Time for a Sterling Crisis?

The UK pound plunged again earlier this month:

two dates are marked with vertical lines: the the Brexit vote (red line) and the Prime Minister's speech signalling that the most likely outcome was a "hard Brexit" (green line) where the UK leaves the European single market (i.e., that it won't become part of the European Economic Area, like Finland* Norway, or negotiate an arrangement like Switzerland's).

Departure from the EU and the single market make the UK a less attractive location for foreign investment (see, e.g., comments from Nissan's CEO about its Sunderland plant).  A decrease in demand for UK assets implies a drop in the pound.  The UK is also a less attractive location for domestic investment now as well, and the situation is probably not a good one for consumer confidence - a reduction in demand due to lower desired consumption and investment would imply lower interest rates, which also would cause the pound to fall.

Is this yet another "sterling crisis"?  Not in the usual sense - as Gavyn Davies notes, there is no fixed exchange rate to defend this time, and most of the UK's external debt is denominated in pounds.

As Paul Krugman explains, a fall in the pound is a part of the adjustment process.  He writes:

But it’s important to be aware that not everyone in Britain is equally affected. Pre-Brexit, Britain was obviously experiencing a version of the so-called Dutch disease. In its traditional form, this referred to the way natural resource exports crowd out manufacturing by keeping the currency strong. In the UK case, the City’s financial exports play the same role. So their weakening helps British manufacturing – and, maybe, the incomes of people who live far from the City and still depend directly or indirectly on manufacturing for their incomes.

However, a rebalancing of the UK economy in favor of manufacturing exports will not come quickly, according to Barry Eichengreen (Robert Skidelsky goes further and argues for helping the process along through "import substitution" policies).

One likely consequence is inflation, as Ambrose Evans-Pritchard writes.  Prices of imported goods will rise significantly (though the process of "exchange rate pass-through" generally occurs with a lag - the "marmite row" may have been a harbinger of things to come).  The inflation will hit lower-income families especially hard, according to Evans-Pritchard's column, because the government has frozen some benefit payments, so inflation will cause their real value to fall.

Rising costs for imports don't only impact consumers - they also affect producers.  On the one hand, domestic producers benefit from increases in the relative prices of imported substitutes.  On the other - and this is becoming more and more relevant in an age of global supply chains - prices of imported inputs (intermediate goods) will rise, increasing production costs.

With the rise in cost of intermediate inputs and the greater costs of selling to its main trading partners, the impact of Brexit looks like a negative supply shock.  Supply shocks create a nasty dilemma for monetary policy.  Policy can "accommodate" the shock by allowing inflation to rise - doing so minimizes the increase in unemployment and helps keep output near its (diminished) potential.  Or the Bank of England could tighten policy to keep inflation in check, with negative consequences for output and employment.

The risk with accommodation is not just inflation itself, but a potential increase in inflation expectations and loss of the central bank's credibility. Part of the standard interpretation of 1970's stagflation is that the Fed was too accommodating after the 1973 oil shock, and which contributed to inflation expectations getting out of control.

The Bank of England has a formal 2% inflation target; right now inflation is running below target, but that will change.

I personally think its to Bank of England's credit that it's allowed inflation go above target at a couple of points during the turmoil of recent years.  If their policy is credible, an occasional miss doesn't cause inflation expectations to rise.  But the point of inflation targeting is to achieve credibility by meeting a stated target, so the BofE may be putting that at risk if it's always seen to be accommodating shocks.

*corrected 10/26

Revisiting Lehman

The eighth anniversary of the bankruptcy of the Lehman Brothers investment bank is coming up later this month.  It marked a point where the financial crisis, which had been simmering since summer 2007, seemed to go from bad to catastrophic.

One indicator of financial stress that we were all watching closely at the time was the "TED Spread" - the difference between the 3-month LIBOR (a rate on interbank loans) and the yield on 3-month US Treasuries - essentially a measure of the risk premium paid by financial institutions, which is normally quite low.

The blue line is drawn at Sept.15, 2008, the date of the Lehman Bankruptcy.

The Fed creatively expanded its "Lender of Last Resort" toolkit during the crisis, creating a number of new lending programs.  In March, it helped arrange the takeover of Bear Stearns by JP Morgan Chase.

Monday-morning quarterbacking of the government's actions (both the Fed's the Treasury's) began immediately and has never really stopped (academic macroeconomists consider it part of our jobs, after all).  One of the biggest questions has been why didn't Lehman Brothers get the same treatment as Bear Stearns?

The Fed did try to arrange a takeover by a healthier firm - a potential deal with Barclays was reportedly scuppered by British regulators - but no deal was finalized in time.  At the time, "moral hazard" concerns were prominent, and people felt the US government wanted to show that it was willing to let a financial institution fail.  Lehman's troubles were well-known, so it was hoped that the financial disruption would be modest since everyone had time to prepare for its demise.  More recently, officials have claimed that the Fed lacked the legal authority to rescue Lehman because it was truly insolvent - the intention of lender of last resort is to lend to illiquid banks, not insolvent ones (the Fed's loans are supposed to be backed by good collateral).

Laurence Ball of Johns Hopkins has dug into the records and is questioning the argument that the Fed did all it could (and should) have.  In a summary at VoxEU, he writes:

I conclude that officials’ explanation for the non-rescue of Lehman is incorrect, in two senses.
First, a perceived lack of legal authority was not the reason for the Fed’s inaction; and
Second, the Fed did in fact have the authority to rescue Lehman.
I base these broad conclusions on several findings, given below.

• First, before the bankruptcy, Fed staff extensively analysed Lehman’s liquidity risk and how the Fed might assist the firm. In the record of these discussions, there is little concern about the adequacy of Lehman’s collateral, and nobody suggests that legal issues might preclude a Fed loan.
• Second, arguments about legal authority made by policymakers since the bankruptcy are unpersuasive. These arguments involve flawed economic reasoning, such as confusion between the concepts of illiquidity and insolvency. They also include factual claims that are not supported by evidence. The Financial Crisis Inquiry Commission repeatedly asked Ben Bernanke for details about Lehman’s collateral problem, but Bernanke was unresponsive.

Further, from a de novo examination of Lehman’s finances, it is clear that the firm had ample collateral for a loan to meet its liquidity needs. In particular, I estimate that Lehman could have survived with $88 billion of overnight lending from the Fed’s Primary Dealer Credit Facility (PDCF), and the firm had at least $131 billion of assets that were acceptable as PDCF collateral.

Ball's argument was also discussed in a column by James Stewart in the New York Times.

In a Bloomberg View column, Barry Ritholtz disagrees with Ball's argument that Lehman was solvent, but, nonetheless, he thinks it could have rescued Lehman:

As subsequent events have shown, most especially with the Fed-led bailout of insurance giant American International Group, if there was a will, there most certainly was a way. Given all of the various bailouts of dubious legality, the Fed, Treasury and Congress most certainly could have devised a rescue plan for the 158-year old bank.

Even though he thinks Lehman could have been rescued, on the question of whether it should have, Ritholtz disagrees with Ball and believes that the Fed was correct to let it go:

No, Lehman Brothers did not “precipitate” the financial crisis. The better metaphor is that Lehman was the first trailer in the park to be destroyed by the tornado. Whether it lived or died was not going to stop the financial forces that had been decades in the making and unleashed when the credit bubble popped.

I agree with Ann Rutledge, a principal with New York-based R&R Consulting, and co-author of two books on structured finance. She noted “It wasn’t a mistake to let Lehman fail, it was a mistake to let it live so long.”

I haven't yet tackled Ball's monograph - perhaps that would be a good project for my Money and Banking students in block 5...

Hysteresis and Monetary Policy

In the Washington Post last week, Larry Summers wrote about some new research finding evidence of "hysteresis."  This is a term borrowed from the natural sciences for when temporary occurrences have lasting effects - e.g., when you hold a magnet up to a piece of metal, the metal remains magnetized even after you remove the magnet.  In macroeconomics, hysteresis occurs when an economic downturn has a lasting effect on economic capacity (i.e., reduced "potential output"); that is, lack of demand creates its own lack of supply.

Hysteresis could occur through a number of channels. Consider an economy described by an aggregate production function Y* = AF(K,N*) where potential GDP (Y*) depends on productivity (A),  capital (K) and labor at its "natural" or "full-employment" level, N*.  A recession occurs when output falls below Y* and labor is below N* (i.e., there is unemployment in excess of the "natural rate").  Hysteresis implies that there is a lasting impact on Y* - this could occur through technology, capital or labor.

All three channels could be operative. In the past several years, productivity growth has been sluggish, though its not clear if this is linked with the recession (productivity trends are always somewhat mysterious).  The recovery of investment (the rate of flow into the stock of capital) from the recession has been less than spectacular, even taking out housing - the share of GDP devoted to nonresidential fixed investment is somewhat below its peak in previous expansions. 

Here, I want to focus on labor, where the hysteresis effects are pretty evident, and raise an interesting policy dilemma. 

Although the unemployment rate has fallen to what we might consider a reasonably healthy level of 5% (the normal turnover of a healthy labor market generates some unemployment so we never expect it to get to zero), the labor market still clearly bears the scars of the 2008-09 recession.

The duration of unemployment spells rose to unprecedented levels and has remained elevated (a useful comparison is to the 1981-82 recession - the unemployment rate peaked at 10.8% at the end of 1982, but the dynamics of duration were not nearly as severe).

People with spells of long-term unemployment have a harder time finding jobs.  But looking at the unemployed leaves out those who left the labor force entirely.  The last several years have seen a significant drop in labor force participation rates, even among people aged 25-54 (focusing on this group is a rough way to control for the drop in overall participation due to an aging population, though as this Calculated Risk post notes, there is a composition effect even within the 'prime age' group).

The labor market clearly is not as robust as the headline unemployment rate suggests.

What are the implications for monetary policy of having a high proportion of long-term unemployed, and possibly a substantial latent group of unemployed who have left the labor force?  One answer is suggested by this St Louis Fed blog post by Stephen Williamson:

[I]f we think of the long-term unemployed as being subject to the mismatch problem and highly likely to leave the labor force, then these unemployed workers are not contributing much to labor market slack. They are unlikely to be hired under any conditions. 

That is, the unemployment (and presumably the depressed particpation rate, too) is "structural" in nature, and not amenable to any improvement in aggregate demand that might be generated with expansionary monetary policy.

An alternative view is that the long-term unemployed, and some of those who have exited the labor force, could be brought back into employment by particularly strong aggregate demand - what used to be called a "high pressure" economy.  This would be possible if the forces of hysteresis work in both directions, as this 1999 paper by Laurence Ball suggested.

That seemed to me to be what Janet Yellen was hinting at in her September speech at UMass-Amherst when she said:

Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilizing at 2 percent. For example, attracting discouraged workers back into the labor force may require a period of especially plentiful employment opportunities and strong hiring. Similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filling part-time positions. Beyond these considerations, a modest decline in the unemployment rate below its long-run level for a time would, by increasing resource utilization, also have the benefit of speeding the return to 2 percent inflation. Finally, albeit more speculatively, such an environment might help reverse some of the significant supply-side damage that appears to have occurred in recent years, thereby improving Americans' standard of living.

It seems to be that doing this would likely entail the Fed overshooting its 2% inflation target.  I have my doubts about their willingness to do this (and Yellen certainly did not suggest it).  And for it to work, inflation expectations would need to remain anchored (i.e., if any additional inflation just ratched up expectations, it would not bring unemployment down).

One of These Things is Not Like the Others

Among the steps the Fed has taken to increase transparency in recent years is the release of projections by the board members and regional bank presidents.  This includes the "dot plot" indicating each participant's belief about what the appropriate federal funds rate target will be at the end of this year and the next three years.

One of the dots from the latest release (I've indicated with a red arrow) shows a preference for a negative fed funds rate this year and next, and a much lower rate than everyone else expects at the end of 2017.

People on twitter seem to think its most likely Minneapolis Fed President Kocherlakota's dot.  It called to mind this, from the deep recesses of childhood memory:
(That's from Sesame Street). 

Of more serious interest, the projections also included a reduction in the median "longer run" federal funds target, to 3.5%, from 3.8% at the last release in June, and also a lower estimate of the "longer run" unemployment rate, which might be taken as a proxy for a NAIRU estimate (see Krugman).

A Note on "Credibility"

Fed watchers are speculating that the FOMC meeting later this month might be the occasion to raise the federal funds rate target off the "zero lower bound," where it has been since December 2008.  In a column arguing against such a move, Larry Summers writes:

From the Depression to the Vietnam War to the Iraq war to the euro crisis, we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors. The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions. The greatest damage it could do to its credibility would be to embrace central-banking shibboleth disconnected from current economic reality.

At the Fiscal Times, Mark Thoma writes:

The inflation problems of the 1970s, the loss of Fed credibility that came with it, and the need to impose the Volcker recession in the early 1980s to bring inflation down to tolerable levels made an indelible impression on policymakers who lived through that time period. The Fed’s trigger-happy response to any suggestion of an inflation problem is directly related to the desire to never let such an inflation outburst happen again.

But it has been more than four decades since the beginning of the inflation problems of the 1970s, and the economic environment in which monetary policy operates has changed considerably since that time. Those changes support patience, particularly in response to increases in wages, wages that have been stagnant since the 1970s even as labor productivity has been increasing.

The "credibility" argument in monetary policy is based on the idea that the central bank will be tempted to use inflation to "overheat" the economy and bring unemployment down below its "natural" (or equilibrium) levels for political reasons - e.g., to help the incumbent party in an election year.  Any gains would be, at best, short-lived, as people would incorporate a higher level of inflation into their expectations and set wages and prices accordingly.  Based on this logic - which seems helpful for interpreting how we got into the "stagflation" of the 1970s - economists look for policies and institutional structures to correct this perceived inflationary bias.

In the past several years, this logic seems turned on its head.  If anything, the biases of our monetary policymakers appear to be in the other direction.  Inflation continues to be subdued, as this plot of one of the Fed's preferred measures, the "core" deflator for personal consumption expenditures, shows:

The red line is drawn at 2%.  Measures of expected inflation are also below 2%.  David Beckworth recently argued that the Fed is acting as if 2% is a ceiling, not a target - he suggests the Fed's behavior is consistent with it aiming to keep inflation between 1% and 2%.

But the the Fed declared in 2012: "The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate." If the goal is to "anchor" expectations at 2%, the Fed is at risk of failing, but the greater threat to its credibility seems to be too little inflation, not too much.

Pushing on a String

One for the footnotes: Timothy Taylor has tracked down the origin of the "pushing on a string" metaphor for expansionary monetary policy in a depressed economy.  It looks like we owe it to Maryland congressman Thomas Alan Goldsborough, who used it in a 1935 hearing with Fed Chairman Marriner Eccles.

The Birth of Inflation Targeting

Inflation targeting, where monetary policy is directed to aim for a specific level or range for the inflation rate, has become a widespread practice.  The Times' Neil Irwin looks back at its first implementation by New Zealand; he writes:

Sometimes, decisions that shape the world’s economic future are made with great pomp and gain widespread attention. Other times, they are made through a quick, unanimous vote by members of the New Zealand Parliament who were eager to get home for Christmas.

That is what happened 25 years ago this Sunday, when New Zealand became the first country to set a formal target for how much prices should rise each year — zero to 2 percent in its initial action. The practice was so successful in making the high inflation of the 1970s and ’80s a thing of the past that all of the world’s most advanced nations have emulated it in one form or another. A 2 percent inflation target is now the norm across much of the world, having become virtually an economic religion.

Irwin goes on to provide a nice description of how and why New Zealand adopted this policy. Although it initially seemed quite successful in achieving the goal of avoiding a repeat of the high inflation if the 1970s (which continued well into the 80s in some countries) while maintaining reasonable growth rates, it has been tested by the experience of the past seven years.  One question is whether the level of 2 percent is the right one.  Irwin describes how Janet Yellen successfully argued against those at the Fed who wanted to go for zero inflation in the mid-1990s, but even 2 percent may be too low:

Starting in the late 1990s, Japan found itself stuck in a pattern of falling prices, or deflation, even after it cut interest rates all the way to zero. The United States suffered a mild recession in 2001, and the Fed cut interest rates to 1 percent to help spur a recovery. Then came the global financial crisis of 2007 to 2009, spurring a steep downturn across the planet and causing central banks to slash interest rates.

All of this has quite a few smart economists wondering whether the central bankers got the target number wrong. If they had set it a bit higher, perhaps at 3 or 4 percent, they might have been better able to combat the Great Recession because they could cut inflation-adjusted interest rates by more.

The apparent initial success as well the reasons for recent doubts can be seen in the UK's experience, which adopted inflation targeting in 1998:

(the chart data is from the OECD, via FRED.  The UK's target was initially 2.5%, but expressed in terms of a different price index measure, when it switched to using the CPI, it moved the target to 2% based on differences in the measures.)

While the UK generally has had low and (relatively) stable inflation since the early 1990s, it did miss its target considerably in 2007-2012, and it may be in danger of undershooting its target (as the Fed is) - inflation in November was 1% (this is not evident in the chart because it plots the percentage change in the price index from the year before).

Although I think the Bank of England deserves credit for not tightening in the face of inflation which ultimately proved transitory, this does call the inflation targeting framework into question.  Arguably, it may have helped keep inflation expectations "anchored" even as inflation deviated from target.  However, at some point, one would expect such deviations to undermine the credibility of the regime, and it was the idea of establishing credibility that made it attractive to academic economists in the first place (the underlying intuition for this was nicely described in this speech by Philadelphia Fed President Charles Plosser).

The other question, of whether a higher target, or a different one - such as a target price level (inflation is the rate of change of the price level) or nominal GDP - would be better is an interesting and important one.  The difficulty now is that, having established a monetary policy rule, the credibility of any new rule could be diminished by a change in rules.

 

FOMC 2008

On Friday, the transcripts of the Federal Open Market Committee meetings from 2008, the year when the financial crisis intensified and the economy collapsed.

The striking thing is how little sense the board members had of how bad things were getting.  Even late in the year, the committee was seriously concerned by inflation.  The Times' Binyamin Appelbaum writes:

The Fed’s understanding of the crisis, however, was clouded by its reliance on indicators that tend to miss sharp changes in conditions. The government initially estimated, for example, that the economy expanded in the first half of 2008 because it basically assumed that some economic trends, like the pace of business creation, had continued apace. The Fed also relied on economic models that assumed the existence of smoothly functioning financial markets, limiting its ability to project the consequences of a breakdown. And the outlook of Fed officials also reflected a deeply ingrained bias to worry more about the risk of inflation than the reality of rising unemployment.

As Fed officials gathered on Sept. 16 at their marble headquarters in Washington for a previously scheduled meeting, stock markets were in free fall. Housing prices had been collapsing for two years, and unemployment was climbing.

Yet most officials did not see clear evidence of a broad crisis. They expected the economy to grow slowly in 2008 and then more quickly in 2009.

The Times also put together a fantastic interactive graphic linking quotes from the meetings to the events of the year.

A couple of things stood out to me in looking over the transcript from September 16 (the day after the Lehman bankruptcy), when the committee voted to hold the fed funds rate target at 2 percent:

The committee member with the best perception of how bad things were getting was Eric Rosengren, President of the Boston Fed, who argued for a rate cut: 

This is already a historic week, and the week has just begun. The labor market is weak and getting weaker. The unemployment rate has risen 1.1 percentage points since April and is likely to rise further. I am not convinced that the unemployment rate will level off where the Greenbook is assuming currently.

The failure of a major investment bank, the forced merger of another, the largest thrift and insurer teetering, and the failure of Freddie and Fannie are likely to have a significant impact on the real economy. Individuals and firms will become risk averse, with reluctance to consume or to invest. Even if firms were inclined to invest, credit spreads are rising, and the cost and availability of financing is becoming more difficult. Many securitization vehicles are frozen. The degree of financial distress has risen markedly. Deleveraging is likely to occur with a vengeance as firms seek to survive this period of significant upheaval. Given that many borrowers will face higher interest rates as a result of financial problems, we can help offset this additional drag by reducing the federal funds rate.

I think those of us who reside in District One can be proud of our Fed president. District Eleven (Dallas), on the other hand, well.... Richard Fisher:

That said, in my anecdotal interchanges, I am still hearing about the likelihood, as I think President Pianalto mentioned, that people are seeking to preserve their margins. They’ve been stung for many years, and I’ll just give you one case because I think it tells us something. If you talk to the CEO of Wal-Mart USA, what they are pricing to be on their shelf six to eight months from now has an average price increase of 10 percent. Now, of course, you might have this reversed as we go through time. My biggest disappointment, incidentally, was that the one bakery that I’ve gone to for thirty years, Stein’s Bakery in Dallas, Texas, the best maker of not only bagels but also anything that has Crisco in it, [laughter] has just announced a price increase due to cost pressures.

Well, there's a pretty good case that the trend of academic economists supplanting bankers and businesspeople on the FOMC has been a good thing.  To be fair to Fisher, though, part of the reason for the use of anecdotal evidence is that the data does not give the Fed a clear, real-time picture of the state (and direction) of the economy.  The chart below, from ALFRED, compares what the GDP data that were released shortly after that meeting showed (blue line), compared to the most recent vintage of data (i.e., what we know now, in red):

It is easy, with the benefit of hindsight, to criticize the committee members whose worries over inflation and optimism about the impact of the financial crisis look so foolish today (and this applies to some of the academic members, not just Fisher).  But looking at the data they had at the time underscores the fact that their task isn't so easy.

On the Yellen Bandwagon

The quasi-campaign for the next Federal Reserve chair continues... Heidi Hartmann and Joyce Jacobsen (my office neighbor) have organized an open letter from economists in support of Janet Yellen, which concludes:

[W]e believe that Janet Yellen is an extremely effective leader who has demonstrated her capacity to work with the other FRB governors and to bring important perspectives of the American people to her leadership and decisions.  In our opinion, she is the best possible leader for the Federal Reserve Board at this critical time in our nation’s history.

The whole thing can be read here, and there is a link for economists who wish to add their names.

The letter has already been successful in attracting quite a few signatories, including some big names, like Michael Woodford (who Richard Clarida called "the leading monetary theorist on the planet right now" in this Bloomberg profile), Alan Blinder, Christina Romer, David Romer, Robert Shiller, Maurice Obstfeld, James Hamilton (who endorsed Yellen at Econbrowser), Mark Gertler, Menzie Chinn and Charles Engel.

In addition to having the support of economists, Yellen has also been endorsed by The Economist.

There has been quite an outpouring of commentary on this, though I don't think any of it has fundamentally changed the preference for Yellen over Summers I expressed in July after Ezra Klein's initial report that Summers was the front-runner (was that the worst trial balloon ever?).  However, Jared Bernstein, who worked with him in the White House, did argue persuasively that some of the vilification of Summers as a Wall Street stooge is off-base.  This story by Zachary Goldfarb details how and why President Obama became so enamored of Summers.  But as Steven Pearlstein argued (and so did Felix Salmon) that very closeness to the President is problematic from the standpoint of central bank independence.

One of the things I like about Yellen is that she appears to represent stylistic continuity with Bernanke, who has tried to de-personalize the making of monetary policy.  However, I think an argument could be made for a regime change in substance - a shift to a new monetary rule, like nominal GDP targeting as Christina Romer called for (and Scott Sumner persistently evangelizes for), or Laurence Ball's suggestion of a higher inflation target (which I also raised back in 2008), or Ken Rogoff's "sustained burst of moderate inflation."  A Fed chair openly advocating such a fundamental policy shift does not appear to be in the cards - certainly it would be problematic in the confirmation process, and there is no guarantee that the FOMC could be brought along anyway.  Of the options that are on the table now, Janet Yellen clearly seems the best to me.

Of Summers, Discontent

Based on conversations with "plugged-in sources", Ezra Klein reports:

The word among Federal Reserve watchers right now is that the choice is down to Janet Yellen or Larry Summers as Ben Bernanke’s replacement. I can’t find anyone who really thinks it’ll be Roger Ferguson, Tim Geithner, Alan Blinder, or some other dark horse.

People dismissed Summers’s chances a month or two ago, but he’s increasingly viewed as the leading candidate today — and opinions on this, for reasons I don’t fully understand (though I suspect have to do with a bunch of elite trial balloons going up at the same time), have really hardened in the last 72 hours.

I'd thought the persistent reports that Summers was a leading candidate represented some wishful thinking among writers in need of a more interesting story; like Matt Yglesias, I thought Yellen over Summers a no-brainer.  Yellen's qualifications are beyond doubt - she has strong academic credentials and experience at high levels of the Fed.  From a political perspective, Summers seems to have obvious drawbacks - supposedly one of the reasons Obama appointed him CEA chair rather than Treasury Secretary at the beginning of his administration was to avoid a messy confirmation fight (the CEA position does not require Senate approval).

Moreover, as Bill McBride details, "Yellen has a much better track record of correctly analyzing the economic situation, while Summers has frequently been wrong (but never in doubt)" and Cardiff Garcia's endorsement of Yellen provides further evidence on that point.  Scott Sumner is also unimpressed with Summers' views (or lack thereof) on monetary policy.

Also, as Paul Krugman notes:

[Y]ou need someone who can be effective at bringing the rest of the Fed along — but that’s a bit of a mysterious quality. Ben Bernanke has been far better at that than one might have expected from an academic. Looking forward, which is better: someone who has already demonstrated an ability to get along with her Fed colleagues, or someone who has a reputation as a tough guy but also a reputation for raising hackles? 

As Richard Grossman explains, one of Bernanke's big achievements has been to move away from the "cult of personality" style of central banking that was one of the worst aspects of the Greenspan era.  In that respect, appointing someone with a reputation for being obnoxious "strong personality" like Summers would likely be a step backward.

Up to this point, I've refrained from mentioning the fact that an appointment of Yellen would be historic because she would be the first woman to lead the Fed.  Even without taking that into consideration, its clear that she is a strong candidate, and Summers a highly problematic one.  But breaking the "glass ceiling" that still seems to exist in the monetary policy world would be no small thing.

Ezra Klein recently argued in a column that there was an undercurrent of sexism in some of the arguments being made against Yellen (e.g., "She lacks 'toughness.' She’s short on 'gravitas.' Too 'soft-spoken' or 'passive.'").  He pointed out that

An interesting wrinkle is that the current chairman of the Federal Reserve doesn’t fit the default masculine leadership model himself. Bernanke is soft-spoken and conciliatory. He doesn’t pound the table in meetings or preen at conferences. When he took the job, there were concerns about his gravitas. He’s not a social or political force around Washington in the way his predecessor, Alan Greenspan, was. He leads by consensus, with none of the high-stakes showdowns that burnished the legend of former Fed chairman Paul Volcker. Yet Bernanke has managed to pull the Federal Reserve through an extraordinarily turbulent period.

Yellen’s background bears similarities to Bernanke’s, though she’s got more Washington and Fed experience than he did at the time of his appointment. 

Klein generally seems to know what he's talking about, and I believe him when he says his reporting is well-sourced.  His story lays out the reasons Obama is apparently leaning towards Summers, none of which I find very persuasive.  I hope he's wrong on this one.

See also: Noam Scheiber, who asks "can we at least talk it over first?"

Update (8/1): There has been quite an outpouring of commentary on this in the last week.  While much of it focuses on the perceived drawbacks of Summers (e.g., Paul Krugman), James Hamilton makes a case for Yellen.  The New York Times has editorialized in favor of Yellen, and President Obama defended Summers at a meeting with congressional Democrats (he also mentioned Don Kohn as a possibility for the Fed position).  This widespread, almost campaign-like debate is little uncomfortable for those who subscribe to the view that the Fed should be somewhat removed from politics.

Ezra Klein dug further into the administration's arguments for Summers, and Brad DeLong makes a (somewhat lonely) pro-Summers case (see also his blog post).

The 'Woodford Period': A Bourbon for Bernanke?

The news release summarizing  St. Louis Fed President's James Bullard's recent speech on the "current stance of monetary policy" includes the following:

He stated that “the current St. Louis Fed forecast for the unemployment rate implies that the 6.5 percent threshold will be crossed in June 2014.” However, he noted, the policy rate implied jointly by the Taylor (1999) rule and the St. Louis Fed forecasts should increase in August 2013.  Thus, “The Committee’s thresholds imply a ‘Woodford period’ since the policy rate would be held at zero past the point where ordinary FOMC behavior would indicate an increase,” Bullard said.   

William McChesney Martin, who chaired the Fed in the 1950's and 60's once said it was the Fed's job "to take the punch bowl away just as the party gets going."  It sounds like the Fed's new corollary to Martin's rule involves leisurely sipping bourbon for a while when the economic slump is ending.  If the slump is the hangover from a financial crisis, maybe its kind of a "hair of the (monetary) dog" thing.

The release continues:

The period from August 2013 to June 2014 would be the “Woodford period,” which refers to Michael Woodford of Columbia University.  “According to received theory, this is a more stimulative monetary policy and possibly even an optimal monetary policy when the zero lower bound is constraining,” Bullard added.  

Oh, "Woodford" is the author of Interest and Prices, not Woodford Reserve bourbon whiskey.

Perhaps that's for the best... if distilleries expected the Fed to print money to buy bourbon we might expect to see them them start diluting it in anticipation.  Hmmm...

The End of Mystique

Until fairly recently, central banks tended to be secretive and cultivate a "mystique" (hence "Secrets of the Temple" as the title for the 1987 William Greider book about the Fed, which helped inspire my interest in economics). In the early 1980's Karl Brunner explained (via Marvin Goodfriend):

Central Banking [has been] traditionally surrounded by a  peculiar and protective political mystique. Criticism of Central Banks, if it occurred at all in the political arena, [has been] muted and infrequent. The Federal Reserve operated in the USA over decades with little criticism from the public or its political representatives. The same phenomenon can be found in many other countries. The political mystique of Central Banking was, and still is to some extent, widely expressed by an essentially metaphysical approach to monetary affairs and monetary policy-making. The possession of wisdom, perception and relevant knowledge is naturally attributed to the management of Central Banks. The possession of such knowledge and perception bearing on matters of concern to Central Banking is a function of the political position. The relevant knowledge seems automatically obtained with the appointment and could only be manifested to holders of the appropriate position. The mystique thrives on a pervasive impression that Central Banking is an esoteric art. Access to this art and its proper execution is confined to the initiated elite. The esoteric nature of the art is moreover revealed by an inherent impossibility to articulate its insights in explicit and intelligible words and sentences. Communication with the uninitiated breaks down. The proper attitude to be cultivated by the latter is trust and confidence in the initiated group's comprehension of the esoteric knowledge.

Things have changed a great deal since then, and the pace of change has accelerated.  In a recent speech, Fed Vice Chair Janet Yellen traced this "revolution" in central bank communication, which academic economists generally regard as an improvement.  It was only in 1994 that the Fed began announcing changes in the federal funds rate target, and I was pretty surprised last year when Bernanke began holding press conferences.

Given all the recent changes, I shouldn't have been surprised to see a further step towards greater central bank openness - Federal Reserve banks are now sending jokey tweets:

So much for that mystique.

New From the Fed: TBG

That is, "Threshold Based Guidance." 

The Federal Open Market Committee's statement today included the following:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Since the federal funds rate hit the zero lower bound - four years ago - other monetary policy tools have taken on a more prominent role.  One of them is the Fed's ability to influence expectations, which it tries to do by making promises about future policy ("forward guidance").  Because long-term interest rates depend on expected future short term rates, convincing people that short-term rates will be low for longer can bring down long-term rates, and thereby reduce the cost of investment and credit purchases.  One of the difficulties that the Fed has to get around, though, is that people believe it places a high priority on keeping inflation low and would tighten policy at any hint of the economy heating up.  As Mark Thoma explains:

The Fed believes that policy will be most effective if it can convince people policy will remain loose even after there are signs of a strong recovery.

However, one of the problems the Fed has had in its communications strategy is convincing people it will carry through with this commitment even if inflation drifts above the 2 percent target. In some sense, the Fed has too much credibility on inflation.

The adoption of numerical thresholds -- in particular an inflation threshold that is a half a percent above target and the commitment to maintain present policy "at least" until the thresholds have been met -- is an attempt to overcome this communication problem though a commitment to a clear, well-defined policy rule.

This month's announcement was a shift from its previous statements, which had provided forward guidance in terms of the timing of expected rate increases - e.g., in October, the FOMC said "exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."

Of course, quite a lot can happen between now and mid-2015 and the economy may do considerably better or worse than anticipated. Nobody really believes the Fed would keep the federal funds rate target at zero through mid-2015 if the economy suddenly boomed in 2013 (and, though some seemed to interpret it that way, its wasn't trying to claim that it would).  Alternatively, if things aren't much better in 2015, the fed funds rate could stay at zero considerably longer.

Shifting to thresholds spares the Fed the embarrassment of repeatedly re-adjusting the date in its forward guidance.  Announcing that it will allow forecast inflation to go up to 2.5%, which is 0.5% above the long run goal it formalized in January, seems to be an attempt to convince everyone that the Fed doesn't treat its 2% goal as a "below, but close to" target like the ECB does, and that it is willing to give a little on the "stable prices" side of its "dual mandate" in service of its other objective, "maximum employment."  But it won't let inflation get out of hand (or even close) - its a "dovish" statement only  by the standards of monetary policy discourse long-dominated by inflation "hawks".  Stating the goal in terms of the Fed's forecast of inflation means that it won't feel obliged to tighten in response to a burst of inflation it sees as transitory (e.g., due to an energy price shock).  However, putting it in terms of forecast inflation also makes it a little squishier (which is part of Stephen Williamson's critique).

In his press conference, Ben Bernanke also suggested that the threshold based guidance had an "automatic stabilizer" characteristic (and it appeared he was making this argument off the cuff): in the event of a negative shock to the economy, the threshold would cause markets to lengthen the period of expected zero short-term rates, which would bring long-term rates down.  A positive shock would cause the market to expect the threshold for potentially raising rates to come sooner, which would lead to higher long-term rates.

The other part of the Fed's announcement was that it planned to purchase $45 billion of Treasuries per month, which is intended to continue the expansionary effect of its effort to shift the composition of its balance sheet towards longer maturities ("operation twist").  It will also continue to buy $40 billion of mortgage backed securities per month.  This follows through on its October statement that it would be purchasing assets and expanding its balance sheet with no definite limit or end date until a substantial improvement in the labor market "is achieved in a context of price stability."

Overall, the Fed really seems to be stepping up to the plate and seriously trying to address the crisis of persistent high unemployment as best it knows how.  Bernanke's genuine concern about unemployment was evident in the press conference.

Of course, it remains to be seen how much effect the Fed's policies will really have (the Economist's Greg Ip struck a cautionary note) and fiscal policy appears likely to be either somewhat, or highly, contractionary in the coming year depending on the outcome of the "fiscal cliff" bargaining.

As an academic economist, I was particularly amused by Bernanke's response to a question in the press conference about how the FOMC chose the thresholds.  He said that they were based on staff assessments "under so-called optimal policy, or in the best policy that we can come up with, what would the interest rate path look like and how would it be connected or correlated with changes in unemployment and inflation."  That embodies the tension between academic and policy-making economics.  Bernanke comes from the academic world, where we write and discuss papers about "optimal" policies - usually specified in terms of the utility functions of "agents" in the economy - but he now works in the world of "the best policy that we can come up with".

We academics will be debating how sub-optimal the Fed's policy is for years, but at least they're trying to come up with the best policies they can.

See also: Binyamin Applebaum's NYT story, Neil Irwin, Michael Woodford and David Beckworth.

Richard on Gold

The inclusion of a plank supporting a commission to study a return to the gold standard in the Republican platform has prompted a number of economists to explain (again) why it is a bad idea.

In an LA Times op-ed, my Wesleyan colleague Richard Grossman writes:

History provides ample evidence that the gold standard is a bad idea. After World War I, the major industrialized nations established the gold standard, which is widely seen as having contributed to the spread and intensification of the Great Depression. The gold standard tied the hands of monetary policymakers, forcing them to maintain high interest rates in order to maintain the price of gold, thereby making a bad economic situation even worse.

See also Paul Krugman.  My version of the case against gold is in this earlier post.

Dirty Mario?

From a story by the Times' Landon Thomas about ECB President Mario Draghi:

“You do not go back to the lira or the drachma or whatever,” Mr. Draghi declared at that same early-August news conference. By alluding to the former currency of his home country, Italy, and seeming to place it in the same category of woebegone Greece, Mr. Draghi — who played a crucial policy role in the euro’s creation — signaled that he was taking the bears’ skepticism personally. 

“It’s like Dirty Harry saying, ‘Make my day,”’ said Stephen Jen, a former economist at the International Monetary Fund who now manages a hedge fund based in London. “You can’t imagine Greenspan or Bernanke saying something like this,” he said, referring to the previous and current U.S. central bank chairmen, Alan Greenspan and Ben S. Bernanke. “It was very Italian and very powerful.” 

Mr. Draghi’s weapon of choice, of course, is more subtle than the Smith & Wesson .44 Magnum favored by Clint Eastwood in the “Dirty Harry” movies. But from a financial markets perspective, there is no less firepower in his suggestion that the E.C.B. might buy the bonds of countries like Spain and Italy if they commit to tough measures to reduce deficits and restructure their economies. 

Of course, what made Eastwood's Inspector Callaghan "Dirty" was his willingness to break the rules.  If he really means to save the Euro,  Mario Draghi may need to show a similar disregard for legal niceties.  I'm not an expert on the ins and outs of the Maastricht treaty, so I won't take a position on whether large-scale purchases of the bonds of distressed governments by the ECB exceeds its authority (or on the related question of whether the "European Stability Mechanism" is constitutional), but some - particularly in Germany - have been making that case (see, e.g., here and here).

Some of the relevant language from the Maastricht treaty:

Article 104 1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments...

Article 104b 1. The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.

If Draghi is serious about doing whatever it takes to save the Euro, he won't let that slow him down.

Critics of intervention can make appeals - perhaps with some validity - to the "rule of law," but this is a case where following the letter of the law (at least if its interpreted strictly) would lead to a real human disaster if the Euro cracked up in a crisis.

Some people found Dirty Harry's rule-breaking objectionable (Pauline Kael called it "fascist medievalism"). But John Wayne's perspective - in the context of explaining why he turned down the role - might be instructive for Draghi:

I thought Harry was a rogue cop. Put that down to narrow-mindedness because when I saw the picture I realized that Harry was the kind of part I'd played often enough: a guy who lives within the law but breaks the rules when he really has to in order to save others.

A little rule breaking is part of the tradition of central banking - as Brad DeLong explained, modern central banking came into being when the Bank of England acted outside its legal authority by assuming the role of "lender of last resort" during the panic of 1825.

Unlike Dirty Harry, whose magnum had six bullets, there will be no question of whether or not Dirty Mario has run out of firepower.  The question that remains is the extent of his willingness to use it, even if it means risking having to turn in his badge later.

Draghi probably wouldn't like the analogy, but I'd imagine its preferable to being called "Super Mario" all the time.

Central Bank Firepower

Bundesbank's Jens Weidmann (via Bloomberg):

"Monetary policy is not a panacea and central bank firepower is not unlimited, especially not in a monetary union,” he said. “We can only win back confidence if we bring down excessive deficits and boost competitiveness. And it is precisely because these things are unpopular that makes it so tempting for politicians to rely instead on monetary accommodation."

As a factual matter, Weidmann is just plain wrong (and I think he knows it - perhaps this was just a poor word choice on his part).  In a fiat money system the central bank's firepower - its ability to create money - is unlimited.  There are good reasons why central banks choose to exercise restraint, but it is a policy choice.  In the case of Europe today, the ECB could create money to buy government bonds.  A mere expression of willingness to use its "firepower" this way could significantly bring ease the pressure on bond spreads.

The objections to this are twofold: (i) it creates "moral hazard" by allowing governments to escape the consequences of their own fiscal policies (though as Krugman and others have pointed out, the standard narrative about profligate peripheral governments is not really accurate) and (ii) money creation could lead to inflation.  Some of us think a little more inflation in Europe would actually be quite helpful, but others - particularly in Germany due to the memory of hyperinflation in the 1920s - are quite averse to it, and modern central bankers worry alot about maintaining the "credibility" of low inflation expectations.

In any case, the ECB has the firepower, its just choosing not to use it.

Transparency Versus Clarity at the Fed

In the Times, a nice story by Binyamin Appelbaum about how confusion and uncertainty about monetary policy persists, despite the Fed's moves towards greater transparency, such as publishing forecasts and holding press conferences (remember: before 1994, the Fed didn't even announce changes in the Fed Funds rate target).

Experts and investors have continued to disagree about the plain meaning of the Fed’s recent policy statements. Some say the increased volume of communication is creating cacophony rather than clarity. Political criticism of the Fed has continued unabated.

I'm not sure the uncertainty regarding the Fed's intentions should be considered a failure of communication.  This is an unusual time for monetary policy, with the financial crisis and "zero lower bound" forcing the Fed to experiment with different policy tools.  To the extent that the Fed's signals are unclear, I suspect that reflects genuine uncertainty within the Fed.

There is also significant degree of genuine disagreement among the members of the FOMC.  While Bernanke's tolerance for expressions of divergent views may enable "cacophony," in forming expectations about future policy it is quite useful to have a sense of the individual members' opinions since decisions will ultimately be made by a committee.

Just like monetary policy itself, the Fed's communication policy should be evaluated relative to a counterfactual (i.e., what would have happened without it).  While we may have a hard time predicting the course of monetary policy now, I think the outside world would be in a state of much deeper confusion if all of the unconventional monetary policy moves over the past several years had been conducted under the older tradition of secretiveness at the Fed.

What is the Fed Doing?

Last week, the statement following the Federal Open Market Committee meeting was accompanied by a summary of projections by the participants, which included for the first time projections on future interest rates.  The FOMC also released a statement clarifying its policy goals, and Bernanke held a press conference.

The statement on the policy objectives included the following:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

That appears to somewhat formalize what we've known for a while, that the Fed is shooting for 2 percent inflation.  Their interpretation of the employment part of their mandate was somewhat squishier:

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee's policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. 

That sounds like a statement about the "natural rate" or NAIRU, which changes over time, and which economists can disagree about.  In this context, "maximum level of employment" isn't a very good phrase - it sounds like something Stalin would try to achieve in industrializing the Soviet Union - but "maximum" is the word in the Federal Reserve Act, so they probably wanted to stick with it.

The FOMC participants' projections of the federal funds target rate were summarized in this chart:

This indicates that most of them expect the federal funds rate to be above its current range of 0-0.25% in 2014, their projections that inflation in 2014 will be 1.6-2.0% and unemployment will be 6.7-7.6% notwithstanding.  Now that they've made their interpretation of their mandate more explicit, we can say the Fed is projecting inflation will be below their "mandate consistent" level and unemployment will be above it, but they will be raising rates anyway...

The language in their regular meeting statement was:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. 

To be fair, though most of the participants are projecting a rate increase by 2014, all of the projected rates are still quite low relative to their "longer run" projection.

Many people seem to be interpreting the language about keeping rates "exceptionally low" through "late 2014" as an expansionary "open mouth operation" where the Fed tries to stimulate the economy by influencing expectations (and since the December statement said "mid-2013" they have opened the mouth wider).  If people believe short term rates will be lower for longer, long term rates will also fall.  Bernanke explained how this would work in his 2002 speech about deflation:

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. 

Credibility is indeed one major problem with such a strategy, as Gavyn Davies noted in a blog post previewing the FOMC release:

The problem for practitioners, however, is the time inconsistency of these proposals. It is one thing to promise now to hold interest rates at zero if inflation starts to rise in several years time, and quite another actually to do that in the circumstances of the time.

The temptation to renege on a long forgotten commitment, possibly made by an earlier Fed chairman under a previous administration, would surely be overwhelming once the economy is recovering. Since the private sector knows in advance that this would be the case, it would be extremely hard to persuade people today that such a policy would in fact be pursued in the future. And that would defeat its purpose.

However, while many knowledgeable observers are interpreting it that way (e.g., Stephen Williamson and Ryan Avent) it seems to me that the Fed is being careful to say that it is not promising to keep rates low, only that it believes the economy in 2014 will still be lousy enough that rates should still be low then. 

During the press conference, Bernanke seemed to place quite a bit of emphasis on the dual nature of the Fed's mandate, and even said "the Committee always treats its primary objectives on price stability and maximum employment symmetrically." Really?  In the past, I've thought he's seemed to give higher priority to inflation, so that sounded unexpectedly dovish to me.  One interpretation might be that he's listening to Chicago Fed President Charles Evans, who has argued the Fed needs to be more aggressive to try to reduce unemployment.  Scott Sumner also found dovish signs in the press conference.

An alternate interpretation is Bernanke felt the need to be extra careful to sound like he is being faithful to the dual mandate because the statement making the 2% inflation goal explicit sounds like another step towards "inflation targeting," which Bernanke advocated during his academic days.  Indeed, one of the reporters said: "Congrats on the inflation target or goal. That's a big achievement for you, I'm sure."

So, what is the Fed doing?  I'm really not sure, but I hope it works.

Is the ECB Determined to Go Down with the Ship?

With the risk premium on Italian government debt growing, the best hope for a resolution to the Euro crisis would seem to be for the European Central Bank to announce an unlimited intervention to cap the yield on sovereign bonds.  However, it steadfastly refuses to do so - presumably because it feels that such an action might risk a violation its prime directive of "inflation rates of below, but close to, 2% over the medium term."

In a recent Project Syndicate column, Brad DeLong argued that the ECB is failing to step up to the plate as the lender of last resort:

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Facility. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.

Similarly, Barry Eichengreen writes:

Here’s where the political cover comes into play. Merkel and Sarkozy need to make the case that if the euro is to become a normal currency, Europe needs a normal central bank – one that does not merely target inflation like an automaton, but that also understands its responsibilities as a lender of last resort.

More on this from The Economist, Antonio Fatas, Gavyn Davies and Martin Wolf as well as a nice "news analysis" from the NY Times. 

If Italy is fundamentally solvent and merely facing a self-fulfilling "liquidity" panic (as investors sell bonds, yields rise, making it more costly to service its debts, which lowers the chances it will avoid default leading to investors selling bonds...), then it may not require much more than an announcement of a willingness to intervene to quell the crisis.  By restoring confidence, the ECB could bring yields down without having to do much actual bond-buying (i.e., Super Mario* can be Chuck Norris).

The crisis potentially spells the end of the Euro - so the ECB is putting its mandate ahead of its own self-preservation.  That is, it appears willing to risk its very existence for the sake of what it sees as its duty.  As a matter of economic policy, it looks disastrously foolish, and yet, there's something oddly noble-seeming about it.


*Admittedly, referring to Italian policymakers named Mario as "Super Mario" is getting stale quickly (and I can't imagine how much they must despise it); and the press needs to decide whether it is ECB President Mario Draghi or new Prime Minister Mario Monti who is called "Super Mario" (or perhaps not... a quick search of "Super Mario" on the FT reveals a potentially confusing solution: "Super Mario Brothers").  The Guardian compares two of the "Super Marios" and this FT profile argues Draghi earned his "super."

Sigh.

NYTimes.com headline:

The Fed's forecasts are here.  Their projection for 2012 real GDP growth is 2.5-2.9%, down from the June estimate of 3.3-3.7%.