Archive for January 2016


When organizations have made up their mind

I suppose that most of us have experienced that sense of helplessness when our employers are determined to do something, even though it’s becoming clear that it’s the wrong move. In my field (academia) it might be a new and “innovative” MBA program, which is not well thought out.  Once a lot of effort has been put into developing the program, it’s hard to stop.

This problem occurred in the space program, back in 1986:

More than 30 years ago, NASA launched seven crew members to space on the space shuttle Challenger, but they never got there.

Seventy-three seconds after lift-off, one of the shuttle’s fuel tanks failed, generating a rapid cascade of events that culminated with a fireball in the sky, eventually killing all the passengers on board.

While we all probably know this story, there’s another equally tragic account from engineer Bob Ebeling that strikes a chord with us for a different reason.

The night before the disaster, Ebeling, along with four other engineers, had tried to halt the launch, according to an exclusive interview from NPR with Ebeling.

The five engineers worked for NASA contractor Morton Thiokol, who manufactured the shuttle’s rocket boosters — the two rockets on either side of a shuttle that fired upon lift off.

They knew that this mission would involve the coldest launch in history, and that the shuttle’s rocket boosters weren’t designed to function properly under such extreme temperatures.

The night before the explosion, Ebeling said in the NPR interview, he’d told his wife: “It’s going to blow up.”

I recall reading that while NASA pretended to be bewildered by the accident, the stock market figured out the cause almost immediately, and Morton Thiokol stock plunged.  Now we find out that the NASA bigwigs knew all along who was to blame, they were.

In December, Narayana Kocherlakota warned that the Fed was in danger of losing credibility, as market indicators of inflation expectations fell increasingly far below target.  But the Fed had put a lot of effort into developing a “liftoff” of interest rates, and wasn’t going to be pushed off that goal by warnings that it was a mistake.  Let’s hope NGDP in 2016 does better than the Challenger. If not, the Fed will pretend to be bewildered by “shocks” that mysteriously hit the economy in 2016.

The beauty of markets is that they admit mistakes within milliseconds, and reverse course when new data comes in. They have no ego.  Recall Keynes’s famous comment:

When the facts change, I change my mind.  What do you do, Sir?

This applies to very few people and almost no organization.  But it perfectly describes markets.  That’s why intellectuals with minds closed to new ideas are so contemptuous of the flighty nature of market prices.  “Make up your mind!”  No, don’t make up your mind—keep changing it as new information comes in.  Every millisecond.

BTW, Ramesh Ponnuru sent me an interesting article by Jed Graham, showing that the Fed raising rates during a quarter of 1.5% NGDP growth was unprecedented in modern history:

Screen Shot 2016-01-29 at 8.55.07 PM

If you take a four quarter perspective, the rate increase looks even more unusual. The 4 quarter NGDP growth rate came in at 2.9%, which is well below the levels of previous rate increases:

The data discussed above and displayed in the accompanying chart reflect the annualized pace of growth in each quarter the Fed hiked rates. But if one looks at the pace of GDP growth from the year-earlier quarter, the Yellen Fed stands alone as the only Fed to hike rates when nominal growth was below 3%.

Commerce Department data show the economy grew 2.9% from the fourth quarter of 2014, unadjusted for inflation. There have only been three other times that the Fed hiked when nominal year-over-year growth was less than 5%. Once was in 1986, when growth was 4.9%. The other two times came during the Volcker recession in 1982, when nominal growth fell as low as 3.2%.

While the Yellen Fed didn’t go so far as to admit a mistake, its policy statement after Wednesday’s meeting did implicitly acknowledge that policymakers were no longer confident about the path of inflation.

A footnote on the Japanese decision to adopt negative IOR.  I’m told it only applies to new reserves, not existing reserves. This is similar to an idea I proposed back in April 2009, in a (ridiculously long) reply to Greg Mankiw.

Suppose the government pays 4% positive interest on required reserves and negative 4% interest on excess reserves.  The penalty rate on excess reserves affects behavior at the margin, and should reduce ER holdings to the very low levels that existed before reserve and T-bill rates were nearly equalized.

Not exactly what the BOJ did, but close in spirit.  Just one more crazy MM idea that people told me could never be done in the “real world”, because I’m just an academic in an ivory tower that knows nothing about finance and banking.

Check out Nick Rowe’s post on this same general issue.

PPS.  I won 10 euros in the Hypermind market last year, as I shorted NGDP early in 2015, when the price was around 4.2%

Macroeconomics does make progress

Sometimes it seems like macroeconomics never makes any progress.  Fads go in an out of style in an endless cycle: classical, Keynesian, classical, Keynesian, classical, Keynesian, etc.  Beneath the surface, however, progress is steadily occurring.  Today provided one more example.

A few years ago there was a lively debate as to whether negative interest on reserves would be expansionary or contractionary.  Pundits who took a “finance approach” suggested the effects would likely be contractionary, due to their impact on the financial markets.  Market monetarists argued that policies that pay less interest on base money are expansionary, because they reduce the demand for base money.  Today provides another powerful example that the monetary approach to macro is superior to the finance approach, as the yen plunged on news that the BOJ had unexpectedly adopted negative IOR (after dismissing the idea just weeks ago.)  There had been previous experiments in Europe with the same outcome, but some of them were combined with QE.  This was a particularly clean test, in a major economy:

Bank of Japan Governor Haruhiko Kuroda sprung another surprise on investors Friday, adopting a negative interest-rate strategy to spur banks to lend in the face of a weakening economy.

The move to penalize a portion of banks’ reserves complements the BOJ’s record asset-purchase program, including 80 trillion yen ($666 billion) a year in government-bond purchases, which was kept unchanged at the board meeting. By a 5-4 vote, Kuroda led his colleagues to introduce a rate of minus 0.1 percent on certain excess holdings of cash.

Long a pioneer in adopting unorthodox policies to tackle deflation and revive economic growth, the BOJ is now taking a page out of European policy makers’ playbooks in the goal of stoking inflation. The yen tumbled after the announcement, which came after Kuroda just last week rejected the idea of negative rates.

It will be interesting to see if those claiming negative IOR would be contractionary will now admit their error.

PS.  Here’s a FTAlphaville post by Izabella Kaminska from 2012:

If imposed, negative rates would be enforced via the base money market. This could see banks charged for holding excess reserves at the central bank. Which ever way you look at it, the move would ultimately be contractionary rather than expansionary because it would lead to base money destruction, or wider credit destruction as banks hand over credit to cover charges.

HT:  Cameron,  Julius Probst

Mike Konczal on 2008

Mike Konczal has a new post criticizing the recent NYT piece by Beckworth and Ponnuru.  He makes four points.  The first is that Senator Cruz’s views on money are not always consistent.  Even if true, that has no bearing on the Beckworth/Ponnuru argument.  Here’s the second:

A lot depends on what we mean by “cause.” Google “define:cause” and I get “make (something, typically something bad) happen.” But the authors really mean “didn’t prevent” here. There is a fascinating Myth of Ownership/”you didn’t build that” element here – where is the line between the market and the state that structures it? But the story is simple: there was an aggregate demand shortfall from the housing collapse, and the government didn’t step in to fix it.

In that same exact way, the stimulus not being large enough also caused the Great Recession. Sure, but I doubt Ted Cruz would agree with that statement.

This is a completely meaningless distinction, when it comes to monetary policy.  As Nick Rowe points out there is no meaningful distinction between the Fed acting and not acting.  Monetary policy can be described along many dimensions, including interest rates, the base, M2, exchange rate, and NGDP expectations.  Acting in one dimension might mean not acting in terms of another.  And this isn’t even one of those “Keynesian vs. Monetarist” things where no one can say who’s right. Konczal’s fellow Keynesian Paul Krugman frequently describes Fed action/inaction in terms of changes in the base, whereas Konczal considers action in terms of changes in interest rates.  The growth rate of the base slowed sharply in late 2007 and early 2008, so using Krugman’s criterion Fed “acted” to make policy tighter right before the recession.  Under Konczal’s the Fed “acted” to make it easier.  (Of course later the base soared, so by Krugman’s criterion money became much looser.)

In my view neither the base nor the level of interest rates are good indicators of what the Fed “is doing”, and I’m pretty sure that Beckworth and Ponnuru agree. We evaluate Fed policy in terms of changes in NGDP, or expected NGDP growth. By that criterion, policy got more contractionary.  Konczal may not like this view, but it’s basically the view of Ben Bernanke before he became Fed chair, so no one can claim we are trying to come up with some whacky new way of describing the stance of monetary policy.

As for the housing “collapse”, it had almost no impact on unemployment.  Housing construction plunged by more than 50% between January 2006 and April 2008, and unemployment merely edged up from 4.7% to 5.0%, so Konczal is flat out wrong in claiming that AD plunged due to a housing collapse.  AD plunged due to a tight money policy from April 2008 to October 2009, which caused unemployment to soar from 5% to 10%.  Jobs were lost in many industries, not just housing construction.

Konczal continues:

I think a lot of people’s frustrations with the article – see Barry Ritholtz at Bloomberg here – is the authors slipping between many possible interpretations. Here’s the three that I could read them making, though these aren’t actual quotes from the piece:

(a) “The Federal Reserve could have stopped the panic in the financial markets with more easing.”

There’s nothing in the Valukas bankruptcy report on Lehman, or any of the numerous other reports that have since come out, that leads me to believe Lehman wouldn’t have failed if the short-term interest rate was lowered.

I’m no expert on Lehman, but the financial crisis as a whole would have been far milder if the Fed had kept NGDP growing at roughly 5%/year.  And the reason is simple; at that growth rate the asset markets would have been far stronger, and the crash in asset prices severely impacted the balance sheets of many banks, including Lehman.  Keep in mind that the subprime crash was not big enough to bring down the banking system.  Rather when NGDP growth expectations plunged, the prices of homes in the (non-bubble) heartland states, as well as commercial property, began falling.  This is what turned a manageable financial crisis into a major crisis.  But even with a major crisis, the Fed was quite capable of boosting NGDP sharply.  They showed this in 1933, when NGDP rose strongly despite one of the most severe banking crises in American history, which shut down 1000s of banks for many months.

(b) “The Federal Reserve could have helped the recovery by acting earlier in 2008. Unemployment would have peaked at, say, 9.5 percent, instead of 10 percent.”

That would have been good! I would have been a fan of that outcome, and I’m willing to believe it.

Talk about damning with faint praise!  If the Fed had kept NGDP growing at 5% then obviously unemployment would not have risen to 9.5%, a figure like 6% is more plausible.  So is Konczal claiming that the Fed would have been unable to boost NGDP?  Why?  And why did they succeed in 1933?  Devaluation?  Then do the modern equivalent—level targeting.

Is the argument that we’d somehow avoid the zero-lower bound? Ben Bernanke recently showed that interest rates would have had to go to about -4 percent to offset the Great Recession at the time. Hitting the zero-lower bound earlier than later is good policy, but it’s still there.

There are lots of problems here.  The Bernanke claim was that the Taylor rule implied a minus 4%, but that’s in 2009, not 2008. And that distinction really matters!  The graph Konczal shows has the Taylor Rule suggesting an interest rate in positive territory in 2008.  In any case, the Bernanke article Konczal links to is critical of the Taylor Rule, so it cannot possibly be used as evidence that Bernanke thought a negative 4% interest rate was appropriate in 2008, or even 2009.  If he had thought that, why would the Fed have set rates at positive 2% in mid-2008? Sure, there are data lags but not 600 basis points worth of them.  The fact of the matter is that the Fed didn’t cut rates more aggressively because at the time they thought it would lead to excessive inflation.  It’s pretty hard to now claim that our wonderful economic models somehow show that even far lower interest rates could not possibly have prevented deflation and deep recession in 2009.  If our models were that accurate we never would have had a Great Recession.

As an analogy, it would be like claiming that a small adjustment in steering by a bus driver could not possibly have prevented a bus from going over a cliff further on, because 100 yards further down the road even a big adjustment in steering would not have been enough.

A lot of the “expectations” stuff has a magic and tautological quality to it once it leaves the models and enters the policy discussion, but the idea that a random speech about inflation worries could have shifted the Taylor Rule 4 percent seems really off base. Why doesn’t it go haywire all the time, since people are always giving speeches?

I’m tempted to say that one needs to first understand “stuff” like rational expectations models, before dismissing them. Speeches only matter when they provide new information that causes markets to change their views as to the expected future path of monetary policy.  Very few speeches do that.

And couldn’t it be just as likely that since the Fed was so confident about inflation in mid-2008 it boosted nominal income, by giving people a higher level of inflation expectations than they’d have otherwise? Given the failure of the Evans Rule and QE3 to stabilize inflation (or even prevent it from collapsing) in 2013, I imagine transporting them back to 2008 would haven’t fundamentally changed the game.

Inflation “collapsing” in 2013?  I don’t think Mike Konczal wants to go there.

If your mental model is that the Federal Reserve delaying something three months is capable of throwing 8.7 million people out of work, you should probably want to have much more shovel-ready construction and automatic stabilizers, the second of which kicked in right away without delay, as part of your agenda. It seems odd to put all the eggs in this basket if you also believe that even the most minor of mistakes are capable of devastating the economy so greatly.

No, if these three-month errors are so consequential then you want to shift to a monetary regime where they are not so consequential, like NGDP level targeting. With that regime a three month miss would not cause asset prices to collapse.


Beckworth and Ponnuru at the New York Times

Today’s NYT has a piece written by David Beckworth and Ramesh Ponnuru.  I’m not going to excerpt it because you MUST read the entire article—it’s not that long.

It’s the single best piece on monetary economics to appear in a major publication since the Great Recession began.  One step at a time, market monetarists are attracting more and more attention.

I’m traveling today, so I won’t have much time for comments.  David has additional commentary at his blog.

Update:  I hope Robert Hetzel enjoys their column, he’s been making similar arguments from within the Fed ever since 2008.

How does monetary policy affect asset prices?

This is an issue that comes up all the time; so let me try to put things in perspective:

1.  Asset prices are procyclical, dropping sharply in slumps like 1929-33, 1937-38, 2000-02, and 2007-09.  (This entire post focuses on real asset prices.)

2.  Interest rates are also strongly procyclical.  Thus interest rates and asset prices often tend to move in the same direction.

3.  When interest rates fall for reasons other than the business cycle, asset prices tend to rise.  Thus if rates fall due to a global savings glut, it will tend to raise asset prices.  That’s the most likely explanation for the asset price boom of 2009-15.

4.  What about monetary policy?  Asset prices tend to rise when monetary policy is easier that expected.  But on closer examination it seems like real stock prices don’t “like” either easy or tight money, stocks like stable money.  Stocks do very well in low inflation booms (1920s, 1980s, 1990s, etc.) and do poorly during either deflation (early 1930s, 1938, 2009) 0r high inflation (1966-81).  Thus it would be more accurate to say that stable money is good for stocks, not easy money.  The January stock slump is accompanied by lower interest rates, but not caused by lower interest rates.  It’s caused by the thing causing lower interest rates (lower NGDP growth expectations—and hence tighter money.)

5.  David Glasner did a study that suggests stocks tend to rise strongly on easier money (bigger TIPS spreads) precisely when deficient AD is a serious problem.  That shows that asset markets “root for” sound monetary policy.   In the 1980s, asset prices rallied on tighter money (lower NGDP growth.)

Conclusion:  Monetary policymakers are probably unable to create bubbles, even if they try.  That’s because asset prices will be highest when policy is boring and appropriate.  Monetary policymakers can create asset price crashes by doing crazy stupid things, but they cannot push real asset prices higher than they would be with sound policy.  Trump might say that asset prices like situations where “America wins.”

This post is similar to a post I did over at Econlog (which is the better post, BTW.)  There I pointed out that wage growth usually slows when RGDP growth slows, but paradoxically lower wage growth causes higher RGDP growth.  And interest rates usually fall when NGDP growth slows, but paradoxically when the Fed cuts its target rate that causes NGDP growth to rise.  Now we can see that interest rates usually fall when asset prices crash, but paradoxically a Fed target rate cut usually boosts asset prices.

The failure of reporters to internalize the implications of these paradoxes explains much of the nonsense you read in the media, such as the current popular theory that Chinese devaluation is deflationary.  The real issue is, “does Chinese devaluation cause other central banks, in places like Brazil, to run more deflationary monetary policies?”  Or, “does Chinese devaluation reflect weak growth, cause stronger growth, or both?  And what is the independent effect of each of those factors?

PS.  A comment by Kevin Erdmann over at Econlog anticipated some of my thinking on this issue.


I will be traveling today, not much time for comments.