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Krugmenistan vs the Permahawks

Lift Off! That was the announce­ment by the Fed­er­al Reserve this week when the world’s biggest and most influ­en­tial cen­tral bank start­ed the long await­ed rais­ing of its bench­mark short-term rate a quar­ter point from near-zero lev­els, mark­ing the first time the Fed has raised rates since 2006 [1]. Based on that alone it would seem like this was big news. But giv­en that this rate hike was telegraphed for quite a while now and vir­tu­al­ly every­one was expect­ing the Fed to do exact­ly what it did, it’s not quite as big a sto­ry as it could have been. For instance, if the Fed had decid­ed not to raise rates, despite all the telegraph­ing, that prob­a­bly would have been a big­ger sto­ry. But would it have been a bad sto­ry if the Fed decid­ed to keep rates at their cur­rent near-zero lev­els? Would that have been a sto­ry that dam­ages the cred­i­bil­i­ty of the Fed­er­al serve in the eyes of the mar­ket? There’s a big debate in the eco­nom­ic com­mu­ni­ty over that. And since the Fed has been pon­der­ing its his­toric “lift off” moment for years now, it’s a debate that’s been going on for years too and as we’re going to see in this post, it’s a debate that pits pru­dent econ­o­mists with excel­lent track-records like Paul Krug­man [2], some­one who opposed [3] the Fed’s Decem­ber “lift off” deci­sion [4], against the broad array of “per­ma­hawks” who have a seem­ing­ly end­less list of often con­tra­dic­to­ry rea­sons to raise rates now, now, now [5].
But it’s not just the ques­tion with respect to Fed. The Euro­pean Cen­tral Bank made a pol­i­cy announce­ment this month too regard­ing its stim­u­lus mea­sure and it was indeed rather sur­pris­ing. And as we’re also going to see in this post, it was sur­pris­ing in the way that just might have done seri­ous dam­age to not just the cred­i­bil­i­ty of ECB Pres­i­dent Mario Draghi but the ECB itself. Or at least cred­i­bil­i­ty in the ECB’s com­mit­ment to its sin­gle man­date of keep­ing infla­tion hov­er­ing around 2 per­cent.

To pla­cate the per­ma­hawks (to main­tain cred­i­bil­i­ty) or not pla­cate the per­ma­hawks (to main­tain cred­i­bil­i­ty)? That is the ques­tion. Or at least one of the ques­tions cen­tral banks face. Unfor­tu­nate­ly.

********************

So the Fed final­ly did it: Fed rates rose for the first time in years from their near-zero lev­els. And while many in the finan­cial mar­kets cheered this his­toric day, it’s impor­tant to keep in mind that the under­ly­ing log­ic for rais­ing rates isn’t real­ly very strong based on the under­ly­ing macro­eco­nom­ic land­scape. In oth­er words, if this was­n’t the right move, which folks like Paul Krug­man think is the case, it was his­toric fol­ly too [6]:

The New York Times
The Con­science of a Lib­er­al

Fed Fol­lies

Paul Krug­man
Dec 16 4:01 pm Dec 16 4:01 pm 30

No, I don’t mean the deci­sion to raise rates, although noth­ing I’ve seen changes my view that it’s a bad idea. I mean the des­per­ate efforts to say some­thing new about today’s move. I under­stand that there are strong jour­nal­is­tic incen­tives here, but it real­ly is try­ing to squeeze blood from a stone.

After all, this move was com­plete­ly telegraphed in advance; I guess there was some small chance that the Fed would wait, but real­ly very lit­tle. Longer-term bond rates bare­ly moved, show­ing that there was very lit­tle news.

And it will be quite some time before we have any evi­dence about whether the Fed’s judge­ment of the economy’s tra­jec­to­ry was right. (I think this was an ex ante mis­take even if it turns out OK ex post, but it’s still inter­est­ing to see how it goes.) We’re talk­ing months if not quar­ters, and it may take years.

I guess even the fact that the Fed suc­ceed­ed in com­mu­ni­cat­ing its inten­tions is a kind of news sto­ry. But it’s pret­ty thin gru­el.

“And it will be quite some time before we have any evi­dence about whether the Fed’s judge­ment of the economy’s tra­jec­to­ry was right. (I think this was an ex ante mis­take even if it turns out OK ex post, but it’s still inter­est­ing to see how it goes.) We’re talk­ing months if not quar­ters, and it may take years.”
Yep, the first Fed rate hike since 2006 was basi­cal­ly a big his­toric *yawn*. And per­haps a big his­toric mis­take too giv­en the del­i­cate nature of the US’s eco­nom­ic recov­ery and extreme­ly low lev­els of infla­tion.

But as Krug­man points out, it’s going to take a while before the wis­dom of this deci­sion becomes appar­ent. And as for­mer Trea­sury Sec­re­tary Lawrence Sum­mers points out below, whether or not it was the cor­rect move to do eco­nom­i­cal­ly speak­ing, because the Fed had been strong­ly telegraph­ing this rate hike in the months lead­ing up to this, it basi­cal­ly boxed itself in because when cen­tral banks strong­ly tele­graph some­thing, a sud­den “sur­prise!” might have the impact of under­min­ing the Fed’s cred­i­bil­i­ty. Unfor­tu­nate­ly, as Sum­mers also points out, start­ing the Fed’s rate nor­mal­iza­tion at this point was prob­a­bly also a mis­take which isn’t exact­ly cred­i­bil­i­ty-enhanc­ing [7]:

LarrySummers.com
What Should the Fed Do and Have Done?

Lar­ry Sum­mers
12/15/2015

The Fed­er­al Reserve meets this week and has strong­ly sig­naled [8] that it will raise rates. Giv­en the strength of the sig­nals that have been sent it would be cred­i­bil­i­ty destroy­ing [9]not to car­ry through with the rate increase so there is no inter­est­ing dis­cus­sion to be had about what should be done on Wednes­day.

There is an inter­est­ing coun­ter­fac­tu­al dis­cus­sion to be had. Should a rate increase have been so clear­ly sig­naled? If rates are in fact going to be increased the answer is almost cer­tain­ly yes [10]. The Fed has done a good job of guid­ing expec­ta­tions towards a rate increase while gen­er­at­ing lit­tle trau­ma in mar­kets. Assum­ing that the lan­guage sur­round­ing the rate increase on Thurs­day is in line with what the mar­ket expects, I would be sur­prised if there are major mar­ket gyra­tions after the Fed state­ment.

But was it right to move at this junc­ture? This requires weigh­ing rel­a­tive risks. A deci­sion to keep rates at zero would have tak­en sev­er­al risks. First, since mon­e­tary pol­i­cy acts only with a lag fail­ure to raise rates would risk an over­heat­ing econ­o­my and an accel­er­a­tion of infla­tion pos­si­bly neces­si­tat­ing a sharp and desta­bi­liz­ing hike in rates lat­er. Sec­ond, keep­ing rates at zero would risk encour­ag­ing finan­cial insta­bil­i­ty par­tic­u­lar­ly if there became a per­cep­tion that the Fed would nev­er raise rates. Third, keep­ing rates at zero leaves the Fed with less room to low­er rates in response to prob­lems than it would have if it increased rates.

Final­ly, per­haps zero rates have adverse eco­nom­ic effects. Per­haps eco­nom­ic actors take the con­tin­u­a­tion of zero rates as evi­dence that the Fed is wor­ried and so they should be as well. Some believe that zero rates are a sign of pathol­o­gy and we no longer have a patho­log­i­cal econ­o­my and so no longer should have zero rates. Or per­haps there is a fear that when rates go up some­thing cat­a­stroph­ic will hap­pen and this source of uncer­tain­ty can only be removed by rais­ing rates.

These argu­ments do not seem huge­ly com­pelling to me. Infla­tion is run­ning well below 2 per­cent [11] and there is not yet much evi­dence of accel­er­a­tion [12]. Decades of expe­ri­ence teach­es that the Phillips curve can shift dra­mat­i­cal­ly so rea­son­ing from the unem­ploy­ment rate to infla­tion is prob­lem­at­ic [13]. Declin­ing prices of oil [14] and oth­er com­modi­ties sug­gest infla­tion expec­ta­tions may actu­al­ly decline [15]. Fur­ther­more, if one believes that pro­duc­tiv­i­ty is under­stat­ed by offi­cial sta­tis­tics one has to as a mat­ter of log­ic believe that infla­tion is over­stat­ed. I have recent­ly argued [16] that this is quite like­ly the case giv­en the ris­ing impor­tance of sec­tors like health care where qual­i­ty is dif­fi­cult to mea­sure.

Even if one assumes that infla­tion could reach 2.5 per­cent, this is not an immense prob­lem. There is no con­vinc­ing evi­dence that economies per­form worse [17] with infla­tion mar­gin­al­ly above 2 per­cent than at 2 per­cent. Then there is the ques­tion of whether it is bet­ter to tar­get the annu­al rate of infla­tion or the price lev­el [18]. On the lat­ter stan­dard [19] it is rel­e­vant that infla­tion over any mul­ti­year inter­val would still have aver­aged less than 2 per­cent. And I am not sure why bring­ing down infla­tion would be so dif­fi­cult if that were desired espe­cial­ly giv­en that it would sure­ly take a long time for expec­ta­tions to become unan­chored towards the high side of 2 per­cent.

It seems to me look­ing at a year when the stock mar­ket has gone down a bit, cred­it spreads have widened sub­stan­tial­ly [20] and the dol­lar has been very strong it is hard to say that now is the time to fire a shot across the bow of finan­cial eupho­ria. Look­ing espe­cial­ly at emerg­ing mar­kets I would judge that under-con­fi­dence and exces­sive risk aver­sion [21] are a greater threat over the next sev­er­al years than some kind of finan­cial eupho­ria.

...

“It seems to me look­ing at a year when the stock mar­ket has gone down a bit, cred­it spreads have widened sub­stan­tial­ly [20] and the dol­lar has been very strong it is hard to say that now is the time to fire a shot across the bow of finan­cial eupho­ria. Look­ing espe­cial­ly at emerg­ing mar­kets I would judge that under-con­fi­dence and exces­sive risk aver­sion [21] are a greater threat over the next sev­er­al years than some kind of finan­cial eupho­ria.
So sim­i­lar to Paul Krug­man’s take on mat­ter, the way Lar­ry Sum­mers sees it, while the actu­al deci­sion to sig­nal this impend­ing rate hike (which was based on the Fed’s inter­nal deci­sions months ago) may not have been so great giv­en the rel­a­tive costs and ben­e­fits of a rate hike giv­en the state of both the US and glob­al econ­o­my, the Fed’s deci­sion to raise rates today was indeed the cor­rect one giv­en the fact that not doing so would destroy the Fed’s cred­i­bil­i­ty after all the Fed sig­nal­ing.

Although it’s although worth not­ing that when Sum­mer’s writes:

...
The Fed­er­al Reserve meets this week and has strong­ly sig­naled [8] that it will raise rates. Giv­en the strength of the sig­nals that have been sent it would be cred­i­bil­i­ty destroy­ing [9]not to car­ry through with the rate increase so there is no inter­est­ing dis­cus­sion to be had about what should be done on Wednes­day.

...

the Sep­tem­ber 23, 2013, Wall Street Jour­nal arti­cle about “cred­bil­i­ty destroy­ing” cen­tral bank behav­ior Sum­mers links to actu­al­ly iron­i­cal­ly describes a sce­nario when the Fed did­n’t fol­low through on the expec­ta­tions to scale back its QE pro­gram, cit­ing lin­ger­ing con­cerns over the health of the US’s recov­ery. And was its cred­i­bil­i­ty dam­aged by that sur­prise? It’s hard to see any indi­ca­tion of that. Sure, most sur­veyed econ­o­mists were expect­ing the Fed to reduce its bond buy­ing at that point in 2013 based on the Fed’s guid­ance ear­li­er in the year that the Fed’s QE pro­grams might start get­ting scaled back in the Fall if the the recov­ery was deemed robust enough. And the Fed, now we know, did­n’t view the recov­ery as robust enough and left the QE pro­gram intact. And as the WSJ arti­cle Sum­mers linked to points out, con­ser­v­a­tive econ­o­mists like the Fed’s then-board mem­ber Richard Fish­er (a per­ma­hawk who want­ed to end QE and raise rates at that point) were warn­ing that such a “sur­prise” deci­sion not to cut back QE would threat­en the Fed’s cred­i­bil­i­ty. But the mar­ket’s response to the fol­low­ing two years of extend­ed QE did­n’t exact­ly reflect a loss of “cred­i­bil­i­ty” and giv­en the lack of infla­tion and still frag­ile eco­nom­ic recov­ery, it’s hard to argue that mild­ly ‘sur­pris­ing’ the mar­kets was­n’t the right thing to do. What’s more cred­i­bil­i­ty dam­ag­ing? Doing the right thing despite a mild ‘sur­prise’ fac­tor or doing what the mar­kets expect even when it’s the wrong move?

It’s a reminder that cen­tral bank cred­i­bil­i­ty with respect to mar­ket sur­pris­es is par­tial­ly depen­dent on how much the cen­tral bank’s pri­or sig­nal­ing clash­es with what it actu­al­ly decides to do, but it’s also large­ly depen­dent on the eco­nom­ic cred­i­bil­i­ty of the argu­ments for or against the bank’s deci­sion. And when you con­sid­er that the per­ma­hawks like Richard Fish­er have been con­sis­tent­ly wrong for years [22], it’s also a reminder that it’s prob­a­bly cred­i­bil­i­ty-enhanc­ing to sur­prise the seg­ments of the mar­ket that are con­sis­tent­ly wrong [9]:

The Wall Street Jour­nal
Fed’s Fish­er: Taper­ing Delay Threat­ens Cred­i­bil­i­ty

By Ben Lefeb­vre
2:36 pm ET Sep 23, 2013

The Fed­er­al Reserve‘s fail­ure to make the expect­ed cut in its bond- buy­ing pro­grams calls the body’s cred­i­bil­i­ty into ques­tion, Dal­las Fed Pres­i­dent Richard Fish­er said in pre­pared remarks Mon­day [23].

The S&P 500 hit an all-time-high and 10-year Trea­sury note yields fell Wednes­day after the Fed decid­ed to post­pone a wide­ly expect­ed reduc­tion of its $85 bil­lion-a-month bond buy­ing. The taper­ing, as it is known in the mar­ket, was sup­posed to sig­nal that the econ­o­my had improved enough that the Fed felt con­fi­dent start cut its bond buy­ing by up to $10 bil­lion a month.

By back­ing off the expect­ed taper­ing, the Fed con­tra­dict­ed the mes­sage it had been send­ing to mar­kets for months and has made future pol­i­cy direc­tion murki­er, Mr. Fish­er said dur­ing a speech to bank­ing- indus­try rep­re­sen­ta­tives.

“Today, I will sim­ply say that I dis­agreed with the deci­sion of the com­mit­tee and argued against it,” said Mr. Fish­er in his speech. “Here is a direct quote from the sum­ma­tion of my inter­ven­tion at the table dur­ing the pol­i­cy ‘go round’ when Chair­man [Ben] Bernanke called on me to speak on whether or not to taper: ‘Doing noth­ing at this meet­ing would increase uncer­tain­ty about the future con­duct of pol­i­cy and call the cred­i­bil­i­ty of our com­mu­ni­ca­tions into ques­tion.’ I believe that is exact­ly what has occurred, though I take no plea­sure in say­ing so.”

The market’s reac­tion showed that the Fed’s need to reform its com­mu­ni­ca­tions pol­i­cy, pos­si­bly by hold­ing post-meet­ing press con­fer­ences more fre­quent­ly, Mr. Fish­er said.

“You should nev­er wink at a girl in the dark,” Mr. Fish­er said. “Our com­mu­ni­ca­tions pol­i­cy is a lit­tle off–we should work hard­er to refine it.”

The Fed would con­tin­ue dis­cussing taper­ing its bond buy­ing and pos­si­bly reduce pur­chas­es of both Trea­surys and mort­gage-backed secu­ri­ties, Mr. Fish­er said. The deci­sion against start­ing it soon­er came part­ly because of a per­ceived “ten­der­ness” in an oth­er­wise strong hous­ing recov­ery, Mr. Fish­er said.

Mr. Fish­er, a non-vot­ing mem­ber of the board, is opposed to con­tin­ued bond buy­ing by the Fed. He is also against the Fed’s con­tin­ued pol­i­cy of rock-bot­tom inter­est rates, some­thing favored by Janet Yellen, the favorite to replace out­go­ing Fed Chief Ben Bernanke.

“She’s wrong on pol­i­cy, but she’s a darn good, decent won­der­ful per­son,” Mr. Fish­er said.

Mr. Fish­er also took issue about how the White House float­ed the name of Lawrence Sum­mers as some­one to replace Mr. Bernanke because it threat­ened to draw the inde­pen­dent Fed­er­al Reserve Board into the realm of pol­i­tics. Mr. Sum­mers with­drew his name as a can­di­date after a back­lash from sen­a­tors.

“The White House has mis­han­dled this ter­ri­bly,” Mr. Fish­er said. “This should not be a pub­lic debate.”

The Fed remains wary that the U.S. econ­o­my, while show­ing steady improve­ment, is still not strong enough for the cen­tral bank to start scal­ing down its efforts to spur stronger growth, Fed­er­al Reserve Bank of New York Pres­i­dent William Dud­ley said ear­li­er in the day.

....

“The S&P 500 hit an all-time-high and 10-year Trea­sury note yields fell Wednes­day after the Fed decid­ed to post­pone a wide­ly expect­ed reduc­tion of its $85 bil­lion-a-month bond buy­ing. The taper­ing, as it is known in the mar­ket, was sup­posed to sig­nal that the econ­o­my had improved enough that the Fed felt con­fi­dent start cut its bond buy­ing by up to $10 bil­lion a month.”
Well, at least the mar­kets took the alleged­ly poten­tial­ly cred­i­bil­i­ty-dam­ag­ing surpise Fed deci­sion in stride. It’s a reminder that a surpise to the down side (i.e. keep­ing rates low­er than expect­ed) is inher­ent­ly expan­sion­ary because low­er rates are inher­ent­ly expan­sion­ary (and con­trac­tionary poli­cies are con­trac­tionary [24]). That’s just how finances works.

So how about the warn­ing from now-retired Dal­las Fed chair­man Richard Fish­er, one of the Fed’s biggest infla­tion-hawks? Was there a col­lapse in Fed cred­i­bil­i­ty and a sub­se­quent spike in infla­tion that Fish­er so fears [25]?

...
“Today, I will sim­ply say that I dis­agreed with the deci­sion of the com­mit­tee and argued against it...Here is a direct quote from the sum­ma­tion of my inter­ven­tion at the table dur­ing the pol­i­cy ‘go round’ when Chair­man [Ben] Bernanke called on me to speak on whether or not to taper: ‘Doing noth­ing at this meet­ing would increase uncer­tain­ty about the future con­duct of pol­i­cy and call the cred­i­bil­i­ty of our com­mu­ni­ca­tions into ques­tion.’ I believe that is exact­ly what has occurred, though I take no plea­sure in say­ing so.
...

That was the warn­ing, but it’s hard to see any evi­dence of that dam­age to the Fed’s cred­i­bil­i­ty giv­en the fact that mar­kets weren’t con­tin­u­al­ly pre­dict­ing a sur­prise rate hike fol­low­ing the Fed’s assur­ances that rates would stay low until the econ­o­my picked up and/or infla­tion spiked. It’s anoth­er reminder that cen­tral bank sur­pris­es are far more like­ly to be cred­i­bil­i­ty dam­ag­ing if they turn out to be eco­nom­i­cal­ly dam­ag­ing and ill advised too and if the peo­ple being ‘sur­prised’ have a decent pre­dic­tion track record.

Accu­rate fore­cast­ing is hard. Per­sis­tent­ly inac­cu­rate fore­cast­ing is a lot eas­i­er, although cre­ativ­i­ty will be required.
Inter­est­ing­ly, fol­low­ing this intra-Fed ker­fuf­fle, in April 2014, Richard Fish­er actu­al­ly came out against the whole con­cept of cen­tral banks pro­vid­ing for­ward guid­ance (i.e. pub­licly stat­ing the medi­um-term pol­i­cy bias­es like assur­ing mar­kets that rates would prob­a­bly stay low for the new few years until employ­ment and infla­tion objects are achieved). Instead, Fish­er argued that for­ward guid­ance was point­less because “those who think we can be more spe­cif­ic in stat­ing our inten­tions and broad­cast­ing our every next move with com­plete cer­tain­ty are, in my opin­ion, cling­ing to the myth that eco­nom­ics is a hard sci­ence and mon­e­tary pol­i­cy a pre­cise sci­en­tif­ic pro­ce­dure rather than the applied best judg­ment of cool-head­ed, unemo­tion­al deci­sion-mak­ers” [26]:

The Wall Street Jour­nal

Fed’s Fish­er Says Lim­its to Fed For­ward Guid­ance

By Michael S. Der­by

6:37 am ET Apr 4, 2014

Fed­er­al Reserve Bank of Dal­las Pres­i­dent Richard Fish­er said Fri­day that what the cen­tral bank can say about the future of mon­e­tary pol­i­cy is more lim­it­ed than many rec­og­nize.

Those who think we can be more spe­cif­ic in stat­ing our inten­tions and broad­cast­ing our every next move with com­plete cer­tain­ty are, in my opin­ion, cling­ing to the myth that eco­nom­ics is a hard sci­ence and mon­e­tary pol­i­cy a pre­cise sci­en­tif­ic pro­ce­dure rather than the applied best judg­ment of cool-head­ed, unemo­tion­al deci­sion-mak­ers,” Mr. Fish­er said in the text of a speech to be deliv­ered in Hong Kong.

Mr. Fish­er was wad­ing into the ongo­ing debate about what cen­tral bankers refer to as “for­ward guid­ance.” Most offi­cials cur­rent­ly agree that pro­vid­ing guid­ance about the tim­ing of future inter­est-rate increas­es can pro­vide clear ben­e­fits to the econ­o­my now. By sig­nal­ing that short-term rates will stay very low for well into the future, Fed offi­cials believe short-term rates will stay low cur­rent­ly, pro­vid­ing addi­tion­al sup­port for the econ­o­my.

The pow­er of for­ward guid­ance has grown in impor­tance as the Fed has moved to wind down its asset-buy­ing pro­gram over the course of this year. As the asset buy­ing comes to an end, cen­tral bankers hope that their strong hints that inter­est rates will stay low will allow mon­e­tary pol­i­cy to remain very sup­port­ive of growth, boost­ing hir­ing and push­ing very low lev­els of infla­tion back up to the cen­tral bank’s tar­get rate.

The man­ner in which the Fed guides views about the out­look for rate increas­es under­went a sig­nif­i­cant shift last month. Then, the Fed stopped pro­vid­ing numer­i­cal thresh­olds for the job­less rate and infla­tion that had to be met in order for rate increas­es to be con­sid­ered. Now, Fed guid­ance is based on a broad­er array of fac­tors that are more impres­sion­is­tic in nature.

Mr. Fish­er said, in his speech, the guid­ance the cen­tral bank now pro­vides may need to be even sim­pler than it is cur­rent­ly stat­ed so as to best reflect what cen­tral bankers tru­ly know about the future path of pol­i­cy. Cur­rent­ly, most cen­tral bankers reck­on the Fed will first raise short-term rates some time in 2015 as long as the eco­nom­ic out­look plays out as expect­ed.

Fore­casts pro­vid­ed by the Fed are “large­ly guess­work, espe­cial­ly the fur­ther out in time they go,” Mr. Fish­er said. When it comes to mon­e­tary pol­i­cy, “com­mit­ments aren’t always cred­i­ble, espe­cial­ly if they pur­port to extend far into the future.”

The Fed should tell mar­kets what it knows, and lit­tle more. Mr. Fish­er said the Fed should state it will con­duct pol­i­cy to achieve a sus­tained recov­ery, con­tained infla­tion, and finan­cial sta­bil­i­ty. “Regard­less of the way we may final­ly agree at the [Fed­er­al Open Mar­ket Com­mit­tee] to write it out or have Chair [Janet] Yellen explain it at a press con­fer­ence, we real­ly can­not say more than that.”

Mr. Fish­er not­ed that, in his past career as an investor, he would pre­fer as much cer­tain­ty about the mon­e­tary pol­i­cy out­look as cen­tral bankers can pro­vide. But now that he is on the oth­er side of the fence, he is not so sure.

...

Keep in mind that much of the crit­i­cism from infla­tion-hawks like Fish­er towards the Fed’s low-rate poli­cies comes from the strong assump­tion that high infla­tion is just around the cor­ner unless rates are raised soon. So while Fish­er does make a some­what valid point when he states:

...
Fore­casts pro­vid­ed by the Fed are “large­ly guess­work, espe­cial­ly the fur­ther out in time they go,” Mr. Fish­er said. When it comes to mon­e­tary pol­i­cy, “com­mit­ments aren’t always cred­i­ble, espe­cial­ly if they pur­port to extend far into the future.”
...

it’s a some­what iron­ic point com­ing from a per­ma-infla­tion hawk. But an iron­i­cal­ly valid point can still be a valid point and Fish­er’s iron­i­cal­ly valid point high­lights a key aspect of cen­tral bank deci­sion-mak­ing that’s often for­got­ten in these debate: Since it’s very pos­si­ble that the eco­nom­ic fore­casts can go awry, one of the biggest ques­tions fac­ing pol­i­cy-mak­ers [27] is “on what side should we err?” In oth­er words, since it’s very pos­si­ble that a cen­tral bank’s pre­dic­tions may not pan out, what are the rel­a­tive costs and ben­e­fits of being wrong for the dif­fer­ent pol­i­cy options? And in this case, with rates at lev­els where they can only go up or hold near zero, it’s a ques­tion of what are the like­ly cost/benefit to being wrong if a rate hike is pre­ma­ture vs being over­ly delayed?

And as we saw above, for per­ma-infla­tion hawks like Fish­er, that answer isn’t sim­ply the risk of infla­tion if rates aren’t raised soon, but also the risk of a loss of cred­i­bil­i­ty. And as Fish­er put it in March of this year when the tim­ing of the first rate rise was still under debate, the deci­sion isn’t sim­ply between “lat­er and steep” (i.e. delay­ing a rate rise, but then hav­ing to raise rates quick­ly, pre­sum­ably to ward off infla­tion) or “ear­li­er and grad­ual” (i.e. rais­ing rates right away under the assump­tion that doing so will spread out the inevitable rate rise over a longer peri­od of time). It’s very pos­si­ble, in Fish­er’s view, that if the Fed decides to delay the rate rise until lat­er in the year (which it did), the pub­lic might inter­pret that as indi­cat­ing that the Fed is gen­er­al­ly “dovish” and dis­in­clined to raise rates in gen­er­al. In oth­er words, a “lat­er and grad­ual” sce­nario. And accord­ing to Fish­er a “lat­er and grad­ual” Fed sen­ti­ment would be cred­i­bil­i­ty dam­ag­ing. Who knows why exact­ly that would be cred­i­bil­i­ty dam­ag­ing, but if you’re a per­ma-infla­tion hawk “lat­er and grad­ual” is for some rea­son cred­i­bil­i­ty destroy­ing [28]:

Fast FT
Fed’s Fish­er: delay­ing rate rise risks cred­i­bil­i­ty

March 9, 2015

The US Fed­er­al Reserve risks los­ing its cred­i­bil­i­ty if it doesn’t soon embark on the first rise in offi­cial inter­est rates since the finan­cial cri­sis, a senior pol­i­cy­mak­er has warned.

Push­ing back a rise in its overnight lend­ing rate until much lat­er in the year or to ear­ly 2016 will lead investors to ques­tion whether there is any appetite at the Fed to tight­en pol­i­cy, accord­ing to Richard Fish­er, the retir­ing pres­i­dent of the Dal­las Fed­er­al Reserve.

The Fed is instead, Mr Fish­er argues, bet­ter off with an “ear­li­er and grad­ual” approach to rais­ing rates. In a speech in Hous­ton on Mon­day, the pol­i­cy­mak­er said:

The cred­i­bil­i­ty of a “lat­er and steep” pol­i­cy strat­e­gy is sus­pect, it seems to me. Isn’t it pos­si­ble— even likely—that the pub­lic will inter­pret a deci­sion to defer liftoff as a sig­nal that the com­mit­tee is gen­er­al­ly “dovish” and gen­er­al­ly dis­in­clined to raise rates?

In oth­er words, mightn’t the pub­lic see the choice as between “ear­li­er and grad­ual” and “lat­er and grad­ual” rather than between “ear­li­er and grad­ual” and “lat­er and steep”?

...

One of the most colour­ful speech­mak­ers at the Fed, Mr Fish­er has argued for more than a year that the dan­gers of delay­ing an increase out­weigh any risks attached to doing so.

Yep, if the mar­kets per­cieve a “lat­er and grad­ual” bias at the Fed, some­how that’s cred­i­bil­i­ty dam­ag­ing accord­ing to Mr. Fish­er because it might “lead investors to ques­tion whether there is any appetite at the Fed to tight­en pol­i­cy”. And notice that there isn’t even the typ­i­cal (and wrong) warn­ing of an infla­tion spike [29]. It’s an asser­tion look­ing for a jus­ti­fi­ca­tion, and a great exam­ple of a phe­nom­e­na that Paul Krug­man often rails about when it comes to the infla­tion hawks: their end­less cre­ativ­i­ty in devel­op­ing ques­tion­able jus­ti­fi­ca­tions for a rate hike [30]:

The New York Times
The Con­science of a Lib­er­al
The Cre­ativ­i­ty of the Per­ma­hawks

Paul Krug­man
Sep­tem­ber 19, 2015 9:46 am

Tim Tay­lor writes about low inter­est rates [31]. As he notes, many econ­o­mists see low rates as a nat­ur­al (in both the col­lo­qui­al and Wick­sel­lian sense) response to a weak econ­o­my; but he respect­ful­ly cites the Bank for Inter­na­tion­al Set­tle­ments [32], which argues that low rates are a source of ter­ri­ble eco­nom­ic dis­tor­tions. But it seems to me that there’s some con­text miss­ing.

Tay­lor writes,

Notice that none of the BIS con­cerns are about the risk of a rise in inflation–which it does not think of as a sub­stan­tial risk.

Ah, but it used to think oth­er­wise. It has been call­ing for high­er inter­est rates for around 5 years, and at first it was indeed warn­ing about infla­tion. In its 2011 report [33], in fact, it declared that

High­ly accom­moda­tive mon­e­tary poli­cies are fast becom­ing a threat to price sta­bil­i­ty.

That was dead wrong, and the ECB — which believed in the infla­tion threat and raised rates — clear­ly made a big mis­take. So you might have expect­ed the BIS to ask why it was so wrong, and recon­sid­er its pol­i­cy rec­om­men­da­tions. Instead, how­ev­er, it con­tin­ued to demand the same poli­cies, while invent­ing new jus­ti­fi­ca­tions.

And I mean invent­ing. As I’ve writ­ten many times, the remark­able thing about pol­i­cy since 2010 is that out­siders, par­tic­u­lar­ly beard­ed aca­d­e­mics, have based their crit­i­cisms of pol­i­cy on main­stream, text­book eco­nom­ics; where­as seri­ous-sound­ing bankers in suits have been cre­at­ing whole new eco­nom­ic doc­trines on the fly to jus­ti­fy what they claim are sound poli­cies.

In this case, the BIS not only claims that low inter­est rates cause finan­cial insta­bil­i­ty, but goes on to expound a sort of widow’s cruse [34] the­o­ry of inter­est rates, in which low rates today lead to even low­er rates tomor­row, because they pro­duce bub­bles that weak­en the econ­o­my fur­ther when they burst. That’s pret­ty wild stuff; you wouldn’t want to take it seri­ous­ly with­out a lot of evi­dence, which the BIS does not pro­vide.

Or put it this way: if, say, Jere­my Cor­byn or Bernie Sanders were to invent whole new, dubi­ous eco­nom­ic the­o­ries to jus­ti­fy the poli­cies they clear­ly want for oth­er rea­sons, every­one would be com­ing down on them hard for being flaky and irre­spon­si­ble. Yet when the BIS — which was, once again, dead wrong on infla­tion — does the same thing, it’s tak­en very seri­ous­ly.

...

Again, if some­one from the cen­ter-left were to pro­duce an eco­nom­ic analy­sis this ten­den­tious, this much at odds with decades of main­stream eco­nom­ics, it would be met with increduli­ty. It’s awe­some to see the ultra-respectable BIS go down this path, and be tak­en seri­ous­ly along the way.

Yes, after years of warn­ing that low inter­est rates would cause an infla­tion spike , the right-wing Bank of Inter­na­tion­al Set­tle­ments shift­ed gears this Sep­tem­ber and made the case that low inter­est rates would basi­cal­ly per­pet­u­ate them­selves by cause finan­cial bub­bles that neces­si­tate even low­er rates in the future after the bub­ble bursts:

...
In this case, the BIS not only claims that low inter­est rates cause finan­cial insta­bil­i­ty, but goes on to expound a sort of widow’s cruse [34] the­o­ry of inter­est rates, in which low rates today lead to even low­er rates tomor­row, because they pro­duce bub­bles that weak­en the econ­o­my fur­ther when they burst. That’s pret­ty wild stuff; you wouldn’t want to take it seri­ous­ly with­out a lot of evi­dence, which the BIS does not pro­vide.

Or put it this way: if, say, Jere­my Cor­byn or Bernie Sanders were to invent whole new, dubi­ous eco­nom­ic the­o­ries to jus­ti­fy the poli­cies they clear­ly want for oth­er rea­sons, every­one would be com­ing down on them hard for being flaky and irre­spon­si­ble. Yet when the BIS — which was, once again, dead wrong on infla­tion — does the same thing, it’s tak­en very seri­ous­ly.
...

Is the the Bank of Inter­na­tion­al Set­tle­ments com­ing up with bogus the­o­ries to jus­ti­fy bad pol­i­cy that’s not in the pub­lic’s inter­est? Well, it cer­tain­ly would­n’t be the first time [35] the insti­tu­tion act­ed against the pub­lic inter­est.

Short-term per­son­al finan­cial incen­tives and a desire for wage sup­pres­sion also assist in per­sis­tent inac­cu­rate eco­nom­ic fore­cast­ing
And if the BIS is indeed engag­ing in per­ma­hawk puffery, it’s also worth not­ing anoth­er key point Paul Krug­man made regard­ing the com­pul­sion to raise rates no mat­ter what the cir­cum­stances: while doing so may not be in the pub­lic inter­est, there are some extreme­ly influ­en­tial pri­vate inter­ests where high­er rates are great for the bot­tom line [36]:

The New York Times
The Con­science of a Lib­er­al

Rate Rage

Paul Krug­man
Sep­tem­ber 19, 2015 1:51 pm

OK, I should have seen that one com­ing, but didn’t: the bank­ing indus­try has respond­ed to the Fed’s deci­sion not to hike rates with a pri­mal cry of rage. And that, I think, tells us what we need to know about the polit­i­cal econ­o­my of per­ma­hawk­ery.

The truth is, I’ve been get­ting this one wrong. I’ve tried to under­stand demands that rates go up despite the absence of infla­tion pres­sure in terms of broad class inter­ests. And the trou­ble is that it’s not at all clear where these inter­ests lie. The wealthy get a lot of inter­est income, which means that they are hurt by low rates; but they also own a lot of assets, whose prices go up when mon­e­tary pol­i­cy is easy. You can try to fig­ure out the net effect, but what mat­ters for the pol­i­tics is per­cep­tion, and that’s sure­ly murky.

But what we should be doing, I now real­ize, is focus­ing not on broad class­es but on very spe­cif­ic busi­ness inter­ests. In par­tic­u­lar, com­mer­cial bankers real­ly dis­like a very low inter­est rate envi­ron­ment, because it’s hard for them to make prof­its [37]: there’s a low­er bound on the inter­est rates they can offer, and if lend­ing rates are low that com­press­es their spread. So bankers keep demand­ing high­er rates, and invent­ing sto­ries [30] about why that would make sense despite low infla­tion.

...

So the demand for high­er rates is com­ing from a nar­row busi­ness inter­est group, not the one per­cent in gen­er­al. But it’s an inter­est group that has a lot of clout among cen­tral bankers, because these are peo­ple they see every day — and in many cas­es are peo­ple they will become once they go through the revolv­ing door. I doubt there’s much crude cor­rup­tion going on at this lev­el (or am I naive?), but offi­cials at pub­lic mon­e­tary insti­tu­tions — cer­tain­ly the BIS, but also the Fed — are con­stant­ly hold­ing meet­ings with, hav­ing lunch with, com­mer­cial bankers who have a per­son­al stake in see­ing rates go up no mat­ter what the macro sit­u­a­tion.

Like every­one, the bankers no doubt are able to per­suade them­selves that what’s good for them is good for Amer­i­ca and the world; more alarm­ing­ly, they may be able to per­suade offi­cials who should know bet­ter. Does this explain the puz­zling diver­gence between the views of Fed offi­cials and those of out­siders like Lar­ry Sum­mers (and yours tru­ly) who have a sim­i­lar mod­el of how the world works, but are hor­ri­fied by the eager­ness to raise rates while infla­tion is still below tar­get?

I don’t know about you, but I feel that I’m hav­ing an Aha! moment here. Oh, and rais­ing rates is still a ter­ri­ble idea.

“So the demand for high­er rates is com­ing from a nar­row busi­ness inter­est group, not the one per­cent in gen­er­al. But it’s an inter­est group that has a lot of clout among cen­tral bankers, because these are peo­ple they see every day — and in many cas­es are peo­ple they will become once they go through the revolv­ing door. I doubt there’s much crude cor­rup­tion going on at this lev­el (or am I naive?), but offi­cials at pub­lic mon­e­tary insti­tu­tions — cer­tain­ly the BIS, but also the Fed — are con­stant­ly hold­ing meet­ings with, hav­ing lunch with, com­mer­cial bankers who have a per­son­al stake in see­ing rates go up no mat­ter what the macro sit­u­a­tion.
Con­stant­ly hold­ing meet­ings with, hav­ing lunch with, com­mer­cial bankers who have a per­son­al stake in see­ing rates go up no mat­ter what the macro sit­u­a­tion prob­a­bly isn’t the best pol­i­cy-mak­ing envi­ron­ment. But if Krug­man’s analy­sis is cor­rect, one of the most pow­er­ful and influ­en­tial indus­tries on the plan­et, com­mer­cial bank­ing, has a strong finan­cial incen­tive to see a Fed that’s ready and will­ing to err on the side of not just “soon but grad­ual”, as Richard Fish­er might put it, but maybe even “soon and steep”. It’s a rather alarm­ing con­flict of inter­est.

And as Richard Fish­er informed us back in Sep­tem­ber of 2014, it may not just be com­mer­cial bankers that would want to see rates rise soon­er rather than lat­er. It might be any­one that’s
wor­ried about ris­ing wages [38]:

FX Street
Fed’s Fish­er: Fed Must Weigh Wage Pres­sures

Mar­ket­Pulse
Mon, Sep 29 2014, 03:07 GMT
by Stu­art McPhee | Mar­ket­Pulse

The Fed­er­al Reserve mustn’t “fall behind the curve” as it weighs when to start rais­ing inter­est rates, Dal­las Fed Pres­i­dent Richard Fish­er said, cit­ing strength­en­ing U.S. growth and build­ing wage-price pres­sures.

Fish­er, a vocal advo­cate for tighter mon­e­tary pol­i­cy to pro­tect against infla­tion, also said today that two soon-to-be-released eco­nom­ic reports from his Fed dis­trict would “knock your socks off.”

“I don’t want to fall behind the curve here,” Fish­er said in a Fox News inter­view. “I think we could sud­den­ly get a patch of high growth, see some wage-price infla­tion, and that is when you start to wor­ry.”

“I think we could sud­den­ly get a patch of high growth, see some wage-price infla­tion, and that is when you start to wor­ry.”
Uh oh! If we don’t raise rates soon we might “sud­den­ly get a patch of high growth” and then *gasp* wages might rise. Nooooo! [39]

ECB’s “Life Off!” of 2011. And sub­se­quent cra­ter­ing.
So, as we’ve seen, while the recent Fed rate hike may not have been the best deci­sion at the point giv­en the tepid nature of the eco­nom­ic recov­ery thus far, the deci­sion to raise rates could have been far worse in the sense that it could have come a lot soon­er. How much worse? Well, as Krug­man remind­ed us above:

...
Tay­lor writes,

Notice that none of the BIS con­cerns are about the risk of a rise in inflation–which it does not think of as a sub­stan­tial risk.

Ah, but it used to think oth­er­wise. It has been call­ing for high­er inter­est rates for around 5 years, and at first it was indeed warn­ing about infla­tion. In its 2011 report [33], in fact, it declared that

High­ly accom­moda­tive mon­e­tary poli­cies are fast becom­ing a threat to price sta­bil­i­ty.

That was dead wrong, and the ECB — which believed in the infla­tion threat and raised rates — clear­ly made a big mis­take. So you might have expect­ed the BIS to ask why it was so wrong, and recon­sid­er its pol­i­cy rec­om­men­da­tions. Instead, how­ev­er, it con­tin­ued to demand the same poli­cies, while invent­ing new jus­ti­fi­ca­tions.
...

Yep, back in 2011 the whole world received an infor­ma­tive les­son in what hap­pens when cen­tral banks pri­or­i­tize infla­tion fears over the macro­eco­nom­ic real­i­ties com­pli­ments of the Euro­pean Cen­tral Bank (ECB). In was March of 2011, when the euro­zone was still in the grips of a major sov­er­eign debt cri­sis and just bare­ly claw­ing its way out of one of the nas­ti­est reces­sions its in recent mem­o­ry, the ECB issued some for­ward guid­ance to the mar­kets: In order to ensure infla­tion does­n’t rise about 2 per­cent (it’s tar­get rate), and does­n’t result in ris­ing wages, the ECB was will­ing to raise rates. Repeat­ed­ly. And part of the ratio­nal was based on the ECB’s new­ly high­er pro­jec­tions of 2.3 per­cent for the year, up from an ear­li­er pre­dic­tion of 1.8 per­cent. And since the ECB has a sin­gle man­date of keep­ing infla­tion below 2 per­cent, that new pro­jec­tion of 2.3 per­cent infla­tion was appar­ent­ly enough of a jus­ti­fi­ca­tion to raise rates in the midst of major eco­nom­ic dis­tress. Need­less to say, the mar­kets were rather sur­prised (not in a good way) [40]:

Bloomerg Busi­ness
Trichet Says ECB May Raise Rates, Show ‘Strong Vig­i­lance’

By Chris­t­ian Vits and Jana Randow
March 3, 2011 — 11:23 AM CST

Euro­pean Cen­tral Bank Pres­i­dent Jean-Claude Trichet said the ECB may raise inter­est rates next month for the first time in almost three years to fight mount­ing infla­tion pres­sures.

An “increase of inter­est rates in the next meet­ing is pos­si­ble,” Trichet told reporters in Frank­furt today after the cen­tral bank set its bench­mark rate at a record low of 1 per­cent for a 23rd month. “Strong vig­i­lance is war­rant­ed,” he said, adding that any move would not nec­es­sar­i­ly be the start of a “series.”

The com­ments sur­prised econ­o­mists and investors, most of whom hadn’t expect­ed the ECB to raise rates before August. The euro jumped more than 0.9 per­cent to $1.3976, the high­est since Novem­ber. Ger­man gov­ern­ment bonds, a bench­mark for Europe, dropped, send­ing the yield on the two-year bund 18 basis points high­er to 1.713 per­cent.

Trichet is sig­nal­ing tighter pol­i­cy at a time when Ire­land and Greece are strug­gling to cope with the terms of last year’s Euro­pean Union bailouts and gov­ern­ments are ham­mer­ing out a plan to draw a line under the cri­sis. The dan­ger is that rais­ing rates to tack­le infla­tion will exac­er­bate the finan­cial ten­sions that still run through euro region bond mar­kets.

‘The ECB Will Hike’

“The ECB will hike rates by 25 basis points in April and I wouldn’t be sur­prised to see anoth­er increase in Sep­tem­ber or Octo­ber,” said Natascha Gewaltig, chief Euro­pean econ­o­mist at Action Eco­nom­ics in Lon­don, who fore­cast before today’s meet­ing that the ECB would tight­en pol­i­cy in the first half. “Infla­tion expec­ta­tions are pick­ing up, that’s a clear sig­nal for rate set­ters.”

The ECB is con­cerned about so-called sec­ond-round effects, when com­pa­nies raise prices and work­ers demand more pay to com­pen­sate for soar­ing ener­gy and food costs, entrench­ing faster infla­tion. Crude oil surged above $100 a bar­rel last week amid polit­i­cal ten­sions in the Mid­dle East and North Africa. Euro-area infla­tion accel­er­at­ed to 2.4 per­cent last month.

“There is a strong need to avoid sec­ond-round effects,” Trichet said, call­ing for mod­er­a­tion from wage and price set­ters. The ECB is “pre­pared to act in a firm and time­ly man­ner.”

He sig­naled any rate move would like­ly be a quar­ter-point step, say­ing a big­ger increase would not be appro­pri­ate in his view. A rate increase in April would put the ECB ahead of its U.S. and U.K. coun­ter­parts.

Fed­er­al Reserve

Fed­er­al Reserve Chair­man Ben S. Bernanke said on March 1 that the surge in oil and oth­er com­mod­i­ty prices prob­a­bly won’t cause a per­ma­nent increase in broad­er infla­tion and repeat­ed that U.S. bor­row­ing costs are like­ly to stay near zero.

The Bank of Eng­land may be mov­ing clos­er to rais­ing its key rate from 0.5 per­cent, with three of its nine pol­i­cy mak­ers vot­ing for an increase last month.

Chi­na on Feb. 8 raised rates for the third time since mid-Octo­ber to curb infla­tion and pre­vent its econ­o­my from over­heat­ing.

The ECB today raised its infla­tion and growth fore­casts.

Infla­tion will aver­age 2.3 per­cent this year, up from a Decem­ber fore­cast of 1.8 per­cent and in breach of the ECB’s 2 per­cent lim­it, before slow­ing to 1.7 per­cent in 2012, the pro­jec­tions show. The 17-nation euro-area econ­o­my will expand 1.7 per­cent this year and 1.8 per­cent next, up from pre­vi­ous fore­casts of 1.4 per­cent and 1.7 per­cent, accord­ing to the ECB.

Debt Cri­sis

At the same time, Europe’s debt cri­sis is far from over, with politi­cians yet to agree on new steps to bol­ster the region’s res­cue fund.

While gov­ern­ments are cut­ting spend­ing to rein in deficits, risk pre­mi­ums for Spain, Por­tu­gal and Italy have increased since a Feb. 4 EU sum­mit that failed to endorse an eco­nom­ic com­petive­ness plan pro­posed by Ger­many and France as a con­di­tion for aid.

“The ECB is prepar­ing to raise rates too ear­ly,” said Julian Cal­low, chief Euro­pean econ­o­mist at Bar­clays Cap­i­tal in Lon­don. “It should give the euro-area econ­o­my more chance to get on a sus­tain­able foot­ing, par­tic­u­lar­ly since it is still too ear­ly to tell how the intense fis­cal con­sol­i­da­tion in many coun­tries will affect demand this year and next.”

...

“The sov­er­eign debt cri­sis would have to inten­si­fy sig­nif­i­cant­ly for the ECB to delay the start of the rate hik­ing cycle,” he said. “The mes­sage from today’s meet­ing is clear: with infla­tion risks crys­tal­liz­ing, the ECB stands ready to act in April.”

“The ECB is con­cerned about so-called sec­ond-round effects, when com­pa­nies raise prices and work­ers demand more pay to com­pen­sate for soar­ing ener­gy and food costs, entrench­ing faster infla­tion. Crude oil surged above $100 a bar­rel last week amid polit­i­cal ten­sions in the Mid­dle East and North Africa. Euro-area infla­tion accel­er­at­ed to 2.4 per­cent last month.”
An infla­tion­ary spi­ral is just around the cor­ner if rates are raised soon! Watch out! At least that was the warn­ing from the ECB, along with this bit of for­ward guid­ance:

...
“The sov­er­eign debt cri­sis would have to inten­si­fy sig­nif­i­cant­ly for the ECB to delay the start of the rate hik­ing cycle,” he said. “The mes­sage from today’s meet­ing is clear: with infla­tion risks crys­tal­liz­ing, the ECB stands ready to act in April.”

And sure enough, fol­low­ing a rate hike in April [41] and anoth­er in July [42], the sov­er­eign debt cri­sis inten­si­fied sig­nif­i­cant­ly and the ECB, while con­tin­u­ing to warn of future infla­tion, decid­ed to delay fur­ther rate hikes [43]:

The Econ­o­mist

The ECB realis­es infla­tion may not be Europe’s biggest wor­ry just now

Aug 4th 2011, 14:06 by R.A. | WASHINGTON

IT REALLY is dif­fi­cult to over­state the extent of the Euro­pean Cen­tral Bank’s fail­ure in recent months. Ear­li­er this year, head­line infla­tion rose in Europe behind ris­ing com­mod­i­ty prices. The Bank of Eng­land and the Fed­er­al Reserve con­sid­ered the increase in infla­tion, looked at emerg­ing mar­ket efforts to tight­en pol­i­cy, tight­en­ing fis­cal con­di­tions in their economies, and gen­er­al eco­nom­ic weak­ness and con­clud­ed that the bump would be short-lived. It’s not going too far to say that it was obvi­ous it would be short-lived. But the ECB appar­ent­ly suf­fers from a severe case of cen­tral-bank myopia, and so it respond­ed to high­er head­line infla­tion with an April inter­est rate increase, despite the vul­ner­a­bil­i­ty of the euro-zone econ­o­my, and despite an extreme­ly seri­ous ongo­ing euro-zone debt cri­sis.

Since that time, com­mod­i­ty prices have dropped, just as every­one expect­ed they would. Infla­tion has eased; in the euro zone, pro­duc­er prices indi­cate that it’s come to a screech­ing halt. Mean­while, much of the euro zone is fac­ing a return to reces­sion. Indus­tri­al pro­duc­tion is con­tract­ing across south­ern Europe. And the euro zone is on the precipice of an exis­ten­tial cri­sis. Ital­ian stocks have fall­en near­ly 30%. Span­ish stocks are down 20%. Even Ger­man shares are off 13%. Oh, and did I men­tion that the ECB raised rates again just last month?

Hav­ing dri­ven the euro zone to the brink of col­lapse, the ECB is seem­ing­ly hap­py to let some­one else push the econ­o­my over the edge. In today’s mon­e­tary pol­i­cy announce­ment, the cen­tral bank con­tin­ued to warn about infla­tion but opt­ed not to raise inter­est rates yet again. The ECB may also resume pur­chas­es of bonds to try and main­tain func­tion in sov­er­eign-debt mar­kets and lim­it ris­es in bond yields. It hard­ly mat­ters at this point; the dam­age has been done. Euro­pean mar­kets con­tin­ue to drop, and bond yields con­tin­ue to edge upward. It will take mas­sive gov­ern­ment inter­ven­tion to stem the cri­sis, and even if euro-zone gov­ern­ments suc­ceed there is a risk the euro-zone econ­o­my will fol­low its periph­er­al mem­bers into reces­sion. If the euro zone does fall apart, a fit­ting epi­taph might read, “The ECB feared 3% infla­tion”.

What would indeed be a fit­ting epi­taph:

If the euro zone does fall apart, a fit­ting epi­taph might read, “The ECB feared 3% infla­tion”.

And yet, despite the ECB’s lin­ger­ing infla­tion-pho­bia, the eco­nom­ic real­i­ties forced it to “sur­prise” the mar­kets in Novem­ber of that year with a rate cut under the new lead­er­ship of today’s ECB pres­i­dent Mario Draghi [44]. And was we now know, the sov­er­eign debt cri­sis con­tin­ue to get worse, lead­ing to the his­toric dec­la­ra­tion by Draghi in July of 2012 to “do what­ev­er it takes” to keep the euro­zone finan­cial mar­kets and sov­er­eign debt mar­kets held togeth­er [45], embark­ing the ECB on the path towards quan­ti­ta­tive eas­ing, near-zero inter­est rates, and the kinds of poli­cies that the infla­tion-hawks and Ordolib­er­als at the Bun­des­bank fear so much. To put it anoth­er way, by lis­ten­ing to the infla­tion hawks in 2011, the ECB bun­gled things up so bad­ly that, by the mid-2012, the ECB was forced to become the kind of cen­tral bank folks like Richard Fish­er hate. It was either that or let the euro­zone implode.

The ECB’s mini-coup sur­prise of 2015. It was­n’t exact­ly cred­i­bil­i­ty-enhanc­ing.
And that brings us to anoth­er episode in cred­i­bil­i­ty-dam­ag­ing cen­tral bank behav­ior: While the Fed’s his­toric rate hike was get­ting much of the atten­tion of late among cen­tral bank watch­er, the Fed was­n’t the only major cen­tral bank mak­ing deci­sions this month. Specif­i­cal­ly, the ECB’s recent deci­sions on how much to expand its QE stim­u­lus pro­grams end­ed up send­ing a very dis­turb­ing sig­nal to the mar­kets. But the cred­i­bil­i­ty dam­age, while sim­i­lar in ways to the warn­ings of from folks like Richard Fish­er that not meet­ing mar­ket expec­ta­tions based on for­ward guid­ance made months ago could dam­age a cen­tral bank’s cred­i­bil­i­ty, was actu­al­ly quite dif­fer­ent. As we saw with Richard Fish­er’s warn­ings in 2013, the dam­age to the Fed’s cred­i­bil­i­ty was sup­posed to arise from the fact that the for­ward guid­ance the Fed gave ear­li­er in the year sug­gest­ed that rate hikes could be com­ing lat­er in the year assum­ing the recov­ery stayed on track, and by not fol­low­ing through with pre­dict­ed rate hike, the mar­kets would be less like­ly to believe the Fed lat­er (despite that fact that hik­ing rates in the fal 2013 could have been a real­ly stu­pid thing to do).

But what hap­pened with the ECB this month was actu­al­ly quite dif­fer­ent. In this case, ECB Pres­i­dent Mario Draghi made a num­ber of com­ments to the mar­kets in the weeks and days before the ECB’s Decem­ber pol­i­cy-mak­ing deci­sions that fur­ther QE mea­sures were prob­a­bly forth com­ing, in keep­ing with his “do what­ev­er it takes” pledge from 2012 and the over­all weak­ness of the euro­zone recov­ery. And then cred­i­bil­i­ty prob­lem arose: Mario Draghi was over­ruled by the infla­tion hawks [46]:

Reuters
ECB anti-cli­max takes shine off Draghi

FRANKFURT | By John O’Don­nell
Fri Dec 4, 2015 11:52pm IST

Mario Draghi’s knack of aim­ing high and then ful­fill­ing expec­ta­tions did not quite come off on Thurs­day, rais­ing a ques­tion mark over how much the Euro­pean Cen­tral Bank and its pres­i­dent can be expect­ed to act in future.

Although he is the head of the cen­tral bank, Draghi relies on con­sen­sus-build­ing among the 19 coun­tries in the euro zone, from con­ser­v­a­tive Ger­many to debt-strapped Italy, to mould pol­i­cy, a task he has pre­vi­ous­ly deft­ly man­aged.

This time, how­ev­er, his announce­ment of a range of mea­sures to enhance mon­ey-print­ing fell short of what investors had hoped for, prompt­ing some to ques­tion whether Draghi is los­ing his mag­ic touch.

“There was a build up of expec­ta­tions based on Draghi’s strong track record of over­com­ing polit­i­cal oppo­si­tion,” said Lena Komil­e­va of con­sul­tan­cy G+ Eco­nom­ics.

“By wrong-foot­ing the mar­kets, the ECB has lost some cred­i­bil­i­ty. It renews con­cerns about polit­i­cal divi­sions.”

Since the run-up to the launch of full-scale mon­ey-print­ing, Draghi has estab­lished a pat­tern of pub­licly talk­ing up prospects of action, back­ing skep­tics such as Ger­many into a cor­ner and win­ning the major­i­ty of ECB gov­er­nors for his plan.

His pow­ers of per­suad­ing mar­ket skep­tics were most famous­ly demon­strat­ed in 2012 when he promised to do “what­ev­er it takes” to shield the euro, instant­ly quelling spec­u­la­tion that a debt cri­sis could bring about the col­lapse of the cur­ren­cy.

Yet on Thurs­day, Draghi’s words were not, in the eyes of investors, matched with the action some felt he had promised.

As recent­ly as late Novem­ber, Draghi had under­lined the need for “the econ­o­my ... to move back to full capac­i­ty as quick­ly as pos­si­ble”, dis­cussing the need for a pos­si­ble recal­i­bra­tion of ECB sup­port and warn­ing of the bloc’s mod­est prospects.

Short­ly after­wards, a rare pub­lic split emerged on the six-per­son Exec­u­tive Board, when Sabine Laut­en­schlaeger from Ger­many said she opposed an exten­sion of mon­ey-print­ing.

While there have long been dif­fer­ing views on the bank’s 25-mem­ber Gov­ern­ing Coun­cil, which sets inter­est rates, it was unusu­al for divi­sions on the Exec­u­tive Board, which is at the core of ECB deci­sion-mak­ing, to spill into the open.

There is no pub­lic record of Ger­many’s stance at the meet­ing on Thurs­day, the recal­i­bra­tion, when it came, was indeed a small­er-than-expect­ed increase in the charge on banks for deposit­ing mon­ey with the ECB.

Its one-tril­lion-euro-plus mon­ey print­ing pro­gram was extend­ed by six months. That increas­es its size by rough­ly one third but there is no top-up to month­ly buys. Munic­i­pal or region­al debt will be includ­ed in the ECB’s bond-buy­ing shop­ping list although Draghi could not yet say how much this would mount to.

“My under­stand­ing is the mar­kets expect­ed some changes which were not forth­com­ing,” Fed­er­al Reserve Chair Janet Yellen told Unit­ed States’ law­mak­ers.

That was per­haps an under­state­ment giv­en the mar­ket reac­tion: Euro­pean shares suf­fered their biggest fall in three months while and the euro leapt more than 2 cents, its biggest surge since March.

“The mar­ket’s dis­ap­point­ment is impor­tant for the future,” said Toby Nan­gle of asset man­ag­er Colum­bia Thread­nee­dle. “It lim­its Pres­i­dent Draghi’s abil­i­ty to guide mar­kets who will nat­u­ral­ly become more sus­pi­cious of his pow­er to deliv­er.”

For once put on the defen­sive by jour­nal­ists press­ing him abut the dis­ap­point­ed mar­ket reac­tion, Draghi was at pains to point out that fur­ther action was pos­si­ble and that mar­kets would under­stand bet­ter the ECB moves on clos­er inspec­tion.

...

“The mar­ket’s dis­ap­point­ment is impor­tant for the future...It lim­its Pres­i­dent Draghi’s abil­i­ty to guide mar­kets who will nat­u­ral­ly become more sus­pi­cious of his pow­er to deliv­er.”
That’s a pret­ty good way to put it. When Draghi implied much more aggres­sive mea­sures than he actu­al­ly deliv­ered just days before the new poli­cies were announced, that cer­tain­ly did­n’t help his cred­i­bil­i­ty and there­fore the cred­i­bil­i­ty of the entire ECB. And the pub­lic spat with Ger­many’s mem­ber of the ECB’s exec­u­tive coun­cil did­n’t help either:

...

Since the run-up to the launch of full-scale mon­ey-print­ing, Draghi has estab­lished a pat­tern of pub­licly talk­ing up prospects of action, back­ing skep­tics such as Ger­many into a cor­ner and win­ning the major­i­ty of ECB gov­er­nors for his plan.

His pow­ers of per­suad­ing mar­ket skep­tics were most famous­ly demon­strat­ed in 2012 when he promised to do “what­ev­er it takes” to shield the euro, instant­ly quelling spec­u­la­tion that a debt cri­sis could bring about the col­lapse of the cur­ren­cy.

Yet on Thurs­day, Draghi’s words were not, in the eyes of investors, matched with the action some felt he had promised.

As recent­ly as late Novem­ber, Draghi had under­lined the need for “the econ­o­my ... to move back to full capac­i­ty as quick­ly as pos­si­ble”, dis­cussing the need for a pos­si­ble recal­i­bra­tion of ECB sup­port and warn­ing of the bloc’s mod­est prospects.

Short­ly after­wards, a rare pub­lic split emerged on the six-per­son Exec­u­tive Board, when Sabine Laut­en­schlaeger from Ger­many said she opposed an exten­sion of mon­ey-print­ing.

...

Yeah, pub­licly diss­ing Draghi and then, lo and behold, the new ECB poli­cies were basi­cal­ly a watered-down ver­sion of his planned stim­u­lus expan­sion. It was­n’t exact­ly the best cred­i­bil­i­ty builder for the ECB.

But it could be worse. And since this is the euro­zone we’re talk­ing about, it got worse. At least Mario Draghi’s cred­i­bil­i­ty got worse when, lat­er in the day, Bun­des­bank chief Jens Wei­d­mann
announced his oppo­si­tion to the watered-down stim­u­lus and announced that below-tar­get infla­tion is no rea­son for the cen­tral bank to do more [47]:

Mar­ket­Watch

Bun­des­bank’s Wei­d­mann sets face against ECB moves

By Todd Buell

Pub­lished: Dec 4, 2015 2:16 a.m. ET

FRANKFURT–European Cen­tral Bank Gov­ern­ing Coun­cil mem­ber Jens Wei­d­mann quick­ly voiced his oppo­si­tion Thurs­day to new pol­i­cy eas­ing announced ear­li­er in the day by the ECB, under­scor­ing com­ments made ear­li­er in the day by the ECB pres­i­dent that the Gov­ern­ing Coun­cil was­n’t unit­ed in pump­ing more mon­ey into the euro­zone econ­o­my.

Accord­ing to pre­pared remarks to be deliv­ered in Frank­furt, Mr. Wei­d­mann said that even though one should­n’t casu­al­ly ignore below-tar­get infla­tion for the fore­see­able future, this isn’t a rea­son for the cen­tral bank to do more.

“Con­sid­er­ing the dom­i­nant role of the ener­gy-price decline for the price devel­op­ment in the euro­zone and ear­li­er com­pre­hen­sive mon­e­tary pol­i­cy mea­sures, that also can have risks and side effects, I did not believe a fur­ther loos­en­ing of pol­i­cy was nec­es­sary,” he said.

Mr. Wei­d­mann, who heads Ger­many’s Bun­des­bank, is con­sid­ered one of the most out­spo­ken hawks on the ECB’s 25-strong Gov­ern­ing Coun­cil. He opposed the cre­ation of the cur­rent quan­ti­ta­tive eas­ing pro­gram and dis­sent­ed against cre­at­ing the bond pro­gram for stressed coun­tries a lit­tle over three years ago.

Speak­ing last month, Mr. Wei­d­mann also sug­gest­ed that he opposed an expan­sion in the cur­rent bond-buy­ing pro­gram.

“Mr. Wei­d­mann said that even though one should­n’t casu­al­ly ignore below-tar­get infla­tion for the fore­see­able future, this isn’t a rea­son for the cen­tral bank to do more.”
So fol­low­ing what amount to a pub­lic mini-coup by the per­ma­hawks on the ECB, the chief per­ma­hawk, Jens Wei­d­mann, announced that he does­n’t see sub‑2 per­cent infla­tion as a rea­son for the ECB to do more. And keep in mind that, unlike the Fed­er­al Reserve which has a duel man­date of price sta­bil­i­ty (2 per­cent infla­tion) the ECB only has a sin­gle man­date: main­tain­ing infla­tion below, but not too far below, 2 per­cent. That’s it. Also note the US per­ma­hawks like Richard Fish­er think switch­ing the Fed to a sin­gle man­date like the ECB (and ignor­ing unem­ploy­ment com­plete­ly) is an idea worth con­sid­er­ing [48]. But appar­ent­ly, accord­ing to Wei­d­mann, even that sin­gle man­date should be ignored by the ECB at this point. And, again, the Wei­d­mann wing just pulled off a pub­lic mini-coup at the ECB and then Wei­d­mann declared that the ‘sin­gle man­date’ is real­ly more of a ‘sin­gle sug­ges­tion’. What kind of dam­age will that do to the ECB’s cred­i­bil­i­ty?

And this pub­lic smal­ck down of the ECB pres­i­dent all hap­pened not long before the Fed made its his­toric deci­sion to start the glob­al “lift off” of near zero rates, which means that the per­ma­hawks at the ECB are going to prob­a­bly be even more empow­ered to raise rates in the euro­zone the high­er the Fed’s rates go.. So assum­ing the Fed fol­low­ing through with its rate hik­ing for­ward guid­ance in 2016, we could be enter­ing the kind of sce­nario next where where the ECB per­ma­hawks get an excluse to repeat their epic blun­der of 2011.

“To the stars!” *ouch* “See­ing stars!”
So how like­ly is such a “Lift Off”/“crash down” sce­nario? Well, as Richard Fish­er not­ed in 2014 [26], macro­eco­nom­ic prog­nos­ti­ca­tions aren’t easy to do. Or at least do well. That said, based on a recent sur­vey of econ­o­mists, the Fed’s new “lift off” era might be cra­ter­ing soon­er than you think. Their evi­dence? All the oth­er cen­tral banks that have tired to raise rates in recent years that only end­ed up trash­ing their recov­er­ies and see­ing those rates go right back down [49]:

The Wall Street Jour­nal
Fed Offi­cials Wor­ry Inter­est Rates Will Go Up, Only to Come Back Down
More than half of econ­o­mists polled pre­dict fed­er­al-funds rate back near zero with­in next five years

By Jon Hilsen­rath
Updat­ed Dec. 13, 2015 7:16 p.m. ET

Fed­er­al Reserve offi­cials are like­ly to raise their bench­mark short-term inter­est rate from near zero Wednes­day, expect­ing to slow­ly ratch­et it high­er to above 3% in three years.

But that’s if all goes as planned. Their big wor­ry is they’ll end up right back at zero.

Any num­ber of fac­tors could force the Fed to reverse course and cut rates all over again: a shock to the U.S. econ­o­my from abroad, per­sis­tent­ly low infla­tion, some new finan­cial bub­ble burst­ing and slam­ming the econ­o­my, or lost momen­tum in a busi­ness cycle which, at 78 months, is already longer than 29 of the 33 expan­sions the U.S. econ­o­my has expe­ri­enced since 1854.

Among 65 econ­o­mists sur­veyed by The Wall Street Jour­nal [50] this month, not all of whom respond­ed, more than half said it was some­what or very like­ly the Fed’s bench­mark fed­er­al-funds rate would be back near zero with­in the next five years. Ten said the Fed might even push rates into neg­a­tive ter­ri­to­ry, as the Euro­pean Cen­tral Bank and oth­ers in Europe have done—meaning finan­cial insti­tu­tions have to pay to park their mon­ey with the cen­tral banks.

Traders in futures mar­kets see low­er inter­est rates in com­ing years than the Fed projects in part because they attach some prob­a­bil­i­ty to a return to zero. In Decem­ber 2016, for exam­ple, the Fed projects a 1.375% fed-funds rate. Futures mar­kets put it at 0.76%.

Among the wor­ries of pri­vate econ­o­mists is that no oth­er cen­tral bank in the advanced world that has raised rates since the 2007-09 cri­sis has been able to sus­tain them at a high­er lev­el. That includes cen­tral banks [51] in the euro­zone, Swe­den, Israel, Cana­da, South Korea and Aus­tralia.

“They effec­tive­ly have had to undo what they have done,” said Susan Sterne, pres­i­dent of Eco­nom­ic Analy­sis Asso­ciates, an advi­so­ry firm spe­cial­iz­ing in track­ing con­sumer behav­ior.

The Fed has nev­er start­ed rais­ing rates so late in a busi­ness cycle. It has held the fed-funds rate near zero for sev­en years and hasn’t raised it in near­ly a decade. Its deci­sion to keep rates so low for so long was like­ly a fac­tor that helped the econ­o­my grow enough to bring the job­less rate down to 5% last month from a recent peak of 10% in 2009. At the same time, wait­ing so long might mean the Fed is start­ing to lift rates at a point when the expan­sion itself is near­er to an end.

Ms. Sterne said the U.S. expan­sion is now at an advanced stage and con­sumers have sat­is­fied pent-up demand for cars and oth­er durable goods. She’s wor­ried it doesn’t have engines for sus­tained growth. “I call it late-cycle,” she said.

Sev­er­al fac­tors have con­spired to keep rates low. Infla­tion has run below the Fed’s 2% tar­get [52] for more than three years. In nor­mal times the Fed would push rates up as an expan­sion strength­ens to slow growth and tame upward pres­sures on con­sumer prices. With no signs of infla­tion, offi­cials haven’t felt a need to fol­low that old game plan.

More­over, offi­cials believe the econ­o­my, in the wake of a debil­i­tat­ing finan­cial cri­sis and restrained by an aging pop­u­la­tion and slow­ing work­er-pro­duc­tiv­i­ty growth, can’t bear rates as high as before. Its equi­lib­ri­um rate—a hypo­thet­i­cal rate at which unem­ploy­ment and infla­tion can be kept low and stable—has sunk below old norms, the think­ing goes.

That means rates will remain rel­a­tive­ly low even if all goes as planned. If a shock hits the econ­o­my and sends it back into reces­sion, the Fed won’t have much room to cut rates to cush­ion the blow.

...

Nor­mal­ly in a reces­sion the Fed cuts rates to stim­u­late spend­ing and invest­ment. Between Sep­tem­ber 2007 and Decem­ber 2008 it cut rates 5.25 per­cent­age points. Between Jan­u­ary 2001 and June 2003 the cut was 5.5 per­cent­age points, while from July 1990 to Sep­tem­ber 1992 it was 5 per­cent­age points.

If the Fed wants to reduce rates in response to the next shock, it will be back at zero very quick­ly and will have to turn to oth­er mea­sures to boost growth.

Fed offi­cials wor­ry a great deal about the risk. The small gap between zero and where offi­cials see rates going “might increase the fre­quen­cy of episodes in which pol­i­cy mak­ers would not be able to reduce the fed­er­al-funds rate enough to pro­mote a strong eco­nom­ic recovery…in the after­math of neg­a­tive shocks,” they con­clud­ed at their Octo­ber pol­i­cy meet­ing, accord­ing to min­utes of the meet­ing.

In short, the age of uncon­ven­tion­al mon­e­tary pol­i­cy begun by the 2007-09 finan­cial cri­sis might not be end­ing.

Note the crit­i­cal para­dox at work here: When­ev­er the Fed rais­es rates, it simul­ta­ne­ous­ly cre­ates a larg­er ‘cush­ion’ for future rate cuts that can be employed. But it also simul­ta­ne­ous­ly slows down the econ­o­my, mak­ing a future rate cut more like­ly.

This para­dox is part of why the larg­er glob­al eco­nom­ic envi­ron­ment is crit­i­cal in mak­ing his­toric deci­sions like rais­ing near-zero rates after the longest peri­od of no rate hikes in his­to­ry. And that’s why the ECB’s mini-coup this month is poten­tial­ly so sig­nif­i­cant to not just euro­zone but every­where else too: If the ECB repeats its blun­der of 2011, maybe not by actu­al­ly rais­ing rates but anal­o­gous­ly by scal­ing back its QE poli­cies reck­less­ly and gen­er­al­ly sig­nal­ing that the Wei­d­mann-wing is call­ing the shots, that’s prob­a­bly going to drag down the US and every­one else too and make the odds of see near-zero rates from the Fed a lot more like­ly.

So here we are, with the Fed quite pos­si­bly rais­ing rates pre­ma­ture­ly, and the ECB send­ing sig­nals to the mar­ket that the Wei­d­mann-wing of per­ma­hawks has the pow­er it needs to over­rule Mario “do what­ev­er it takes” Draghi. But hey, prog­nos­ti­cat­ing is hard and it’s cer­tain­ly pos­si­ble that the econ­o­my will indeed pick up as expect­ed in 2016 and maybe this rate hike was pru­dent and well-time. And few things would enhance the cred­i­bil­i­ty of the Fed or ECB bet­ter than a robust recov­ery in both the US and euro­zone in the face of this his­toric “lift off” and a scal­ing back of the ECB’s stim­u­lus pro­grams.

On the oth­er hand... [53]