Fed Transparency

Thanks to my friend David Kotok to share this:
Fed Transparency
February 01, 2012

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at http://www.cumber.com. He may be reached at Bob.Eisenbeis@cumber.com.

A lot has already been written on the FOMC’s latest efforts to increase the transparency of its conduct of monetary policy. It has been a long, drawn-out, deliberate process that has transcended more than one Chairman. When William McChesney Martin was chairman, not even the FOMC was always privy to how policy was conducted. Martin and the manager of the Open Market Desk relied upon “tone and feel of the market” to determine policy until other FOMC members engineered a change in the procedures. Lack of transparency was the rule until Greenspan’s regime, when the Committee began to indicate publicly after its meeting whether it had actually changed its funds rate target. Before that a cottage industry of Fed watchers evolved and flourished by looking at what was happening in short-term money markets and divining whether policy had changed and by how much. That was a golden time for former Fed officials, but not so good for the economy.

Under Bernanke, sea changes have emerged as the Committee has begun to provide forward guidance, hold press conferences, and generally encourage members to try to clarify in public statements and speeches what the policies are. This last meeting saw another interesting step taken.

What have they done that is different, and more importantly what have and haven’t we learned about how policy is likely to evolve over the near term? I would suggest that the new transparency policy is less significant than some have suggested and is better viewed as a further evolution of what has been a continual and gradual process.

Let me make one observation before proceeding, based upon several years of having sat in on FOMC meetings. I observed the efforts of several different committees charged with addressing how better to communicate what the FOMC is doing and what the future course of policy might be. In each instance, the committees failed to ask or to address two important questions: Who is the audience, and what do they need to know? If there are multiple constituencies, then it is critical to determine whether “one-size-fits-all” statements are sufficient.

Clearly, there are at least two and most likely three distinct and important audiences: the general public, the markets, and the Congress. Since the Fed and FOMC are creatures of Congress and have to answer to that body if policy does not go right, it is important to be communicating effectively to that group as well as to the public and markets. It seems obvious that each of these constituencies may need different kinds of information to meet their needs for transparency, and hopefully these different needs will be recognized and addressed as the Committee’s transparency efforts continue to evolve.

For example, markets are fixated on what is going to happen in the shorter run and what short-term changes in policy might mean for asset positioning and the shape of the term structure. Markets are concerned about this week and this quarter and not yearly summary statistics. The general public is more likely to be concerned about how the Fed sees the present economy – what is the unemployment situation and what is likely to happen to inflation? What about Congress? Congress has given the FOMC statutory mandates concerning employment and inflation that are admittedly vague and subject to considerable interpretation.

During election years, for example, real GDP growth and employment and how the Fed is doing relative to its charge are of critical interest to politicians. Congressman Ron Paul has put these issues front and center, and other candidates have chimed in as well. I can’t remember an election season when so much attention has been given to the Fed, the value of the currency, the gold standard, and how well the FOMC has or has not performed. Some of it harkens back to William Jennings Bryan and the “cross of gold.” The amount of misinformation and simplistic rhetoric is evidence enough that there remains a significant communications problem in ensuring that the Congress understands what the Fed is doing and why.

Clearly, the informational needs of these disparate constituencies are not mutually exclusive; but we need to ask ourselves how well each has been served by the changes announced following last week’s FOMC meeting. Let us look first at what the FOMC did that was and was not new.

The Committee did several things, and some can’t really be viewed as expanding the transparency efforts. For example, the Committee reaffirmed and extended its policy of lengthening the maturity of its portfolio and reinvesting interest payments received and maturing principal of agency securities and Treasury holdings. This is not a new policy for this meeting, but rather is a continuation of its recent “operation twist” policy. Second, the Committee extended the time horizon over which it expected to hold the target Federal Funds rate between 0 and .25% from the middle of 2013 until late in 2014. Again, this is a continuation of existing communications efforts put in place previously to provide forward guidance to markets. It also suggested that these policies might be adjusted, if needed. Finally, the Chairman held a press conference to explain what was done and why. Again, nothing is new here.

But two things were done that did expand the FOMC’s communications policies. The first was the establishment of an explicit inflation target of 2%, but demurred from establishing an explicit unemployment target.

Delivering on an explicit inflation target is probably best viewed as an affirmation of what should have been fairly apparent from speeches and from the Committee’s longer-run quarterly inflation projections. For some years now, the Committee’s longer-run projections had always suggested that the Committee was aiming for an inflation outcome for PCE between 1.5 and 2.0. If you look at past projections you will see that the range has narrowed over time and the lower range has increased.

During Chairman Greenspan’s tenure, the Committee evolved a “preference” for PCE inflation between 1 and 2%. So what we have learned from the Committee’s most recent decision is that it will now be targeting a point estimate of 2% for inflation rather than a range. Moreover, this current Committee seems to have settled on a more dovish preference for inflation than previous Committees, whose members had expressed a preference for keeping inflation between 1 and 2%. Obviously, with inflation hovering close to the 1% lower bound for some while and with the Fed’s problem of not being able to lower its funds rate target below zero, this most likely conditioned the preference for a 2% target to preserve policy flexibility.

Three immediate questions now arise, and no clarification of them was provided, either in writing or in Chairman Bernanke’s post-FOMC press conference. First, what is the time horizon over which that 2% target will be pursued? Is it monthly, or a year or over some longer time horizon?

Second, how much of a deviation from the target will be tolerated before a policy move in either direction is likely to be forthcoming? Having a single percentage-point target is one thing, but it will be impossible to hit with any precision. Unless the Committee is prepared to react every time inflation moves off of 2%, that single point target has to imply a range or tolerance interval around 2%, which is as yet unspecified. The benefit of a range, like 1.5% to 2.5% for example, would normally suggest that the probability of a policy move increases the close observed inflation gets to the upper or lower bound. With a point target like 2%, however, it is now uncertain as to what the probabilities of policy moves are as observed inflation deviates from 2%. Regardless, the 2% target now implies that the Committee is more tolerant of inflation than it was under Greenspan, since the implicit range has been ratcheted upward.

Third, what are the likely policy tradeoffs when both unemployment and inflation deviate from their desired paths? The most important question in the current environment is, how much inflation overshoot will the Committee tolerate if unemployment remains undesirably high, before a policy move is triggered?

Now, let us consider the Committee’s logic for not putting forward a specific target for the unemployment rate. The reason given was that while “The inflation rate of the longer run is primarily determined by monetary policy…. The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.”

What is the Committee really saying? To this observer, the Committee is confirming what seems to be the consensus among most contemporary economists. That is, the FOMC can’t have much if any influence over employment and that it will seek its own level if the overall economy is performing acceptably. In other words, the Committee has a statutory, mandated objective but monetary policy is not the appropriate tool to address it. Thus, there is little reason for the Committee to have that charge in the first place, and some in Congress have recently urged changing the FOMC’s mandate for that very reason. Having said that, it is interesting to note that the FOMC’s forecasts for the equilibrium unemployment rate range between 5% and 6%. This is really a squishy projection, especially since the rate was very close to or below 5% for several years before the financial crisis and is now substantially above even the upper bound of the range.

Ok, so far, aside from the explicit inflation target, little more has come from last week’s decision than a further evolution of the FOMC’s communications policy. But one thing the Committee did do that was very interesting was to release some of the detail on individual member’s forecasts.

The information released provided the distribution for each FOMC participant’s assumptions as to whether the Fed Funds rate would be increased this year and over each of the next four years. Most pundits are calling this a projection or a forecast, but that is not the case. It is an assumption by each FOMC participant about what he or she considers the appropriate path for policy over the forecast horizon.

The Committee also provided each participant’s assumption of what the prevailing rate would be at the end of each of the three years 2012-2014 and over the longer run. Notice that information on when rates might be changed covered two additional years (2015 and 2016) than information provided on the prevailing rate at the end of three years ending in 2014. Digesting this information suggests several interesting questions. For example, the Committee committed to keeping rates unchanged until near the end of 2014, yet six participants assumed that rates would increase this year and next. Another five thought rates would increase by the end of 2014. One can guess which three participants assumed the rate would increase this year. Indeed, President Plosser stated on January 30 that he was one of those three. Given past policy positions, it is likely that Presidents Fisher and Lacker (the latter is the only voting member among the three) were the other two. It certainly would be interesting to know what their forecasts for inflation, growth, and unemployment looked like, compared with those of other members of the Committee.

Moreover, five participants thought rates would increase in 2014, but how many thought those rate increases would come before the time period the Committee specified in its statement? Finally, the extreme differences in views among the participants are reflected in the fact that four thought the first rate increase would occur in 2015, and two not until 2016. That means that over a third of the participants thought the first rate increases were really far off, while another third assumed rates would increase before late 2014, the time span the Committee stated. So what did their forecasts for the other key variables look like? What we are likely looking at are wide differences in views about the prospects for unemployment versus inflation and differences in the tradeoffs between the two objectives. If the six participants who thought that rates would not increase until well after 2015 were all Board members and the President of the Federal Reserve Bank of New York, this would be a very significant piece of information, since they are all permanent voting members of the Committee and can thus hold out for their preferred policies, regardless of what the other Committee participants want.

Even more interesting is that six of the participants assumed that by the end of 2014 the Funds rate would be between 1.5% and 2.75%; and over the longer run rates would be between 4% and 4.5% (only one had rates below 4%). Given that six people thought rates would be still at 0-.25% by the end of 2014, the path they assume to get to 4% or higher must imply a rapid change in policy of more than 25 basis points at a clip. That policy path would seem to be substantially different from that assumed by participants expecting rates to be between 1.5 and 2.75 percent at the end of 2014. All of this matters critically to markets.

The wildly divergent views among the FOMC participants is very important and suggests that a lot of time and effort will be spent by market watchers and outsiders to determine who holds what views. Again, we have seen this already as President Plosser was pressed in his January 30 interview about his forecasts and policy preference. More of this is likely to come. Layer upon this the fact that we are looking at a changing Committee, because four members rotate off each year, and policy could swing significantly. The dynamics of Committee membership and rate assumptions introduce great uncertainty, not only over the shorter run but especially over the next few years.

How much have the disclosures helped the market? I would argue not much, since yearly rate information is not very informative when day-to-day and month-to-month variations can make or break portfolios. As for the other constituents, there is not much there to help them either, since the really important details about the meeting-to-meeting paths for rates and views of the economy, together with the tradeoffs between objectives, are where the rubber hits the road. Hopefully, the Committee will revisit and refine its transparency efforts as time goes on, but for now they have taken another modest step toward providing the transparency that the various interested parties really would like to see.

Bob Eisenbeis, Chief Monetary Economist

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Loopholes v Taxes

From my friend David Kotok to share

Loopholes, Subsidies, Incentives, and Taxes
January 31, 2012

Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at http://www.cumber.com. He may be reached at Bob.Eisenbeis@cumber.com.

The political arena has been filled recently with rhetoric on both sides of the aisle concerning how much taxes various people pay. Mitt Romney’s tax return for 2010 showed that he paid an effective tax rate of 13.9%. And President Obama made it a point in his State of the Union Address earlier this week to highlight that it wasn’t right that Warren Buffet’s assistant had a higher tax rate than did Mr. Buffet. As we have argued in the previous commentary “What is Fair?,” one can’t look at effective tax rates or what various income groups pay or don’t pay and make a judgment from the numbers as to what is or isn’t fair, just, or “right.” For example, tables from the Tax Foundation for 2009 show that the top 1% of taxpayers’ share of total adjusted gross income (AGI) was 17% and they paid 37% of the taxes. These people earned over $343 thousand. The top 5 % earned 32% of AGI but paid 59% of the taxes. The cutoff income for the top 5% was $155 thousand. The average tax rate for the top 1% was 24% and for the top 5% it was 21%.

So the tax rates of 13.9% paid by candidate Romney and the alleged 15% paid by Warren Buffett are low, and they are low because of the sources of their income. Income from wages and salaries, for example, is taxed at a much higher rate than income from dividends or capital gains. The capital gains tax rate for individuals like Romney and Buffett is 15% and the rate on qualified dividends is also 15%.

But there is more. If income is from tax-free municipal securities, there is no federal tax liability. That provision in the tax law was put in for a purpose, to lower the cost of borrowing to state and local governments. Then there are allowable deductions and tax credits, which include energy efficiency investments, educational expenses, new car purchases, first-time home purchases, and of course charitable deductions, just to name a few. The objectives were promote energy conservation, spur consumption, and lower the cost of education. In the case of energy investments , tax credits are permitted for purchase of geothermal heat pumps, solar water heaters, solar panels (remember Solyndra?), small wind turbines, and fuel cells. Taxpayers who make such investments can lower their effective tax rates significantly, because a tax credit lowers taxes paid dollar for dollar, while a tax deduction only lowers the tax burden by an amount equal to the expenditure times the marginal tax rate.

Regardless, whether the payer is an individual or a corporation, taking advantage of tax credits and deductions lowers the effective tax rate paid. If you don’t like the fact that someone can reduce their effective tax rate through the use of tax credits and deductions, then you are apt to argue they are taking advantage of “tax loopholes” that should be eliminated. On the other hand, if you are a state or local municipality, then the favorable treatment of interest on municipal securities is a clear subsidy from the federal government to the taxpayers in the municipalities issuing the securities. Similarly, if you are for clean energy and saving the environment, or want to encourage firms to hire veterans and disabled people, or seek to spur investment in certain technologies like solar panels or geothermal heat pumps, then the tax break is viewed as a desirable “incentive” to get people or corporations to “do the right thing.”

In the case of capital gains and dividend income, the favorable tax treatment is viewed as a way to get people and corporations to invest in the long haul, to encourage the multiplier effect that includes job creation and stimulation of demand. The tax treatment of dividends is interesting in this respect. When a company is successful and earns a profit, it can do one of five things. It can accumulate cash, it can pay off debt, it can expand, it can make new investments, or it can pay dividends. In this respect, capital gains are simply the value of retained earnings and the capitalized value of investments. Paying off debt or making new investments are typically not taxed, since they are allowable expenses before profits or tax liabilities are determined. And, of course, a corporation pays taxes on its profits. Again, the tax rate varies between 15% to 35% while the effective tax rate depends upon allowable tax credits and deductions. Unlike other transfers, dividend payments are treated as income to the recipient and are taxed again. Hence, when one hears arguments for eliminating the taxation of corporations, it is because the owners are effectively taxed twice, once at the corporation level and again when dividends are paid or capital gains realized. So the true tax rate on corporate income can range from 25% to well over 40%, from the investor’s perspective.

The point that needs to be recognized is that one man’s tax loophole may be another man’s incentive, depending upon whether the goal is to increase revenue or incent behavior. Of course, from the recipient’s perspective, deductions and tax credits are effectively a price cut and thereby change relative prices of goods and services and affect purchasing behavior.

The politicians are arguing both sides of this issue at the moment. They talk about cutting tax rates. At the same time they urge elimination of tax credits and deductions, and these are nothing but tax increases in another form. Then they go on to offer up more tax “incentives” (read tax credits and deductions) to encourage energy conservation or to promote hiring or housing – pick your poison. Cut rates, eliminate loopholes, then start the process all over again by piling on more incentives. Come on, man, you can’t have it both ways!

Bob Eisenbeis, Chief Monetary Economist

To sign-up for Market Commentaries from Cumberland Advisors: http://www.cumber.com/signup.aspx
For Cumberland Advisors Investment Portfolio Styles: http://www.cumber.com/styles.aspx?file=styles_index.asp
For personal correspondence: bob.eisenbeis@cumber.com