Archive for the Category Monetary Policy


Swedish central bankers and Korean ferryboat captains

For years I’ve been fighting against the (new) conventional wisdom in economics—that the 2008 crisis shows that monetary policy must move beyond macro stability, and focus on asset price bubbles. Unfortunately, Ambrose Evans-Pritchard reports that we seem to have achieved our first important success.  I say unfortunately, because it came at the expense of Sweden:

The Riksbank has been trying to “lean against the wind” to curb house price rises and consumer credit, pioneering a new policy that gives weight to the dangers of asset bubbles. But this is proving easier said than done without hurting the productive economy, suggesting that it may be better to use mortgage curbs or other means to rein in property mania.

But Jeremy Stein says that regulation doesn’t “get in all the cracks,” you need to smash asset price bubbles with a monetary sledgehammer.  Or like a tidal wave that gets in all the cracks of a leaky old boat. Here are the results:

Sweden has become the first country in northern Europe to slide into serious deflation, prompting a blistering attack on the Riksbank’s monetary policies by the world’s leading deflation expert.

Swedish consumer prices fell 0.4pc in March from a year earlier, catching the authorities by surprise and leading to calls for immediate action to avert a Japanese-style trap.

Lars Svensson, the Riksbank’s former deputy governor, said the slide into deflation had been caused by a “very dramatic tightening of monetary policy” over the past four years. He called for rates to be slashed from 0.75pc to -0.25pc to drive down the krona, and advised the bank to prepare for quantitative easing on a “large scale”.

Prof Svensson said Sweden was at risk of a “liquidity trap” akin to the 1930s, with deflation causing debt burdens to ratchet up in real terms. Swedish household debt is 170pc of disposable income, among Europe’s highest.

The former Princeton University professor wrote the world’s most widely cited works on deflation, his advice being sought by the US Federal Reserve’s Ben Bernanke during the financial crisis.

You can’t “get in all the cracks” without hitting AD hard.

And then after being warned by Svensson, and a wide range of bloggers from market monetarists to Paul Krugman, the Riksbank has the gall to claim no one could have foreseen it:

Sweden’s Riksbank admitted in its latest monetary report that something unexpected had gone wrong, perhaps due to a worldwide deflationary impulse. “Low inflation has not been fully explained by normal correlations between developments in companies’ prices and costs for some time now. Companies have found it difficult to pass on their cost increases to consumers. This could, in turn, be because demand has been weaker than normal,” it said.

Yes, and when that Korean captain ordered those 300 children to stay inside the ship as it was sinking, while he waltzed away, no one could possible have foreseen a bad outcome.  Right?

An exaggeration?  Of course.  But consider the following:

1.  The Riksbank was given a legal mandate to target inflation and unemployment, not asset price bubbles.

2.  For several years they have been explicitly ignoring this mandate.  They have set interest rates at a level so high that their own internal research unit has consistently predicted that they would fall short on both the inflation and employment front.  There’s no dispute about these facts.  The board included one of the world’s leading monetary experts, Lars Svensson, and a bunch of amateurs who are in completely over their heads.  They repeatedly ignored Svnesson’s warnings, even accusing him of being rude.  Eventually he got so frustrated with their incompetence that he resigned.

And now they claim no one could have foreseen this policy failure?

This is exactly what would have happened in the US in the mid-2000s if the Fed had tried to pop the housing “bubble.”  It’s exactly what did happen in 1929 when the Fed popped the stock price “bubble.”

Will this stop the bubblemongers?  Don’t count on it.  They are so convinced they are right that no amount of information will sway them.

If Sweden wants to regain its reputation for monetary policy excellence then they will fire the entire Riksbank board, put Svensson in charge, and give him a veto over any proposed additions to the board.

PS.  Of course it’s NGDP that really matters, not inflation.  Which is why market monetarists were ahead of the curve on these issues.  It really doesn’t make much difference if the ECB inflation rate is 0.5%, or 2.5%.  As long as NGDP growth in Europe is ultra-slow, the debt and jobs crises will continue.

PPS.  Lars Christensen linked to an excellent new paper by Clark Johnson, discussing Ben Bernanke’s take on the events of 2008.  Clark’s analysis is influenced by Keynes’s Treatise on Money.  (A better book than the General Theory.)

Bernanke reveals frustration that the Fed’s effort to lower long term rates did not bring recovery: “We have gotten mortgage rates down very low. You would think that would stimulate housing, but the housing market has not recovered.”

Bernanke scarcely regards the underlying monetary problem, which was the rise in systemic demand for money. His discussion in the following pages returns to the importance of targeting a low inflation rate – apparently through all phases of the business cycle – and the importance of letting financial markets know the central bank’s interest rate targets. These are the targets identified above as ill-chosen, and use of which Bernanke has himself criticized in the past.

.  .  .

In in pre-Fed writings, Bernanke acknowledged the ability of central banking to satisfy demand for liquidity, and thereby to boost demand for goods and services – even under extreme conditions. There is no evident reason why such methods would not work several years after a banking crisis, or for that matter, immediately after.

HT:  Paul Krugman

Joe Gagnon on what the Fed got wrong

Marcus Nunes sent me a post by the always excellent Joe Gagnon.  I’m not sure I fully agree with Gagnon’s view of the situation, but his post does a beautiful job of explaining the issues faced by the Fed in December 2008, and how they evaluated their various policy options:

The FOMC did not discuss the possibility of a negative interest rate on bank reserves, but it is widely agreed that a significantly negative interest is not feasible because banks would convert their reserve balances to paper currency. A lingering puzzle is why the Fed never lowered interest on reserves to zero in subsequent years, when financial strains had diminished and depositors and market participants had gotten used to the low rate environment, but standard macroeconomic models imply that the benefits of such a small decline would have been correspondingly small.

This paragraph shows that the Fed had two serious misconceptions.  Vault cash is a part of bank reserves, and hence there is no reason that the negative IOR could not also be applied to vault cash. (There may be legal barriers, but laws can be changed.) In earlier posts I’ve recommended that banks be exempt from negative IOR on a “normal” level of bank reserves, perhaps required reserves plus X%. The key is to make excess reserve holding costly at the margin, so that new injections of base money go out into circulation as cash. Because cash is very costly to store, this would depress market interest below zero, if the policy failed.  More likely it would succeed and dramatically boost AD, and therefore the mere threat of negative IOR would make the actual implementation of negative IOR unnecessary.

Update: Mark Sadowski clarifies the legal status of vault cash

The second misconception is the assumption that the benefits from a further small reduction in interest rates are minor.  That comes from flawed Keynesian models of monetary economics, which ignore the role of money as a medium of account.  If you set IOR at a rate slightly above the T-bill yield, then the demand for base money rises dramatically, which is highly deflationary.  To be sure, a lower rate might decrease T-bill yields by a roughly similar amount, in which case the spread is preserved, but that assumption raises all sorts of further questions, such as what impact does lower interest rates have on the expected future path of monetary policy.  There are numerous cases where over a trillion dollars in global stock market wealth has been created or destroyed within minutes by a decision over a 25 basis point change in the fed funds target. In other cases that sort of change has little impact. There is no basis for simply assuming that a small change in the fed funds target would be unimportant when the economy is poised on the knife edge of a depression.

There was some discussion, both within the meeting and in the background memos, about the possible benefits of committing to hold the policy rate low for so long that the economy would be likely to overshoot the long-run desired levels of employment and inflation temporarily. Some participants questioned the credibility of such a commitment, given the likelihood that the Fed would come to regret it later. More generally, FOMC participants seemed to have little appetite for tying their hands in such a dramatic fashion. Although they were all for getting back to their economic goals quickly, they had no desire to speed up the recovery at the expense of overshooting their goals.

Not willing “to speed up the recovery at the expense of overshooting?”  Sorry Fed officials, but that is against the law.  You have a dual mandate.  A decision that you are unwilling to overshoot 2% inflation by even a tiny bit, even when unemployment is 10%, is tantamount to admitting that only inflation matters.  A policy of never trying to overshoot 2% inflation is basically a single mandate policy, inflation targeting pure and simple.  That which has no practical implications, has no policy mandate implications.  If your policy is indistinguishable for a single mandate IT regime, then it is a single mandate IT regime.

There was widespread approval of the Fed’s generous provision of liquidity during the crisis, with some participants noting that measures of financial stress were beginning to ease a bit. Both the discussion and one of the background memos agreed that the liquidity facilities had a macroeconomically important effect to the extent that they were preventing cutbacks in consumption and investment that would otherwise have occurred. Some noted that these facilities were less effective at providing additional stimulus than they were at offsetting negative shocks because market participants could not be coerced into using these facilities.

God help us all if 80 years after the Great Depression Fed officials were still worried about pushing on strings and leading horses to water.

The FOMC discussion shows that there was little appetite for a dramatic push to increase inflation expectations, with some participants expressing doubt that the Fed could raise expectations substantially through statements about its intentions without any additional actions. But there was also an acknowledgment that the Fed had not been as clear as it could have been about what inflation rate it aimed to achieve. Speeches and other published materials seemed to show a comfort zone for inflation with a lower end around 1 to 1.5 percent and an upper end at 2 percent. One of the background memos assumed an inflation goal of 1.75 percent. Participants did not agree on a common inflation goal at this meeting.

The first sentence might be translated as: “There was little appetite for pushing inflation expectations up to a level where the policy was expected to succeed, and in any case in order to actually raise inflation expectations we might have to actually do something.”  Not quite sure what “little appetite” has to do with optimal monetary policy.  Perhaps it just means the FOMC members were not as hungry as the 15 million unemployed.

On the plus side, the actual adoption of a 2% inflation target in January 2012 might be viewed as a limited victory for Ben Bernanke, given that the implicit target was a bit lower.  Keep in mind that a 2% PCE inflation rate implies a 2.4% CPI inflation rate.  Very few people understand that the current 5 years TIPS spread of 2.16% means that markets expect the Fed to fall short of their PCE inflation target. And since unemployment is also elevated, there is an overwhelming case for easier money (if you accept the Fed’s announced policy goals–perhaps not if you favor a lower target.)

PS.  Just to be clear, I’m not recommending negative IOR in the current situation, the Fed has far better options.

PPS.  Note that the excerpts I quoted here aren’t necessarily Gagnon’s views.  He occasionally recommended a more aggressive Fed stance. They are his view of what the Fed was thinking.

PPPS.  My second link was to a recent Charles Evans speech which contained this gem:

Although all central banks face these strategy and communications issues, and they implement them somewhat differently, my view is that 90 percent of the communications challenge is met by expressing policy intentions clearly so that the public can understand the Federal Reserve’s goals and how the Fed is committed to achieving these goals in a timely fashion.A clear expression of policy intentions requires stating the Fed’s policy goals clearly and explicitly. These messages need to be repeated – over and over again. It is also necessary to clearly demonstrate our commitment to achieving these goals in a timely fashion with policy actions.

That’s what the Fed did not do in 2008-09.

Update:  Mark Sadowski also has some comments on Gagnon’s post.

Fed hawk who helped implement Obama’s tight money policy announces resignation

TravisV sent me the following:

A top Federal Reserve official who has expressed concerns about the possibility that the central bank’s policies could spark financial instability said Thursday he is resigning from his post on May 28.

Jeremy Stein, an economics professor at Harvard University, will be returning to Cambridge, Mass. to teach again, Mr. Stein said in his resignation letter to President Barack Obama.

Just last month, the 53-year old highlighted his argument that the Fed must be mindful of the possibility that its policies could contribute to asset bubbles. “Monetary policy should be less accommodative — by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level—when estimates of risk premiums in the bond market are abnormally low,” he said.

While his views weren’t shared by many of his colleagues, Mr. Stein’s role as an academic economist made him an influential figure within the central bank’s powerful Washington-based board.

.   .   .

In combating a deep recession and supporting a weak economic recovery, the Fed has kept official interest rates effectively at zero for over five years now. It has also purchased some $3 trillion in mortgage and Treasury bonds in an effort to keep long-term rates down and spur economic activity. But the program has not been without its skeptics. Mr. Stein, while supporting bond buys when they were launch, has been most vocally skeptically of them among board governors.

Given that Stein played a key role in the Fed’s premature taper, this is good news. Let’s hope the seat remains unfilled.

PS.  In 2009 I was encouraging Obama to fill Board seats as quickly as possible, until I figured out that he thinks monetary policy is credit policy, not AD management.

PPS.  Obama appointed Stein and Powell 2 years ago. Stein was the Democrat.  The slow recovery?  It’s all the Republican Party’s fault.

Let’s play 1960s-era Fed

Marcus Nunes has a nice post comparing the views of Janet Yellen and Martin Feldstein.  I noticed that Feldstein is worried that we are going to repeat the mistakes of the 1960s.

Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later.

Before we consider whether we are likely to repeat the mistakes of the 1960s era Fed, let’s review precisely what those mistakes actually were. Here’s the data as of November 1966:

Unemployment rate = 3.6%, and falling.

Inflation = 3.6% over previous 12 months.  That’s a big increase from the 1.7% of the 12 months before that, and the 1.3% inflation rate two years previous.  The “Great Inflation” began here.

The fed funds rate was 5.76%.

Hmm, what should the Fed do in a situation like this?  Inflation is beginning to accelerate.  Unemployment is near all time lows for peacetime.  Decisions, decisions.  You’ve taken EC101, what do we do next?

The answer is easy.  The Fed decided the economy needed a massive emergency jolt of easy money.  By December 1966 the fed funds rate was cut to 5.40%.  By January 1967 the rate was cut to 4.94%.  By April it was cut to 4.05%.  By October 1967 it’s at 3.88%.  Keep in mind NGDP was rising at 6% to 8% throughout the late 1960s.  If you prefer the monetary base as your “concrete steppe”, that indicator started growing much faster as the 1960s progressed.

Now read the minutes of September 2008, when the Fed refused to cut rates in the midst of the mother of all financial panics because of inflation worries, despite TIPS spreads showing 1.23% inflation over the next 5 years, and commodity prices plunging.  Does this seem like a Fed that would slash interest rates much lower when inflation is soaring above target and unemployment is 3.6%?

PS.  Keep this data in mind when some fool tells you that the Great Inflation was caused by oil shocks or the Vietnam War or budget deficits or unions, or some other nonsense.

PPS.  The economics profession (with a few exceptions) was complicit in the crime of 1966.  The Fed generally does what the consensus thinks it should do.  The “best and the brightest,” the VSPs.  Still think it’s impossible that the entire profession could have been as crazy in 2008-09 as I claim they were?  How will the Fed’s behavior in 2008 look 50 years later?  I’d say about like the 1966-67 Fed looks today. Out of their ******* minds.  And then there’s the ECB . . .

PPPS.  One economist that did understand what was going on was Friedman.  I find this (from an Edward Nelson paper) to be amusing:

From April 1966 to the end of the year, the evidence of monetary policy tightening started appearing uniformly across monetary aggregates; the “credit crunch” of 1966 is also evident in other financial indicators and is widely recognized as a period of monetary tightness (Romer and Romer, 1993, pp. 76−78). The Federal Reserve would shift to ease in 1967, and that easing marked a dividing point for Friedman. He would classify 1967 as the beginning of an extended departure from price stability, one in which monetary policy fitted the pattern he had laid out in 1954: an inflation roller-coaster around a rising trend, with the occasional deviations below that trend reflecting shifts to monetary restraint that were abandoned once recessions developed (M. Friedman, 1980, p. 82; Friedman, 1984, p. 26).

The FOMC did not, however, appreciate the scale of its easing during 1967. By explicitly associating high nominal interest rates with tight policy, Committee members and other Federal Reserve officials neglected the distinction between real and nominal interest rates. Friedman, in contrast, was pressing this distinction on policymakers. Chairman Martin could not ignore the criticism, not least because Friedman had attracted the interest of Martin’s Congressional interlocutors. Friedman’s revival of the Fisher effect was referred to when Martin appeared at a February 14, 1968, hearing of the Joint Economic Committee (1968, p. 1980):

Senator SYMINGTON. A famous economist has developed the theory that easy money creates higher interest rates. If you have not examined that concept, would you have someone on your staff do so? It is an interesting theory. I discussed it with the economist in question only last week. Would you have somebody look into it?

Mr. MARTIN. I will be very glad to. 

The “famous economist” was, of course, Friedman.

In 2008 no senator asked Bernanke to look into the theory of an obscure Bentley economist that low interest rates are often a sign that money has been tight.

Mian and Sufi on monetary policy

Unfortunately I’m not able to keep up with all the new blogs, but I’m told that Atif Mian and Amir Sufi are brilliant new bloggers who have great ideas on debt.   Ryan Avent showed that their expertise on monetary economics is much weaker.  Here he discusses a graph they present that showed PCE core inflation has fallen below a 2% trend line since 1999:

Unfortunately, I think they’ve got this wrong in a few ways. First, the Fed doesn’t target core inflation. It targets headline inflation, but it uses core as an indicator because past core inflation is a better predictor of future headline inflation than past headline inflation. So here’s something interesting: take a look at what happens when you track headline inflation (as measured by the price index for personal consumption expenditures) since 2000.

Finally everything is clear: the Great Recession was a necessity engineered by the Fed in order to disinflate back to the 2% trend. I’m kidding, of course. In fact, this is the wrong period to consider entirely, because the Fed didn’t adopt an official inflation target until January of 2012.

Why did Mian and Sufi do a study of actual inflation compared to target inflation?  Here’s why:

The chart above plots the implied core PCE index if inflation had met its 2% target (red line), and the actual core PCE index (blue line) starting from 1999. The blue line is consistently below the red line, the gap has only diverged further since the Great Recession. The cumulative effect is that today the price level is 4.7% below what it should have been had the Fed achieved its long-run target…

What we are witnessing is the limit of what monetary policy alone can do. Sometimes there is a tendency to assume that the Fed can “target” any inflation rate it wishes, or that it can target the overall price level – the so-called nominal GDP targeting. The evidence suggests that the Fed may not be so omnipotent.

So their study was aimed at establishing whether the Fed is able to hit its 2% inflation target.  They found it was not, on the basis that core PCE fell 4.7% below trend over 14 years.  (Put aside the fact that in the 1970s, before they were inflation targeting, inflation often overshot the target by 4.7% in less than one year.)

If you are a sweet, naive, trusting, honest, idealistic soul, you will naturally assume this story has a happy ending.  Ryan corrected the data error.  With the correct data the study shows the Fed in fact hit its target almost perfectly in the long run. Great news!!  So Mian and Sufi will naturally change their conclusion to fit the actual outcome of the study that they themselves thought provided a window into whether the Fed was able to successfully target inflation.  Just as Paul Krugman changed his mind about MM after the results were in from what Paul Krugman himself said would be a 2013 test of MM. They will print a retraction, and change their forthcoming book to show the conclusion that is in fact correct.  The Fed can target inflation at 2%.  Because we are all scientists, aren’t we?  We learn from the results of our tests.  I very much hope you are right, but just in case they do not change their conclusions regarding the ability of the Fed to hit a 2% inflation target, let me explain why.

Most economists are not interested in finding the truth; they are interested in using ideas to advance their career.  Empirical studies become swords in the battle, to be used when effective and thrown away when they are found useless.  I sincerely hope Mian and Sufi are not like most economists.  (And to be fair, there have been times when I slip into bad habits as well, so perhaps I should not be throwing stones here.)

Ryan Avent was actually pretty kind to Mian and Sufi, as he overlooked this:

What we are witnessing is the limit of what monetary policy alone can do. Sometimes there is a tendency to assume that the Fed can “target” any inflation rate it wishes, or that it can target the overall price level – the so-called nominal GDP targeting. The evidence suggests that the Fed may not be so omnipotent.

First of all, price level targeting is not at all NGDP targeting.  I apologize if this sounds snarky, but they really need to get up to speed on the 2014 blogosphere debate over monetary policy.  After everything that has happened you simply cannot still be arguing that monetary policy is ineffective at the zero bound, and use as “evidence” the fact that low interest rates have failed to push the rate of inflation higher. That would be like claiming that the fact that; “more police patrol high crime areas proves that police patrols are ineffective.”

Fiat money central banks can debase their currencies if they chose to.  So far as I know none of them really deny this.  You can’t be a serious monetary economist in 2014 and claim that a fiat money central bank can’t debase its currency.  You can claim there are political barriers.  Savers would be upset.  Or foreign countries would complain if you depreciated the yen in the forex markets. Or you’d have to buy so many assets that the central bank would be uncomfortable with the size of its balance sheet.  Don’t get me wrong, I think even those arguments are wrong, but they are defensible.  But in 2014 one simply CANNOT any longer argue that the fact that low rates and QE have been accompanied by low inflation proves central banks are out of ammo.  Too much has happened, the debate has moved on.

If you don’t trust me and the MMs, read Ben Bernanke, Michael Woodford, Christina Romer, Bennett McCallum, Milton Friedman, etc, etc.

PS.  I promised a friend that I would do a April Fools post.  I apologize, but I simply couldn’t think of one that was plausible.  Nobody would believe it if I claimed to have converted to MMT.  And then I tried to come up with whacky news stories, a la The Onion.  Like a story that the IRS ruled that Bitcoins were property, so if you used Bitcoins to buy a Coke from a vending machine, you had to file a tax form for the capital gains on the difference between the 90 cents you paid for the Bitcoin, and the $1.25 is was worth when you bought the Coke. Or that the IRS offered me $10,000 per year to divorce my wife, continue living with her, and continue to tell all our friends that we were married (establishing common law marriage.) But every time I thought up a whacky story like those two, I realized it was true.  I feel I live a sort of Groundhog Day film, where every day is April 1st.  Where very day someone repeats that low interest rates show easy money doesn’t “work.” Where high interest rate show that money was “tight” during the German hyperinflation.  I can’t keep up with reality.

Update:  Marcus Nunes also has a good post on Mian and Sufi.