Archive for June 2016

 
 

Summers on monetary policy

Many commenters have asked me for my views on a recent WaPo article by Larry Summers.  (And by the way, doesn’t anyone proofread at WaPo? They have the wrong inflation expectations graph, showing the Michigan survey instead of TIPS spreads.)

Here’s how Summers begins:

As the Federal Reserve meets today and tomorrow, I am increasingly convinced that while they have been making reasonable tactical judgement, their current strategy is ill adapted to the realities of the moment.

Summers is known for favoring discretion over rules, but this is exactly why the Fed needs to shift to a policy rule.  In recently years I’ve made much the same argument, the problem is not the current stance of policy, it’s the entire policy regime, which has no mechanism to prevent a repeat of 2008.

Japan’s essential macroeconomic problem is no longer lack out output growth. Unemployment is low. Relative to its shrinking labor force, output growth is adequate by contemporary standards. Japan’s problem is that it seems incapable of achieving 2 percent inflation. This makes it much harder to deal with debt problems and leaves the Japanese with little spare powder if a recession comes.

I’ve been saying the same thing, for quite some time.

Any consideration of macro policy has to begin with the fact that the economy is now seven years into recovery and the next recession is on at least the far horizon. While recession certainly does not appear imminent, the annual probability of recession for an economy that is not in the early stage of recovery is at least 20 percent. The fact that underlying growth is now only 2 percent, that the rest of the world has serious problems, and that the U.S. has an unusual degree of political uncertainty all tilt toward greater pessimism. With at least some perceived possibility that a demagogue will be elected as president or that policy will lurch left, I would guess that from here the annual probability of recession is 25 percent to 30 percent.

This seems to me the only way to interpret the yield curve. Markets anticipate only about .65 percentage point of increase in short rates over the next three years. Whereas Fed officials’ projections suggest that rates will normalize at 3.3 percent, the market thinks that even five years from now they will be about 1.25 percent.

Summers agrees with us market monetarists; market predictions are more plausible than Fed predictions. Perhaps Summers learned that the wisdom of the crowd applies to interest rate forecasts, from a painful episode as Harvard President.

Despite an impressive resume that includes stints as Treasury Secretary and chief economist of the World Bank, there is a very good reason Summers shouldn’t be in charge of monetary policy: He seems to have trouble with interest rates.

During the financial crisis, Harvard lost nearly $1 billion because of some unusual and ill-judged interest rate swaps that Summers implemented in the early 2000s during his troubled tenure as the university’s president.

Back to the WaPo article:

What does this mean? First, it implies that if the Fed is serious — as it should be – about having a symmetric2 percent inflation target, then its near term target should be in excess of 2 percent. Prior to the next recession — which will presumably be deflationary — the Fed should want inflation to be above its long term target.

Just the opposite.  The Fed should aim for below 2% inflation before the next recession, and above 2% inflation during the next recession.  That’s not just a good idea, it’s the law.  (I.e. an implication of the dual mandate is that inflation should be countercyclical.) In Summers’ defense, he may argue that it’s reasonable to assume that recessions are caused by bad monetary policy, i.e. by fluctuations in NGDP.  If that is the case, then inflation will end up being procyclical.  And if inflation is procyclical, then to hit the 2% inflation target on average, you’d need inflation above 2% during booms and below 2% during recessions.  But again, why not stabilize NGDP growth instead, which would be more consistent with the Fed’s mandate to produce countercyclical inflation?

Those who think that raising rates somehow helps the economy prepare to be counter-cyclical are confused. Given lags, raising rates now would increase the chances of recession, along with the likely severity. Raising inflation and inflation expectations best prevents and alleviates recession.

Summers is right to criticize those who believe that raising rates gives the Fed less more (conventional) ammo to fight the next recession, but his explanation is inadequate. It would give the Fed less ammo even if it did not raise the risk of recession. The real problem is that raising the fed funds target right now would lower the nominal Wicksellian equilibrium rate, and it is the nominal equilibrium rate that determines how much ability the Fed has to ease policy by conventional means (interest rate cuts.)

Experience has proven that Yellen was correct to be skeptical of the idea very low inflation rates would improve productivity.  And it is plausible that the error in price indices has increased with the introduction of new categories of innovative and often free products.

This means that if a two percent inflation target reflected a proper balance when it first came into vogue decades ago, a higher target is probably appropriate today. This is another reason to allow inflation to rise above 2 percent.

I do believe that high inflation reduces productivity, but Summers is right that there is virtually no difference in productivity between 2% and 3% inflation.  It’s not even clear which one would lead to higher productivity.

Summers concludes:

Over the last 12 months nominal GDP has risen at a rate of only 3.3 percent. We hardly seem in danger of demand running away.  Today we learned that Germany has followed Japan into negative 10 year rates. We are only one recession away from joining the club. The Fed should be clear now that its priority is not preventing a small step up in inflation, which in fact should be welcomed, or returning interest rates to what would have been normal to a world gone by.

Instead the Fed should focus on assuring adequate growth in both real and nominal incomes going forward.  (emphasis added)

I agree, except for the three words highlighted.  The Fed should focus like a laser on NGDP and ignore RGDP, in the hope that stable growth in NGDP will result in more stable growth in RGDP.  A subtle distinction, but an important one.

PS.  I’m encouraging my daughter to change her last name from Sumner to Summer, when she goes away to college.

The Fed doesn’t have a new mandate

Marcus Nunes directed me to a recent Project Syndicate piece by Alexander Friedman:

“In this world, there are only two tragedies,” Oscar Wilde once wrote. “One is not getting what one wants, and the other is getting it.” As the US Federal Reserve inches closer to achieving its targets for the domestic economy, it faces growing pressure to normalize monetary policy. But the domestic economy is no longer the Fed’s sole consideration in policymaking. On the contrary, America’s monetary authority has all but explicitly recognized a new mandate: promoting global financial stability.

The US Congress created the Fed in 1913 as an independent agency removed from partisan politics, tasked with ensuring domestic price stability and maximizing domestic employment. Its role has expanded over time, and the Fed, along with many of its developed-country counterparts, has engaged in increasingly unconventional monetary policy – quantitative easing, credit easing, forward guidance, and so on – since the 2008 global financial crisis.

Now, the unconventional has become conventional. A generation of global market participants knows only a world of low (or even negative) interest rates and artificially inflated asset prices.

But the Fed’s dual mandate remains in force. And while the Fed’s recent rhetoric has been dovish, the fundamentals of the US economy – particularly those that supposedly matter most for the Fed – indicate a clear case for further rate hikes.

Consider, first, the Fed’s employment mandate. The unemployment rate is down to just 5%, job growth is strong and consistent, and jobless claims have been on a clear downward trajectory for several years.

As for the price-stability mandate, the oil-price collapse has naturally affected headline figures over the past year, but the trend in core inflation (excluding the energy component) suggests that the Fed is falling behind the curve. Core CPI is at a post-crisis high, having risen 2.3% year on year in February, and 2.2% in March.

As I get older I get steadily grouchier, and that last sentence really set me off. Sometimes I wonder if people who write that sort of thing are intentionally trying to mislead the public, who may not know that the Fed doesn’t target the CPI, indeed it doesn’t even care about the CPI.  But I’ll try to take a deep breath and assume that Mr. Friedman is just someone who is ignorant of the Fed’s actual policy goals, and was not trying to intentionally deceive.  He does work for the Bill and Melinda Gates Foundation, so he’s probably a good guy.

For the record, the Fed targets the PCE index, which has been running below 2% and is expected to continue running below 2%.

What about the main issue, has the Fed adopted a third mandate?  I suppose anything is possible, but older people like Janet Yellen and I are pretty set in our ways.  She’s a traditional Keynesian, who cares a lot about unemployment and low inflation, and I can’t imagine why she would add a third goal.  Here’s what’s really going on.  The global Wicksellian real rate has fallen very sharply, and is likely to stay low.  People like Krugman/DeLong/Summers/Kocherlakota understand this, as do market monetarists, but many people don’t.  To them it seems strange that rates are so low, despite 5% unemployment.

One of the groups that do understand the new reality is the financial markets. When they see a sign of the Fed pushing rates up prematurely, they fire a shot across the bow of the Fed, in the form of a sharp asset price break.

To the uninitiated, that might make the financial markets look sinister, as if they are trying to push the Fed to keep rates low in order to benefit the top 1%.  But in fact traders don’t coordinate their decisions (indeed that would be almost impossible). Stocks falls on signs of excessive tightness because traders genuinely feel that at the current time, even a 2% or 3% fed funds rate would cause a deep recession (which would also hurt the bottom 99%, BTW).

Miles Kimball on negative interest rates

David Beckworth did a very interesting podcast with Miles Kimball.  You probably know that Miles is an economics professor at Michigan and blogs under the name “Supply Side Liberal” (a label not far from my own views.)

Here are some good points that Miles emphasized:

1.  If the Fed had been able to do negative interest back in 2008, the average interest rate over the past 8 years would probably have been higher than what actually occurred.  Lower in 2008-09, but then higher ever since, as the economy would have recovered more quickly.  He did not mention the eurozone, but it’s a good example of a central bank that raised rates at the wrong time (in 2011) and as a result will end up with much lower rates than the US, on average, for the decade of the “teens”.  Frustrated eurozone savers should blame German hawks.

2.  He suggested that if the Fed had been able to do negative interest rates back in 2008-09, the financial crisis would have been milder, because part of the financial crisis was caused by the severe recession, which would itself have been much less severe if rates had been cut to negative 4% in 2008.

3.  Central banks should not engage in interest rate smoothing.  He did not mention this, but one of the worst examples occurred in 2008, when it took 8 months to cut rates from 2% (April 2008) to 0.25% (December 2008.)  The Fed needs to be much more aggressive in moving rates when the business cycle is impacted by a dramatic a shock.

Although I suggested negative IOR early in 2009, I was behind the curve on Miles’s broader proposal (coauthor Ruchir Agarwal), which calls for negative interest on all of the monetary base, not just bank deposits at the Fed.  To do this, Miles recommends a flexible exchange rate between currency and electronic reserves, with the reserves serving as the medium of account.  Currency would gradually depreciate when rates are negative.  Initially I was very skeptical because of the confusion caused by currency no longer being the medium of account.  I still slightly prefer my own approach, but I now am more positively inclined to Miles’s proposal and view it as better than current Fed policy.

Miles argued that the depreciation of cash against reserves would probably be mild, just a few percentage points.  Then when the recession ended and interest rates rose back above zero, cash could gradually appreciate until brought into par with bank reserves.  He suggested that the gap would be small enough that many retailers would accept cash at par value. As an analogy, retailers often accept credit cards at par, even though they lose a few percent on the credit card fees.

If cash was still accepted at par, would that mean that it did not earn negative interest, and hence you would not have evaded the zero bound?  No, because Miles proposes that the official exchange rate apply to cash transactions at banks.  This would prevent anyone from hoarding large quantities of cash as an end run around the negative interest rates on bank deposits.  So that’s a pretty ingenious idea, which I had not considered.  Still, I think my 2009 reply to Mankiw on negative IOR holds up pretty well, even if I did not go far enough (in retrospect.)

Why is negative interest still not my preferred solution?  Because I don’t think the zero bound is quite the problem that Miles assumes it is, which may reflect differing perspectives on macro.  Listening to the podcast my sense was that he looked at macro from a more conventional perspective than I do.  At the risk of slightly misstating his argument, he sees the key problem during recessions as the failure of interest rates to get low enough to generate the sort of investment needed to equilibrate the jobs market.  That’s a bit too Keynesian for me (although he regards his views as somewhat monetarist.)

In my view interest rates are an epiphenomenon.  The key problem is not a shortfall of investment, it’s a shortfall of NGDP growth relative to nominal hourly wage growth.  I call that my “musical chairs model” although the term ‘model’ may create confusion, as it’s not really a “model” in the sense used by most economists.  In my view, the key macro problem is the lack of one market, specifically the lack of a NGDP futures market that is so heavily subsidized that it provides minute by minute forecasts of future expected NGDP.  If the Fed would create this sort of futures/prediction market (which it could easily do), then the price of NGDP futures would replace interest rates as the key macro indicator and instrument of monetary policy. Recessions occur when the Fed lets NGDP futures prices fall (or shadow NGDP futures if we lack this market).  Since there is no zero bound on NGDP futures prices, we don’t need negative interest rates.  However, in place of negative rates the central bank may need to buy an awful lot of assets.  You could say there is a zero lower bound on eligible assets not yet bought by the central bank.  Which is why we need to set an NGDPLT path high enough so that the central bank doesn’t end up owning the entire economy.

To conclude, although Miles’s negative interest proposal is not my first preference, put me down as someone who regards it as better than current policy.

PS.  I was struck by how many areas we have similar views.  For instance he thought blogging was really important because what mattered in the long run was not so much the number of publications you have, but whether you’ve been able to influence the younger generation economists (grad students and junior faculty).

PSS.  I will gradually catch-up on the podcasts, and then do another post on the 2nd half of the Brookings conference on negative IOR.

Brookings conference on negative IOR (pt. 1)

I spent almost 3 hours watching the morning session of the recent Brookings conference on negative interest on reserves. Tomorrow another 3 hours, which may have more material of great interest (Kimball, Bernanke, etc.)  But today’s presentations were very good, and deserve a post.

I am indebted to JP Koning for directing me to the best part, after the 1:15 mark, where a lady from the Swiss National Bank was asked why the Japanese yen appreciated after the BOJ introduced negative IOR.  I was very glad to see her give the same answer that I’ve been giving; it didn’t appreciate, it depreciated.  She explained that you need to look at the market reaction in the hours after the announcement, not the move in the yen over the next few weeks.  When you do so, you find the yen is no different from the other currencies that adopted negative IOR—the effect is expansionary, as evidenced by the fall in the yen.  She also points out that all monetary stimulus tends to depreciate currencies, whether rates are positive or negative.  Hence the exchange rate is not some sort of special channel that is only operative at negative IOR.

The discussion of Denmark was kind of interesting.  There are actually some adjustable rate mortgages in Denmark that have recently gone negative.  Not many, because the mortgage rate is above the short term risk free rate, but a few.  In addition, the tax authorities now have to worry about people paying taxes too soon, which leads to new tax rules.  Corporate dividends have increased since negative IOR was introduced, perhaps because large institutional bank accounts offer negative rates while small retail accounts are generally set at zero.  So smaller savers earn more on their cash than big corporations.  Listening to the discussion you begin to realize that if rates stayed significantly negative for an extended period, then the public’s way of handling money would gradually evolve in unexpected ways.

The Swiss like their SF1000 bills (roughly $1000) and use them frequently.  Another Swiss expert confirmed that the currency appreciation last year had slowed inflation and reduced RGDP about as much as expected, but that the SF had now fallen to about where they wanted it—which confirms a recent post of mine.

Even the German hawk that I did not agree with gave a very impressive presentation.

HT:  Patrick Horan

The opportunity cost of helicopter drops

Tyler Cowen links to a Wolfgang Münchau post advocating helicopter drops:

I have argued in favour of a ‘helicopter drop’ , even before the recent deterioration in economic growth and the outlook.

A helicopter drop means that the ECB would print and distribute money to citizens directly. If it were to distribute, say, €3,000bn or about €10,000 per citizen over five years, that would take care of the inflation problem nicely. It would provide an immediate demand boost, and drive up investment as suppliers expanded their capacity to meet this extra demand. The policy would bypass governments and the financial sector. The financial markets would hate it. There is nothing in it for them. But who cares?

The ECB has not run out of ammunition but the number of effective policy tools is clearly finite.

I criticized this view in many different ways, so today I’ll use the “opportunity cost” argument.  First of all, the ECB never runs out of ammunition, as there is an almost infinite set of assets that they could purchase, at least in principle.  Second, while some types of asset purchases would be controversial, obviously a helicopter drop would be 10 times more controversial.

Münchau’s proposal could actually be seen as combining two distinct policies:

1.  First, buy up enough assets to hit your inflation target, no matter what it takes.

2.  Then give the assets away to the public.  This would be like if Norway were to suddenly do a helicopter drop of its Sovereign Wealth Fund onto the residents of Norway.

Since step 1 already solves the AD problem, step two must be evaluated separately, on its own merits.  Unless Münchau thinks it would be a good idea for the Norwegian government to suddenly drop all of its assets on the Norwegian public, there is no argument for helicopter drops.

Suppose the ECB were to use the “whatever it takes” approach, and buy €X trillion in assets.  Then it could move from OMOs to a helicopter drop by simply giving away these assets.  So what’s wrong with that?  One problem is that if the ECB is actually successful, then interest rates may rise above zero.  In that case to prevent hyperinflation the ECB would have to buy back much of the money that’s been injected.  But what would they use to buy back the money?  After all, they’ve given away their bonds in a helicopter drop.

Instead, Eurozone governments would have to raise distortionary taxes in order to recapitalize the ECB.  This is just another example of the basic proposition that if a fiscal action can only be justified on the grounds that it would boost AD, then it’s completely unjustified.   Obviously the Norwegian government would never do a helicopter drop of bonds on classical public finance grounds, which means they should never do a helicopter drop of bonds.

Münchau does briefly address the option of buying bonds instead of doing a helicopter drop, but in a completely unsatisfactory fashion:

My second recommendation is about measures that should not be taken — policy gimmicks. These are decisions that get some people excited but will not lift the rate of inflation. For example, the ECB should not buy bank bonds, or indeed any other form of corporate bonds, or equity. The reason banks are not lending is not a lack of funding but the presence of too many toxic assets on their balance sheets. It would be much better to address this problem directly.

This makes no sense.  If you were going to buy exotic assets then the whole point would be to raise inflation (or NGDP.) That is, you’d want to buy enough to boost inflation up to target.  So it makes no sense for Münchau to suggest the policy might fail to boost inflation.  If it were not going to be pursued aggressively enough to succeed, then what would be the point of doing it at all? And of course bank lending is completely beside the point, and has no relevance for whether OMOs would boost inflation.  OMOs are inflationary because they boost the money supply relative to demand, and that sort of OMO would be inflationary even in an economy where banks did not exist at all.

The opportunity cost of doing a helicopter drop is that you forego a much cheaper option, merely relying on a “whatever it takes” set of OMOs, which do not require distortionary taxes to recapitalize the central bank.

Here’s one of those rare cases where the common sense of the man on the street is correct.  Dropping money from helicopters really is too good to be true.

PS.  The anti-helicopter drop message of this post should not discourage fans of eurozone reflation.  A helicopter drop would be very politically contentious.  In contrast, much more effective tools such as OMOs are less controversial, and also superior policy options.  It’s a win-win.  I very much doubt the ECB would even need to buy exotic assets like stocks and corporate bonds; God knows the eurozone has plenty of public debt to buy.

PS.  I have a related post over at Econlog.