Another sign of Fed incompetence

Face palm time:

U.S. stock index futures indicated a sharply lower open on Thursday as traders reacted to a sharp fall in European stocks and looked ahead to the second day of Fed Chair Janet Yellen’s testimony in Washington.

Dow futures were indicating a drop of around 250 points in premarket trading, after falling more than 300 points. The pan-European Stoxx 600 index (^STOXX) was down by more than 2.8 percent.

Meanwhile, U.S. Treasurys soared, as the 10-year yield fell to 1.59 percent.

On Wednesday Yellen told the House Financial Services Committee that the Fed was not sure it could legally take rates negative as Europe and Japan have. She also said it was unlikely the Fed would cut rates, having just raised them.

Not sure?!?!?!?  Now they tell us?  This is almost mindbogglingly incompetent.

OK, I admit it.  I was wrong about Yellen.  Obama should have nominated Larry Summers.  I’m sorry Larry.

PS.  Here’s William Dudley back in October:

Federal Reserve officials now seem open to deploying negative interest rates to combat the next serious recession even though they rejected that option during the darkest days of the financial crisis in 2009 and 2010.

“Some of the experiences [in Europe] suggest maybe can we use negative interest rates and the costs aren’t as great as you anticipate,” said William Dudley, the president of the New York Fed, in an interview on CNBC on Friday.

And here’s Janet Yellen in November:

The Federal Reserve would consider pushing interest rates below zero if the U.S. economy took a serious turn for the worse, Fed Chair Janet Yellen said on Wednesday.

“Potentially anything – including negative interest rates – would be on the table. But we would have to study carefully how they would work here in the U.S. context,” Yellen told a House of Representatives committee.

This would happen if the economy were to “deteriorate in a significant way,” she said, adding that she believed negative rates “would have some at least modest favorable effect on banks’ incentives to lend.”

How do we identify sticky wages?

Tyler Cowen has a new post on the subject:

When you disaggregate the data at the state level, wages don’t look so sticky any more:

…states that experienced larger employment declines between 2007 and 2010 had significantly lower nominal wage growth during the same time period…Our estimates suggest that real wages also vary significantly with local measures of unemployment at the state level…there is a strong relationship between local employment growth and local wage growth at business cycle frequencies.

In other words, the supply and demand model doesn’t do so badly after all.

As I explain in this post, this is exactly what you’d expect if nominal wages were sticky.  If this were not true, there’d be something very much wrong with the sticky wage model.

The empirical evidence in favor of sticky wages is simply overwhelming. It’s just about the only thing in macroeconomics that we can be certain is true.

PS.  The supply and demand model cannot explain unemployment (in equilibrium), and hence has nothing to say about the empirical evidence described by Tyler.  In order to even attempt to apply supply and demand to the issue of unemployment, you’d have to assume wages are not in equilibrium, i.e. are “sticky”.  Or am I missing something?

Who predicted what, when and why

Let’s go back to March 3, 2009.  Here’s Paul Krugman:

As Brad DeLong says, sigh. Greg Mankiw challenges the administration’s prediction of relatively fast growth a few years from now on the basis that real GDP may have a unit root — that is, there’s no tendency for bad years to be offset by good years later.

I always thought the unit root thing involved a bit of deliberate obtuseness — it involved pretending that you didn’t know the difference between, say, low GDP growth due to a productivity slowdown like the one that happened from 1973 to 1995, on one side, and low GDP growth due to a severe recession. For one thing is very clear: variables that measure the use of resources, like unemployment or capacity utilization, do NOT have unit roots: when unemployment is high, it tends to fall. And together with Okun’s law, this says that yes, it is right to expect high growth in future if the economy is depressed now.

But to invoke the unit root thing to disparage growth forecasts now involves more than a bit of deliberate obtuseness.

And here is Greg Mankiw’s reply:

Paul Krugman suggests that my skepticism about the administration’s growth forecast over the next few years is somehow “evil.” Well, Paul, if you are so confident in this forecast, would you like to place a wager on it and take advantage of my wickedness?

Team Obama says that real GDP in 2013 will be 15.6 percent above real GDP in 2008. (That number comes from compounding their predicted growth rates for these five years.) So, Paul, are you willing to wager that the economy will meet or exceed this benchmark?

And here’s what I wrote, 5 years later:

Krugman wisely decided to avoid this bet, which suggests he’s smarter than he appears when he is at his most political. In any case, the actual 5 year RGDP growth just came in at slightly under 6.3%. That’s not even close. Mankiw won by a landslide.

In January 2011, Tyler Cowen wrote a book entitled “The Great Stagnation.”  So far Tyler’s hypothesis has proven correct. (Oddly, the media often refer to Larry Summer’s stagnation hypothesis, which (AFAIK) came much later.)

In 2013 Tyler made a bet with Bryan Caplan, that unemployment would not fall quickly back to 5%:

Tyler just bet me at 10:1 that U.S. unemployment will never fall below 5% during the next twenty years.  If the rate falls below 5% before September 1, 2033, he immediately owes me $10.  Otherwise, I owe him $1 on September 1, 2033.

Readers of my blog know that I would have agreed with Bryan.  Tyler Cowen responded by pointing to reasons why these bets are not a good idea:

Bryan Caplan is pleased that he has won his bet with me, about whether unemployment will fall under five percent.  I readily admit a mistake in stressing unemployment figures at the expense of other labor market indicators; in essence I didn’t listen enough to the Krugman of 2012.  This shows there were features of the problem I did not understand and indeed still do not understand.  I am surprised that we have such an unusual mix of recovery in some labor market variables but not others.  The Benthamite side of me will pay Bryan gladly, as I don’t think I’ve ever had a ten dollar expenditure of mine produce such a boost in the utility of another person.

That said, I think this episode is a good example of what is wrong with betting on ideas.  Betting tends to lock people into positions, gets them rooting for one outcome over another, it makes the denouement of the bet about the relative status of the people in question, and it produces a celebratory mindset in the victor.  That lowers the quality of dialogue and also introspection, just as political campaigns lower the quality of various ideas — too much emphasis on the candidates and the competition.  Bryan, in his post, reaffirms his core intuition that labor markets usually return to normal pretty quickly, at least in the United States.  But if you scrutinize the above diagram, as well as the lackluster wage data, that is exactly the premise he should be questioning.

As I’m the only one in this exchange fessing up to what I got wrong, and what I still don’t understand, and what the complexities are, in a funny way…I feel I’m the one who won the bet.

I agree with Tyler’s skepticism regarding the utility of public bets; they oversimplify a very complex set of issues.  They also subtly imply that greatness is a function of not being “wrong” about particular questions.  I’d argue that one doesn’t become a truly great scientist until one’s views have been partially discredited.  That means people are taking your ideas seriously, and pushing them to the point where they are no longer intellectually progressive.  (Think Copernicus, Newton, Einstein, Darwin, etc.)

However, as someone who agreed with Caplan, I don’t entirely accept the implication of Tyler’s final sentence.  I can’t speak for Bryan, but here are the views I’ve expressed:

1. Cycles in unemployment are largely caused by nominal wage stickiness, and unemployment will usually revert back to the natural rate, which tends to be fairly stable in the US (but not completely stable).

2. The US is entering a Great Stagnation, where 3% NGDP growth will be the new norm, measured RGDP growth will also slow sharply, but of course it’s not clear what RGDP actually is, because it’s not clear what economists mean by the term “price level.”

3. The Labor Force participation rate has historically been unstable, unlike the natural rate of unemployment, responding to demographics, welfare reform, disability insurance, prison incarceration, etc., etc., etc.)  Wage stickiness doesn’t explain this.  But Tyler was also skeptical of how far Bryan and I pushed the wage stickiness concept.  Since our view is that wage stickiness explains changes in the unemployment rate, but not the LFPR, Bryan winning his bet is at least as small point in favor of the sticky wage model.

4. Fiscal austerity would not slow growth in 2013, a claim Paul Krugman contested.  I was right and Krugman was wrong.

5. Repealing the extended unemployment benefits in early 2014 should have modestly increased new job creation, by boosting the supply of labor.  This would be true even if NGDP growth (i.e. AD) did not accelerate.  Paul Krugman also contested this claim.  Again, I was right.  Job growth in 2014 was substantially above the 2010-13 rate, despite very modest growth in NGDP. Of course Krugman has been right about many things, especially when he agreed with market monetarists.  Thus he has criticized the mainstream conservative prediction that “easy money” would lead to high inflation.

6. I’ve consistently predicted that unemployment would fall faster than the Fed thought, and that NGDP growth and inflation would be less than the Fed thought.  That’s actually sort of threading the needle, as faster falling unemployment would normally be associated with faster than normal NGDP growth.

Despite the fact that I’ve recently ended up being right more often than wrong, I think the importance of specific predictions is overrated.  If I had been blogging in 2006-09 I would have been wrong about lots of things, because the market was wrong about lots of things.  The economy is very hard to predict, and hence I’ve been lucky.  More important is the reasoning process used.  Here is how I’ve approached this:

1. For low NGDP growth and inflation predictions I’ve relied on market forecasts, which generally seemed more bearish than Fed forecasts.

2. For the Great Stagnation, early on I noticed a “job-filled non-recovery”, which many people oddly called a jobless recovery.  The unemployment rate fell sharply despite anemic RGDP and NGDP growth (for a recovery period).  So I reasoned that if RGDP growth was only 2.0% to 2.5% during a period of fast falling unemployment, then the trend rate of growth must be really slow.  So far I’ve been correct (and I hope my prediction is soon refuted, for the sake of the economy.)

3. For the unemployment compensation issue I relied on basic theory, and on previous studies of the effect of UI on jobless rates.  Back in 2008, Brad DeLong predicted higher unemployment as a result of a very small increase in benefits under President Bush.  It seemed to me that people like Krugman were abandoning mainstream economics for ideological reasons.

4. Standard theory, pre-2008, also implied that the monetary authority drove AD, and that fiscal policy would only impact growth by shifting the AS curve.  I saw no reason to abandon the standard view.

5. As far as wage stickiness and unemployment, my views were shaped by many factors, including my study of the Great Depression, and the fact of wage stickiness documented by many studies.  I also relied upon the strong theoretical implication that if nominal wages are sticky then nominal GDP shocks will lead to volatility in hours worked.  As far as the unemployment rate recovery predicted by Caplan, I relied on both theory (Friedman/Phelps) and evidence—the fact that the US natural rate seems fairly stable at around 5%. That’s the best I could do, and in this case I was right.  But if I’d lived in Western Europe in the late 1970s and early 1980s, I would have been wrong and Tyler would have been right, as the unemployment rate jumped sharply, and never went back down (except in a few countries like Germany, and even then only much, much later.)

Market forecasts are the best we can do.  I suggest that readers pay less attention to who predicted what, and more on the reasoning process behind their predictions.  Occasionally people will get lucky and nail a prediction that the markets missed (think Roubini, John Paulson, Shiller, etc.)  But when you look at their overall track record it’s clear that luck was involved; no one can consistently predict the macroeconomy. Nor should we focus on who has the most impressive mathematical model. Instead we should focus on who has a coherent explanation for what is occurring, an explanation that is consistent with well established theory, and that can be applied to a wide range of cases.  I hope market monetarism is one of those coherent explanations.

PS.  I just returned from the Warwick Economics Summit, and was very impressed by the Warwick students.  I would especially like to thank Ibraheem Kasujee, who helped arrange the visit.  It was good to get out of the Puritan States of America for a few days, and attend a student ball where drinks are served to 18 year olds.  At Bentley even the faculty can’t drink a glass of wine at the Holiday Party.  And Bentley just banned smoking everywhere—basically telling the smokers (who used to huddle outside in the cold) to go away, we don’t want you here.  This university is only for PC puritan paternalists.  (On the plus side, our students do get good jobs.)

I had planned on being home for dinner on Monday, but instead (due to snow at the Boston airport) I was 30 miles north of Reykjavik (at 11 pm Iceland time), in the middle of nowhere, standing in a cold wind with no hat on, looking straight up at a zillion stars in the sky–and a few northern lights as well.  But now I’m back and have a huge amount of catching up to do. (Here’s my earlier unexpected layover in Iceland.)

For readers who didn’t get their fill of Krugman bashing here, I also have a new Econlog post.

A contrarian worth rooting for

From BloombergBusiness:

Three years ago, at the tender age of 38, married with three children and $4 billion richer, Arnold shut his fund and decided to spend the rest of his professional life giving away his money as counterintuitively as he had earned it. He had made millions at Enron and billions at Centaurus, zigging when others zagged. Now, that rare person who grows less popular the more he gives away, he is focusing on dilemmas dragging down the nation that no one else wants to confront.

Sitting in the Houston offices of his foundation, he explained, “I was troubled when I was trading that it’s hard to make that direct tie between the financial industry and the greater good. My life was 100 percent trying to make money in the first phase, then 100 percent trying to do good in the second.”

Contrarian Causes

Arnold and his wife, Laura, a former corporate attorney, are targeting contrarian, underappreciated causes, things like research integrity, drug-sentencing reform, organ donations and broken pension systems, an especially radioactive issue.

.  .  .

And Arnold, a moderate Democrat who believes a rich country like the U.S. should provide a high safety net for its citizens, sees the stakes as being no smaller than the survival of the very governments that provide that net.

Good for him—those are under-appreciated issues.

Critics say pension reform is a euphemism for denying workers what they have been promised and paid for. One Rolling Stone writer called Arnold a “ubiquitous young right-wing kingmaker.”

Bailey Childers, president of the National Public Pension Coalition, a union-backed group set up in part to help counter Arnold’s influence, said, “There’s not this crisis that they want you to believe there is in states that are doing what they’re supposed to do. This is an attack on workers who have played by the rules.”

The Dems have moved so far left that a moderate Democrat is now a “right-winger.”

Recent discussion of monetary policy

Commenter SDOO sent me the following:

Kocherlakota quoted you on Twitter re: Fed, ECB, BoE and BOJ getting together next week.

That’s quite an honor.  Stephen Kirchner sent me a couple of FT articles.  The first contains some extremely interesting information on the zero lower bound, which is looking less and less like a lower bound:

But the Bank of Japan’s set-up for negative rates, which apparently follows the Swiss National Bank’s, casts doubt on the premise that the nominal cost of holding cash is zero. As we have explained, if a private Japanese bank wishes to exchange its central bank reserves for cash, the BoJ will adjust the portion of its reserves to which negative rates apply by the same amount. That means any extra cash that a bank wishes to hold will cost it as much as if it kept it on deposit at the central bank.

But what really matters is what the public wants to do. JP Koning nicely explains the “hot potato effect” of pushing central bank reserve rates below zero: banks will bid down rates on other assets in the financial system as they try to swap reserves for cash. Ultimately, they will be forced to lower rates on deposits below zero as well, so that customers will have to pay to keep their money on deposit. This is where the liquidity trap is really supposed to snap shut: will there not be a run for cash as depositors refuse to pay banks to hold their money?

But consider two things. First, it is not as if depositors as a class actually have a legal right to convert all their money to cash as it is. You cannot present a debit card at the Bank of England and demand cash. Indeed, even your own bank limits how much cash you can withdraw, as Frances Coppola has pointed out. Just read the fine print of your account terms of service.

And how could private banks honour mass withdrawals of cash even if they wanted to? No law provides for the central bank to swap client deposits for cash; only central bank reserves. And despite the huge growth of reserves in recent years, these still amount to only a fraction (about one-fifth in the UK) of bank deposits. So, to honour customers’ demands, banks would have to borrow more reserves from the central bank, which could impose terms as onerous as it wished. Onerous enough that banks would try to pass the cost on to customers. As my colleague Richard Milne argues in an analysis of Danske Bank’s success — its market value now exceeds that of Deutsche Bank — Danske is thriving because it has adapted to Denmark’s negative rates, in part by indeed passing them on to customers.

Second, the BoJ’s and SNB’s set-ups to neutralise banks’ incentive to hold cash instead of reserves can be exactly duplicated by the banks themselves vis-à-vis their customers. You want to take cash out of your account? Be our guest, but we will keep track of your total balance of net cash withdrawn and charge you the same interest on that balance as we charge on your deposits. This can be implemented through one of the regular “updated terms and conditions” that our banks seem to impose on us unilaterally every so often.

Read the whole thing.  This article (by Martin Sandbu) confirms my claim back in 2009 that the central bank could impose negative IOR on vault cash, but it also provides lots of options that I never contemplated.  More evidence that central banks never really tried very hard, which is obvious now that the Fed is no longer at the zero bound (and should have been obvious during 2008-12 when the ECB was above the zero bound.)

The second FT article is an odd one, with some good stuff:

December 16 2015 may go down as the date of one of the most monumental policy errors in history. The financial markets were nervously anticipating that the US Federal Reserve would raise the interest rate for the first time in nearly a decade — but few grasped the inadequacy of the data driving the decision.

The Fed had never before initiated a tightening cycle when the manufacturing sector was shrinking. . . .

The bond market, meanwhile, sees no shades of grey in the data; it is shifting rapidly from pricing in one rate hike this year towards pricing in the possibility of the next move being a rate cut, all but ridiculing the Fed’s insistence that four rate hikes would come to pass in 2016.

Tellingly, Fed officials are softening their tone on the number of times the rate might rise this year. “Don’t fight the Fed” — the idea that markets ultimately benefit from the Fed’s decisions — has become a cliché. The truth is the Fed has never dared fight the markets.

There’s that term ‘dare’ again, which Tyler Cowen mentioned a few weeks back (and I quoted in a recent post.) Unfortunately this generally good article (by Danielle DiMartino Booth) is marred by one dubious claim:

With hindsight, few dispute that the Fed missed an opportunity to raise rates in 2014. No doubt, tightening policy at that stage would have created its own messy side-effects. That said, the benefits would have been significant.

First, for example, commodity prices might not have risen so high or so fast without the cheap money flowing from the US to emerging markets. Property prices worldwide might not be as frothy had investors not sought refuge in the sector from what they rightly recognised as risky valuations in equity and bond markets. And “fragile” would not now be the word for financial markets and economies worldwide.

Is it really true that “few” dispute this claim?  I certainly do.  I’m not saying it’s impossible, counterfactuals are always tricky, but it certainly should not represent the conventional wisdom at this point, unless I’m missing something.

BTW, Just to be clear I am currently much more worried about NGDP growth than jobs.  I still think a recession is unlikely for the US in 2016.  Rather I worry that if NGDP growth and long-term rates stay low, the Fed will be ill-prepared for the next recession—unless it shifts to NGDPLT.  And let’s face it; no one can predict recessions.

PS.  I have a new article in The Fiscal Times discussing my Depression book, and its implications for current policy debates.

PPS.  Over at Econlog I have a new post on a talk given by James Bullard.

PPPS.  I will be giving a couple talks at the Warwick Economics Summit this weekend, so my blogging may tail off for a few days.