The government is beginning to see the light

Before getting into the main topic of the post, I’d like to point out that Mercatus has recently published a new primer on NGDP targeting, as well as futures targeting, written by Ethan Roberts and myself. I recommend it to people who want a short introduction to the concept:

The first section will clearly define monetary policy, describe the two main methods that central banks have traditionally used to carry out policy, and analyze the weaknesses of these methods. Later sections will articulate what NGDP is and how a policy of NGDP targeting works. Subsequent sections will list the most common criticisms of NGDP targeting and explain why these criticisms are misguided, and they will present arguments in support of the policy. Finally, the primer will provide specific recommendations for how to move from the current system to a system based on NGDP futures targeting.

I have a relatively low opinion of government, so I was very pleasantly surprised to see an outstanding report on monetary policy by the Joint Economic Committee.  You really need to read the entire thing, or at least the entire chapter entitled “Macroeconomic Outlook” from page 51 to 94, but here are a few excerpts:

The Report and Federal Reserve officials find low inflation rates “puzzling,” especially given the low unemployment rates. The “Phillips Curve” theory of price inflation posits that low unemployment rates drive up wages, which leads firms to raise prices to offset rising costs. The Committee Majority explores alternative explanations for below-target inflation. Notably, monetary policy may not have been as “accommodative” as commonly perceived.

The report then began describing policy in 2008, which was aimed at rescuing banks, not the broader economy:

Federal Reserve Bank of Richmond senior economist Robert Hetzel succinctly described the unusual credit policy:

Policies to stimulate aggregate demand by augmenting financial intermediation provided an extraordinary experiment with credit policy as opposed to monetary policy.

The Fed bought financial instruments from particular credit markets segments to direct liquidity toward them, which had the effect of injecting reserves into the banking system. This action alone would incidentally ease monetary conditions, but the Fed then sold Treasury securities from its portfolio to withdraw those reserves from the banking system (called “sterilization”), thereby restricting nominal spending growth.

I also get cited a few times:

Furthermore, despite the low level of the Fed’s fed funds rate target, monetary policy arguably remained relatively tight, as monetary economist Scott Sumner notes in the context of a 2003 Ben Bernanke speech:

Bernanke (2003) was also skeptical of the claim that low interest rates represent easy money:

[Bernanke:] As emphasized by [Milton] Friedman… nominal interest rates are not good indicators of the stance of monetary policy…The real short-term interest rate… 55 is also imperfect…Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

Ironically, by this criterion, monetary policy during the 2008-13 was the tightest since Herbert Hoover was President.

Then it discusses why various QE programs had little impact:

The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program:

Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future.

Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues. Furthermore as Sumner (2010), Feldstein (2013), Beckworth (2017), Selgin (2017), and Ireland (2018) note, payment of IOER at rates competitive with market rates led banks to hoard the reserve, which contributed at least partially to the collapse of the money multiplier (Figure 2-3).

And it wasn’t just right of center economists that objected to IOR:

Regarding IOER, former Federal Reserve Vice Chairman Alan Blinder advised in 2012:

I’ve been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.

He later observed in 2013:

If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves? Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.

I suggested negative IOR way back in early 2009.

They also point out that the Fed has ignored the intent of the Congressional authorization of IOR:

The law specifies that IOER be paid at “rates not to exceed the general level of short-term interest rates.” However, from 2009- 2017, the IOER rate exceeded the effective fed funds rate 100 percent of the time, the yield on the 3-month Treasury bills 97.2 percent of the time, and the yield on 3-month nonfinancial commercial paper 82.1 percent of the time (Figure 2-5). The Fed is including its own discount rate (the primary credit rate) in the general level of short-term interest rates to demonstrate compliance with the law.

In connection to IOER, Representative Jeb Hensarling, Chairman of the House Financial Services Committee, stated:

[It] is critical that the Fed stays in their lane. Interest on reserves – especially excess reserves – is not only fueling a much more improvisational monetary policy, but it has fueled a distortionary balance sheet that has clearly allowed the Fed into credit allocation policy where it does not have business.

Credit policies are the purview of Congress, not the Fed. When Congress granted the Fed the power to pay interest on reserves, it was never contemplated or articulated that IOER might be used to supplant FOMC. If the Fed continues to do so, I fear its independence could be eroded.

The following is also an important point—making sure than monetary policy continues to be about money:

Noting that the large quantity of reserves produced by the Fed contributed to the fed funds rate trading at or below the IOER rate, John Taylor of Stanford University’s Hoover Institution said:

[W]e would be better off with a corridor or band with a lower interest rate on deposits [IOER] at the bottom of the band, a higher interest rate on borrowing from the Fed [the discount rate] at the top of the band, and most important, a market determined interest rate above the floor and below the ceiling… We want to create a connect, not a disconnect, between the interest rate that the Fed sets and the amount of reserves or the amount of money that’s in the system. Because the Fed is responsible for the reserves and money, that connection is important. Without that connection, 63 you raise the chances of the Fed being a multipurpose institution.

Most importantly, the government is beginning to recognize that it was tight money that caused the Great Recession:

The preceding observations and alternative views merit consideration. In particular, Hetzel (2009) states:

Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.

When people like Hetzel, Beckworth and I made that claim back in 2008-09, we were laughed at.  Who’s laughing now?

China is cleaning up fast

Here’s the NYT:

On March 4, 2014, the Chinese premier, Li Keqiang, told almost 3,000 delegates at the National People’s Congress and many more watching live on state television, “We will resolutely declare war against pollution as we declared war against poverty.” . . .

Four years after that declaration, the data is in: China is winning, at record pace. In particular, cities have cut concentrations of fine particulates in the air by 32 percent on average, in just those four years.

Back in 2013, I was very skeptical of claims that pollution was dramatically shortening life expectancy in China.  Despite the following, I’m still skeptical.

To investigate the effects on people’s lives in China, I used two of my studies (more here and here) to convert the fine particulate concentrations into their effect on life spans. . . . Applying this method to the available data from 204 prefectures, residents nationally could expect to live 2.4 years longer on average if the declines in air pollution persisted.

The roughly 20 million residents in Beijing would live an estimated 3.3 years longer, while those in Shijiazhuang would add 5.3 years, and those in Baoding 4.5 years. . . .

The U.S. Clean Air Act is widely regarded as having produced large reductions in air pollution. In the four years after its 1970 enactment, American air pollution declined by 20 percent on average. But it took about a dozen years and the 1981-1982 recession for the United States to achieve the 32 percent reduction China has achieved in just four years.

. . . Bringing all of China into compliance with its own standards would increase average life expectancies by an additional 1.7 years (as measured in the areas where data is available). Complying with the stricter World Health Organization standards instead would yield 4.1 years.

I’m still not buying these claims.  Beijingers currently live to be 82.  Will this reduction in pollution push their life expectancy up to 85.3?  I doubt it.  Would meeting the WHO standards boost life expectancy up an additional 4.1 years to 89.4?  Very unlikely.

To be sure, life expectancy has been rising in Beijing, and will keep rising–perhaps to 85 or 86.  But that was equally true when pollution was getting worse.  The effects of pollution have been exaggerated in the press, as Andrew Gelman so ably pointed out back in 2013.

Having said all that, this news is certainly very good, and means that Chinese RGDP growth was overstated during the boom period of 1980-2012, and is currently being understated.

What should our public schools teach?

With Trump the ordinary rules don’t apply.  Mere scandals are hardly worth reporting—the GOP will protect him regardless of what’s he’s done.  But yesterday brought something a bit novel, even for Trump.

Trump lied to Canadian leader Justin Trudeau, claiming the US ran a trade deficit with Canada.

Then Trump joked about the fact that he lied to Trudeau.  It was caught on tape, and it was played on all the TV news shows.

Then he repeated the lie in a tweet.

If you want to claim that it’s not a lie, that we do have a trade deficit with Canada, you are faced with the following problem.  The “Economic Report of the President” signed by Trump, claims the US has a trade surplus with Canada.  So he’s either lying in the Economic Report of the President, or in his tweets.

All this supports Bryan Caplan’s case against public education.  One of the most common arguments for public schools is that they teach civics.  We need a well educated population so that we do not elect bad people.  And having gone through the public school system, I can vouch for the fact that they do teach civic virtue.  My teachers seemed to sincerely want us to be good people.  English classes taught us the importance of character.  In history and social science we learned about various figures who gained power through demagoguery, demonizing minorities, engaging in “the big lie”.  Lots of historical examples were cited.  Indeed if I think back to my middle and high school years, I’d sum up the education as basically emphasizing one point:

Under no circumstances should you ever, ever, ever consider electing a candidate like Donald Trump.

And yet we did.  He’s a textbook example of everything we were taught is bad.  The continual lying, the bullying, the corruption, the racism, the misogyny, the willful ignorance.  Either Trump is bad or public education is useless.

I vote for “both”.

Applying Occam’s Razor to the forward value of the yen

After my previous post, Brian McCarthy left the following remarks:

I believe there is a fair bit of empirical evidence that current spot rates are a better predictor of future spot rates than are current forward rates. So a naive “long carry” strategy does generate positive returns over time. The reason this “free money” isn’t arbitraged away, I would imagine, is that the strategy doesn’t have a good sharpe ratio. ie low returns relative to the volatility. In market slang it’s “picking up pennies in front of the steam roller,” involving a significant risk of ruin if done “in size.”

So the market really does “expect” the yen to be at 106 in 30 years, which is where it is today.

This is a good argument, but in the end I favor the alternative view.

Over the past 40 years, the US price level has risen from 1 to 3.975, while the Japanese price level has risen from 1 to 1.556. That means the US price level has risen by 2.555 relative to the Japanese price level.  Over the same period, the yen has appreciated from 241.37 to 106 to the dollar, a ratio of 2.227.  So the appreciation of the yen in the very long run is pretty close to the change predicted by PPP (although over shorter periods there are quite wide discrepancies.)

So here’s how I look at things.  The simplest explanation for the forward yen trading at 50 is that the public expects Japan to continuing having lower inflation than the US, just as has been the case for the past 40 years.  They expect the yen to continue appreciating, just as it has over the past 40 years.

The alternative explanation is possible, but involves more “epicycles”:

1.  Yes, the Japanese yen has been appreciating in the very long run.

2.  Yes, the Japanese inflation rate is consistently lower than in the US.

3.  Yes, the 30-year forward yen is trading at a strong premium, just as you’d expect if these trends were going to continue.

4.  But these facts are actually unrelated.  Starting right now, the Japanese inflation will suddenly rise to US levels, even though the markets don’t seem to expect that.  And starting right now the yen will stop appreciating.  And instead some other “real factor” explains why the forward yen is trading at a strong premium, some real factor that would cause 30-year Japanese real interest rates to be hundreds of basis points lower than American real interest rates.

That’s all theoretically possible, but isn’t the simplest explanation that the forward yen is at a strong premium because investors expect the spot yen to appreciate, and they expect the spot yen to appreciate for the same reason that it’s strongly appreciated over the past 40 years?

PS.  After I wrote this post (a few days ago), I discovered a similar post written earlier by Julius Probst, who has a very nice monetary economics blog.  He anticipates my basic point.  But read his post anyway, as it ends with some interesting remarks on Japanese monetary policy.


Money is fundamental, interest rates are secondary

Let’s try one more time, with the dollar/yen forward exchange rate.  I’d like to make the following assumptions.  It doesn’t matter whether you think these assumptions describe the real world; I’d simply like you to consider them as a hypothetical.  When we’re all done, we’ll think about what it means.

1.  Let’s assume the BOJ is determined to adopt a very tight money policy, over the next 30 years.  This policy will be so tight that the yen will end up valued at 50 to the dollar, more than double its current value.

2.  This very tight money policy causes very low inflation and very low NGDP growth in Japan.

So far interest rates don’t enter the picture, indeed interest rates need not even exist—imagine a world with no debt. I’m trying to make the appreciation of the yen into the fundamental shock, from which everything else flows.

3.  Now let’s add interest rates.  Because of the ultra-low expected inflation, and the ultra-low expected NGDP growth, nominal interest rates in Japan are more than 200 basis points below nominal interest rates in the US.  These low rates are caused by a tight money policy that leads to yen appreciation.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

4.  Now let’s assume that the US and Japanese debt markets are very deep and liquid, and the 30-year forward yen contract is very lightly traded and not very liquid at all.  Let’s also assume that the forward premium on the yen is linked to the interest rate differential according to the covered interest parity theorem, although the theorem doesn’t work perfectly due to various market imperfections caused by regulations.  It’s roughly true.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

Now let’s take stock of where were are.  Thus far, I have NOT claimed to describe the real world.  I’ve described a scenario where, by assumption, the huge forward premium on the yen drives the interest rate differential.  Quite possibly, this imaginary scenario has nothing to do with the real world.

But here’s the problem.  Not one commenter has given me a single fact that would lead me to conclude that this imaginary scenario does not in fact describe the real world.  Note, for instance, that I assumed that the two bond markets are highly liquid and traders focus on the interest rate spread.  I assumed the forward yen is lightly traded, and hence considered peripheral in the world of finance.  But I’ve also constructed an example where, by assumption, that difference in liquidity between the two markets has no bearing on causality.

So what would count as evidence against my imaginary scenario?  Perhaps you could convince me that while the 30-year forward yen is 50, traders actually expect the yen to be trading at 105 in the year 2048.  And investors continue to buy low yield JGBs in any case, because of market segmentation, or some other reason.  So the differences in interest rates are unrelated to differences in inflation, etc. If you offered that sort of explanation, and backed it up with evidence, I would be persuaded.  But I’m not seeing people do that.  Until then, I’m going to assume the causality goes from an appreciating yen to a situation where Japanese interest rates are lower than American interest rates.

PS.  The “carry trade” may partly explain why people disagree with me, but carry trades suffer from the “peso problem”, so I’m not convinced the carry trade will “work” going forward.  If Japanese inflation stays well below US inflation (as I expect), then the carry trade will break down at some point.

PPS.  Financial variables may or may not be linked to macro events.  The 1929 stock market crash seems to have been linked to fears of depression, while the 1987 stock market crash seems to have been sort of random.  You can view my claim here as being that the 1929 case is more typical.  Asset prices move based on shifting expectations regarding economic fundamentals.  Even if a forward exchange rate market did not exist, I’d claim that expectations of the future spot rate drive the interest rate differential.