Archive for the Category Monetary Policy

 
 

Two big mysteries

Nick Rowe has a post discussing 30 year bond yields in Canada.  He begins by quoting from an official at the Bank of Canada:

All told, we think that the neutral rate of interest is lower than it was in the years leading up to the crisis because of these structural developments. We estimate that the real neutral policy rate is currently in the range of 1 to 2 per cent. This translates into a nominal neutral policy rate of 3 to 4 per cent, down from a range of 4 1/2 to 5 1/2 per cent in the period prior to the crisis.

Then Nick comments:

But what puzzles me is this: the 30-year bond is currently yielding 2.74%. That’s below Carolyn’s 3% to 4%. And Carolyn is talking about the Bank of Canada’s target for the overnight rate (the “policy rate”), and that’s normally below the 30-year bond yield.

I checked the 30-year rate in Germany and the US:

US 30-year bond yield = 3.21%

German 30-year bond yield = 1.91%

So it’s a sort of global mystery.  Why are long-term interest rates so low?

But it’s not the only big global mystery.  There’s also the absurdly slow “recovery” from the 2008-09 recession.  This is the only recovery I ever recall seeing where the growth rate of real GDP in the US was below the trend growth rate.  And nominal GDP growth has also been very low. Indeed both growth rates might well be the lowest in American history for a recovery period.

And it’s not just the US.  Some countries like Canada may have done a bit better, but lots of countries in Europe are seeing even slower recoveries in both NGDP and RGDP.

I am always suspicious of coincidences.  I suppose you could dream up an explanation for the low bond yields.  Maybe all that QE has depressed long term bond yields.  Maybe I am wrong that money has been really tight; maybe it’s really easy, and that explains the low bond yields.

But there’s one problem with that explanation–it makes the other mystery even more mysterious. How likely is it that money has been so easy that it has produced almost unbelievably low bond yields, and yet NGDP is growing at the slowest rates ever seen in a recovery?  Easy money is supposed to lead to fast NGDP growth.  I don’t like “answers” that solve one mystery at the expense of making another mystery even more mysterious.  [There's no law of the conservation of net mysteriousness.]  I like “answers” that solve both mysteries at the same time, using standard off-the-shelf economic theory.

The Great Stagnation!

It explains the low bond yields, and it explains the slow economic growth despite rapidly falling unemployment rates.  But what explains the differences in bond yields between countries?  Here I’d like some help, but I’ll throw out a couple tentative hypotheses.  Although both the US and Canada have 2% inflation targets, I recall reading that the US is more aggressive in the “hedonics” of price adjustments.  Indeed one Fed official said their 2% PCE target is actually more like a 2.4% CPI inflation target.  Is that right?  If so, might that explain why Canada has lower bond yields?  If both countries have 2% inflation targets, but Canada measures inflation more conservatively, then Canada would end up with lower NGDP growth, other things equal.

In the case of Germany, it might be related to the fact that the ECB is targeting inflation at slightly below 2%, an asymmetric target.  In addition, inflation has recently fallen to only 0.3%, and the ECB’s response — how can I put this politely — hasn’t exactly inspired confidence.

So perhaps the entire developed world is entering the sort of growth stagnation that hit Japan 20 years ago, producing low real interest rates everywhere.  Then the differences in bond yields reflect differences in the techniques used to measure inflation, differences in inflation targets (especially the ECB), and differences in how confident investors are that the central bank will actually hit its target (the ECB and Japan.)

I’m glad to see the BOC re-evaluate their interest rate assumptions, but the markets suggest they are still behind the curve.  Of course the Fed has consistently overestimated the Wicksellian equilibrium interest rate, and hence over-estimated RGDP growth, ever since 2007.  And the ECB? There aren’t any words to express my contempt for that organization.

We’re 15 years into the 21st century.  How much longer will it take the world’s central bankers to realize that we aren’t in Kansas anymore?  None of the 20th century rules of thumb have any value in today’s world.

Abenomics is doing better than I expected (shades of grey)

Here’s commenter dtoh:

I think you’re disheartened a little bit by the results of monetary policy which has been less effective in Japan than you had hoped and therefore you are trying to blame it on socio-economic and supply side factors. Yes…. these are problems, but the primary reason monetary policy has not been effective is the hike in the consumption (and other) tax rates.

Stop worrying, it will take a little longer, but Japan will prove you are a clairvoyant genius.

This is half wrong.  Certainly less effective than I had hoped, but more effective than I expected. In my early posts on Abenomics I suggested that it was likely to have a positive effect, but that Japan would fall short of the 2% inflation goal.  I expected about 1% inflation, still a significant improvement.  Japan has exceeded 1% inflation, even if you discount the effects of the sales tax. The yen has also depreciated much more than I (and the markets) expected.  Japanese stocks have risen much more than I (and the markets) expected.  Indeed by almost every metric they’ve done better than I expected.

So why does dtoh (a careful reader) have the opposite impression?  Because I am also very pessimistic about Japan, due to its big public debt and rapidly falling working age population.  I supported the sales tax increase, but even as I did so I predicted it would hurt the economy, and it has.  And regarding monetary stimulus, it’s technically possible for a policy to improve an economy that is doing very poorly, while still leaving it doing fairly poorly.  That’s Japan.

Read this and this for my earlier pessimism about Japan.

For the same reason, people often wrongly believe I’m a fan of the Chinese government, or its economic policy.  It’s a bad policy–perhaps as bad as Greece. But if China ever became as rich as Greece it would be the single most successful economic policy in all of world history.  And China probably will become as rich as Greece, as moving from a nightmarish policy under Mao to a merely bad policy under Deng and Xi has released the entrepreneurial energies of the Chinese population.

Real world economics is never black and white; it’s always about shades of grey. I’ve frequently pointed out that Abenomics was doing all sorts of things that the liquidity trap Keynesians said was impossible.  It boosted stock prices, it depreciated the yen, and it boosted nominal and real GDP.  That made me seem like an optimist. But I also said it would fall short of the announced goals, and I now feel that more strongly than ever.  Contrary to dtoh, if Japan does well I will be forced to admit I was wrong, as I did not expect Japan to do well.

I’ve also been saying that while QE and forward guidance helped, the Fed has consistently been too optimistic about US growth.  We are in a Great Stagnation. Just yesterday I noticed that Fed officials are hard at work explaining why their latest 3% growth forecast will fail to materialize, just like the previous 5 years.

A sharply stronger dollar could hamper Federal Reserve efforts to spur growth and lift inflation, a senior Fed official said today, in unusually direct remarks about the U.S. currency from the central bank.

By the way, Nick Rowe recently had this to say about central bankers:

But I do have a lot more confidence in the BoC than in the BoJ, ECB, or the Fed. Yes. The people who run the BoC are better macroeconomists, they speak with one voice, and they have the support of the government in doing what they are doing. You do not hear them say totally stupid things, like you do with people making decisions at other central banks.

Yesterday I noticed a perfect example of what Nick was thinking about:

Japan is in danger of falling into a recession as the yen’s decline reduces the purchasing power of households and squeezes corporate profits, said a former deputy governor of the Bank of Japan.

“The current yen weakness is slightly excessive,” Kazumasa Iwata, the deputy from 2003-2008, said in an interview on Sept. 19 in Tokyo. “Abenomics entails the risk of ‘beggar thyself’ consequences and signs are already emerging.”

Hmmm . . . .

Totally off topic, fans of drug legalization will love this youtube.

Yglesias on Obama’s missed opportunity

Here’s a great post by Matt Yglesias:

But as the country waits to hear the latest announcement from the Fed about how rapidly it will end its Quantitative Easing programs, we are witnessing the biggest mistake of Obama’s presidency: the systematic neglect of the Federal Reserve and of his ability to influence its course of action.

.  . .

The FOMC that makes these decisions is mostly composed of presidential appointees — the seven members of the Federal Reserve Board of Governors. But Obama has failed to make a point of tapping proponents of monetary stimulus for these positions. Even worse, he’s left two of the slots entirely vacant — not vacant because of GOP obstruction, but vacant because he hasn’t nominated anyone to fill them.

Obama’s neglect of Federal Reserve appointments is, in some ways, mysterious. Nobody denies that the Fed is an extremely important institution — albeit one that operates independently from the elected branches of government. When it comes to other important independent institutions such as the federal judiciary, it’s broadly acknowledged that the presidential appointment powers are among his most important powers of office. Precisely because judges operated independently of presidential oversight, picking the right ones is vital.

The Fed is similar. Except that because the Fed has an important influence on short-term economic growth and short-term economic growth has an important influence on the president’s popularity, it’s even more important.

Except Obama doesn’t seem to see it that way. Earlier in his administration he reportedly told Council of Economic Advisors Chair Christina Romer that “monetary policy has shot its wad.” This remark was dissected for alleged sexism, but is more worth paying attention to as a reflection of monetary policy views.

The viewpoint that there is nothing the Federal Reserve can do to boost the economy when short-term interest rates are already at zero, leaving deficit spending as the only effective stimulus option, is not believed by most experts. This particular combination of views is most closely associated with a somewhat marginal group of left-wing thinkers who describe themselves as modern monetary theorists. Except it’s also something that key Obama advisor Larry Summers believes, and the fact that Obama tried to install Summers as Fed Chair indicates that Obama believes it too.

This belief in monetary impotence likely explains why Obama is so lackadaisical about filling vacancies. He believes the Fed’s role in fighting a potential crisis is crucial, but the current team helmed by Yellen and Deputy Chair Stanley Fisher is up to that job. Bolstering the left flank on the FOMC so that Yellen’s consensus-building efforts would land in a more stimulative spot isn’t on the agenda.

The current vacancies are not a new phenomenon. By April of 2010 when Obama had been in office for well over a year there were three vacancies on the Fed. One of his earlier nominees was a Republican and another — Jeremy Stein — is a Democrat who holds to an eccentric view that tight money is sometimes appropriate even when unemployment is high. That’s the same opinion that led to economic stagnation in Sweden, and electoral defeat for its incumbent government.

How much good could have been done if Obama had listened to Romer, Scott SumnerJoseph Gagnon, or others and placed a higher priority on appointing unemployment-fighters to the Fed? Nobody can say for sure. But the experience of the United Kingdom is illustrative. The UK government has enacted much sharper levels of fiscal austerity than anything done in the US, perhaps partly as a result the UK’s overall economic performance has been dismal. And yet largely thanks to more stimulative monetary policy, the UK has done as well or better than the United States in terms of job creation. If we had paired that kind of monetary policy with our superior fiscal policy and better luck at fossil fuel extraction, we could potentially have enjoyed significantly faster employment growth.

I don’t entirely agree with the last paragraph, but otherwise Yglesias is exactly right.

Some commenters tell me “we Keynesians agree the Fed should do more stimulus, the problem is the right wing.”  That’s half right.  The right wing is a problem, but so are the Keynesians. Keynesians overwhelming oppose additional monetary stimulus, according to polls.  I base that on the fact that only about 5% of economists favor more stimulus, and most economists are Keynesians.  Furthermore, some of the economists who do favor additional stimulus are non-Keynesians.

Update:  TravisV pointed me to an excellent Yglesias follow-up post.

I haven’t had much time to post recently, as I am quite busy now.  But a few other posts worth reading:

1.  Saturos sent me to this post by Greg Mankiw.

2.  File this under “strange but true.”  Noah Smith makes a case for civility.  (Sorry if I sound snarky.)

3.  An excellent post on politics by Ezra Klein.  He points out that most voters agree with the GOP that government is too big.  And most voters agree with the Dems that we should spend more on actual, specific real world programs.  Thus most voters agree with both parties, even where they have diametrically opposed views.

4.  Matt Yglesias says it’s easy to decide who to vote for.  Easy for him!  But what if your views are split roughly 50-50 between the parties?  And what if the parties often govern in ways that is dramatically different from what they promise?  (Bush pushed big government, Obama ignored civil rights in the War on Terror.)  And how do you know which issues will even be addressed? Will Congress act on the War on Drugs?  Will they change monetary policy?  It’s actually really hard to know who to vote for, if you are me.

5.  Thus I won’t tell the Scots (Scottish?  Scotch?) which way to vote.  Just that if they do become independent, they should adopt a Scottish pound, and peg it to the English pound in a one for one currency board system.  Oh wait, they already have a Scottish pound note, and it’s already accepted throughout the UK.  OK, just keeping do that.

Screen Shot 2014-09-18 at 10.36.52 AM

Williamson on monetary policy and interest rates

In the past, Stephen Williamson has attracted some fierce criticism for his views on the relationship between money and interest rates, specifically some posts that seemed to deny the importance of the “liquidity effect.”  Nick Rowe and others criticized Williamson for seeming to suggest that a Fed policy of lowering interest rates would actually lower the rate of inflation–via the Fisher effect. Williamson has a new post that seems to have somewhat more conventional views of the liquidity effect, but still emphasizes the longer term importance of the Fisher effect:

If the central bank experiments with random open market operations, it will observe the nominal interest rate and the inflation rate moving in opposite directions. This is the liquidity effect at work – open market purchases tend to reduce the nominal interest rate and increase the inflation rate. So, the central banker gets the idea that, if he or she wants to control inflation, then to push inflation up (down), he or she should move the nominal interest rate down (up).

But, suppose the nominal interest rate is constant at a low level for a long time, and then increases to a higher level, and stays at that higher level for a long time. All of this is perfectly anticipated. Then, there are many equilibria, all of which converge in the long run to an allocation in which the real interest rate is independent of monetary policy, and the Fisher relation holds.

Before discussing Williamson, let me point out that back in 2008-09, 99.9% of economists thought the Fed had eased policy, and that the deflation of 2009 occurred in spite of those heroic easing attempts.  That 99.9% included the older monetarists.  Only the market monetarists and the ghost of Milton Friedman insisted that money was tight and that interest rates were falling due to the income and Fisher effects.  I’d like to think that Williamson agrees with us, but of course he’d be horrified by the specifics on the MM model, indeed he wouldn’t even recognize it as a “model.”

Williamson continues:

A natural equilibrium to look at is one that starts out in the steady state that would be achieved if the central bank kept the nominal interest rate at the low value forever. Then, in my notes, I show that the equilibrium path of the real interest rate and the inflation rate look like this:

Screen Shot 2014-09-13 at 10.41.23 AM

Is that really monetary tightening?  After all, inflation rises.  Here’s the very next paragraph by Williamson:

There is no impact effect of the monetary “tightening” on the inflation rate, but the inflation rate subsequently increases over time to the steady state value – in the long run the increase in the inflation rate is equal to the increase in the nominal rate. The real interest rate increases initially, then falls, and in the long run there is no effect on the real rate – the liquidity effect disappears in the long run. But note that the inflation rate never went down.

The scare quotes around “tightening” suggest that Williamson is also skeptical of the notion that tightening has actually occurred.  Indeed inflation increased, then policy must have eased. However to his credit he recognizes that “conventional wisdom” would have viewed this as a tightening.  Nonetheless the final part of the paragraph has me concerned.  Williamson refers to the disappearance of the liquidity effect, but in the example he graphed there is no liquidity effect, as the rise in interest rates was not caused by a tightening of monetary policy.  If it had been caused by tighter money, inflation would have fallen.

So how can the graph be explained?  As far as I can tell the most likely explanation is that at the decisive moment (call it t=0) the equilibrium Wicksellian interest rate jumps much higher, and then gradually returns to a lower level over the next few years.  And the central bank moves the policy rate to keep the price level well behaved.  I suppose you might see this as being roughly the opposite of the shock that hit the developed economies in 2008, except of course it was more gradual.

Suppose there had been no change in the Wicksellian equilibrium rate, and the central bank simply increased the policy rate by 100 basis points, and kept it at the higher level.  In that case, the economy would have fallen into hyperdeflation. When you peg interest rates in an unconditional fashion, the price level becomes undefined.

Is there any other way that one could get a path like the one shown by Williamson? Could the central bank initiate this new path? Maybe, at least if you don’t assume a discontinuous change in the interest rate, followed by absolute stability.  To explain how you could get roughly this sort of path lets look at the reverse case.

Suppose the Fed had been increasing the monetary base at about 5% a year for many years, and the markets expected this to continue.  This led to roughly 5% NGDP growth.  The markets assumed the Fed was implicitly targeting NGDP growth at about 5%.  But the Fed actually also cared about headline inflation, which suddenly rose higher than desired (due to an oil shock.)  The Fed responded by holding the base constant for a period of 9 months.  (For those who don’t know, so far I’ve described events up to May 2008.)

This unexpectedly tight money turned market expectations more bearish.  As expectations for NGDP growth became more bearish, the asset markets fell and the Fed responded by cutting interest rates.  And since inflation did not immediately decline, real short term rates also fell (still the mirror image of the Williamson graph.)  BTW, we know that even 3 month T-bill yields FELL on the news of policy tightening at the December 2007 FOMC meeting.  Williamson would have approved of that market reaction!!

Normally the Fed would have realized its mistake at some point, and monetary policy would have nudged us back onto the old path.  In this case, however, market rates had fallen to zero by the time the Fed realized its mistake.  And the Fed was reluctant to do unconventional stimulus.  There was a permanent reduction in the trend rate of NGDP growth, as well as nominal interest rates. This showed up in lower than normal 30-year bond yields.  The process played out even more dramatically in Europe (and earlier in Japan.)

I do have one quibble with the Williamson post.  He seems too skeptical of the claim that the ECB recently eased policy.  But before I criticize him let me say that I find his error much more forgivable than the conventional wisdom, which views low interest rates as easy money.

Williamson points out that the ECB recently cut rates, and that if the ECB leaves rates near zero for an extended period of time, then inflation is likely to stay very low, as in Japan.  All of this is correct.  But I think he overlooks the fact that while the overall policy regime in Europe is relatively “tight”; the specific recent actions taken by the ECB most definitely were “easing.”  We know that because the euro clearly fell in the forex markets in response to that action.

I think this puzzles a lot of pundits.  It’s very possible for central banks to take relative weak actions that are by themselves expansionary, even while leaving the overall policy stance contractionary, albeit a few percent less so than before. That’s the story of the various QE programs in America.

I encourage all bloggers to never reason from a price change.  Do not draw out a path of interest rates and ask what sort of policy it is.  First ask what caused the interest rates to change—the liquidity effect, or the income/Fisher effects?

PS.  Of course I agree with most of the Williamson post, such as his criticism of “overheating” theories of inflation.

HT:  TravisV

Level vs. growth rate targeting

Here’s Lars Christensen:

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

Actually I would have been very upset, as indeed I was as soon as I saw what they were doing.  I favored a policy of level targeting, which meant returning to the previous trend line.

Now of course if they had adopted a permanent policy of 4% NGDP targeting, I would have had the satisfaction of knowing that while the policy was inappropriate at the moment, in the long run it would be optimal.  Alas, they did not do that.  The recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.

However I do agree with Lars that the Fed has done much better than the ECB.

HT:  TravisV.