Wednesday, July 23, 2014

Insure Against Central Bank Incompetence: My Reply to the New Keynesian Strikeforce

Apparently, it is open season on market monetarists. The red dots you see on our chest are from the laser scopes on the new keynesian guns of Tony Yates, Simon Wren-Lewis, and Paul Krugman. These individuals have been firing away with their critiques of market monetarism. Scott Sumner and Nick Rowe have already responded to many of them. Here I want to focus on what I view as one of their better criticisms: even if we are correct that monetary policy alone can end the slump, central banks have not shown themselves willing to do so. So why argue for them to do more? Here is Simon Wren-Lewis making this point:
MM agrees that fiscal stimulus will work unless it is actively counteracted by monetary policy. Nick says we can't always rely on fiscal policymakers being able and willing to do the right thing. But since at least 2011 we have not been able to rely on monetary policymakers in the Eurozone to do either the right thing, or consistently the wrong thing.
I think this is a fair point. The Fed failed to unload both barrels of its gun--by signalling its monetary injections were to be temporary--over the past five years while the ECB actually tightened monetary policy in 2011. Given this reality, the new keynesians want to know why not use fiscal policy? They contend that if monetary policy is too timid or tight, surely fiscal policy could make up for its shortcomings. 

My view, and one that I believe is shared by most market monetarists, is that fiscal policy will not matter much as long as these two central banks are committed to their inflation targets. Any surge in aggregate demand created by fiscal policy would be sterilized by the central bank if it pushed inflation too high. And by all accounts both the Fed and ECB take their low inflation targets seriously. 

In the case of the Fed, it seems to be aiming for core PCE inflation to fall between 1% and 2%. Any fiscal stimulus that pushed inflation outside this corridor would probably be offset. That is why I argued that had there been no American Recovery and Reinvestment Act of 2009 the Fed probably would have taken more expansionary steps back in 2009. It also why the Fed offset the effects of fiscal austerity of 2013. The Fed, then, appears to be doing just enough to maintain its corridor inflation target, which is nowhere near enough to close the output gap. Fiscal policy is bound to be offset in such an environment.

So what is needed is a better way to do macroeconomic policy. One that would allow monetary policy to close the output gap and, in its absence, allow fiscal policy to do the same. I have a proposal does just that. It is a two-tiered approach to NGDP level targeting:
First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap... [I]f the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits.

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow [say due to central bank incompetence] and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.
The nice thing about this proposal is that it provides insurance against central bank incompetence. Scott Sumner initially did not like this proposal, but as he loves to say the fiscal multiplier is nothing more than an estimate of central bank incompetence. That is, the fiscal multiplier is large only when the central banks fail to properly stabilize aggregate demand. Helicopter drops are fiscal policy and in this proposal they would be applied only when the Fed failed to stabilize demand. Therefore, it is a perfect fit. Employ fiscal policy only when it packs a punch and do so in a manner to preserve a NGDP level target. This should make both market monetarists and new keynesians happy.

Note that this approach with its NGDP level targeting implies a commitment to permanent monetary injections, if needed. It, therefore, holds up against the critiques of helicopter drops that Paul Krugman, Scott Sumner, myself, and others have raised. It would also provide a more systematic approach to monetary policy, a big improvement over the current ad-hoc approach of the Federal Reserve. This increased certainty by itself would be a boon to the economy. Finally, it would eliminate the need for the politically-charged fiscal stimulus spending programs. There is much to like about this proposal on both the political left and right.

Tuesday, July 15, 2014

Follow up to My Washington Post Piece on Secular Stagnation

I have an new article in the Washington Post where I make the case against secular stagnation. My argument is based on three observations. The details of these arguments and evidence for them are spelled out in the piece, but here is a quick summary.

First, the prima-facie evidence most secular stagnation advocates point to is misleading. They see the long-decline of real interest rates since the early 1980s as supporting their view. Their real interest rate measures, however, do not account for a trend decline in the risk premium. Once that is done there is no downward trend in real interest rates. And this measure--the 10-year real risk-free interest rate--is the one at the heart of the secular stagnation story. 

This long-run measure of the natural interest rate is currently negative, but only because of the current slump--its deviations tracks the CBO's output gap--and appears to be simply deviating around a roughly 2% trend. Based on this evidence, there is no reason to believe it has permanently turned negative.

Second, claims about a trend decline in technical innovation and productivity growth are overstated. It is getting increasingly hard to measure economic activity with GDP in an increasingly digitized economy. This means productivity gets under measured. Moreover, there is reason to be believe we are on the cusp of a rapid growth spurt as noted by Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. If so, the return to capital will rise and so will investment demand This should put upward pressure on the natural interest rate.

Third, the demographic outlook is not so dire. Baby boomers are no longer the largest U.S. cohort and around the globe the outlook for the prime-age working population is improving. This too implies a higher return to capital, more investment spending, and upward pressure on the natural interest rate.

One thing I did not get to fully explain in the article is why the growth of productivity and the labor force should affect the natural interest rate. To do this, we need to first recognize there was a trend and cyclical component to the 10-year real risk-free interest rate. This is equivalent to saying there is a long-term and short-term natural interest rate, with the latter gravitating around the former. So we need to distinguish how these different components are determined. Also, I left out a third determinant of the natural interest rate: household time preferences. My assumption in the article is that this part is relatively steady and all the interesting developments come from changes in productivity and labor force growth. 

So with all that said, below is an explanation of long-term and short-term natural interest rate determinants. It is drawn from an earlier post:
[T]he long-term nominal natural interest rate is determined by trend changes in the expected productivity growth rate, the population growth rate, and household time preferences... Productivity matters because it affects the expected return to capital and expected household income. Faster productivity growth, for example, translates into a higher expected return on capital and higher expected household incomes. In turn, these developments should lead to less saving/more borrowing by firms and households and put upward pressure on the natural interest rate. The opposite would happen with slower productivity growth. Population growth matters because it too affects the expected return to capital. More people means more workers and output per unit of capital. For example, the opening up of China and India's labor supply to the global economy, meant a higher expected return to the global stock of capital over the past decade. That should put upward pressure on interest rates and vice versa. Finally, for a given level of expected income, a change in households time preferences means a change in their desire for present consumption over future consumption. This, in turn, affects households' decision to save and borrow. If households, say, start living more for the moment there would be less saving, more borrowing, and upward pressure on the natural interest rate.

Some like Paul Krugman and Larry Summers believe these determinants have changed enough such that the long-term nominal natural interest rate has been negative. I am not convinced and hope to explain why in a subsequent post (if you cannot wait, see my views in this twitter discussion). In my view, then, the important question is whether the short-run nominal natural interest rate has been negative since the crisis started.

So what do we know about the short-run nominal natural interest rate? It is shaped by aggregate demand shocks that create temporary deviations of the economy above or below its  full-employment level (i.e. output gaps). For example, a large negative aggregate demand shock that temporarily weakens the economy will put downward pressure on interest rates. This happens because firms do less investment spending and therefore less borrowing in anticipation of lower future profits. It also happens because households, particularly credit and liquidity constrained ones, save more and borrow less in anticipation of lower future incomes. In short, aggregate demand shocks that create output gaps will also push the short-run nominal natural interest rate in a procyclical direction. This is a natural process that allows the economy to heal itself. What is not natural is when interest rates are prevented from fully adjusting to their market-clearing levels. That happens when interest rates are pinned down at the ZLB. See this earlier post for a graphical representation of this ZLB problem.
I hope that helps. Be sure to read the article at the Washingont Post.

PS. Josh Hendrickson and John Cochrane provide critiques of the formal modeling of secular stagnagtion by Gautti Eggertson and Neil Mehrotra.

Monday, July 14, 2014

The Data Problem with the Natural Interest Rate Debate and How to Fix It.

Many observers claim the Fed has been keeping interest rates artificially low over the past five years. They contend this low-interest rate policy is creating financial instability via an unnatural reach for yield and harming folks who depend on fixed income. They want to see the Fed raise interest rates now.

Paul Krugman has recently taken it on himself to contest this view. His reply is that interest rates can only be artificially low if they are below the natural interest rate level, but he sees most evidence pointing to the opposite case. Interest rates appear to have been higher than the natural interest rate level and explain the persistence of the slump. This situation arises because of the zero lower bound as explained here. Accordingly, monetary policy has been effectively tight.

I agree with Krugman that when thinking about an interest-rate targeting central bank one should look at the gap between the actual and natural interest rate to determine the stance of monetary policy. Otherwise, one could conclude monteary policy was tight in the 1970s and loose in the 1930s. No one would make that argument. So the interest rate gap makes more sense.

But there is a big problem with this approach. There is hardly any data on the natural interest rate. The Fed provides none and there are only a few private estimates of it. This debate will never be settled without some consensus measure of the natural interest rate and currently there is none.

As I argued before, this should be a scandal for an interest-rate targeting central bank. It would be akin to a central that targets the M2 money supply but chooses not to publish M2. Yes, the natural interest rate is trickier to measure than the money supply, but the Fed already estimates its as seen in this figure from a 2005 FOMC meeting. At a minimum, the Fed should be reporting its estimates for the natural interest rate across the entire term structure of interest rates. It would go a long way in ending the confusing over the stance of monetary policy and would keep the Fed more accountable for its actions.

That's the minimum. It would be even better if the Fed started regularly surveying market participants, forecasters, and other interested parties on their estimates of the natural interest rates across the term structure. Then report the distributions of these estimates along side the Fed's own estimates. The Fed has the resources to do this, so why not? All this information would be bring much clarity to the big debate on natural interest rates.

Until these changes happen, I look forward to more confused discussion about the stance of monetary policy. Adopting these policies would be a great way for Janet Yellen to leave her mark at the Fed.

PS. Yes, this is a pragmatic proposal. I actually would like the Fed to switch to NGDP level targeting and stop using short-term interest rates as an intermediate target. Rather, I would have the Fed look to a NGDP futures contract as its intermediate target and adjust the monetary base accordingly. There is also a place for Divisa monetary aggregates as indicator variables, as shown by Michael Belongia and Peter Ireland. Had observers in this debate been looking at them, they would see that monetary policy has been tight.


Friday, July 11, 2014

It's Time for the Fed to Move Beyond Inflation Targeting (and Officialy Do what Israel and Australia are Unofficially Doing)

I have a new policy paper that argues inflation targeting has passed its expiration date. Here is the title and abstract:
Inflation Targeting: A Monetary Policy Regime Whose Time Has Come and Gone
Inflation targeting emerged in the early 1990s and soon became the dominant monetary-policy regime. It provided a much-needed nominal anchor that had been missing since the collapse of the Bretton Woods system. Its arrival coincided with a rise in macroeconomic stability for numerous countries, and this led many observers to conclude that it is the best way to do monetary policy. Some studies show, however, that inflation targeting got lucky. It is a monetary regime that has a hard time dealing with large supply shocks, and its arrival occurred during a period when they were small. Since this time, supply shocks have become larger, and inflation targeting has struggled to cope with them. Moreover, the recent crisis suggests it has also has a tough time dealing with large demand shocks, and it may even contribute to financial instability. Inflation targeting, therefore, is not a robust monetary-policy regime, and it needs to be replaced.
In the paper I go through the history of inflation targeting and tie together together several existing critiques of it to show that it no longer is an adequate way to do monetary policy. One critique of it that is topical and should be of interest to readers is my discussion of how inflation targeting can contribute to financial instability. A number of observers, including prominent economists like William White and Lawrence Christiano, Roberto Motto, and Massimo Rostagno, have found that even flexible inflation targeting has a propensity to give rise to the buildup of financial imbalances and exacerbate boom-bust cycles. I draw upon their work and provide empirical evidence supporting their claims. 

I also note the failure of inflation targeting to close the output gap in the United States and the Eurozone as further evidence of its limited ability. And for those who like a more rules-based approach to monetary policy I discuss how the evolution of inflation targeting into flexible inflation targeting opens the door for more judgement calls and opportunities for bad calls as monetary policy is executed in real time.

Since most of the paper covers the problems with inflation targeting--there is a brief section at the end on what should replace it--I thought I would plug here another recent article I coauthored with Ramesh Ponnuru that provides a nice follow up. It shows, based on what happened in recent crisis, what should be the next step in the evolution of monetary policy:
A global economic crisis may be painful, but it can provide some useful lessons. Countries recovered from the great Depression in the order that they exited the gold standard of the time, which is a major reason most economists no longer favor that monetary regime. The turmoil of the last few years has followed a pattern as well: The more a country’s central bank has done to keep nominal spending growing at a steady rate, the better that country has done. This international experience adds to an already-strongtheoretical case for keeping nominal spending—the total amount of money spent in an economy—on a predictable path


Targeting nominal spending avoids these pitfalls [facing inflation targeting]. If the Fed were trying to keep total dollar spending growing at a 5 percent rate each year, for example, it would not need to loosen or tighten in response to supply shocks. Such shocks would alter only the composition of spending, with positive [negative] ones translating into more [less] goods and services at lower prices. To stay on target, the central bank need respond only to shifts in the demand for money balances. It has to increase the money supply when people are more inclined to hold money balances—when, for example, they are scared of economic trouble and want liquid assets—and decrease the money supply when they are rapidly spending money. To put it another way, the central bank must decrease the money supply when money is circulating quickly and increase it when its turnover or velocity is low. And the more markets expect spending to stay on its target path, the more stable velocity should be in the first place.
We provided several figures that make this point. First, here are the paths of total money spending relative to trend for Israel, Australia, the United States, and the Eurzone (the U.S. trend path is adjusteded to reflect CBO's estimates of full-employment NGDP):

As the above figure shows, Israel and Australia roughly stayed on their trend paths while the United States and the Eurozone did not. These developments can be seen in terms of money supply and money velocity deviations from their trends. In order for total money spending to stay on path, monetary policy has to adjust its stance so that changes in the money supply and money velocity offset each other. As seen below, all of these countries were effectively doing that prior to crisis, but only Israel and Australia continued doing so during the crisis. The grey bars show where the United States and the Eurozone did not do the offsets.

Both Israel and Australia are great success stories of what monetary policy can do even in a severe crisis. Israel's performance, in particular, is instructive as seen here. And the closer a central bank kept its total money spending to its trend path the less unemployment it had during and after the crisis:

So yes, it is time for the Fed to move beyond inflation targeting and officially do what Israel and Australia have unofficially have been doing: stabilizing the growth path of total money spending. This is the same thing as targeting nominal GDP.

PS. Josh Hendrickson has a nice paper that shows an welfare-maximizing central bank could aim to minimize the loss function of money supply and money velocity deviations. If this approach were more commonly used--as oppossed to using a loss function of output and inflation deviations--it would put focus back on what central banks at their core do: stabilize total money spending. And it may have helped avoid the problems seen in the second figure above.

Wednesday, July 9, 2014

It's All But Official: There is No 2% Inflation Target

Rather, there is a 2% upper bound to the Fed's inflation target. This is an argument that Ryan Avent, Matt Yglesias, Paul Krugman, and others have been making for some time. I am sympathetic to this view and have made the case that the Fed has been effectively targeting a core PCE inflation corridor of 1% to 2% over the past five years. The evidence continues to mount in favor of this view. 

First, consider the timing of the Fed's QE programs and changes in the core PCE inflation rate as seen below. The figure suggests that the FOMC iniatiates QE programs when core inflation is under 2% and has been falling for at least six months. It also indicates the FOMC tends to end QE programs when core inflation is above 1% and has been rising for at least six months. That ending of QE3 in October later this year follows this pattern. 

Reinforcing this point, the Fed's purchases of treasuries since the crisis started is correlated with changes in core PCE inflation. Specifically, changes in the Fed's holdings of treasuries as percent of all treasuries can explain almost half of the variation in core PCE inflation since 2007 as seen below:

Second, consider the central tendency ranges of inflation forecasts provided by members of the FOMC. This information can be found in the 'projection' material. These forecasts are consistent with the observed core PCE inflation data highlighted above. They consistently show 2% as an upper bound.

Though it gets clearer with longer forecast horizons, the 2% upper bound can be seen in the current, one-year, and two-year inflation FOMC forecasts shown in the figures blow. A 1% lower bound is most evident in the current year forecast, but slowly gets higher at longer forecast horizons. (Note: not every FOMC meeting has projection materials, but for every meeting that does provide them they are lined up chronologically in the figures.)

FOMC members are predicting inflation no higher than 2% even two years out. Since the FOMC has meaningful influence on inflation this far out, this forecast reflects FOMC members' beliefs about current and expected Fed policy. They see the Fed doing just enough to keep core PCE inflation under 2%. The actual core PCE inflation evidence provided above suggests the Fed is doing just that. 

So it is all but official. There is no 2% inflation target.

Coming Soon to an Economy Near You: Personal Checking Accounts at Your Central Bank

The June FOMC minutes were released today. One interesting development we learned from it is that some FOMC members are becoming concerned that the Fed may be slowly taking on more and more financial intermediation activities that traditionally have been provided by banks. In the limit, this would amount to a nationalization of banking. The Fed would become the only bank and your local bank, if it were still around, would be its branch office. All money would be Fed liabilities and there would no longer be a distinction between inside and outside money. In other words, the Fed would directly control the money supply.1 Money supply targeting might actually become vogue again!

We are a long way from that point, but some FOMC members are concerned we are on that path to it. This concern centers around the Fed's new overnight reverse repurchase agreement program (ON RRP). It provides a means for the Fed to temporarily return some its treasury holdings to a safe asset-scarce market and to influence short-term interest rates. It also provides a super safe alternative to institutional investors who normally park their funds in the money market. And that is where it could be problematic. Here is the FOMC:
In addition, a number of participants noted that a relatively large ON RRP facility had the potential to expand the Federal Reserve’s role in financial intermediation and reshape the financial industry in ways that were difficult to anticipate.
Writing in the Financial Times, Tracy Alloway expands on this problem:
The Federal Reserve Bank of New York has emerged as the single largest player in an important segment of the short-term lending market that was at the epicentre of the financial crisis.The Fed’s decision to quadruple its trading with government money market funds in the repurchase or “repo market” is a sign that the central bank is now engaging more directly with the shadow banking system at the expense of large Wall Street banks... Armed with a balance sheet of $4.3tn of bonds purchased during quantitative easing, the Fed is using what it calls its reverse repo programme, or RRP, to trade with money funds at a time when tough new regulatory standards have made such borrowing less attractive for the banks. Rather than lending to the banks, money market funds have sharply boosted their dealings with the US central bank.


Bill Dudley, New York Fed president, warned last month that if use of the repo facility were to grow too quickly it might “result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further enlargement of the shadow banking system.” Without a cap on use of repo with the Fed, investors who ordinarily lend to banks could instead flock to the central bank in times of market stress, exacerbating a flight from funding of banks, he warned.
Now, as noted by Izabella Kaminski, if this specific concern actually happens it would only usurp the financial intermediation services provided to institutional investors. There would still be the retail investor market to conquer. She says this second step could occur if the Fed started issuing e-money for retail customers. That may be a way off, but Kaminski believes it is coming. And she believes the June FOMC minutes indicate the members sees it coming too. Here is Kaminski:
What the Fed seems to be acknowledging is that if its reverse repo programme (RRP) proves too popular it could end up undermining the business of conventional deposit-taking banks. In other words, the Fed is prepping us for the idea that this is the route by which the central bank could become a universal banker... The thing to note, however, is the language and tone being used to communicate these ideas. The message is clearly that the Fed is mindful and fearful of becoming a universal banker and that this is not at all something that it wants. 
If all of this comes to fruition I will be worried. The Fed is already a monopoly producer of the unit of account and this would make it a monopoly producer of the medium of exchange too. Monopolies have less incentive and less ability to nimbly respond to changing market conditions. In this case, that means changes in money demand. Unless technology changes so that the Fed is capable of knowing in real time region-specific changes in money demand, it will be applying a one-size-fits-all monetary policy that will intensify regional economic differences. We might begin to think twice about the United States as an optimal currency area. But hey, at least we will all have our own Fed checking accounts!

1 Tomas Hirst and Frances Coppola note that if the Fed does become a universal  bank there will still be some private financial intermediation, even if on the margin. So it would not have 100% direct control of the money supply, but close.

Friday, July 4, 2014

How Long Did It Take the United States to Become an Optimal Currency Area?

This is a great question to consider as we celebrate Independence Day here in the United States. It is also a great question for Europeans who have learned the hard way that the Eurozone is not an optimal currency area. Fortunately, economic historian Hugh Rockoff has already worked on this question and concluded it took only 150 years. Yep, that means the Eurozone project needs another 135 years or so before it works. I can hardly wait.

Here is the NBER summary of Rockoff's paper:
In 1788, Congress was given the exclusive right to "coin money" and "regulate the value thereof." Since then, Americans have spent and invested within the immense area of this country without ever having to worry about different exchange rates. The only exception to the monetary union occurred during the Civil War, when the nation was divided into three monetary regions.

In How Long Did It Take the United States to Become an Optimal Currency Area? (NBER Working Paper No. H124), NBER Research Associate Hugh Rockoff explores the costs and benefits of the monetary union. He notes that "the survival of the U.S. monetary union is at best muted evidence that the net effects have been positive."

The incentive for a region to join a monetary union is the minimizing of transaction costs. But the costs of uniting include giving up the exchange rate and changes in the money stock as policy tools. Whether a specific area composes an optimal currency area, or whether it would be better off as a segment of a larger monetary union, depends on the net sum of the costs and benefits. During the first 150 years of the U.S. monetary union, regional battles over monetary policy and institutions were widespread. Simply put, what was beneficial monetary policy for one region was not necessarily beneficial for another.

Rockoff finds numerous examples of regional shocks magnified by monetary reactions. The typical scenario involves a shock in financial or agricultural markets which would hit one region particularly hard. The banking system in the region would lose reserves resulting in a monetary contraction. A political battle would often erupt, and the regions that had experienced the contraction would demand a reform of the monetary system. The resulting uncertainty about the future of existing monetary institutions would further intensify the initial contraction.

In the 1930s institutional changes, such as the adoption of interregional fiscal transfers and bank deposit insurance, overcame the problem of regional banking shocks. Federally funded transfer programs, such as unemployment insurance, Social Security, and agricultural price supports, cushioned regional shocks and pumped high-powered money into regions losing reserves. Deposit insurance tended to reduce regional banking problems that characterized recessions.

So, how long did it take the United States to become an optimal currency area? Rockoff concludes that a reasonable minimum may be 150 years. It was not until the 1930s that all regions in the country could be said to be components of a single optimal currency area, the United States. Thus for a country debating whether to join a monetary union, it would be wise to examine the U.S. history first.
Great news for the Eurozone! 

Krugman, Mankiw, and the US as an OCA
The Three Monetary Regimes During the US Civil War