Tuesday, April 2, 2013

Fed: A Story of Success and Failure?

Hi folks, it’s good to be back again. A change in job and hectic study schedule has proven too much for me recently. But nevertheless, the germs of curiosity in my blood have kept me motivated for searching and analyzing data (a thing I’m crazy about).

While Federal Reserves (Fed) and other central banks have faced a diversity of opinions (both positive as well as negative), one thing can be said with fair amount of certainty. The central bank has been broadly successful in arresting the escalation of crisis, (if not helping recovery). Even Ben reiterated on several occasions that the current crisis was indeed a novel yet challenging experience for the policymakers (including the central banks). However, despite fiscal constraints in place -amid fiscal cliff fiasco- fed has to undertake the risky yet uncertain task of simulating the crisis ridden economy. While overall picture may not be as impressive as one could hope, but there are certainly some bright spots for which Fed deserves its due share of appreciation.

Let me start up by a simple concept that why fed needed to act when the economy was dwindling. As the economic activity contracted, so the prices started to cool down. Now though a common man would love to see the prices fall (since it increases his real income), a consistent fall of prices is as equally dangerous for an economy as a consistent rapid increase (aka hyperinflation). On the face of it this looks quite disturbing -since the deflation has a positive effect on consumer’s welfare- yet a deflation spiral is as dangerous for the general economy as hyperinflation. And yes we do have living examples of both phenomenon. If the examples of hyperinflation include Germany, Russia and more recently Zimbabwe. Japan serves as the classical example of a deflation spiral where consistently falling prices can cause an economic limbo. How does that work? It’s quite simple. The spending and saving decisions of economic agents are inter-temporal (though Stochasticity is also an important component but it’s less relevant to current discussion). This means that economic decisions are not only motivated by current state of affairs but also the expectations. So if expectations change, the optimal mix of saving consumption decision changes.  Thus, if an average economic agent expects that the prices are going to be lower in the subsequent period, he will postpone his consumption. Resultantly, the aggregate demand will shrink, resulting in further deflation and market surpluses. The producers don’t like surpluses, so the aggregate supply curve would shrink resultantly, bringing economy to lower output (GDP) level. And this spiral would turn vicious if the deflation expectations are not combated by appropriate policy mix.

Here I have put forth some data analysis of inflation expectations using data from Bloomberg and FRED to understand whether Fed’s achievements are confirmed  empirically. The data consists of monthly observations from Jan-05 to Nov-12 (95 Obs) for a generalized index of inflation expectations (U Michigan Inflation Expectations) , data for short and long term Nominal Rates (2Y,10Y) –intentionally skipped 5Y- and their respective breakeven –another proxy for market inflation expectations- I also included the data for avg weekly labor hours and overtime for analyzing the implications of Fed’s policies on Labor market.

Question 1: Does implied inflation necessarily reflects the general inflation?
Well since the participants in financial markets are believed to behave in a similar way as the economic agents in the general economy, it can be implied that the expectations revealed by the investors in financial markets should be similar to the latent preferences in the general economy. Here is a graph showing relationship between U Michigan IE  and 2 Year BE. Figure 0A reveals a strong relationship between general inflation expectations and BE. However, the analysis through time –Figure 0B- reveals that BE is a more sensitive and volatile measure than the general inflation expectations. This makes intuitive sense since the participants in the financial markets adjust more rapidly to new inflation expectations than the general economy.

Question 2: Was Fed able to successfully combat the deflation spiral?
 A close analysis of Figure 1 reveals that though the inflation expectations fell sharply amid the financial meltdown. Fed’s QE program (Especially QE2) was able to restore the inflation expectations to pre-crisis levels, successfully evading the dangerous deflation spiral (though deleveraging impact undermined the importance and success of restoration of inflation expectations). So Fed does deserve the credit for not allowing US economy to slip into Japan-type economic limbo.

Question 3: Was the introduction of O-Twist and QE3 a good decision?
Well Fed can be allowed benefit of the doubt since the macroeconomic picture was 1)Desperate 2)Complex. However, Figure 3A suggests that inflation expectations were pretty much averaged along the long term mean and became more well behaved. Furthermore, Figure 3B indicates a decoupling between the longer term nominal interest rates and Breakeven. This effectively means promotion of a wealth destruction effect for the longer term. In fact, it was post QE2 that the decoupling effect became more prominent. Thus if Fed continues to encourage wealth destruction, agents would tend to rebalance their portfolios by either 1) Seeking insurance in TIPS 2) Spending (which Fed Wants them to do)  3)shifting to the shorter end of the curve being risk averse. Thus, except scenario 2 Fed’s policy -of promoting lower long-term lending rates- would be undermined as long term funds market may face a shrinkage of supply. Yet one thing that goes to Fed’s advantage is that the long term inflation expectations are fairly upward sticky (Figure 2).

Question 4: What are the implications for Labor Markets?
Since Fed operates with dual mandate (inflation and employment), it is also crucial to see if Fed’s actions may have a significant effect on the labor market.
Figures 4A, 4B and 4C plot the average weekly over-time and labor-hours against inflation expectations against both short and the long term inflation expectations. What’s more interesting to note is that the short term inflation expectations actually drive the dynamics of the labor market. The average amount of labor and overtime supplied tend to fall as the inflation expectations exceed around 3.5%. However, the long term inflation expectations don’t have any negative impact on the labor market. Thus this leaves us with two arguments 1) Fed can employ as much OT as it wants in the Longer-end of the yield curve because it doesn’t impact the labor dynamics or 2) Fed is targeting the wrong expectations since the bulk of the labor market is driven by more volatile short term inflation expectations.

Its getting 2:23 in the night and I have a training to attend at 8PM so I would call this a day. However, I’ve uploaded both the data as well as the code file (do file). Feel free to extend the analysis and correct me if I have got it wrong somewhere. Here's the link

(This material (blogpost and codefile) is the intellectual property of the author. It can be used for all legal and valid purposes given the original source is properly acknowledged.) 

(Note: Pictures get messed up as I upload them. However, they are appropriately numbered so you shouldn't find it much difficult to figure out which figure belongs where)