDP is between 1.4% and 4.1% higher because of the recovery act (ARRA), according to the Congressional Budget Office.  This has been nicely illustrated by the Center for Budget and Policy Priorities:

Also, the stimulus has lowered the unemployment rate by 0.8 to 2 percentage points - i.e., without it we'd be looking at 10.4% - 11.6%, instead of 9.6%.

$700 Billion Bailout Update

From the Congressional Budget Office, another downward revision to the estimated cost of that "$700 Billion Bailout":

CBO estimates that the cost to the federal government of the TARP’s transactions (also referred to as the subsidy cost), including grants that have not been made yet for mortgage programs, will amount to $25 billion. That cost stems largely from assistance to American International Group (AIG), aid to the automotive industry, and grant programs aimed at avoiding mortgage foreclosures: CBO estimates a cost of $45 billion for providing those three types of assistance. Other transactions will, taken together, yield a net gain of $20 billion to the federal government, CBO estimates.

It was not apparent when the TARP was created two years ago that the costs would be this low. 

Indeed.  And I don't think its apparent to most people now that the costs were this low (which is a real problem, as I discussed in this previous post).

Better (But Still Not Good Enough)

The BEA announces:

Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 2.5 percent in the third quarter of 2010, (that is, from the second quarter to the third quarter), according to the "second" estimate released bythe Bureau of Economic Analysis. 

That's an acceleration from the 1.7% annual growth rate in the second quarter, and an improvement over the "advance" estimate of 2%.   Growth is still below average, and far below the pace necessary to close the output gap (i.e., get the economy back to some semblance of "full employment").  But at least the second derivative is positive....

Of the 2.5% growth, consumption accounted for 2%, investment for 1.5% (of which 1.3% was due to inventories), government purchases 0.8%, and net exports -1.8% (i.e., imports grew faster than exports).

Richard's Blog

My Wesleyan colleague Richard Grossman has started a blog, Unsettled Account, which shares its title with his new book on the history of banking.  Check it out!

And Keynes, too

Ahem.  A notable Bloomsbury figure is curiously omitted from the Times' report on 36 Hours in Cambridge:

Punting down the River Cam in a flat-bottom boat is the classic way to see Cambridge, but mastering the long wooden pole takes practice. Book a 90-minute lesson with Scudamore’s Punting Company (Granta Place, Mill Lane; 44-1223-359750, scudamores.com), which will assign a well-muscled tutor to punt you down the gorgeous stretch of river that runs behind the colleges. Halfway through, the pole is handed to you, for a lesson in propelling the unwieldy craft. If you didn’t come to Cambridge for tutoring, rent a kayak from Scudamore’s and paddle to the Orchard Tea Garden (45-47 Mill Way, Grantchester; 44-1223-551125; orchard-grantchester.com), where E. M. Forster, Virginia Woolf, and Bertrand Russell hung out a century ago. 

Its a bit of a hike, but you can walk there (though it was beastly hot the day I did it - punting might have been better).

Marginal, at Best

In an Economix post about the Bush tax cuts, David Leonhardt writes:

The theory for why tax cuts should create growth and jobs is a strong one. When people are allowed to keep more of each dollar they earn, they are likely to work longer and harder. The uncertainty is the magnitude of this effect. With everything else that’s happening in a $15 trillion economy, how large of an effect on growth do tax cuts have?

Every available piece of evidence seems to suggest that the Bush tax cuts did little to lift growth.

Indeed, its fairly easy to demonstrate in simple economic models that higher marginal tax rates distort the economy and might lead to less labor effort and less saving (and hence a smaller capital stock).  To be careful, though, in most models the effect of a tax reduction would be on the levels of income and output, not on the long run growth rate.

Nonetheless, there are pretty solid economic theory reasons why economists - even those of us with generally liberal (in the contemporary American sense) political inclinations - would favor tax reforms that would broaden the tax base (i.e., reduce deductions and credits) and lower marginal tax rates.  But perhaps not as fervently as Glenn Hubbard, who recently wrote:

When I left my job as the deputy assistant Treasury secretary for tax policy in 1993, I left a message on my office blackboard for my successor. I wrote, “Broaden the base, lower the rates” repeatedly until I filled the entire space. I then had it covered with wax so it could not be erased. (Yes, the government charged me for my bit of vandalism. But it was worth it.) 

I share his instinctive sympathy for this aspect of the Simpson-Bowles proposal (though I basically agree with Paul Krugman that the package is bad overall).

However, as Leonhardt points out, as an empirical matter, its not clear that tax rates make that much of a difference to overall economic performance.  The best decade for growth in the postwar period was the 1960's, when the top marginal income tax rate was over 70% (as I noted in the second-ever post here).  The economy did well after the 1993 increase in the top marginal tax rates, and not particularly well after the 2001 and 03 rate cuts.

Of course, that doesn't prove anything - the effect of any policy should to be judged relative to a counter-factual. That is, perhaps the economy would have done even better in the 1990's without the tax increase, and even worse in the 2000's without the tax cuts.  Nonetheless, I think a brief glance at historical evidence is enough to convince us that lower marginal tax rates aren't some magical economic elixir.  As an economist, I'll never say that people don't respond to incentives, but, in the case of taxes, it looks like they don't respond very much.

Thanks Again, Europe?

As Free Exchange noted last week, early in 2010, the recovery appeared to be gaining momentum, but something happened in the spring.  This is visible in the data on private payroll employment (I've used the private sector to avoid the effect of the winding down of census employment), where the rate of growth clearly slips after April:

Free Exchange's preferred story is that the debt crisis in Europe - remember Greece? - is to blame for the wobble in the recovery:

In late April, fears of a serious European debt crisis began to emerge. These fears sparked a mild panic and a renewal in the flight to safety. This flight manifested itself, in part, as a rush to buy American government debt. Treasury yields had been rising in the months prior to the crisis, but plunged from April through the summer. The dollar shot up; the trade-weighted dollar rose nearly 5% from late April to early June. In response to the pressure within markets, the Fed reopened currency swap lines it had used in previous stages of the crisis. It did not, however, take steps to offset the impact of the financial hiccup on growth expectations.

Markets reacted. The Dow fell over 13% from late April to early July, and was still 10% off its April peak in late August. From January to April, 10-year inflation expectations were stable at around 2%. These began falling sharply, and were down to around 1.5% by the end of the summer. Every signal available began flashing a decline in economic expectations starting in late April.

And now, just as things are starting to look better again, the Times says:

Sigh.  Stupid Euro.

Cross of Stupidity

International contention over currencies and the Fed's announcement of another round of quantitative easing seem to have induced another bout of misplaced gold standard nostalgia.  In the Financial Times last week World Bank president Robert Zoellick called for a "cooperative monetary system" employing gold as "an international reference point."  Saturday's Times included an op-ed by James Grant which was even more direct:

Let the economists gasp: The classical gold standard, the one that was in place from 1880 to 1914, is what the world needs now. In its utility, economy and elegance, there has never been a monetary system like it.

I didn't gasp, I groaned.  Here is a plot of the US price level from January 1879, when the US rejoined the gold standard after relying on paper "greenback" money during the Civil War, through December 1913 (the gold standard collapsed around the outbreak of World War I 1914), normalized to 100 at the beginning.

Although the price level in the gold standard era lacked a long run trend, that doesn't mean it was stable.  While the change in the price level from Jan. 1879 to Dec. 1913 was modest (average annual inflation of about 0.5%), there were significant runs of high inflation, and even more perniciously, deflation.  Deflation raised the real value of debt burdens, which exacerbated the economic downturns of the time, which were frequent and severe (according to the NBER chronology, 189 out of 420 months were spent in recession).  Moreover, financial crises were a regular occurrence; the severity of the 1907 "panic" helped motivate the founding of the Fed, which Grant so dislikes, in 1913.  Its little wonder, then, that the gold standard was not universally liked at the time. The monetary system was one of the most bitterly contentious issues of the day, with the debate reaching its high point in the 1896 election, when William Jennings Bryan carried the south and west on a platform of freeing the US from the "cross of gold".

There are plenty of reasons to criticize the Fed and its management of the modern "fiat money" system, but even with all of its mistakes, its doing far better than the gold standard.

Regrets, They've Had a Few

From the Washington Post's Neil Irwin, an interesting report on a conference sponsored by the Atlanta Fed commemorating the 100th anniversary of the conclave at Jekyll Island that laid some of the groundwork for the Fed's founding.

On the issue of the day: 

"There's a sense out there that, quote, quantitative easing or asset purchases are some completely foreign, new, strange kind of thing and we have no idea what . . . is going to happen," Bernanke said, sitting onstage in a conference space that was once J.P. Morgan's indoor tennis court. "Quite the contrary - this is just monetary policy. . . . It will work or not work in much the same way that ordinary, more conventional, familiar monetary policy works." 

It is reassuring to have a Fed chairman who knows enough economic history that he's seen (or at least studied) it all before.

The Ultimate Response to "the Chinese Professor"

One unfortunate aspect of tough economic times is that the fear and anxiety that people feel can be exploited with appeals to tribalism.  For example, a group called "citizens against government waste" has been pushing a right-wing political agenda with this ad:



There are any number of substantive flaws in the ad's argument I could point out, but I could not hope to respond better than this hilarous parody, from Taiwan's Next Media Animation:



That comes to my attention via James Fallows (see also his post on the original ad).

A Hint of a Pulse

......................................................................................................

.......................................................................................meep!.....



The October employment report isn't really that good, but its soooo much better than what we've seen over the last few months... In particular, after falling for four consecutive months, nonfarm payroll employment rose by 151,000 in October.

The June-September reports looked so bad partly because the government was shedding workers (some of them temporary census workers). Because of this, some observers (and the White House) preferred to focus on private-sector payrolls, which have increased every month since January, albeit at a faltering pace. October's increase in private employment was 159,000, which was the best since April.

Of course, with 14.8 million unemployed, that's not nearly good enough to make a dent.  Essentially employment growth is back to a "treading water" pace, which only looks good after several months of drowning.

That is consistent with the headline number from the household survey: the unemployment rate was unchanged at 9.6% in October.  The underlying numbers aren't so hot - the number employed fell by 330,000 and the labor force participation rate fell from 64.7% to 64.5%.

Indeed, given the recent pace of real GDP growth (1.7% in the second quarter; 2% in the third, according to the advance estimate), we're lucky the unemployment rate hasn't risen, as Okun's law - which says that unemployment rises when growth is below 3% -  would imply.

Note that October is a month where the seasonal adjustment is downward; on a non-seasonally adjusted basis, payrolls increased 919,000 (private payrolls increased 409,000), and the unemployment rate fell to 9% (from 9.2% in September).

Paul Krugman refuses to be encouraged (of course):

So, we have a “strong” jobs report — with total employment still 7 1/2 million less than it was three years ago, we had job gains slightly higher than the number needed to keep up with population growth.
At this rate we’ll return to full employment around 2030 or so.

QE2 Sets Sail

Finally, quantitative easing (round 2), is here.  The Federal Open Market Committee announces:

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability. 

That would represent a roughly 25% increase in Fed assets (currently about $2.3 trillion, including $838 billion of Treasuries); and a drop in the bucket relative to $8.6 trillion in US debt held by the public.

Will it work?  That has been the subject of considerable debate, which echoes an old-school Keynesian versus Monetarist scrap: Among the Keynesian skeptics are Paul Krugman and Mark Thoma and Joe Stiglitz, who would prefer more fiscal expansion. On the other hand, David Beckworth and Scott Sumner are more optimistic that QE can be effective.

The markets appear to be siding with the pro-QE camp.  Stock prices and the dollar are little changed today, which indicates that the announcement was pretty close to what was expected.  However, since Ben Bernanke raised the possibility of further expansion in a speech on Aug. 27, the stock market has headed up,

and the dollar has fallen (graph is the dollar price of a euro, so up indicates a relative dollar decline)

Also, a recent auction of TIPS (Treasury Inflation Protected Securities) suggests that inflation expectations are rising (see this NYT story, and this Jim Hamilton Econbrowser post).

One FOMC member is not on board: Thomas Hoenig of the Kansas City Fed.  According to the announcement:

Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.  

That is similar to the view expressed by Martin Feldstein in this FT op-ed. Another worry, expressed by Ambrose Evans-Pritchard, is that QE will start "currency wars," to which I say, "bring it on" (see this previous post).

More details on the policy are available from the New York Fed, which will implement it.

Update: Economix has a more comprehensive set of links to views on QE.  In his Times column, David Leonhardt explains how "dovish" monetary views have been vindicated.  Real Time Economics rounds up reaction from "economists and others" (Mike Pence, really?!).  In a Washington Post op-ed, Bernanke explains "What the Fed did and why."  See also: Free Exchange, Gavyn Davies, Scott Sumner, James Hamilton.

Actual Consols

Today's macroeconomics class arrived at the point where I needed explain how bond prices and yields are inversely related.  Fortunately for us economists, the British government has issued perpetual bonds - i.e., bonds which pay a fixed amount ("coupon"*) to the holder with no end date - known as "consols," which make the concept easy to illustrate.

If one pays £100 for a consol with a coupon of £5, the yield is 5% (5/100).  If market interest rates rise to 10%, the consol would only be worth £50 (since 5/50 = 0.10).

I was asked if the consols, which were first issued in the 18th century, still exist today.  A little internet "research" confirms that, indeed, these long-ago loans to the British government are still providing the descendents of the aristocracy with the income to cruise around Kensington in Rolls-Royces.

This wikipedia entry explains briefly the history of consols. According to the UK Debt Management office, there is £177 million worth of "2.5% consolidated stock" still outstanding (there are several other issues, too).  As of today, according to a British trading website, the 2.5% consol is trading at 56.52, which means a yield of 4.4% (2.5/56.52 = 0.044).  This post at the FT Alphaville blog has a graph of consol yields going back to 1729.

Hmm... perhaps I should buy some, so that next time the question comes up, I can say, "yes, I have some."

*I'm not sure "coupon" is good terminology for consols - it comes from bonds that included coupons that the owner would physically cut off and redeem for the interest payments.  That wouldn't work with a perpetual bond.

Naive and Sophisticated Friedman

My ten words or less version of monetarism is: "the Fed should maintain a constant rate of money growth."  By that standard, Milton Friedman would probably not be pleased with the Fed:

David Beckworth and William Ruger, who have a more sophisticated understanding of Friedman's views, come to a similar conclusion in an op-ed, "What Would Milton Friedman Say About Fed Policy Under Bernanke?" They write:

Friedman would likely make the case today for more aggressive monetary action. It is time for "Helicopter Ben" to earn his nickname.

Beckworth has more at his blog.

On a related note, Brad DeLong argues that neither Friedman nor Keynes would be pleased with the new British government's austerity policy.

QE2 Is Already Working!

I have some sympathy for worries that quantitative easing may not be very effective - that it will prove to be another incarnation of "pushing on a string" (see e.g., Annie Lowrey; Mark Thoma), but this Times story about tensions stemming from the declining dollar indicates its already having an impact:

The dollar’s decline is being driven by what everyone in global markets is now expecting: another round of so-called quantitative easing by the United States. In the next few weeks, the Federal Reserve is expected to inject vast sums of money into the economy in another attempt to spur growth....
Financial markets expect the Fed to announce at its meeting early next month that it will proceed with more quantitative easing, involving purchases of bonds, which reduces longer-term interest rates and puts further downward pressure on the dollar.
That worries other countries. A stronger United States economy is in everyone’s interest, but they fear that investors will flee America’s low interest rates and declining dollar and instead pour capital into their markets, overheating their economies and creating the types of asset bubbles in stocks and housing that burst with such devastating effects in the 1990s.
Already there is evidence of this: American investment in overseas stock funds, which was running at about $4 billion a month over the summer, has surged since Ben S. Bernanke, the Federal Reserve chairman, suggested the possibility of another round of quantitative easing at the end of August. About $19 billion has flowed into these funds since Aug. 1, according to TrimTabs, a funds researcher. 

The great thing about expectations is that a policy can have an effect before it is implemented - the mere fact that the Fed is expected to announce a new round of expansion in November has been enough to help get the dollar down after its summer spike due to the Euro crisis.

Zooming out to a five-year view, we can see that the effect of the rush to buy dollar assets in the financial crisis still hasn't fully reversed, but its getting there:

Exchange rate movements tend to have a significant lag in their effect on the economy, but if the decline in the dollar persists, it will benefit tradable goods sectors and improve the trade balance (i.e., increase the NX component of GDP).

So, while I am concerned about whether pushing down long-term interest rates really will do much to stimulate investment (I in GDP), anticipation of the policy is already building in a stimulative effect through the exchange rate channel (and, moreover, the markets are speaking).

So, what of the worries of those "other countries" that financial inflows will "overheat" their economies?  If they choose to hold their currencies down, that would be a problem; the solution is to allow them to rise.  As Jim Hamilton writes at Econbrowser:

If other countries want to prevent their exchange rates from appreciating, they should respond with easing of their own, which from my perspective would be a win-win outcome for everybody. If other countries feel that easing is contraindicated for their domestic situation, then isn't that part of the case why the dollar needs to depreciate relative to their currencies, given the current economic conditions in the U.S.?

Or, more bluntly, "the dollar may be our currency, but your problem."  That, of course, is what Nixon's Treasury Secretary John Connolly famously said in 1971, as the Bretton Woods system collapse.  While I doubt Tim Geithner would speak so directly today, perhaps we are indeed at the end of the so-called Bretton Woods II regime, as Tim Duy predicted recently (see also Ryan Avent and the amusingly hysterical Ambrose Evans-Pritchard).

Raise Greg Mankiw's Taxes, Please!

I should start out by saying that I'm a fan of Greg Mankiw.  He has written some important (and good!) papers that have made influential contributions to both business cycle and growth theory.  Moreover, he is a very good writer - his academic work is enjoyable to read (which is rare!) and he communicates well to a general audience (though sometimes his political biases - which are different from mine - do show through).  I've used several of his papers in classes I've taught, and I've been a (mostly) satisfied user of his intermediate macroeconomics textbook since I began teaching the course as a grad student back in 2003.

In a column for the NY Times, he uses himself as an example of how a change in marginal tax rates could reduce labor supply:

Suppose that some editor offered me $1,000 to write an article. If there were no taxes of any kind, this $1,000 of income would translate into $1,000 in extra saving. If I invested it in the stock of a company that earned, say, 8 percent a year on its capital, then 30 years from now, when I pass on, my children would inherit about $10,000. That is simply the miracle of compounding.

Now let’s put taxes into the calculus. First, assuming that the Bush tax cuts expire, I would pay 39.6 percent in federal income taxes on that extra income. Beyond that, the phaseout of deductions adds 1.2 percentage points to my effective marginal tax rate. I also pay Medicare tax, which the recent health care bill is raising to 3.8 percent, starting in 2013. And in Massachusetts, I pay 5.3 percent in state income taxes, part of which I get back as a federal deduction. Putting all those taxes together, that $1,000 of pretax income becomes only $523 of saving.

And that saving no longer earns 8 percent. First, the corporation in which I have invested pays a 35 percent corporate tax on its earnings. So I get only 5.2 percent in dividends and capital gains. Then, on that income, I pay taxes at the federal and state level. As a result, I earn about 4 percent after taxes, and the $523 in saving grows to $1,700 after 30 years.

Then, when my children inherit the money, the estate tax will kick in. The marginal estate tax rate is scheduled to go as high as 55 percent next year, but Congress may reduce it a bit. Most likely, when that $1,700 enters my estate, my kids will get, at most, $1,000 of it.

HERE’S the bottom line: Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working.

So, if Mankiw's marginal tax rate reverts to its Clinton-era levels as scheduled under current law, when his editor calls to tell him its time for a new edition of his textbook, he would decline?

If we're doing a social cost-benefit analysis of changing Greg Mankiw's marginal taxes, we should account for externalities, positive and negative.  Following Mankiw's lead, I'll use myself as an example, and explain a benefit to reducing Mankiw's labor supply that should be accounted for in his analysis.

I would be better off if he decided the marginal benefit of an cranking out eighth edition was less than the marginal cost, and so would my students.  The churning of textbook editions (and this isn't Mankiw's fault, to be sure) is a real headache to instructors, and helps keep the cost high for students.  Though I'm sure it was well-intentioned (and thoroughly focus-grouped) a number of the changes from the sixth to seventh edition of his textbook made it worse from my point of view.  For example, I rather liked his discussion of New Keynesian and Real Business Cycle theory, which were supplanted by a "dynamic aggregate demand and supply" chapter that I'm not inclined to mess with.  And don't tell me I need my book "updated" for "current events." One of the fun things about teaching macroeconomics is that the world is always giving us interesting new examples to talk about.  But I can handle that quite well without some new "economics in the news" sidebars grafted into the textbook.

However, while the theoretical case that marginal tax rates can change behavior is clear, I'm not convinced, as an empirical matter, that Mankiw's would actually change.  After all, his book was first published in 1992, and he issued new editions in 1994 and 1997 when higher marginal tax rates on high levels of income (and capital gains and estates) were in effect.

Mark Thoma and Brad DeLong suggest some other possible shortcomings in his argument.

September Employment Report

According to the BLS, in September the economy lost 95,000 jobs, and the unemployment rate held steady at 9.6%.  Neither of those headline numbers is pleasant, but the first is more discouraging than the second - I suppose the choice of which one to emphasize depends on whether one sees the glass 10% full or 90% empty.

In this case, the reason for the discrepancy is the fact that the jobs number comes from a survey of businesses while the unemployment rate is calculated from a separate survey of households.  (Another potential explanation would be a decline in labor-force participation, but in September it remained unchanged.)  According to the household survey, the number of people employed actually increased by 141,000 (the payroll number from the establishment survey is usually preferred because it has a larger sample).

The decline in payrolls of 95,000 is the sum of an increase in 64,000 in private-sector jobs and a loss of 159,000 government jobs.  Federal government employment fell by 76,000 (77,000 temporary census jobs ended), state government employment fell by 7,000 and local government employment fell by 76,000 (of which 49,800 were in education).

So, ironically enough, the headlines from the last BLS report before the election will probably give a little more momentum to those who think "government spending" is the problem, even though the report shows that cuts in government spending are already acting as a drag on the economy.

One potential bit of good news from the bad news is that the gloomy report provides another piece of evidence to support the case within the Fed for more aggressive quantitative easing ("asset purchases").

The headline numbers are all seasonally adjusted to remove regular fluctuations that occur during the year.  On a non-seasonally adjusted basis, the unemployment rate fell from 9.5% to 9.2% (i.e., the seasonal adjustment factor raises the unemployment rate in September).  Also, non-seasonally adjusted payrolls rose 428,000 - including an increase of 865,800 in the "local government-education" category, so I think the correct interpretation of the government job loss is that fewer teachers and education workers were hired this year than usual.  Also, non-seasonally adjusted private payrolls fell by 412,000, so the seasonally-adjusted gain of 64,000 means that the private sector did not shed as many jobs as usual for this time of year.

See also: Economix, Free Exchange, Calculated Risk and RTE's round up of reactions.

The Output Gap

The Washington Post's Neil Irwin has a nice slide show to illustrate the output gap under several scenarios.  Check it out!

TARP: A Failure to Communicate

The Times reports that the estimated cost of TARP (a.k.a. "the bank bailout") has been revised downwards yet again:

Treasury reckons that taxpayers will lose less than $50 billion at worst, but at best could break even or even make money. Its best-case assumptions, however, assume that A.I.G. and the auto companies will remain profitable and that Treasury will get a good price as it sells its corporate shares in coming years. 

The Treasury has come out ahead on the money invested in the banking system - for example, it is making a profit on its investment in Citigroup.  The losses, if there are any, will come from the investments in the auto industry, and in AIG (which has announced a plan for unwinding its government ties).

The reality is certainly far different from the widespread perception that the government simply gave away $700 billion to Wall Street.  The failure to get the facts through people's thick skulls out appears to have had significant political consequences - would there be a "tea party" without this persistent misconception?  The Times story provides an example of the political consequences of this ignorance:

Among those who voted for the program in 2008, several Republicans have lost nominating contests for re-election or for another office, and others are on the defensive in fall races. Senator Robert F. Bennett of Utah was “Bailout Bob” to Republicans who refused to re-nominate him for a fourth term.
“For those who were screaming at me — and screaming was the operative word — ‘You’ve just saddled our children and grandchildren with $700 billion,’ I said, ‘No, I haven’t,” Mr. Bennett said in an interview.
“My career is over,” he added. “But I do hope that we can get the word out that TARP, number one, did save the world from a financial meltdown and, number two, did so in a manner that, I believe, won’t cost the taxpayer anything. And even if it did not all get paid back, it was still the thing to do.”

However, it should be noted that, while the financial cost of TARP will be much less than people think, the taxpayer is on the hook for some other costs because of the takeover of Fannie Mae and Freddie Mae (an indirect bank bailout).  The real cost, Simon Johnson argues, is that TARP (and the Dodd-Frank financial regulation bill) failed to create an incentive structure that will prevent financial crises.  He writes:

The first draft of its history, looking back over the past two years, may be this: TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse — but it was implemented in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle.

He may be right.  But, for now, we are getting most of the money back, and our politics would be significantly different if people understood that much.

Inflation Above (Official) Target

Among its other benefits, a policy regime of inflation targeting, where a central bank has a clear primary focus of keeping inflation as close as possible to a certain level, has a pleasing clarity.  For example, the Bank of England Act of 1998 states:

In relation to monetary policy, the objectives of the Bank of England shall be –
(a) to maintain price stability, and
(b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.  

Compared to the mushy "dual mandate" of the Federal Reserve Act,

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.  

Matthew Yglesias finds the unambiguity of the Bank of England's regime refreshing:

The genius of this is that you now don’t need to have monetary policy matters be the subject of debates on op-ed pages and blogs with various board members giving interviews and speeches. If 2 percent inflation is too much inflation, well that’s on the heads of the politicians who set the target. If inflation is over 2 percent, then the Bank of England needs to tighten. And if inflation is below 2 percent, then the Bank of England needs to expand. Consequently, when faced with a giant downturn the Bank of England has had none of the self-induced paralysis of the Fed, the ECB, or the Bank of Japan. 

Yes, but... the Bank of England has been missing its target lately:

I think the BofE deserves great credit for being aggressive in its response to the economic crisis, but the inflation targeting regime forces it into making awkward excuses, like this from its inflation report:

CPI inflation remained well above the 2% target, elevated by temporary effects stemming from higher oil prices, the restoration of the standard rate of VAT to 17.5% and the past depreciation of sterling.  And the forthcoming increase in the standard rate of VAT to 20% will add to inflation throughout 2011.  As these effects wane, downward pressure on wages and prices from the persistent margin of spare capacity is likely to pull inflation below the target.  But the pace and extent of that moderation in inflation are impossible to predict precisely.  

The FT's Money Supply blog notes that the IMF approves of Britain's current loose monetary/tight fiscal policy mix (see also Free Exchange's comments).  But it is not clear that the inflation target has been helpful... indeed, the risk is that, by allowing inflation exceed the target, the Bank of England is damaging the "credibility" that inflation targeting was designed to buy.  Considering the circumstances, I'm inclined to believe that's a risk worth taking, it does raise questions about the whole inflation targeting concept. 

Inflation targeting is still relatively new. New Zealand was the first country to implement it, in 1988. The current global slump is inflation targeting's first real test, and, after the dust settles it will be interesting to evaluate how it performed.

Inflation Below (Unofficial) Target

In its Tuesday statement, the Federal Open Market Committee said that inflation is too low for its taste:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.  

Of course, we're used to central banks worrying about inflation becoming too high, so this is an unusual thing to see.  As Gavyn Davies writes:

The Federal Reserve broke a taboo yesterday when it said quite baldly that inflation in the US is now below the level “consistent with its mandate”. In other words, it is too low. This is a very big statement for any central banker to make, since the greatest feather in their collective cap is that they successfully combated inflation after the 1970s debacle. Led by the Fed’s Paul Volcker, they re-asserted the importance of monetary policy, after two decades of failed wage and price controls. Since that period, most central bankers have been careful to avoid any language which even hints that a rise in inflation is acceptable to them. I can certainly find no previous record of the FOMC saying that inflation is too low, so it was a jolt to see this stated so starkly in the Fed statement yesterday.  

Those who are still worrying about inflation, in spite of the data, are fighting the last war.  Fortunately, the Fed isn't interpreting the "price stability" part of its mandate to mean "zero inflation." The projection of board members' for inflation in the "longer run" can be taken as its unofficial target; as of the last release in June, they were aiming for expecting 1.7%-2.0% (as measured by the deflator for personal consumption expenditures). 

Both the consumer price index (red line) and core PCE deflator are consistent with the notion that the Fed is missing its target.

Moreover, the markets are skeptical that the Fed will hit it in the future, according to the Cleveland Fed:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.54 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

Moreover, the Cleveland Fed's estimates are for CPI inflation, which is generally higher than PCE inflation.

The Fed didn't actually do anything about this, but the acknowledgment of the problem is a step in the right direction.