I generally avoid writing about monetary policy, since every economics course I’ve taken since college has been a micro course, and besides Simon is a macroeconomist, among other things. But since just about everyone in my RSS feed has been linking to Tim Duy’s recent article on the Fed, I thought I would try to put in context for all of us who don’t understand Fed-speak.

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do. But I digress again.

This is what Duy sees:

• Kevin Warsh of the board of governors: “If ‘whatever it takes’ was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed’s institutional credibility.”
• Richmond Fed president Jeffrey Lacker, from Bloomberg: “The Federal Reserve will need to raise interest rates when the economic recovery is ‘firmly’ in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.”
• Philadelphia Fed president Charles Plosser: “[J]ust as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. …  The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.”

Can you feel the testosterone?

Duy argues that all this manliness is misplaced. The Fed hawks’ basic argument seems to be that, because it acted so aggressively to stimulate the economy last year, it will have to act equally aggressively to dampen growth at some point — just to send a message. And to send that message, they need to be willing to raise interest rates while unemployment is still 10% (Lacker) or “well before unemployment rates and other measures of resource utilization have returned to acceptable levels” (Plosser).

Now, there may be something to this. Duy points out that the hawks seem to be worried about recreating the debt bubble of the last decade through too much cheap money. If cheap money is going to flow straight into overvalued houses, then that’s a problem. But Duy says that that is a failure of regulation. Low rates are supposed to stimulate capital investment by businesses, which is what long-term economic growth depends on. But earlier this decade, despite low rates, capital investment never returned to 1990s levels, because all the cheap money was flowing into housing instead — for reasons we know.

“Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade’s debt bubble? …

“With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.”

The solution, then, is better regulation to protect against misallocation of credit to the next asset bubble. Simply raising rates will choke off an asset bubble, but it will also choke off real investment by businesses.

This goes back to what StatsGuy said in a post here:

“In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). …

“But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.”

In other words, if you’re going to throw in the towel on regulation, then there is no place for cheap money to go except the next asset bubble. You might as well try to prevent that, but then you are consigning the real economy to a long, slow decline since you have no way of getting monetary stimulus where you need it (factories, not new condo towers).

So there seem to be two possible futures. If we repeat the Greenspan policy of low rates during a boom, we’ll just create a bubble all over again, since none of the underlying factors (weak consumer protection, weak bank regulation, etc.) have changed. Or if the hawks win (both in the Fed and in Congress, which controls fiscal stimulus), we’ll have high unemployment for a long, long time, since no one will have the guts to risk higher inflation. Being a “hawk” has become the safe, comfortable choice — even in a week when monthly job losses were up and weekly new unemployment claims were up.

By James Kwak

This post was written by StatsGuy, a regular commenter here and very occasional guest contributor. We asked him to expand on the ideas he put forward in this comment on the relationships between monetary policy, international capital flows, and bank capital requirements.

Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.

Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)

Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines).  How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)

Here is a less semantic answer: When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?

Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).

The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade). This is one of the most dominant trading features in the current market environment.

In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.

So in these regards, Team Obama seems to “get it”. I concede that they have identified the right issues. How well they execute depends on many factors. As Professor Johnson notes, focusing on currency valuations (a very sensitive issue in China) on a highly public world stage like the G20 may not be productive.  By contrast, quietly moving a bill through Congress might be a better option.

But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.* If it tries to support a weak economy by keeping the punchbowl on the table (as in 2003-2005, when we had a “jobless recovery”) then we get a really bad bubble.

That is what a central bank staffer called “Second Best Punchbowlism” on Brad DeLong’s blog, and it is a very scary prospect indeed. Remember when the Fed kept rates tight in August and early September 2008 (arguably to fight the commodity bubble/dollar run)? And when, in the post-September 2008 crisis, the Fed continued its deflationary policies, even though it was abundantly clear to the entire world that aggregate demand was (to paraphrase Warren Buffett) falling off a cliff? The Fed didn’t bring out the heavy weapons until March of 2009, until things looked pretty bleak indeed. This is what we can look forward to if the Fed’s new paradigm becomes Second Best Punchbowlism.

It’s also important to recognize that we can’t just kill the Fed right now. We NEED monetary policy to be effective in order to implement new financial regulation (especially higher capital asset ratios) without killing the US (and world) economy by reducing the total supply of money. As we phase in higher capital asset ratios and other regulations, we must compensate by injecting liquidity to offset a decrease in velocity. This must be done in a highly coordinated fashion. Otherwise, financial regulation that aims at a long term equilibrium with a more stable overall money velocity (which I would argue is a good thing) could risk deflation in the near future (which will undoubtedly cause people to blame the administration currently in charge).

*“I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”

– Dennis Lockhart, President, Atlanta Fed, August 2008

By StatsGuy

According to Reuters, the Federal Reserve recently got a stay of a federal district court’s order that the Fed must reveal details about which banks accessed its emergency loan programs during the financial crisis. The arguments on each side are pretty straightforward. Bloomberg, the plaintiff, is arguing that the public has a right to know where their taxpayer money,* via the Federal Reserve, is going. The Fed is arguing that if it reveals the names, that could trigger a run on those banks, because customers will worry about their solvency; it is also arguing that revealing names now will make banks less willing to access emergency lending programs in the future, taking away an important tool in a financial crisis.

I find both of the Fed’s arguments weak.

I agree that immediate revelation of who is borrowing at the discount window (the Fed’s facility for lending to banks directly) could make creditors worry about a bank, triggering the modern version of a bank run. (Traditional bank runs shouldn’t happen because of FDIC insurance.) But we’re talking about things that happened last year, and the government has done everything it can to convince the public that the banking system is sound again. Even if Citigroup borrowed at the discount window last September, the ample bailouts it has received since then should convince any jittery investors that Citigroup isn’t going anywhere.

That is also something that apparently Barney Frank and Ron Paul agree on – any Fed disclosure should be delayed by several months.

The second Fed argument is interesting. Basically it says that if banks need to be bailed out in time of crisis, we want the ability to bail them out in secret. This only weakens the incentives for bank managers to run their companies prudently. Knowing that the Fed will bail me out in times of trouble already creates moral hazard. Knowing that they will bail me out without even my shareholders ever knowing only increases the moral hazard. Where does this stop?

* I know you can argue about whether Fed lending counts as “taxpayer money,” since the Fed is arguably an independent entity. The argument on the other side is that when the Fed lends money to dodgy institutions, the ultimate downside risk is taken either by the taxpayer, or by anyone who has dollar-denominated assets that would be hurt by inflation.

By James Kwak

With the anniversary of the Lehman-AIG-rest of the world debacle fast approaching, it seems fair to ask: Who accepts any blame for creating our excessively crisis-prone system?

Friends and contacts who work in the financial sector freely discuss their participation in activities they now regret.  But where is the mea culpa, of any kind, from a public figure – our “leadership”?

I suggest we divide the competition into three classes.

1. Policymakers who now admit that any of their actions or inactions contributed to the Great Credit Bubble.  Blaming China gets a person negative points; this may hurt Fed officials.
2. Private sector executives who concede they made mistakes or misjudged the situation so as to lose a lot of Other People’s Money.  Blaming Hank Paulson also earns negative points (too obvious).
3. Anyone charged with safeguarding consumers, in either public or private sector capacity, who now says that they or their organization did a completely miserable job.  My guess is that you will find precisely no one in this category.

You can award points for style, timing, and extent of the apology or near-apology.

Feel free to suggest other categories or to propose additional scoring rules.

By Simon Johnson

Ben Bernanke, chairman of the Federal Reserve, insists that the Fed can protect consumers effectively against defective or dangerous financial products.  He and his allies are therefore signaling opposition to – and even defiance of – key parts of the Treasury’s plan for regulatory reform, which involve setting up a new Consumer Financial Protection Agency.

The Fed is a well-regarded institution in general and Bernanke is currently riding a wave of personal popularity and prestige, but are these claims vis-à-vis consumers plausible?

Not really.

The heart of the problem here lies with the Federal Reserve Act.  As it currently stands, the all-important Section 2A reads, “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.”

This is what the Fed does – in practice by trying to keep unemployment down (ideally around the 4-5% mark, although that can change over time) and inflation low (no more than 2%, roughly).

Formal objectives matter for central banks because they have to weigh trade-offs – “if we try to lower unemployment, what will that do to inflation?” etc – carefully in deciding where to set short-term interest rates and other dimensions of their support to the credit system.

Consumer protection is not in this mix and you can tell.  No one can seriously tell you what a great job the Fed has done protecting consumers.   For example, the Fed has dragged its feet for years on coming up with a sensible definition of the Annual Percentage Rate on loans, i.e., a measure that includes all costs.  As a result, many borrowers have been misled effectively by lenders.

More broadly, Alan Greenspan famously stood by despite being warned by his colleagues about the housing bubble and the associated abuses of consumers.  As the housing frenzy developed in 2003 and low income people got sucked in and – many of them – suckered, Ben Bernanke argued for a further lowering of interest rates on the basis of short-run macroeconomic considerations; apparently he was oblivious to the dangers that implied to consumer-as-borrowers.

As Rep. Barney Frank (D-Mass.) said at the height of the housing madness in 2007, “If I was going to list the top 87 entities in Washington in order of the history of their efforts on consumer protection, the Fed would not make it.”

What would happen if you tried to add formal protection of consumers to the top level of Fed priorities and to make it central to Bernanke’s job?

This would surely require amending the Federal Reserve Act, otherwise consumer protection would remain a second class citizen at the Fed.  The Fed is not a government department, it’s an independent entity.  If you don’t give the Fed specific legislative direction and detailed reporting requirements for a particular task, it won’t get done.

And even that may not be enough.  The Fed has plenty of powers to help consumers, but it just hasn’t used them.  The American Banker (subscription required) quotes Barney Frank on this also, “One of the greatest unused examples of power were the consumer protection powers we’ve given the Fed.”

Why? Again, Frank – as chair of the House Financial Services Committee – should know, “If you look at the Fed governors, their focus has been on the safety and soundness of the banking system, not consumers.”

The tip off here is that banks of all kinds want enforcement of consumer protection laws to stay with existing bank regulators where, John C. Dugan, Comptroller of the Currency claimed recently “it works well.” But he doesn’t mean that this arrangement protects consumers.  He means that it protects banks and the banking system – whenever necessary (like now) consumers can be squeezed to improve the banks’ bottom line.

The Federal Reserve never has and never will put consumers first.

By Simon Johnson

A slightly different version of this post originally appeared on the NYT.com’s Economix blog.  It is reproduced here with permission.  If you wish to repost this material in its entirety, please contact the New York Times. 

There has been a lot of talk recently about Ben Bernanke, he of the Wall Street Journal op-ed and the multiple Congressional appearances. (Hey, can anyone put me in touch with his agent?*) At the risk of seeming ignorant (or revealing myself to be ignorant), I must say I don’t really understand what the fuss is about.

The question seems to be whether the Fed will be able to tighten monetary policy fast enough when necessary to dampen the potential inflationary effect of its current expansive monetary policy (Fed funds rate at zero, buying long-term securities, etc.). My read on the situation is as follows:

1. Almost everyone agrees that expansive monetary policy has been appropriate during the crisis and recession to date.
2. Everyone agrees that at some point monetary policy will have to be tightened.
3. No one knows when that will happen.
4. Everyone agrees that because policy has been so expansionary recently, tightening monetary policy when necessary will be more difficult than usual.
5. Everyone agrees more or less on what tools will be available to the Fed.
6. No one is certain the Fed will or will not be successful, because there are no relevant datapoints to compare it to.
7. No matter what Bernanke actually thought, he would still have to say exactly what he is saying this week.

I don’t see much in there worth arguing about.

As Catherine Rampell says, a more interesting question is when the Fed will start tightening policy. This is the kind of thing that can set the Fed against the administration, as stereotypically one focuses on inflation and the other on unemployment. But since most people think it is too early to start now, that debate would be purely speculative at the moment.

* He does need a grammar checker, though. His first sentence – “The depth and breadth of the global recession has required a highly accommodative monetary policy” – contains an error in subject-verb agreement.

By James Kwak

Policymakers like to make particular kinds of statements at a “low attention” moment, e.g., right before a holiday weekend.  This gets items onto the public record but ensures they do not get too much attention. And if you are asked about these substantive issues down the road, you can always say, “we told you this already, so it’s not now news” – usually this keeps things off the front page.

Released on July 3rd (a federal holiday), and buried inside the Washington Post on Saturday (p.A12): An important speech (from June 26th) by the New York Fed’s controversial President, William C. Dudley.

If the Fed is to become the system or any kind of “macroprudential” regulator, what would it do with that responsibility?  This is a hot topic for Capitol Hill in coming weeks as various committees take on this topic in whole or part.

Dudley says that the Fed can pop or prevent asset bubbles from developing.  This would represent a major change in the nature of American (and G7) central banking.  It’s a huge statement – throwing the Greenspan years out of the door, without ceremony.

It’s also an attractive idea.  But how will the Fed actually implement?  Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to “sniff” bubbles accurately – and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious.

Dudley is quiet on whether or not, for example, we have an emergent bubble in emerging markets today.  Is there also an effective bubble in US Treasuries, as John Campbell has argued persuasively?

“Asset bubbles may not be that hard to identify,” Dudley argues.  Fine, but it would help to know exactly the Fed would do this ex ante – not using the rear view mirror.

Of course, if the Fed can’t get better at spotting bubbles, the implication is that no one can.  Which means that “macroprudential regulator” is just a slogan – a nice piece of what Lenin liked to call “agitprop”.

And if macroprudentially regulating is an illusion, what does that imply?  There will be bubbles and there will be busts.  Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are – or are perceived to be – “too big to fail”?

You cannot stop the tide and you cannot prevent financial crises.  But you can limit the cost of those crises if your biggest players are small enough to fail.

By Simon Johnson

One concept that has gotten a lot of attention the last few months is the household balance sheet: the relationship between household assets and liabilities, and what that means for household behavior (consumption versus saving). Though not the precipitating factor in the current crisis, the weakening of household balance sheets (fewer assets, same liabilities, less net worth, more anxiety) has likely had a significant effect in depressing consumption, which has been the single largest factor in our recent decline in GDP. The Federal Reserve recently released a snapshot of the household balance sheet in its triennial Survey of Consumer Finances, so we can see what the situation looks like in some detail. The survey was actually taking in 2007, but with a few adjustments we can see what the current balance sheet looks like.

On the headline level, median income fell from $47,500 to $47,300 (all figures are in constant 2007 dollars), while median net worth (assets minus liabilities) grew from $102,200 to $120,300. No surprise there: we already knew wages stagnated, while real estate and stocks appreciated. However, since the survey was conducted in 2007, median net worth fell by 17.8% according to the Fed estimate, to $99,300, and that’s just to October 2008. Given that the cumulative returns of the stock market have been about -15% since October 31, and that housing prices have fallen as well (and the Fed used a housing index that has fallen less than the Case-Shiller index*), that net worth is probably between $90,000 and $95,000 – significantly less than in 2004, and back around 1998 levels ($91,300).

I wanted to come up with a composite picture of the median family, to see how they are doing. This is actually impossible to do precisely, because of the way the survey data are presented in the report: for each category of assets (or liabilities), they say what percentage of families (in each income quintile) have that asset, and then the median value owned among families that have that asset.**  So I came up with the following compromise: for each asset or liability, I include it if more than 50% of the families in the middle income quintile have it; in that case, I record the median amount held by families who hold that asset. This isn’t the median family, but we might call it a “typical” family. (If you didn’t follow this, don’t worry about it.)

The picture I get, with some basic assumptions,*** looks like this:

The picture you get is surprising. From 2004 to 2007, the typical family only took on $4,900 more debt – mainly in mortgages, but some for installment loans (primarily for cars and education) – but its assets grew by slightly more, a little bit because of home values but more because of increased retirement savings, presumably due to the rise in the stock market. (For those wondering at that small increase in home values: the median value of all homes increased from $175,000 to $200,000, but the median homeowner is not in the 50th percentile in income; he or she is somewhere in the 60-80th percentile range, so he has a more expensive house than the typical family.)  In this picture, the typical family looks reasonably prudent, although taking on 4% more debt with no increase in income is not necessarily recommended.

When the crisis hit, though, the typical family took large hits in retirement savings and in home equity that cost over one-third of its net worth. So even though the typical household still has the jobs it had before the crisis (unemployment is still “only” 7.6%), it is much more worried about saving for whatever it has to save for – college tuition, retirement, etc. – and hence much less willing to spring for the proverbial flat-screen TV.

(Bear in mind that this picture tells us nothing about the foreclosure crisis, since the typical mortgage holder is not delinquent at this point. The foreclosure crisis and its impact on mortgage-backed securities is about the ability of problems at the margins to have severe impacts on certain kinds of securities and the institutions that hold them.)

At the end of the day, I think we knew all this already. But seeing it in numbers does help illustrate the crisis from the household perspective.

Notes:

* The Fed used the state-level purchase-only Loan-Performance Home Price Index, from which they derive a decline in value of 9.2% from the survey date (sometime in 2007) until 10/31/08. By contrast, the Case-Shiller Composite 20 fell by 14.5% from December 2007 to October 2008, and 16.4% from December 2007 to November 2008. Since inflation was positive during this period, the real fall in the Case-Shiller index was even greater.

** For example, of families in the middle income quintile (40th to 60th percentile), 71.6% own their primary residence, and of those the median house value in 2007 was $148,300 – but that’s just the median value for the 71.6%, not for all 100%.

*** For 2009, retirement savings reduced by 25% (stock market is down ~45%), housing by 16.4% (from Case-Shiller), other values the same as in 2007.

Update: Tom Cunningham did some similar calculations using the data from the Survey of Consumer Finances, and he finds that households in the 50-75th percentiles by net worth (not income, which I used) have seen a 29% fall in their net worth, which is similar to what I got. He also finds that on a percentage basis, the richest households have suffered the least (primarily, I believe, because they are more diversified and have less leverage, which is what really hurts you when asset prices fall).

Ben Bernanke gave a speech today that will be discussed for, well, at least a few days, outlining the Federal Reserve’s response to the financial crisis. We will probably devote a couple of posts to it (Simon already mentioned it below.)

Although the Obama team and Congress have been focusing on the politically popular fiscal stimulus plan, replete with hundreds of billions of dollars in tax cuts, Bernanke emphasized that stimulus will not be enough (something that Larry Summers seems to agree with, as Simon noted). Here’s the relevant passage:

with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions.  Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets.  A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets.  The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. . . . In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.

In a nutshell: as the economy gets worse, more and more loans default, eating into banks’ capital cushions; investors are still nervous about all those toxic assets; and the continuing collapse of the housing market hurts all of those mortgages and mortgage-backed securities banks are holding. And as banks teeter toward insolvency, people stop lending them money, and they stop lending people money.

On the plus side, the famous TED spread dipped below 1 today, a sign that credit markets are doing much better than back in September. (The Calculated Risk article behind that link shows improvements in other parts of the credit markets, not just interbank lending.)

On the minus side, CDS spreads have shot up on Citigroup and Bank of America in the last week – here’s Bank of America:

The main peaks you see are the Lehman bankruptcy, the buildup to the bank recapitalization announcement, and the Citigroup crisis. So while there seems to be general improvement in the credit markets, the underlying problems have not been solved.

According to the Federal Open Market Committee’s (FOMC) minutes, released on Tuesday, some members think inflation targetting would be a useful way to persuade people that prices will not fall, i.e., forestall deflationary expectations.  WSJ.com seems to have the interpretation about right,

“The added clarity in that regard might help forestall the development of expectations that inflation would decline below desired levels, and hence keep real interest rates low and support aggregate demand,” according to the minutes.

In other words, a commitment to an inflation target, say annual growth of 1.5% to 2%, would help keep prices from falling outright and prevent the kind of economic chaos that plagued Japan in the 1990s and the U.S. during the Great Depression.

The Congressional Budget Office thinks there is still time to prevent deflation (or perhaps it is the new measures already in the works that will keep inflation positive).  Their forecast for 2009 (see Table 1 in today’s testimony) predicts low inflation, e.g., the PCE price index is expected to be 0.6 percent for 2009 – but note that the CPI is seen as barely positive, at 0.1 percent, over the same period.

Meanwhile, the financial markets (e.g., inflation swaps) predict minus 4 percent inflation in 2009 (part of which is likely due to lower commodity prices) and then a small degree of deflation over the next few years.  According to this view, we should next see today’s price level again in about 5 or 6 years.

Of course, the financial markets could well be wrong.  It may be that the markets haven’t fully digested or understood the size of the fiscal stimulus, and it may be that further news about other parts of the Obama approach (including the directly on housing and banking) will significantly change inflation expectations.

But it is striking that financial market inflation expectations – e.g., over a five year horizon – have barely moved from their low/near deflation level since it became clear that Mr Obama would win the election or since we first realized that a massive fiscal stimulus would soon arrive (see slide 2 in my presentation from Sunday; the scale is hard to read, but the decline is from around 2% through the summer to around 0% currently).  At least for now, whether or not we are heading for deflation remains the key open question.

I talked yesterday with Steve Weisman, my colleague at the Peterson Institute for International Economics, about where the global economy is likely heading.  Steve asked very good questions about U.S. monetary policy and what effects it will have.  You can listen to our conversation here.

The Federal Reserve’s announcement yesterday makes it clear that we should see its leadership as radical incrementalists.  They will move in distinct incremental steps, some small and some larger, but they will do whatever it takes to prevent deflation.  And that means they will do what it takes to make sure that inflation remains (or goes back to being?) positive.  If they need to err on the side of slightly higher inflation, then so be it.  This is pretty radical (and a good idea, in my opinion.)

What effect does this have on the rest of the world?  Well, if your central bank now sits idly by, most likely you will experience an appreciation of your currency relative to the US dollar.  (The caveat, of course, is that if you have a new major domestic disruption in your banks, or another member of your currency union runs into refinancing trouble, you could still experience a depreciation.)

Who is willing to experience a significant appreciation in a slowing global economy, with exporters everywhere already clamoring for assistance?  Most central banks will be pressed hard to ease further, either with interest rate cuts or their own version of “quantitative easing” (known as printing money to you and me). What happens within the eurozone will, in this context, be fascinating – who will support the Germans in arguing that monetary policy should remain relatively tight?  What happens if the Germans lose this argument at the level of the European Central Bank’s Governing Council?

In any case, the Fed’s move pushes us in the definite direction of higher global inflation.  This is better than the alternative of falling wages and prices, but it comes with risks.  Will we be able to control this inflation now or in the near future?  What are the consequences of inflation during a severe global recession – which seems unavoidable, even if the Obama Administration has all possible dimensions of expansionary policy firing on all cyclinders right away (this was the point in our latest baseline scenario).