FOMC | St. Louis Fed Chief Asks Hawks to Think Harder

James Bullard, President of the St.
Louis Fed, predisposed to raise rates
but wondering if this will actually
increase, not lower, inflation.

The President of the St. Louis Fed, James Bullard, is in line to join Jeffrey Lacker of the Richmond Fed in calling for an increase in the fed funds rate.

The St. Louis Fed has historically been the champion of the monetarist school, which keeps reminding Keynesians and New Keynesians who want to keep stimulating the economy that increasing the money supply will cause inflation.

At one time, zero-lower-bound interest rates were viewed as dangerously inflationary. The fact that inflation has remained low hasn't changed the tune of a hawk like Jeffrey Lacker of the Federal Reserve Bank of Richmond. Six years ago he predicted that the zero-lower-bound approach taken in 2008 would make inflation soar. Now he's been voting for a rate increase at the most recent meetings of the FOMC, warning that inflation will get out of control if the FOMC doesn't raise rates.

However, yesterday Bullard gave some support to the idea that the long period of low interest rates – the "Permazero" – might require a rethinking of monetary policy.  At a Cato conference he said that after seven years, expectations for permanently low interest rates might be baked into the cake.

Bullard says we should pay attention to the ideas of John Cochrane of Chicago's Booth School of Business, who suggests that raising the interest rate target off the zero-lower-bound floor may raise, not lower, inflation. The 94-page paper in which Cochrane lays out his theory and data poses the theory as a question – Do Higher Interest Rates Raise or Lower Inflation? 

Cochrane provides charts showing what happens to inflation under different assumptions. If you disagree with his story, I can hear him say, show me your model.

I note that Cochrane relies on the simple version of the Irving Fisher's equation, using an expected inflation rate added to "real" rate.

Most theories contain the Fisher relation that the nominal interest rate equals the real rate plus expected inflation, it = rt +Etπt+1, so they contain a steady state in which higher interest rates correspond to higher inflation. 

This is a simplification of the actual equation, which is multiplicative (rt * Etπt+1). The distinction doesn't doesn't matter for low levels of expected inflation (the "Fisher premium"), but it certainly does for higher ones – far as that may be from our recent inflation numbers.

Bullard does not take the step of opposing a rate increase based on Cochrane's theories. That would put him in the same boat as Paul Krugman, who opposes a rate increase on Keynesian grounds that we still need more demand and higher rates could choke off demand.

After seven years of Zero Interest Rate Policy, the FOMC is getting cabin fever. They are generals who look like they are avoiding a battle. Bullard made clear that his predisposition in December is to vote to raise rates. The FOMC may in December want to give the benefit of any doubt to a rise in rates.

Cochrane has therefore done everyone a favor by providing a reason for inflation hawks to think a little harder... because raising rates just might be inflationary.

JUNK BONDS | How "Terrifying" Should They Be? Notes for FOMC Meeting

Bears to be released from their
cages at the end of October?

On the one hand, some calm voices are reassuring us that the recent downturn in the stock market is historically followed by a recovery. Usually.

On the other, we hear concerns that the sky above the financial markets is about to fall. Junk bonds are viewed as "terrifying" because they have grown so fast in an environment of zero-bound Federal Reserve interest-rate policies.

The fear is that the second rates do start to go up catastrophe may be waiting. Although the expected increase has been continually postponed because the time is not ripe, we have been told that it is likely to happen before the end of 2015.

A zero-interest FOMC diet for bulls
is like spinach for Popeye.

What worries me is that so many people with money are focused intently on the coming rise in interest rates. It has been such a long, long time on Easy Street, when the market bears confined by the assurance provided by a zero-interest bank environment. The possible global market reaction to higher (i.e., positive real) Fed fund rates is scary.

Better a finger tip than an arm.

The Fed, which has been largely sidelined since 2008 by its need to provide liquidity to the panicked financial markets, will feel powerful again when it starts its next upward climb in interest rates.

I hope that, if the upward march of interest rates starts at the next FOMC meeting on October 27-28, the Fed begins with the smallest possible increase. Better a finger tip bitten off than a whole arm.

JOBS | On Good News, Fears of Sooner Rate Hike

The 295,000 payroll-jobs increase is well above expectations for jobs. Job numbers for January were revised down by 18,000, lowering the base, but even so, the increase suggests a breakout for the economy. This increases concern about the impact of the Fed moving earlier to higher interest rates. Some Fed officials think the February 5.5 percent unemployment rate is full employment.

Sectors showing strong job growth include:

• Eating (food services) and drinking places - reflecting the American appetite for better food and ability to pay for it. This sector accounts for one-fifth of the job growth,
• Professional and business services accounting for one-fifth of the growth. This sector has added 660,000 jobs during the past year. Key growth areas are management and technical consulting services, computer systems design and related services, and architectural and engineering services.
• Construction, adding 29,000 jobs in February, despite worse-than-normal weather in parts of the country. (The BLS in a note says that unusually bad weather affects earnings more than employment.) Employment in specialty trade contractors rose by 27,000, mostly in the residential component.
• Health care services, continuing to rise by 24,000 jobs, with gains mostly in ambulatory care services, with fewer gains in hospital jobs. The increase is lower than the average over the past 12 months. This number is an indicator of the net impact of Obamacare.

Earnings growth was slow. (The recent announcement of raises for workers at Wal-Mart and other large employers has yet to show up as significant changes in earnings data.) The full BLS report is here.

Comment 

Table A-6 shows the labor force participation rate rising year-over-year in February for men (to 81.8 percent from 81.4 percent for adult men without a disability) and declining for women (to 69.9 percent from 70.5 percent for adult women without a disability). It also rose for disabled people of both genders, to 19.8 percent from 19.1 percent.

The overall good news is that the U.S. economy is continuing its momentum. This is a relief for the rest of the world, which depends heavily on the U.S. recovery.

The downside is that the Fed will be poised to raise interest rates - from its existing near-zero level - sooner rather than later (June rather than September). In the zero-bound range the Fed has little room for positively affecting the economy - its foot is all the way down on the pedal. Letting the pedal up gives it room later to be helpful in a downturn.