MacroScope

Dallas Federal Reserve President Richard Fisher is not one to pull his punches. He was one of three dissenters on the Fed’s most recent move to ease policy, and has argued the move will not only be ineffective but also potentially harmful to jobs. Speaking with reporters after his refreshingly frank defense of his dissent this week, Fisher – an architect of the Fed’s new communications policy aimed at more transparency – suggested there are times when he would prefer to be a bit more demure.

Asked if the Federal Open Market Committee’s gloomy economic outlook in its post-meeting statement last week matched his own, he said: “I think the FOMC does its job to honestly state how it views things. We are in an age of enhanced transparency.”

But that’s not always a good thing, he suggested, especially when the market is not used to getting an unvarnished view. Warning that he was about to make a “bad joke” – and then proceeding with it – Fisher said:

We are an almost 100 year old institution … I don’t think that anything that’s 100 years old should give a full frontal view. We do reveal most fully what we discuss, and the markets are going to have to get used to that. It may not be a pretty view, but its a full frontal view.

Sure, many U.S. inflation indicators have been moving higher in recent months. But that’s because most of them are really a look into the rearview mirror, argue economists at JP Morgan. In a note entitled “The rise in U.S. inflation is yesterday’s headache,” they say the same pattern was observed in early 2008, just before a deepening financial crisis dragged prices lower across the world economy:

At first glance the rise in inflation looks anomalous against the backdrop of persistently disappointing U.S. and global growth and hints at an intractable stagflation problem. But it is very likely that the rise in both inflation and core inflation will prove temporary and soon recede. In this regard,the inflation performance in early 2008 provides a useful model. Then, as now, inflation rose while the economy was weakening. And then, as now, the rise in inflation mainly reflected the upward pressure on goods prices from much higher commodity prices and a weakening dollar.

That means the Fed, which has just announced a fresh effort to push down long-term borrowing costs, may have room to ease monetary policy further if it feels the need.

Four leading Republicans wrote to Federal Reserve Chairman Ben Bernanke before the Fed’s Sept. 20-21 policy meeting recommending the Fed stop taking steps to boost growth. Fed interventions to pull down the high unemployment rate may do more harm than good and risk inflation, the officials said.

The Fed to some extent brushed those objections aside, deciding at the end of the meeting that a deteriorating outlook warranted buying and selling $400 billion worth of Treasuries to shift its holdings to longer maturities. Doing so should push down longer interest rates and may promote mortgage refinancing, Fed officials hope.

While the Fed would likely argue that its action was not the same as expanding its balance sheet through outright bond buying – which many critics objected to – it was nevertheless taking an active step, and could draw criticism from Republican lawmakers and candidates for the presidency. How could Congress make life miserable for the Fed? Lawmakers of both parties have proposed measures that would diminish or alter the Fed’s role.

While financial markets are primarily focused on “Operation Twist,” the Fed’s return to buying mortgage-backed securities has helped that market. MBS have outperformed Treasuries and interest rate swaps since the FOMC announcement.

This has yet to translate into much of a drop in mortgage rates for consumers, however. And even if it does, many economists doubt lower mortgage rates can do much to boost home sales and refinancing, helping to put more cash in consumers’ pockets. Banks are reluctant to lend for a variety of reasons, while consumers are reluctant to borrow due to worries about their jobs and the poor outlook for the economy. Homeowners with underwater mortgages remain unable to refinance their loans — barring a sudden improvement in the market or some type of relief from Washington.

As of early Thursday, the current coupon 30-year MBS were 10 basis points tighter in spread versus Treasuries after a 15 basis points tightening on Wednesday, but the average 30-year mortgage rate is down only 3 basis points overnight to 4.10 percent (albeit a record low) according to Bankrate.com.

The Federal Reserve's "Operation Twist" has set the literary- and musical-allusion juices flowing.  It is all about the Fed selling or not rolling over short-term debt and buying long-term bonds instead in order to keep borrowing costs low.

But that is frightfully dull for economists, analysts and reporters trying to get attention for their work. So, so far we have heard:

-- "Let's Twist Again", a reference to the 1960's Chubby Checker record about the dance craze . Problem is that the second line is "Like we did last summer", and the Fed did nothing of the sort, launching plain old quantative easing instead.

“Inflation is always and everywhere a monetary phenomenon.” That insight of Milton Friedman’s underpins the general perception of a rising money supply as associated with a booming economy. So why, as Europe teeters and the United States struggles, have U.S. monetary aggregates like M1 and M2 been spiking sharply in the last two months? According to Paul Ashworth, chief economist at Capital Economics, it is a knee-jerk reaction to fear, which has driven investors away from European securities and into dollar-denominated deposits:

The surge in M2 over the past couple of months is very similar to the one seen after the collapse of Lehman Brothers three years ago.  … The shift clearly reflects renewed concerns about the health of banks in light of their exposure to euro-zone sovereign debt. In particular, investors are withdrawing their money from accounts at foreign banks.

As the U.S. economic recovery stumbles, most observers Federal Reserve policy expect the central bank next week to announce an initiative to replace shorter-term securities on its balance sheet with longer-term ones in a bid to drive longer-term interest rates lower.

Fed watchers call the maneuver Operation Twist after a like-named Cold War-era initiative in which the Fed bought longer term securities with a similar objective.

A twist action could stimulate mortgage refinancing and push investors to invest in corporate bonds, which could spur business borrowing, or in equities, which might help stocks recover, the Fed believes. By adjusting the composition of its portfolio rather than launching an aggressive new round of bond buying, also known as quantitative easing, the Fed would be taking a relatively modest easing step, but be acting all the same.

For markets, it’s a fait accompli: the Federal Reserve, which meets on Tuesday and Wednesday, is expected to push for some variation on a 1961 policy, known as Operation Twist because it aims to push down long-term borrowing costs while nudging short-term rates higher. Primary dealer banks polled by Reuters two weeks ago, just after the Labor Department reported the U.S. job market had stagnated in August, saw an 80 percent chance that some of sort of twist-like measure would be put into place.

Still, there are a number of variants the Fed could employ:

Half Twist: The most modest, perhaps too weak given market fragility, would be to direct proceeds from existing bonds on the balance sheet into longer-dated Treasury securities.

Full Twist: A more aggressive approach would involve active sales of short-dated bills and longer bond buys, and attempt to flatten the yield curve to effectively force investors to take more risk by lending at longer maturities. A February paper from the San Francisco Fed argued that, unlike the conventional wisdom that the original Operation Twist was a failure, the measure actually drove down long term Treasury yields by what the study calls a “highly statistically significant” 0.15 percentage point.

A new Brookings Institution report from the self-appointed Committee on International Economic Policy and Reform suggests that, given a spotty recent record, supervisors and policymakers at the world’s top central banks need to be watched themselves. The group of 16 high-profile economists and financial experts, which includes former Brazilian central bank chief Arminio Fraga, Berkeley professor Barry Eichengreen, Harvard’s Kenneth Rogoff and Mohamed El-Erian from Pimco, proposes a new international watchdog that might ensure actions taken by individual countries are coordinated and smoothed out:

We call for the creation of an International Monetary Policy Committee composed of representatives of major central banks that will report regularly to world leaders on the aggregate consequences of individual central bank policies.

The proposal comes as the Federal Reserve, faced with a weakening U.S. economy, ponders another round of unconventional monetary stimulus. Many analysts believe the Fed will take some type of step to support low long-term rates at its September 20-21 meeting. When the Fed implemented its second round of bond-buying, it came under harsh criticism from emerging economies for pushing up their exchange rates with ultra-low rates in the United States.

Once seen as an extreme, even imprudent notion in the corridors of respectable central banking, the idea that a little bit of inflation is needed to let some of the air out of a decades-long debt bubble is gaining ground in establishment economics. Even the U.S. Federal Reserve, a central bank that prides itself in offering a high degree of steady predictability on inflation, is now actively pondering taking more drastic steps, such as linking the path of interest rates to the direction of unemployment or inflation.

One particularly striking passage in minutes to the Fed’s August meeting signaled such an approach was much closer to becoming policy than investors and economists had believed:

In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee’s intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting.