Friday, May 26, 2017

China vs the Trilemma, Price Level Path, Balance Sheet Confusion, and FOMC Debates

Here are some assorted macro musings from the past week:

1.  Been there, done that, and it did not end well China edition. Once again, China forgets there is a macroeconomic trilemma. From the Wall Street Journal:
China’s central bank is effectively anchoring the yuan to the dollar, a policy twist that has helped stabilize the currency in a year of political transition and market jitters about China’s economic management.... 
The newfound tranquility may not last: The focus seen in recent weeks on stability against the dollar, whether it goes up or down, means pressure on the yuan to weaken could get dangerously bottled up, potentially bring bouts of sharp devaluation.
Pegging an exchange rate, tinkering with domestic monetary policy, and allowing some capital flows can be a dangerous game to play. Chinese officials should stare long and hard at the picture below and recall how by ignoring it they created a crisis back 2015

2. St. Louis Fed President James Bullard notices the U.S. economy is falling off of its trend price level path in a recent speech.

In short, the Fed’s normalization plan calls for it to prop-up banks’ demand for cash, as a prelude to reducing the supply of cash! That means tightening and more tightening. The rub, of course, is that conditions may never justify so much tightening. What's more, no plan for Fed normalization can work that would prevent the Fed from meeting its overarching inflation and employment targets.

4. Peter Ireland on what we can learn from the FOMC debates as seen in the latest minutes. Among other things, Peter notes the following:
Digging into the details of the FOMC’s debate reminds us, as well, of important lessons from economy history. Participants who warn that low unemployment today raises the risk of higher inflation in the future are organizing their thoughts around the idea of the Phillips curve, which describes an inverse relation between those two variables. One lesson from history, however, is that while data do often support the existence of a statistical Phillips curve, its fit is not nearly strong enough to serve as a fully reliable guide for monetary policymaking. The limitations of the Phillips curve approach became clear, for example, during the 1970s, when chronically high unemployment was accompanied by rising, not falling, inflation. Today, we may be seeing something similar: unemployment is below 4.5 percent, yet inflation continues to run below the Fed’s long-run target.     
In fact, as other participants in the debate point out, inflation has been below target for the past eight years. If one accepts Milton Friedman’s famous dictum, summarizing historical experience that “inflation is always and everywhere a monetary phenomenon,” it is difficult to escape the conclusion that, despite an extended period of very low interest rates, Federal Reserve policy over this period has been insufficiently, not overly, accommodative. This echoes another lesson from the past. Milton Friedman, Anna Schwartz, Allan Meltzer, and Karl Brunner all concluded, likewise, that very low interest rates during the 1930s accompanied, and indeed were the product of, monetary policy that was consistently too restrictive.  

Friday, May 19, 2017

Bad Optics: the Fed's Balance Sheet Edition

Despite the all Fed talk about shrinking its balance sheets, many observers are hoping the Fed keeps it large.  They want the Fed to maintain a large balance sheet for various reasons: it earns a positive return for the government; it provides a financial stability tool via provisions of safe assets; it needs to remain big and accommodative until the economy really starts roaring. There are also complications to shrinking the Fed balance sheet.

Whatever you make of these arguments they all ignore an important political-economy consideration: a large Fed balance sheet makes for bad optics because of interest paid on excess reserve (IOER). 

The figure below explains why. Using data from the Federal Reserve's H8 report, the figure shows the cash assets of "large domestically-chartered" banks and "foreign-related" banks.  The figure reveals the cash assets of these two bank categories combined tracks excess reserves fairly closely. They are, in other words, the main holders of excess reserves and consequently the main recipients of the IOER payment. 

Think about the implications: the banks that were bailed out during the crisis and the banks owned by foreigners are getting most of the IOER payment. This is a perfect storm of financial villains for both the political left and the right. That is why I agree with Ramesh Ponnuru that it politically naive to think the Fed can maintain a large balance. 

And note, the bad optics will only look worse if the Fed's balance sheet does not shrink as interest rates go up. For the IOER payment will go up too. Imagine Fed Chair Janet Yellen having to explain to Congress the growing dollar payments going to these banks.

That is not to say it will be easy to shrink the Fed's balance sheet. There will be big challenges as I have noted elsewhere. But the bad optics do mean that it is likely the Fed will be forced to shrink its balance sheet. 

Tuesday, May 16, 2017

Talking Monetary Policy with Paul Krugman

Paul Krugman joined me for the latest Macro Musings podcast. It was a fun show and we covered a lot of ground from liquidity traps to secular stagnation to fighting the last war over inflation. Paul and I have had conversations in the blogosphere since the 2008 crisis so it was real treat to finally chat with him in person.

In our conversation there were two issues brought up that deserved more time, in my view, than we could give on the show. So I want to address them in this post.

The first one is the important distinction between temporary and permanent monetary base injections. This distinction came up up in our discussion on what it takes to reflate an economy in a zero lower bound (ZLB) environment. Krugman's 1998 paper showed that to do so requires a permanent increase in the monetary base whereas a temporary one will not work. This 'irrelevance result' was further developed by Eggertson and Woodford (2003) who showed that QE programs that are temporary in nature will not spur rapid aggregate demand growth. Others have since built upon this point and there is also earlier monetarist literature that makes a similar argument (source). Here is an excerpt from a Michael Woodford FT piece in 2011 that nicely summarizes this view1:
The economic theory behind QE has always been flimsy. The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank's supply of base money. Because of this, at least in the long run, any increase in supply must raise prices proportionally. It followed that, in the short run, QE must also have an effect on spending levels, that will eventually tend to raise prices, even if the channels by which this occurs are obscure.  
The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan's experiment with QE, the added reserves were all rapidly withdrawn in early 2006. More worryingly for Mr Bernanke, whatever the long-run effects would have been, there was no increase in nominal growth over the five years of the experiment.  
The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.
Woodford acknowledges the Fed's large scale assets purchases can help when financial markets freeze up like during QE1, but beyond that will not create the kind of robust aggregate demand growth required to quickly escape a ZLB environment.

For me, the implication of this understanding is that the Fed should have aimed to return the price level (or nominal income) to its previously-expected growth path following the crisis. Krugman, on the other hand, is worried that might not be enough if secular stagnation is real. He, consequentially, prefers a permanently higher inflation rate whereas my approach would imply only a temporary one. In short, I want a level target for monetary policy whereas Krugman wants a higher inflation target.

I also want to be clear as to exactly what is a permanent monetary base injection. First, it is an (exogenous) injection beyond that warranted by normal money demand growth. That is, an increase above the regular growth created by currency demand, required reserves, and other normal (endogengous) sources of monetary base growth. Second, the actual permanent increase need not be very large given the long-run unitary relationship between the monetary base and the price level (after controlling for real growth). Third,  the permanent increase does not mean the monetary base injection is permanent throughout eternity. Only that it is permanent to the extent the current economic conditions that warranted the injection continues to hold. New economic developments may call for additional permanent changes to the monetary base. Finally, most central banks cannot credibly commit to such permanent increases in the monetary base, as evidenced by the record-low inflation in advanced economies since the crisis.  For more on these points see this recent paper of mine.

The second issue is my suggestion that fiscal policy could be used to stabilize the money supply. This came up near the end of the podcast when we started discussing the safe asset shortage problem. The key idea here is that the money supply properly measured includes both retail and institutional money assets. The Center for Financial Stability (CFS) has estimated such a measure. It is the Divisia M4 money supply which includes athe retail money assets in M2 plus institutional money assets. The latter include repos, commercial paper, institutional money market funds, and large-time deposits. 

As Gary Gorton and others have shown, there was a bank run on these institutional money assets during the financial crisis that led to a sizable and persistent reduction in their supply. This can be seen in the figure below which uses the M4 component data from the CFS:

This persistent shortfall in the privately-produced institutional money assets seen above was partially offset by the rise in treasury bills.  More of the shortfall could, in theory, be offset by the issuance of additional treasury bills. That was the point I was trying to make. The big question here is could the U.S. Treasury issue enough treasury bills to fill the institutional money asset shortfall without jeopardizing its risk-free status? I do not know. But it is one possible solution to the safe asset shortage problem.

The chart below builds upon the last figure by plotting the institutional money assets along side the retail money assets (or M2). Together they make up the M4 money supply. The figure reveals that even though the M4 money supply is now past its pre-crisis peak, is still far below its pre-crisis trend path. It never has fully recovered from the Great Recession. This could be part of the story for the weak recovery and, arguably, treasury could help.

Related Links
Permanent versus Temporary Monetary Base Injections: Implications for Past and Future Fed Policy
Scott Sumner on Paul Krugman's podcast

1 The Michael Woodford article ran in the Financial Times on August 26 and was titled "Bernanke Should Clarify Policy and Shrink QE3"

Friday, May 12, 2017

Dollar Domination, Robot Monetary Overloads, and Closing the AD Gap

Some assorted musings:

1. From this week's podcast with Ethan Ilzetzki comes this amazing figure. It shows that approximately 70% of world GDP is tied to the dollar. The implication is staggering: the FOMC is setting monetary conditions for much of the world.

2.  Greg Ip argues our robot fears are misplaced. If anything, we do not have enough robots destroying jobs:
From Silicon Valley to Davos, pundits have been warning that millions of individuals will be thrown out of work by the rapid advance of automation and artificial intelligence. As economic forecasts go, this idea of a robot apocalypse is certainly chilling. It’s also baffling and misguided. Baffling because it’s starkly at odds with the evidence, and misguided because it completely misses the problem: robots aren’t destroying enough jobs...  
This calls for a change in priorities. Instead of worrying about robots destroying jobs, business leaders need to figure out how to use them more, especially in low-productivity sectors.
Okay, what industries fit this description? Greg mentions the usual suspects: education, healthcare, and leisure and hospitality. Here is another one: central banking. It has not changed much in many decades and probably has low productivity. So maybe the hidden message of Greg's article is we need to get robots running the Fed?  My answer: sure, but only if they are targeting a NGDP futures market as proposed by Scott Sumner. This approach, after all, is fairly automatic by design and therefore conducive to our robot overlords taking over the Fed.

3. The CBO estimates the full-employment level of aggregate demand. They unfortunately call it "potential nominal GDP' which is horrific since the potential is truly infinite--think Zimbabwe's NGDP in 2008--so ignore the official name. The idea behind the measure is reasonable: what level of aggregate nominal spending is consistent with full employment. Here is the series lined up against actual aggregate demand as measured by NGDP. 

The figure indicates there was a sharp collapse in aggregate demand during the crisis and the full-employment level has only slowly converged to it. Therefore, there was both a sharp decline in aggregate demand (a cyclical shock) and a downward adjustment in the full-employment trend level of aggregate demand (a structural shock). This understanding is consistent with the recent Fernald et al. (2017) BPEA paper that found that there was both a demand shortfall (that ended by mid-2016) and a decline in potential real GDP. So the CBO's full-employment level of aggregate demand seems quantitatively reasonable.  

For fun, I plotted the difference between the full employment level and actual aggregate demand--the AD gap--against the latest hip labor market indicator. It is the working-age employment rate (a termed coined by Jordan Weissmann) which is more commonly known as the employment-to-population rate for prime-age workers (25-54 year olds). Nick Bunker has been a tireless advocate for using this measure to replace the unemployment rate as the headline labor market indicator. 

So how does the working-age employment rate measure up against the AD gap? Not too bad according to the figure below. The relationship is not perfect, but it is strong enough to indicate that the continued upward recovery of the working-age employment rate over the past few years has been largely due to cyclical factors. 

Thursday, May 11, 2017

Remembering All of Allan Meltzer's Work

Allan Meltzer passed away this week. He is probably best known for his multi-volume history of the Federal Reserve, the 'Meltzer Commission' that aimed to reform the IMF, and most recently his critique of Fed policy since the Great Recession. There was, however, much more to Allan Meltzer than just these developments.

One of the most important contributions, in my view, was his work with Karl Brunner during the 'Monetarist Counterrevolution'. This counterrevolution took place in the 1960s and 1970s and pushed backed against the dominant view of the time that monetary policy did not matter. Milton Friedman and Anna J. Schwartz spearheaded this movement, but it was Meltzer and Brunner who did the most to show why money mattered. They worked hard to show the mechanism through which monetary policy could actually affect the economy. This was no small feat since at the time many economists did not believe in monetary policy. Their insights now permeate modern macroeconomics.

Sadly, however, I suspect many observers will only remember Allan for his critique of Fed policy since 2008. While I disagreed with him on this issue, he was so much more than that one issue. So I hope readers will look at his entire life's work when judging him.

My appreciation for him grew over the past few years for several reasons. First, I got to the chance to interview him before a live audience for my podcast. It was a great interview. He was incredibly sharp, witty, and funny. I can only hope I am that lucid and spry when I hit my late 80s. 

Second, I came to appreciate his work with Karl Brunner on the monetary transmission mechanism as I was working a recent paper. As an example, below is an excerpt from a 1987 article. Read it and see if you can find any relevance for Fed's QE programs (my bold):
The adjustment of reserve positions to transitory change by buying and selling Federal funds (or by borrowing or repaying loans at the central bank) has negligible effects on the interest rates and asset prices relevant for household and business decisions.  A perceived permanent change in the monetary base initiates very different responses and has different costs.  The banks' balance sheet adjustments involve all portfolio items.  The responses by the banks change the money stock, affect interest rates on a variety of assets and the prices of real assets.  The public responds to changing relative costs and returns between loan liabilities and real assets.  The adjustment to a perceived permanent change is reinforced by changes in price expectations or adjustment of the current expected return to capital whenever permanent increase in the base are sufficiently large or persistent.
Meltzer and Brunner, in short, are saying that expected changes in the monetary base have to be permanent to have any meaningful effect.  This is a widely understood point now, one that if ignored leads to the QE "irrelevance results" of Krugman (1998) and Eggertson and Woodford (2003). This understanding explains why the Fed's QE programs failed to generate a robust recovery.  The monetary base injections under them were always meant to be temporary and this limited how much kick they could generate. Put differently, the Fed's temporary monetary injections were never going to create a fast escape from a ZLB environment. (For those interested, I further explain this point in a recent working paper.)

What is remarkable to me is that Meltzer and Brunner understood this principle long before QE was tried in Japan, the United States, the United Kingdom, the Eurozone, and Japan again. His work continues to shed light on current policy debates.

Examples like this one is why Allan Meltzer's life work deserves to be remembered. He is a giant and will be missed. Rest in Peace Allan.   

Friday, April 28, 2017

Macro Musings Podcast: Josh Zumbrum

My latest Macro Musing podcast is with Josh Zumbrum. Josh is a national economics correspondent for the Wall Street Journal. He joined me to talk about the angst facing the economics profession in this current environment. We also talked about the future of economic journalism, economic facts, and what really drives inflation.

It was fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Josh Zumbrum's web page at the Wall Street Journal
Josh Zumbrum's twitter account

Friday, April 21, 2017

Macro Musings Podcast: James Bullard

My latest Macro Musings podcast is with James Bullard. James is the President of the St. Louis Federal Reserve Bank and an accomplished economic scholar. He joined me for a great conversation on macroeconomics that covered everything from the determinants of inflation to the Fed's balance to the future path of monetary policy. We also discussed Jame's work on imperfect credit markets and how it provides a another justification for NGDP level targeting. 

This was a fascinating conversation throughout and the transcripts for the show are here. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
James Bullard's page at the St. Louis Federal Reserve