James Bullard is perhaps the most data-driven member of the Fed, and thus one of my favorite FOMC members.  His only agenda is getting policy right; he’s perfectly willing to shift his views as new data comes in. However in the past I’ve occasionally been critical of his attempts to second-guess the markets.  This is from a post from 3 years back (beginning with a CNBC article):

But the St. Louis Fed president said in Friday’s “Squawk Box” interview, “I think policy is much easier than it was last year because the outright purchases are more potent tool than the ‘Twist’ program was …

Yes, but only because Twist was very weak.

. . . I don’t think markets have fully absorbed that switch.”

That’s not Bullard’s job.  He hasn’t been hired to outguess the markets.  If he wants to do that he should go run a hedge fund.  His job is to be led around by the markets like a stupid ox with a steel nose ring being dragged along by a farmer.

For the year, Bullard predicted gross domestic product (GDP) growth at 3.0 percent.

It’s not going to happen.  Ironically one of the reasons it’s not going to happen is because James Bullard thinks it is going to happen.

For the 100th time: No subsidized NGDP futures market = criminal negligence.

Yikes, that sounds too negative today, I certainly didn’t mean to suggest Bullard is a stupid ox; I just want him to behave like one.  No, that doesn’t sound right either.  Anyway, TravisV sent me to an article that makes me more hopeful about future Fed policy:

One of the U.S. Federal Reserve’s most prominent advocates of higher interest rates on Wednesday declared it “unwise” to move any further in light of weak inflation and global volatility, suggesting the Fed is stepping further away from plans to continue to hike rates.

St. Louis Fed President James Bullard argued steadily last year for the U.S. central bank to tighten policy and sounded alarms over the risk that continued low rates would create dangerous asset bubbles.

But on Wednesday he said the steady drop in U.S. inflation expectations is now his chief worry and said he will not be comfortable with further hikes until the trend reverses. . . .

Bullard is a voting member of the Fed’s rate-setting committee this year. . . .

“I regard it as unwise to continue a normalization strategy in an environment of declining market-based inflation expectations,” Bullard said. One other “pillar” of the Fed’s decision to hike rates in December has also weakened, he said, because falling equity prices and other tightened financial conditions have made the risk of asset bubbles “less of a concern.”

The Fed, he said, now has “more leeway” to take its time with rate hikes. Bullard said he in particular won’t be ready to move again until inflation-linked bonds signal that investors expect prices to rise at the Fed’s target 2 percent rate.

In a presentation to a group of financial analysts here, Bullard noted that the expected rate of inflation built into some bond prices has fallen as much as 50 percent since mid-2014. Bullard said he at first dismissed the slide as likely linked to the falling price of oil, but now views it as more endemic.

To hike rates in that situation, he said, would put the central bank’s credibility at risk because the Fed remains far from reaching its 2 percent inflation target, considered an important sign, alongside low unemployment, of the U.S. economy’s health.

“Central banks need to defend their credibility. That is why this is worrisome,” Bullard said. [Emphasis added]

The Fed taking its marching orders from the markets?  Does that remind you of a small heterodox school of thought?

India pushes into Asia one inch at a time.  But eventually you see that these incremental shifts have created the world’s highest mountains.  The role of expectations seeps into macro a little bit at a time.  How long before we wake up into a market monetarist world?

PS. I can’t believe I thought I could win friends and influence people with that sort of post back in 2013.  Replace “stupid ox” with “a man so wise that he understands that nothing exceeds the wisdom of crowds.”

Update:  TravisV pointed to this comment, from Bullard’s Powerpoint presentation:

Modern theory suggests that inflation expectations are a more important determinant of actual inflation than traditional “Phillips curve” effects.

Great stuff.

Here’s me, back about 13 months ago:

I’d also love to know what Keynesians think of the Dems having a socialist as their lead member on the Senate Budget Committee, who then appoints a MMTer to be chief economist.  And Krugman says the GOP relies on voodoo economics!

Of course my liberals readers have been outraged at my Sanders bashing. But now we have this:

Paul Krugman is now accusing Bernie Sanders of “deep voodoo” economics.

So Europeans work far fewer hours each year than Americans, because of their high-tax welfare state.  As a result per capita GDP in Europe is far lower than in America.  But somehow if we adopt their economic system our per capita GDP, already far higher than almost any other developed country, will start zooming ahead at 5.3%/year.  And I thought Trump was a clown.

Kudos to Krugman, for pointing this out.

(Just to be clear, I still greatly prefer Sanders to Trump—that’s how much I loath Trump.)

Update:  This good article on Sanders and Denmark quotes Lars Christensen.

Tyler Cowen linked to a post by Frances Coppola:

But one thing seems clear. How negative rates would work in practice is no clearer than how QE works in practice. They are experimental, and their effects are complex. Hydraulic monetarist arguments (“if you can get rates low enough the economy will rebound”) are simplistic.

Monetarist?  Don’t they focus on the money supply and/or NGDP expectations?  Most people would consider Milton Friedman a monetarist, and here’s what he had to say about low rates:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.   .   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

In a monetarist model, lower market interest rates are contractionary for any given monetary base, because they reduce velocity.  It’s the Keynesians who are likely to claim that lower rates are expansionary.  Now of course Friedman was talking about market interest rates, not IOR. Lower IOR is theoretically expansionary, and so far markets have reacted to negative IOR announcements as if they are expansionary.

Will that be true in the future?  Nothing is certain, as monetary policy is very complex, and concrete action A can always be interpreted as a signal of future concrete action B.  Anything is possible.  A $1 billion increase in the base can have a contractionary impact if a $2 billion increase was expected.  But any monetary analysis should start from the presumption that reducing the demand for an asset will reduce its value.  A reduction in the value of base money is expansionary.  That means lower IOR has a direct expansionary impact on NGDP.  (Secondary effects are complex, as Coppola suggests.)

Indeed, individual banks can avoid paying negative rates on excess reserves. They can discourage customers from making deposits; they can choose to hold reserves in the form of physical cash; or they can increase new lending (not refinancing), since the balance sheet result of new lending is replacement of reserves with loan assets.*

But of course the reserves do not disappear from the system. They simply move to another bank, which then incurs the tax. The banking system AS A WHOLE cannot avoid negative rates on reserves. The reserves are in the system, so someone has to pay the negative rate. If banks increase lending to avoid the negative rate, the velocity of reserves increases. It’s rather like a game of pass-the-parcel.

This is a common misconception, which I see all the time.  If individual banks don’t want to hold a lot of excess reserves, they can simply buy other assets with them.  If the banking system as a whole wants to reduce its holding of excess reserves, it can reduce the attractiveness of deposits until the excess reserves flow out into currency held by the public.  The central bank controls the monetary base, not bank reserves. The composition of the base is determined by banks and the public.

It seems reasonable to suppose that negative interest rates might increase loan demand. Negative interest rates on reserves put downwards pressure on benchmark rates and thus on bank lending rates, attracting those who would otherwise be priced out of borrowing. But typically those are riskier borrowers. We have just spent eight years forcing banks to reduce their balance sheet risk. Do we really want to force banks to lend to riskier borrowers? Of course, tight underwriting standards could be used to deny those people or businesses loans: but doesn’t that rather defeat the purpose of negative rates? It’s something of a double bind.

We need an easier money policy and, if banks are taking excessive risks, a tighter credit policy.  It’s best not to mix up monetary and credit issues.  Negative IOR is about reducing the demand for base money, which is inflationary; it’s not about increasing bank loans.  Central banks should not be trying to encourage more debt creation—unless you want to end up like China (where the policies are unfortunately linked together.)

In the end I agree with those who are skeptical of negative interest rates.  These ultra-low interest rates are a sign that monetary policy is too contractionary. The developed world needs much higher interest rates, but only if we get there with an expansionary monetary policy.  In December the Fed tried a short cut, raising rates without boosting NGDP growth. This is putting the cart before the horse.  You need to generate higher NGDP growth expectations first, and then you can achieve a permanently higher level of interest rates.

In a recent post I discussed 4 possible interpretations of Tyler Cowen’s post on risk-based recessions:

Perhaps the claim is that we might have a recession this year due to risk, despite 3% plus NGDP growth.  If so, I very strongly disagree.  (This could be viewed as a version of real business cycle theory.)

Perhaps the claim is that if there is a recession, then NGDP growth will slow, but that this will not be the cause.  In other words, even in a counterfactual world where the Fed kept NGDP growing at 3% plus, there would still be a recession for non-monetary reasons.  If so, I very strongly disagree.  (Again, an RBC-type claim.)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk and there is nothing that monetary policymakers can do about it.  If so, I strongly disagree.  (A traditional Keynesian claim)

Perhaps the claim is that falling NGDP growth is a necessary condition for a recession this year, but it will be caused by growing risk that monetary policymakers are too cautious to do anything about.  If so, I mildly disagree.  (A New Keynesian claim.)

Tyler has a new post that discusses some of these issues.  He does not refer to this list, but as far as I can tell he has a fairly eclectic view of business cycles, and thus probably doesn’t want to get pinned down to any single hypothesis.  I’ll go further and speculate that he believes both the RBC and the Keynesian explanations may each apply in some cases.  That is, sometimes recessions are caused by real shocks, and could not be prevented even if the Fed were able to stabilize NGDP growth.  And sometimes there are shocks that it is more useful to think of as “non-monetary” even though they work at least partly through the channel of causing NGDP changes that destabilize the economy.  Perhaps because of some problem such as policy lags or the zero bound, the central bank may not be able to prevent those NGDP shocks, and if they are ultimately caused by some other factor, such as financial distress, then it makes more sense to see the recession as being caused by the financial distress, not the “tight money” label that MMs pin on falling NGDP.

I’m not certain I’ve interpreted his views exactly right, but I’ve tried to state them in a way that I think is quite defensible.

The post also has an extensive critique of areas where market monetarism may overreach, i.e. make claims that are unsupported by evidence, if not borderline tautological.  As I read though this criticism I kept coming back to an observation that seems central to me, but perhaps not to Tyler.  I see his strongest criticism as boiling down to something like “Market monetarism is flawed because we lack a real time indicator of NGDP expectations.”  (My words not his.)  That is we lack a NGDP futures market.  And that is indeed a big flaw.

Right now lots of smart market analysts, like Jan Hatzius, suggest that financial conditions have recently tightened enough to slow growth by 1% to 1.5%.  But it would be better if we had a NGDP futures market.  Indeed even last year at this time we had the Hypermind prediction market, which although flawed, was good enough to give ballpark NGDP estimates.  It showed that no recession was expected in 2015. But now we lack even that.

This is important because MM theory says NGDP expectations are the proper measure of the stance of monetary policy. Lacking that market, we sometimes fall back on actual NGDP.  And Tyler points out that if the central bank targets inflation, then NGDP and RGDP shocks would be perfectly correlated, even if there were no causal link.

So far I’ve been trying to describe his argument in as positive a way as possible.  Now I will start disagreeing:

Here is a recent Scott Sumner post, mostly about me.  It’s basically taking the other side of what I have been arguing, and I would suggest simply disaggregating the ngdp terminology into a more causal language of nominal and real shocks.  Surely there are other independent, ex ante signs for judging the tightness of monetary policy, rather than waiting for ngdp figures to come in, which again is citing a transform of the real gdp growth rate as a way of explaining real gdp.

I find these issues come up many, many times in market monetarist writings.  I think they have basically the right policy prescription, and could provide the world with billions or maybe even trillions of dollars of value, if only policymakers would listen.  But I also think they are foisting a language of causality on the business cycle problem which the rest of economic discourse does not easily absorb, and which smushes together real and nominal shocks into a lower-information accounting variable, namely ngdp, and then elevating that variable into a not entirely deserved causal role.  We ought to talk in terms of ex ante, independent measures of monetary policy looseness, not ex post measures which closely resemble indirect transforms of real gdp itself.

My focus when estimating the stance of monetary policy has generally been NGDP forecasts, not actual NGDP. And NGDP forecasts are available in real time, and hence not subject to the “waiting for ngdp figures to come in” critique above.  This point can be made much more effectively by focusing on the past two months.  Tyler says money is not that tight:

I say [monetary policy is] “not that tight,” while leaving room open for the possibility that it should be looser.

What metrics might we look at?  Federal funds futures no longer expect imminent further rate hikes from the Fed.  Expected rates of price inflation have been very close to two percent.  No matter what you think about the structural component of labor supply, cyclical unemployment has recovered a great deal over the last few years.  And that is through the period of “taper talk” of almost two years ago.  Consumer spending is doing OK, not spectacular but not cut off at the knees.  And while in very recent times price expectations are headed downwards away from two percent, this seems to stem from negative real shocks, to which the Fed has responded passively (perhaps unwisely).  That’s different than the Fed tightening.  There was a quarter point rate hike from December, which is a small tightening for sure, but I don’t see much more than that.

Here’s where I strongly dissent from the thrust of Tyler’s argument.

1. The fact that markets now expect zero Fed funds rate increases this year, not the two expected (or 4 promised) in December, is not a sign that money is getting looser, it’s more likely a sign it’s getting tighter.  While on any given day a rate increase is tighter than not increasing rates, over a 12-month period policy is highly endogenous.  If a crystal ball told me rates would be at zero for another 20 years, I’d take that as evidence that money is currently way too tight.

2. Tyler’s claim that expected inflation is 2% is linked to an earlier post, which discusses not market forecasts, but the forecasts of economists.  Two months ago the consensus of economists called for about 1.8% to 1.9% PCE inflation over the next few years.  But even then, 5 year TIPS spreads showed about 1.2% to 1.3% CPI inflation, which is about 1.0% PCE inflation.  And as the following graph shows, market inflation forecasts have fallen much further in the past two months, so even if policy was roughly on target in December 2015, it’s too tight now.

3. A quarter point rate increase in December may or may not be a “small tightening”.  The size of the rate increase is not a reliable gauge of the degree of tightening, because monetary policy affects rates in two partially offsetting ways (the liquidity effect vs. the income/Fisher effects).  Important recessions (US 1937, Japan 2001, eurozone 2011) have been caused by very small rate increases.

4. The recovery in the labor market doesn’t tell us much about the risk of recession, other than that we aren’t in one yet.

5.  Any “real shock” that reduces NGDP expectations because the Fed responded passively is also a monetary shock.  It could be both monetary and real.  If frightened Venezuelans started hoarding US currency and the Fed didn’t print any more currency, and NGDP fell, I’d call that a tight money policy even if it was “passive.”  In any case “passive” is a meaningless concept in monetary policy, as change can occur along many dimensions; fed funds target, reserve requirement, the monetary base, IOR, exchange rates, price of gold, TIPS spreads, etc., etc.  At any give moment, policy will be active along some dimensions and passive along others.

My views on current business conditions are pretty similar to those of Tyler, AFAIK.  I think we both see a modest risk of recession this year, but less than 50-50.  So suppose there is a recession this year—can I say, “I told you so”?  I certainly didn’t think the rate increase in December would lead to recession (although some other MMs were more pessimistic.)  But that misses the point.  Sorry to be so long winded, but wake up here, this is the key point.

The Fed needs to always keep the “shadow NGDP futures price” close to target.  If at any time they let it slip, as they did in September 2008, and if MMs point out that it is slipping, and if the Fed does not take aggressive actions that it clearly could take to prevent if from slipping, then yes, it’s the Fed’s fault.

That italicized statement does not involve any Monday morning quarterbacking.  I’m not going to blame them for anything that they cannot prevent in real time.  But recall that currently they are not even at the zero bound.  Let’s explain this with a simpler example.  We do have TIPS spreads, so we don’t need shadow prices for inflation expectations.  MMs claim that even with the liquidity bias in TIPS spreads, the current ultra-low 5-year spread suggests money is too tight for the Fed’s 2% inflation target.  That doesn’t mean we’ll have a recession, but if the Fed wants to hit their 2% inflation target they need to ease policy.  If they don’t, and if they fall short of their inflation target, then MMs will have been right.

Now I think it’s possible that the Fed will luck out here, and perhaps even hit their inflation target.  But on balance I believe markets are right more often than not, and the Fed will once again fall short.

Note that if we had a good NGDP futures market I could have reduced the length of this post by 80%.  It would be easy to address Tyler’s various points by referring to NGDP futures prices.  Either they predict recession or they don’t.  Either they are controllable at the zero bound or they are not.  They would be real time indicators, with no Monday morning quarterbacking involved.  But we don’t have that market, so the best we can do is estimate a shadow price of NGDP futures by looking at TIPS spreads, bond yields, stock indices, commodity prices, and a zillion other factors, and construct the best estimate we can of the current market NGDP forecast.  That’s the key variable for me, not actual NGDP.

Actual NGDP comes in to play when we consider level targeting.  MMs believe not just that level targeting would make recessions shorter, we also think it would make them less likely in the first place.  So the one area where we are justified in criticizing the Fed based on actual NGDP numbers is the level targeting issue; are they trying to get us back to the trend line?  If they don’t level target, then recessions are more likely to occur, and will be deeper.

PS.  I’m not sure what Tyler means by saying NGDP is a transform of RGDP.  Does this mean NGDP * (1/p) = RGDP?  If so, isn’t that true of any variable?

M * (V/P) = RGDP

In general,

X * (RGDP/X) = RGDP, where X is the price of a can of tomato paste.

Nor do I understand the “tautology” remark attributed to Angus.  Obviously it’s not a tautology for Zimbabwe. The only way I can make sense of this complaint is that the Fed actually does target inflation, so it makes sense to assume P is stable, whereas it doesn’t make sense to assume V/P or (RGDP/X) is stable.  And if we assume P is stable then NGDP and RGDP become highly correlated.  Fair enough.  But as Nick Rowe recently point out, what matters is the counterfactual where NGDP is kept stable.  Which brings us back to the list at the top of this post.  I think MM critics need to think long and hard about exactly which of those four critiques is the most important, and what sort of empirical evidence we’d use to evaluate that critique.

PPS.  I also have a new post over at Econlog.

PPPS.  I will be doing a “Reddit” on the 23rd at 1 pm, whatever the heck that is.  “Ask me anything.”

Vaidas Urba sent me a very nice speech by Mario Draghi.  Here he points out that monetary policy remains effective at the zero bound:

“Some argue that today the situation is different; that whereas Volcker could raise rates to 20% to tame inflation, central banks fighting disinflation are inhibited by the lower bound on interest rates. The Japanese experience after the bursting of the housing bubble in early 1990s is often presented as evidence.

But the Japanese case in fact only reinforces the importance of full commitment from policymakers. As long as the commitment of the Bank of Japan to a low positive inflation number was not clear, actual inflation and inflation expectations stayed in deflationary zone. Since the Bank of Japan has signaled its commitment to reach 2% inflation, however, core inflation has risen from less than -0.5% in 2012 to close to 1% today. This is still short of the 2% objective, to be sure, but downward price shocks are also hitting Japan like all other advanced economies.”

And here he discusses the mistakes made by “some central banks”:

In fact, when central banks have pursued the alternative course – i.e. an unduly tight monetary policy in a nascent recovery – the track record has not been encouraging. Famously, the Fed began raising reserve requirements in 1936-37, partially due to fear of a renewed stock bubble, but had to reverse course the next year as the economy fell back into recession. That has also been the experience of some central banks in recent years: raising rates to offset financial stability risks has undermined the primary mandate, and ultimately required rates to stay lower for longer.

It’s gratifying to read Draghi’s speech because it contains lots of talking points emphasized by market monetarists (and also by more enlightened Keynesians.) Notice how he realizes that raising rates actually causes them to be lower in the long run, something Milton Friedman recognized back in 1997.  Of course the ECB in 2011 was one of the central banks that tightened prematurely, and triggered a double dip recession.  Will the Fed’s 2015 tightening be added to the list?  It was certainly a mistake, but it’s too soon to suggest the next move will be down.  (The market predicts flat.)

Unfortunately, the outlook for the eurozone is increasingly bleak.  Wolfgang Münchau has a very good post:

Four signs another eurozone financial crisis is looming

The rout in European financial markets last week was a wat­ershed event. What we witnessed was not necessarily the beginnings of a bear market in equities or an uncertain harbinger of a future recession. What we saw — at least here in Europe — is the return of the financial crisis.

Version 2.0 of the eurozone crisis may look less frightening than the original in some respects but it is worse in others. The bond yields are not quite as high as they were then. The eurozone now has a rescue umbrella in place. The banks have lower levels of leverage.

But the banking system has not been cleaned up, there are plenty of zombie lenders around and in contrast to 2010 we are in a deflationary environment. The European Central Bank has missed its inflation target for four years and is very likely to miss it for years to come.

The markets are sending us four specific messages. The first and most imp­ortant is the return of the toxic twins: the interaction between banks and their sovereigns. Last week’s crash in bank share prices coincided with an increase in bond yields in the eurozone’s periphery. The pattern is similar to what happened during 2010-12. The sovereign bond yields have not quite reached the same dizzy heights, though Portugal’s 10-year yields are almost 4 per cent.

You might wonder why the eurozone debt situation is worsening even as the labor market gradually improves.  Perhaps the problem is that debt contracts are often quite long, whereas wage contracts tend to be much shorter.  Thus wage growth is now adjusting to slower NGDP growth, but long-term debt contracts have not fully adjusted.

The FT also has a piece that criticizes QE:

For years, central bankers have been reluctant to suggest that unconventional monetary policies even had costs. But while developed markets plunge ever deeper into uncharted financial territory as a result of central bank actions, the drawbacks and the limitations of such policies are finally becoming apparent.

The negative effects will become even more obvious over time. This will occur as asset price inflation — the main consequence of central bank policies — goes into reverse, robbing financial engineering of its efficacy and flattening the yield curve.

Suddenly, the success of central bankers in lifting financial asset prices through unconventional monetary policies seems to be coming to an end.

In other words, don’t do beneficial policies that help the economy and also raise asset prices as a side effect, because if at some point in the future you foolishly stop doing beneficial policies and NGDP growth plunges then asset prices may fall. Or something like that.

And this:

The Bank of Japan’s use of negative rates, dovish coos from New York Fed Chairman William Dudley, and carefully worded statements from Mr Bernanke’s successor, Janet Yellen, last week spooked markets rather than soothed them.

I suppose if you ignore the fact that the Japanese negative rate announcement triggered a big rise in global equity markets then this article might make some sense.  But I prefer not to ignore reality.

It’s hard not to see the current global situation in Manichaean terms.  On one side you have people like Draghi and Kuroda, desperately trying to nudge their institutions towards higher inflation.  On the other you have people who see up as down and left as right, and who offer no constructive suggestions as to how central banks can hit their targets.  In the middle is the Fed, just twiddling its thumbs.

PS. Discussion of market monetarism is now appearing in academic journals.  Here’s a new paper by Ryan Murphy and Jiawen Chen.  (Ungated preliminary version here.)

I also recommend the new post by Marcus Nunes, which discusses a post by Gavyn Davies in the FT.