"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Thursday, September 30, 2010

Really good links - Risks and policy errors - Basel liquidity standard - Inflation expectations

Adam Posen - Risks and policy errors - "There are… some very serious risks if we make policy errors by tightening prematurely, or even if we loosen insufficiently. Those risks are not primarily the potential for a double-dip recession or even of temporary measured deflation. While bad, those situations would still be within the range of short-term cyclical developments, and could be weighed against simple inflationary pressures from monetary policy trying to stimulate too much. The risks that I believe we face now are the far more serious ones of sustained low growth turning into a self-fulfilling prophecy, and/or inducing a political reaction that could undermine our long-run stability and prosperity. Inaction by central banks could ratify decisions both by businesses to lastingly shrink the economy’s productive capacity, and by investors to avoid risk and prefer cash. Those tendencies are already present, and insufficient monetary response is likely to worsen them."

Lorenzo Bini Smaghi, Member of the Executive Board of the ECB - The proposed Basel liquidity regulation - "The implementation of the new liquidity standard is intended (and expected) to favour those assets that are counted as liquid, and at the same time reduce incentives to hold assets that are considered less liquid. This will affect the functioning of the underlying markets. In particular the yields of liquid securities are expected to decline relative to those of illiquid ones, so that yield spreads between liquid and illiquid assets would become wider.
        At the moment, it is difficult to quantify the impact on the different market segments, or to judge whether the adjustment will take time or be abrupt. But it can be expected that the categorisation of assets into certain classes of liquidity will lead to a ‘cliff effect’, by which the regulatory categorisation of assets as either liquid or illiquid plays a crucial role for the future of their market. Moreover, it implies that changes in market conditions, such as a downgrade, can move assets from one category into the other, leading to sudden changes in banks’ fulfilment of the liquidity coverage ratio. This could make their fulfilment somewhat unpredictable. The cliff effect could also imply sudden changes in the market conditions for the asset in question, which could suffer from a sudden drying-up of market activity or liquidity."

Justin Wolfers - Inflation expectations - "Q: What explains the differences, if any, between consumers and professional economists regarding inflation expectations?
        A: I wrote a paper on this with Greg Mankiw and Ricardo Reis. What we did was analyze inflation expectations data for both consumers and professional forecasters over the past 50 or 60 years. The motivation for this was that Greg and Ricardo had written down a model that they called "sticky information." The idea is that people revisit their expectations on average only once a year. That's a different microfoundation for the Phillips Curve than those based on sticky prices, one that is more resonant with behavioral economics and can help resolve problems like insufficient inflation persistence in New Keynesian models. An interesting implication of this model is that if something changes dramatically in the economy, then inflation expectations become more spread out. There will be more disagreement because you might have had a chance to update your expectations, but I'm not going to update mine for another six months. So when inflation either increases or decreases, we should see more disagreement. We found that was true for both consumers and professional forecasters. That's a bit surprising. You might expect that professional forecasters would update their expectations more often than consumers but it seems that they don't. In fact, by the way, we were able to do the same exercise for members of the Federal Open Market Committee and they, too, exhibit similar behavior.
        What's also interesting is that not only do consumers and professional forecasters update their expectations with roughly the same frequency, but when you do formal tests of rationality both groups also exhibit the same sorts of problems. Forecast errors are highly autocorrelated. So whatever type of error you made last year, you are likely to make the same mistake this year. The thing that is different between the two groups is that when you ask forecasters about their inflation expectations for the upcoming year, they tend to be grouped between 1 percent and 3 percent. But when you ask consumers, there's a lot of variance. Some will say zero, some will say 12. The central estimate will be quite similar to that of the forecasters but there will be quite a lot of outliers. That suggests that many consumers are not particularly well informed about the likely path of inflation."

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