Interpreting the Fed

My friend and sometime coauthor Larry Ball sends me his quick analysis of the Federal Reserve's recent announcement:

I think the FOMC announcement is big news: for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule (TR) dicates.

In my estimation, the pre-crisis TR is something like the following for the real interest rate r:

r = 2.0 - (1.5)(u-u*) + (0.5)(pi-2.0).

Let’s say u* is still 5.0. Then if u=6.5 and pi=2.5, the TR says r = 0, which implies the nominal interest rate is i = 2.5. Yet the Fed says that i will still be zero!

Some argue that u* has risen above 5.0. That would raise the i implied by the TR, strengthening the conclusion that the Fed’s new rule is more dovish than the TR.

Some argue that r* [the constant term in the TR] has fallen from 2.0 to 1.0. I doubt it, but even with that change, the TR still implies i = 1.5. My conclusion about dovishness is robust.

This deviation from the TR has not happened since the TR was discovered. In particular, the Fed was NOT more dovish than the TR in 2003. I believe the numbers for 2003 are roughly u=6.0, u*=5.0, and pi=1.0. For the TR shown above, the 2003 numbers imply r =0 and i=1.0, which is about the same as the actual i.

It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.

Option C

In the negotiations over the fiscal cliff, many people think the House Republicans are in a tough spot.  The logic is that they have little leverage, because they face only two choices:

A. Concede to most of the president's demands.
B. Take the economy over the cliff, and get blamed for it.

As a result, the logic goes, they will end up doing A, because B is so much worse.

Keith Hennessey points out that there is also option C: Extend the tax cuts, except at the top, for one year. Apparently (and I was not aware of this), Senate Democrats passed a bill doing exactly this back in July.  If the House passes it now, it goes to the President's desk, and he would have a hard time vetoing it.

This is not great policy, as it sets up another fiscal cliff one year from now, and it does not address all the spending cuts that are part of the fiscal cliff.  But from the Republicans' point of view, it may be better than either A or B.  Keith argues that the ability of Speaker Boehner to fall back on this option should give him more bargaining power as he negotiates with the president.  That is, because the president won't like option C either, the possibility that it could occur may make him more willing to compromise.  From the president's perspective, it is better to make concessions today than having to do this whole fiscal-cliff thing again a year from now.

The Poverty Trap in France

From Forbes:

Let’s take an unemployed mother living alone with two children between six and 10 years old. In 2010, there were 284,445 French families in this situation that were on welfare.

This mother will be given the “Active Solidarity Income.” Since she has two children, the amount will be $1,100. If she is renting an apartment with a $650 rent, she will be given the “Housing Customized Aid,” amounting to $620. Then she will receive “Family Allowances,” which amounts to another $160. Finally, let’s add the payment known as “Allowance for the start of the school year,” which is $750 once a year, or $62.50 per month. (She might even benefit from other aids, but these are the most common.) She will be given a total of $1,942.50 per month.

Now imagine that this mother has found work and will be paid the “legal minimum wage,” which amounts to $1,820 gross—or $1,430 after taxes. Since she would be earning $1,430, she will no longer receive the “Active Solidarity income.” Her “Housing Customized Aid” will be lowered to $460, but she will still be given “Family Allowances” and the “Allowance for the start of the school year.” Therefore, her total income will amount to $2,112.50....

For this mother of two, working again will bring her family an additional income of only $170. Moreover, this $170 is likely to be lost in the cost of transportation to work, since the cost of gas in France is $7 per gallon. In any case, such a small amount of money is not an incentive to go back to work. Between staying home and working, the choice is simple: welfare is a better deal.

Make Your Own Deficit-Reduction Plan

The Wall Street Journal's interactive graphic lets you choose from a menu of options.

She's German. He's Greek. It's Christmas.

Click here for the previous installment.

Fiscal Cliff Fact of the Day

As reported in the NY Times:

Even if Republicans were to agree to Mr. Obama’s core demand — that the top marginal income rates return to the Clinton-era levels of 36 percent and 39.6 percent after Dec. 31, rather than stay at the Bush-era rates of 33 percent and 35 percent — the additional revenue would be only about a quarter of the $1.6 trillion that Mr. Obama wants to collect over 10 years.

This Debuted at the Harvard Holiday Party

Deck the Halls

Not quite fair to Keynesianism, but fun nonetheless:

An Unfortunate Broken Promise

Back in 2008, when President Obama was running for his first term, he promised to be a post-partisan leader.  While a Democrat, he said he would accept good ideas when they came from Republicans.  At the time, I believed him, at least to some degree.  And I wrote about it in this NY Times column.

Sadly, I was wrong.  The short version of the story is this: As a candidate, President Obama campaigned on a platform of raising taxes on the rich.  Yet he and his economic advisers also said they wanted to raise dividend taxes only slightly, from 15 to 20 percent.  For reasons I explained in the Times article, keeping dividend taxes low was a position bolstered by good economics. Now, however, the president wants to raise dividend taxes to ordinary income tax rates (plus, for high-income taxpayers, the new tax of 3.8 percent that is part of the Obamacare legislation).

To put it another way, he campaigned as a moderate, willing to concede that the other party had some good ideas on tax policy.  Once in office, he gave up on those ideas.

A similar thing happened with Bowles-Simpson.  During his first term, he appointed a bipartisan panel, which concluded we could address our long-term fiscal problem with lower tax rates and a broader tax base.  Now, the President goes around the country lambasting that approach.

Reasonable people can disagree about whether President Obama is a good or bad president.  But the claim that he has tried to transcend partisanship and find a middle ground is just impossible to square with the facts.

A Reading for the Pigou Club

From The New Yorker.  One disappointing quotation:

"We would never propose a carbon tax, and have no intention of proposing one," [White House spokesman Jay] Carney told reporters.

Some Advice on Tax Planning

I don't normally give advice on personal finances, but in light of the fiscal situation we are facing, I will pass along one tidbit.  Consider converting some of your retirement savings into a Roth IRA. Over the past few years, I have converted all that I can, which is about half of my retirement savings. 

To make the best of a Roth conversion, you need liquid assets outside of retirement accounts to pay the resulting tax liability.  But if you can do this, you will shelter more of your savings from capital taxation, and you will avoid required minimum distributions when you turn 70 1/2, which means tax-free accumulation for a longer period of time.

To read more about this option, click here.

Why the President is Not So Keen on Just Limiting Deductions

From the White House blog.  Bottom line: If you apply a $25,000 deduction cap only to households with income above $250K, phase in the cap gradually as income rises above $250K, and exclude charitible giving from the cap, you increase revenue by only $450 billion over ten years.