MacroScope

It may be hard to convince consumers with stagnant wages that their purchasing power is improving. But according to Labor Department, inflation is certainly on the decline. U.S. consumer prices fell unexpectedly in October, a drop that gives the Federal Reserve more room to consider additional monetary easing if the economy continues to stutter into next year.

Compared to a year earlier, consumer prices rose 3.5 percent following September’s 3.9 percent increase. Core prices rose 2.1 percent in the 12 months through October, up from 2.0 percent in September. But looked at over shorter horizons, the pullback in the rate of consumer price growth is even more pronounced.

Research from Credit Suisse economists puts it in perspective:

The 0.4 percentage point easing in the year-on-year headline inflation rate was the first (drop) all year and the biggest since June 2010. Short run trends were as follows: 2.4 percent 3-month annualized from 4.8 percent last month; 2.1 percent 6-month annualized from 3.1 percent last month.

The Federal Reserve, which on Wednesday sharply downgraded its outlook for U.S. economic growth and employment, appears to be seriously considering another round of monetary easing. In what would represent a policy U-turn, any third round of quantitative easing or QE3 appears increasingly likely to be heavily tilted toward purchases of mortgage-backed securities.

The idea was recently floated rather surprisingly by Fed Governor Daniel Tarullo, who normally focuses on regulatory issues. Some analysts had speculated Tarullo might not have broad support, but Fed Chairman Ben Bernanke’s comments on the matter during his post-meeting press conference on Wednesday suggested otherwise:

The housing sector is a very important sector. Problems in that sector are a big reason why our economy’s not recovering more quickly. I do think that purchases of mortgage-backed securities is a viable option. Certainly, something we would consider if the condition were appropriate. So the answer is yes, we will certainly look into that.

As the Fed ponders providing another round of stimulus to a weak U.S. economy, it is difficult to keep track of the views of individual central bank officials. This newly-updated hawks-doves chart should help cut through the clutter. One good rule of thumb: keep a close eye on Ben Bernanke. The Fed Chairman is highly respected by his colleagues and his views usually carry the day.

*Update: here’s another interactive graphic focused on just the 10 current voting members on the Fed’s policy-setting panel.

When the Federal Reserve announced back in August that it expected to keep interest rates at very low levels until at least mid-2013, three top policymakers voted against the decision —  and a number of non-voting officials grumbled as well. St. Louis Fed President James Bullard is one prominent critic of the policy, arguing in a speech last month it ties the central bank down unnecessarily and potentially threatens its credibility if conditions require a course correction:

It is time for the Committee to discard one-time policy changes with fixed end dates. The Committee in the past never contemplated announcing several hundred basis point moves to be completed at a date certain. Yet that is how the Committee behaves today. Research indicates quite clearly that optimal monetary policy should continuously respond to ever-changing economic conditions.

Not to worry, argue two young economists in a paper on VoxEU. Olivier Coibion at William and Mary and Yuriy Gorodnichenko of Berkeley say the move toward using specific time horizons for the purpose of policy guidance is a perfectly consistent next step in the Fed’s gradual push toward greater transparency. They conclude opponents of the policy are misinterpreting its intention:

It was his first speech on the economy in almost three years in office, but Daniel Tarullo did not pull any punches. The Federal Reserve Board governor, who tends to focus primarily on regulation, on Thursday called for the central bank to step up its purchases of mortgage bonds:

I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.

More broadly, Tarullo made a strong call for further monetary easing, arguing quite dovishly that the recovery is still too weak for the central bank not to take further action.

As policymakers debate how to bring down an unemployment rate stubbornly stuck above 9 percent, Chicago Federal Reserve Bank President Charles Evans and Boston Fed President Eric Rosengren are embracing what might be called “the seven-percent solution.”

It works like this: the Fed pledges to keep rates near zero for as long as it takes to get some real improvement in the labor market – an unemployment  rate, say, of 7 percent – as long as inflation doesn’t get out of hand. That way, every time some good economic news comes out, markets don’t immediately start pricing in a rate hike, undoing the very easy policy that the Fed sees as necessary to pull the moribund jobs market from its deep hole. Don’t you worry about a little bit of inflation here or there, the Fed could say –  it’s steady as she goes until unemployment dips below 7 percent.

What, though, is so special about 7 percent? Certainly, it’s much better than the current 9.1 percent. But it still would leave millions unemployed, and Evans himself has said he believes that unemployment normally runs at less than 6 percent. Why settle for a bigger number?

The Federal Reserve’s long-quiet doves are becoming increasingly louder about championing more aggressive forms of monetary easing, including possibly setting employment and inflation targets and/or engaging in another round of bond purchases. Most prominent among these have been Charles Evans, the Chicago Fed president who openly favors more transparent policy guidance and Eric Rosengren, who told CNBC on Wednesday a third round of monetary easing could be in store:

If the economy were to be weaker than most people are forecasting, that would certainly be cause for doing additional monetary policy.

Rosengren also said he favors more explicit policy targets, which could take a rather controversial form known as price-level targeting. Under this arrangement, the Fed would temporarily shoot for higher inflation to make up for the almost deflationary readings seen late last year, in an effort to boost investment, spending and hiring.

Will they or won’t they (ease monetary policy further)? The question will again garner investors’ attention this week as Federal Reserve Chairman Ben Bernanke and a number of regional Fed bank presidents take to the podium. The speeches come against a backdrop of ongoing worries about economic growth, but on the heels of a number of releases that were not as bad as feared. The bar remains high for the Fed to actively engage in a third round of quantitative easing or QE3 — it would probably take renewed deflationary rumblings to get there.

For now, the Fed is likely to focus on less drastic steps, such as new ways of communicating its policy targets, to satiate wobbly financial markets’ apparent need for ongoing monetary support. Here is the line-up of speakers for this week:

Bernanke will deliver remarks on ”The Effects of the Great Recession on Central Bank Doctrine and Practice” at the Boston Fed on Tuesday at 1: 15 pm EDT.

A sharp recent drop in the Fed’s holdings of U.S. Treasuries for foreign central banks probably reflects the effort by many developing economies to stem rapid declines in their currencies, not some frightening move by the likes of China out of U.S. bonds. That’s the argument put forth by Marc Chandler at Brown Brothers Harriman, who notes the pullback of recent weeks appears to have been the most dramatic since the Asian financial crisis of the late 1990s.

His reasoning makes sense: a September spike in the U.S. dollar was accompanied by steep plunges in the exchange rates of many emerging economies. Still, Chandler remains puzzled as to why the selling accelerated to a hefty $21 billion even as the dollar reversed course in the last week:

This is the seventh consecutive weekly decline and over this period, custody holdings have fallen an average of about $12-$12.5 billion a week, making this past week quite large relative to trend. It likely reflects foreign central banks’ selling of Treasuries to intervene to support their currencies rather than a dumping of Treasuries to diversify reserves or as a protest to such low interest rates.

When it comes to the price stability half of their mandate, Federal Reserve officials have made one thing clear: they will not allow inflation expectations to veer very far from their preferred path. That’s because they believe inflation expectations are a good proxy for the pace of future price increases.

This applies both to the upside, when rising prices are a problem, and when the opposite is true, and policymakers fear deflation. The Fed argues that its second round of quantitative easing or QE2, when it purchased $600 billion in Treasury bonds, averted the risk of such a downward spiral of falling prices and wages, which can take years to overcome.

That’s why the latest figures from the Thomson Reuters/University of Michigan survey of consumer sentiment may strike a chord, particularly with the Fed’s more dovish camp. Inflation expectations one-year out dipped to 3.2 percent from 3.3 percent. Even more strikingly, 5-years out, consumers’ inflation projection fell to 2.7 percent from 2.9 percent. That was the lowest in a year and just 0.1 percentage point above the mid-crisis low of 2.6 percent.