Archive for the Category Monetary Policy


Don’t mix up tactics and strategy (The Straight Story)

Here’s commenter Philo, quoting me and then responding:

“It’s hard to evaluate current policy without knowing where the Fed wants to go, and they refuse to tell us where they want to be in 10 years, either in terms of the price level or NGDP. If they would tell us, I’d recommend they go there in the straightest path possible.” But why accept the Fed’s objective, whatever it may be, as valid? If they wanted to take us to hell, would you recommend that they do so as efficiently as possible? I think the Fed needs your advice about *what objective to aim for*, as well as about how to achieve that objective.

I do give the Fed both kinds of advice, but it’s very important not to mix them up. Suppose while living in Madison I get into an argument with friends about whether to vacation in Florida or California.  I lose the argument and we decide on Florida.  I’m in charge of directions.  Do I have the car head SW on highway 151, or southeast on I-90? If I suggest southwest, because I want to go to California, then when the vegetation starts getting sparse they’ll realize we are going the wrong way, and lots of needless extra driving will occur—the travel equivalent of a business cycle.

Now suppose I favor 5% NGDP growth and the Fed favors something closer to 3% in the long run.  In that case I may suggest they change their target to 5%, but it’s silly for me to give them tactical advice consistent with a 5% target.  After a few years of that we’d plunge to 1%, to create the 3% long run average.  Again we’d get a needless business cycle.  Whichever way they want to go, I’d like them to go STRAIGHT.

Tyler Cowen has a post that links to a FT story warning of a possible repeat of 1937. They should have warned of a possible repeat of 1937 and 2000 and 2006 and 2011, when various central banks tightened prematurely at the zero bound.  Did they ever tighten too late?  Yes, in 1951, in circumstances totally unlike today.  So yes, I’m worried about a repeat of 1937.  I currently think the odds are at least 4 to 1 against a double dip recession next year, but I’d like to see the Fed make those odds smaller still.

Tyler also links to a Martin Wolf piece that starts out very sensibly; pointing out that low rates do not mean money has been easy.  But then Wolf slips up:

The explosions in private credit seen before the crisis were how central banks sustained demand in a demand-deficient world. Without them, we would have seen something similar to today’s malaise sooner.

I see his point, and it’s true in a certain way.  But it’s also a bit misleading.  It would be much more accurate to say that central banks sustained demand by printing enough money to keep NGDP growing at 5%, and could have continued doing so if they had wished to.  It so happens that bad regulatory policies pushed much of that extra demand into credit financed housing purchases, instead of restaurant meals, vacations, cars, etc.  But that has nothing to do with monetary policy, which is supposed to determine AD.

Tyler comments on the debate:

I see a few possibilities:

1. Stock and bond markets are at all-time highs, and we Americans are not so far away from full employment, so if we don’t tighten now, when?  Monetary policy is most of all national monetary policy.

I’d say we tighten when doing so is necessary to hit the Fed’s dual mandate.  And how are stock and bond prices related to that mandate?  And what does Tyler mean by “tighten?”  Does he mean higher interest rates?  Or slower NGDP growth (as I prefer to define tighten)?

I do agree that the Fed should focus on national factors, but otherwise I think Tyler needs to be more specific.  Is he giving advice about tactics or strategy?  Does he believe this advice would help the Fed meet its 2% PCE inflation target?  If so, then why?  Notice that the inflation rate is not mentioned in his discussion of what the Fed should do, even though the Fed has recently adopted a 2% inflation target (2.35% if using the CPI), and is widely expected to undershoot that target for years to come.

2. It’s all about sliding along the Phillips Curve.  Where are we?  Who knows?  But risks are asymmetric, so we shouldn’t tighten prematurely.  In any case we can address this problem by focusing only on the dimension of labor markets and that which fits inside the traditional AD-AS model.

I agree with this, although I think the first and last parts of it are poorly worded.  I think he’s saying that we don’t know where we are relative to the natural rate of unemployment, which is true.  But the term ‘Phillips Curve’ is way too vague, unless you are already thinking along the lines I suggested.  Yes, the risk of premature tightening is important.  Even worse, the risks facing the Fed are somewhat asymmetric, due to their reluctance to target the forecast at the zero interest rate bound.  So excessively tight money will cost much more than excessively easy money, in the short run.  But what about the long run?  Again, that depends on the Fed’s long run policy goals, and they simply won’t tell us.  For instance, if the policy was something like level targeting, then the risks would again become symmetric–overshoots are just as destabilizing as undershoots under level targeting.  That’s one more reason to switch to level targeting.

I also find the last part to be rather vague (although maybe that just reflects my peculiar way of looking at things.)  I certainly think the labor market and AS/AD are the key to monetary policy analysis, but those terms can mean different things to different people. I think Tyler sometimes overestimates the ability of his readers (including me) to follow his train of thought.  “Labor market” might mean nominal wage path or U-3 unemployment.  Those are actually radically different concepts, as the first is a nominal variable and the other a real variables.

Tyler continues:

3. The Fed’s monetary policies have created systemic imbalances, most of all internationally by creating or encouraging screwy forms of the carry trade, often implicit forms.  A portfolio manager gains a lot from risky upside profit, but does not face comparable downside risk from trades which explode in his or her face.  The market response to the “taper talk” of May 2013 (egads, was it so long ago?) was just an inkling of what is yet to come.

Which “policies?”  Is he referring to excessively easy or excessively tight money?  No way for me to tell.  I think policy has created imbalances by being too tight.  I think an easy policy would have led to fewer imbalances.  But most people believe exactly the opposite.  Given that Tyler wants to be understood, it’s probably better to assume he’s addressing “most people.”

How has the Fed’s monetary policy contributed to the carry trade?  At this point I know that some people will want to jump in and insist that it’s all about interest rates.  But interest rates are very different from monetary policy.  And even if you think low rates are the issue, you’d have to decide whether the low rates were caused by easy money or tight money.  As I just mentioned, even sensible non-MMs like Martin Wolf are now skeptical of the idea that they reflect easy money.  So if low rates are the problem, should money have been even easier?  Easy enough to produce positive nominal interest rates such as what we see in Australia?  But wait, Australia’s having the mother of all housing “bubbles,” “despite” the fact that their interest rates are higher than in other countries.  (Sorry for two consecutive scare quotes; I’m getting so contrarian that I’ve almost moved beyond the capabilities of the English language.  Maybe that’s a sign I should stop here.)

No, I’m not done yet.  Why does 2013 suggest that Fed policy has a big effect on emerging markets?  As I recall, the unexpected delay in tapering in late 2013 had a very minor impact, suggesting the earlier EM turmoil mostly reflected other issues, not taper fears.

4. The Fed’s monetary policies have created systemic imbalances, most of all internationally by creating or encouraging screwy forms of the carry trade, often implicit forms.  Fortunately, we have the option of continuing this for another year or more, at which point most relevant parties will be readier for a withdrawal of the stimulus.  That is what patience is for, after all.  To get people ready.

OK, now I see.  I misread what Tyler was doing—these are “possibilities” not his actual views.  Yes, the Fed should be patient here, but certainly not in order to bail out speculators.

5. We should continue current Fed policies more or less forever.  Why not?  The notion of systemic imbalances is Austrian metaphysics, so why pull the pillars out from under the temple?  Let’s charge straight ahead, because at least we know the world has not blown up today.

Forever?  If “Fed policies” means the relatively steady 4% to 4.5% NGDP growth over the past 6 years then yes, by all means let’s continue them forever.  If it means zero interest rates, then no.

Of course now that I know that these are not necessarily Tyler’s views, I can see some sarcasm in the last sentence.  Once again, it all comes down to how we define monetary policy, how we define “straight ahead.”

At least physicists know the difference between up and down. It’s a pity that economists continue to debate the proper stance of monetary policy without having a clue as to what the phrase “stance of monetary policy” means.  As we saw in 2008, that confusion is unlikely to end well.

Alternatively, once we all agree to go straight ahead, we need to find some way to agree on what “straight” means.

PS.  The old man in The Straight Story (who reminded me of my dad) went the opposite way from what I proposed–northeast towards Wisconsin.

The biggest basher of them all

Ramesh Ponnuru has a very good article pushing back against Robert Samuelson’s criticism of Fed bashers.  While Mr. Samuelson is certainly right that much of the criticism is a bit nutty, sometimes I think there is a tendency for what Paul Krugman calls “Very Serious People” to be overly protective of institutions such as the Fed.  I am perfectly willing to accept the claim that the Fed is an institution full of very talented people.  I believe that its leadership is well intentioned. I believe Fed policy partly explains why the US has done better than the eurozone in the past 4 years.  I believe that, on average, Fed policy has improved over time.

But . . . no institution should be immune from criticism, as there is always room for improvement.  Today I’d like to talk about the biggest Fed basher of them all: Ben Bernanke.  Here’s Bernanke blaming the Fed for the Great Inflation:

Monetary policymakers bemoaned the high rate of inflation in the 1970s but did not fully appreciate their own role in its creation.

And here’s Bernanke attributing the performance of the Fed during the Great Moderation to improved Fed policy:

With this bit of theory as background, I will focus on two key points. First, without claiming that monetary policy during the 1950s or in the period since 1984 has been ideal by any means, I will try to support my view that the policies of the late 1960s and 1970s were particularly inefficient, for reasons that I think we now understand. Thus, as in the first scenario just discussed (represented in Figure 1 as a movement from point A to point B), improvements in the execution of monetary policy can plausibly account for a significant part of the Great Moderation. Second, more subtly, I will argue that some of the benefits of improved monetary policy may easily be confused with changes in the underlying environment (that is, improvements in policy may be incorrectly identified as shifts in the Taylor curve), increasing the risk that standard statistical methods of analyzing this question could understate the contribution of monetary policy to the Great Moderation.

And here’s Bernanke blaming the Fed for the Great Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

That’s a pretty serious charge, given that the economic collapse of 1929-33 turned the Nazis from a small fringe party to the dominant political force in Germany.  And Bernanke is not just a Fed basher; he lashes out at any other central bank that doesn’t do what he thinks they should be doing:

Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening? To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

So the Fed is to blame for the Great Depression, deserves praise for producing low inflation during the 1950s and early 1960s, deserves praise for producing a stable macroeconomy during the Great Moderation (1984-2007), and is to blame for the Great Inflation of 1966-81.  In this set of PowerPoint slides Bernanke blames the Fed for the severe 1981-82 recession.  Are we to assume that beginning in 2008 the Fed suddenly stopped being responsible for macroeconomic outcomes?  After being to blame or deserving credit for virtually every single major macroeconomic twist and turn since it was created in 1913?

Not according to William Dudley, current New York Fed President and close Bernanke ally.  He argues the Fed continued to make mistakes after 2008:

I would give each of these four explanations some weight for why the recovery has been consistently weaker than expected. But I would add a fifth, monetary policy, while highly accommodative by historic standards, may still not have been sufficiently accommodative given the economic circumstances.  .  .  .

My conclusion is that the easing of financial conditions resulting from non-traditional policy actions has had a material effect on both nominal and real growth and has demonstrably reduced the risk of particularly adverse outcomes.  Nevertheless, I also conclude that, with the benefit of hindsight, monetary policy needed to be still more aggressive. Consequently, it was appropriate to recalibrate our policy stance, which is what happened at the last FOMC meeting.

As I argued in a recent speech, simple policy rules, including the most popular versions of the Taylor Rule, understate the degree of monetary support that may be required to achieve a given set of economic objectives in a post-financial crisis world. That is because such rules typically do not adjust for factors such as a time-varying neutral real interest rate, elevated risk spreads, or impaired transmission channels that can undercut the power of monetary policy.  [emphasis added]

So from the vantage point of October 2012, William Dudley suggests that monetary policy over the previous 4 years was insufficiently expansionary.  He’s “bashing” the Ben Bernanke Fed, and he’s almost a clone of Bernanke in his policy views!

I wonder if Dudley is also admitting that, in retrospect, a certain group of monetary cranks that were bashing the Fed in 2008 and 2009 for inadequate nominal growth might have been right.

I don’t know if “Fed basher” is the right term to apply to Ben Bernanke.  All I can say is that if Bernanke is a Fed basher, then I’m proud to be one too.

The euro is still far too strong

The title of this post does not refer to the exchange rate, the importance of which is overrated.

Tyler Cowen has a new post on the euro.  Here’s his conclusion:

All in all, the weaker euro is likely to prove a net benefit to the eurozone, all the more so if monetary policy can drum up some expansionary domestic benefits above and beyond the exchange rate effect.  Still, if you deliberately engineer a depreciation of your currency out of weakness and desperation, the long-run benefits usually don’t match up to that immediate feeling of short-run juice.

This is correct.  There are many examples of Latin American or Mediterranean countries devaluing their currency, and merely ending up with higher inflation in the long run.  But it’s also important to point out that the euro is still far too strong. Unfortunately there is no single measure of the strength of a currency, but surely it is more meaningful to talk about it’s ability to purchase a basket of all goods and services, as compared to its ability to purchase a pound of zinc, a share of Apple stock, a US dollar, an Australian dollar, or a Zimbabwean dollar.  I’d argue that a still better measure would be the fraction of a year’s eurozone NGDP that can be bought with a single euro.

In any case, whether you use the price level or NGDP as your metric, the euro is far too strong.  So while there are many examples throughout history of countries debasing their currency, the eurozone is not currently one of those examples.

PS.  If in fact the ECB has engineered a weaker euro in the forex markets, then ipso facto it has engineered “some expansionary domestic benefits above and beyond the exchange rate effect” relative to a tighter monetary policy stance. When using monetary policy, you can’t have one without the other.

Update:  Marcus Nunes has a related post on the yen.  Yes, there are actually people claiming the yen is too weak (not Marcus!)  Isn’t the yen right up there with the Swiss franc, vying for the title of the strongest fiat currency in the history of the world?

The rising dollar will not impact US growth

Here’s a new headline from the Washington Post:

U.S. economy’s surprise risk: The dollar’s surge could weaken growth

The surging value of the U.S. dollar promises new bargains for American consumers and travelers but also presents big threats to the U.S. economy — in a trend that is shaping up to be one of the most unexpected and significant factors driving the global economy this year.

This is wrong, one should never reason from a price change.  There are 4 primary reasons why the dollar might get stronger:

1.  Tighter money in the US (falling NGDP growth expectations.)

2.  Stronger economic growth in the US.

3.  Weaker growth overseas.

4.  Easier money overseas.

In my view the major factor at work today is easier money overseas.  For instance, the ECB has recently raised its growth forecasts for 2015 and 2016, partly in response to the easier money policy adopted by the ECB (and perhaps partly due to lower oil prices—but again, that’s only bullish if the falling oil prices are due to more supply, not less demand–see below.) That sort of policy shift in Europe is probably expansionary for the US.

However NGDP growth forecasts in the Hypermind market have trended slightly lower in the past couple of months. Unfortunately, this market is still much too small and illiquid to draw any strong conclusions.  Things will improve when the iPredict futures market is also up and running, and even more when the Fed creates and subsidizes a NGDP prediction market.  But that’s still a few years away.  Nonetheless, let’s assume Hypermind is correct.  Then perhaps money in the US has gotten slightly tighter, and perhaps this will cause growth to slow a bit.  But in that case the cause of the slower growth would be tighter money, not a stronger dollar.

Does that mean exchange rate changes are never informative?  Not at all.  When we observe exchange rates change in response to monetary policy actions, then we can pin down the direction of causality.  Thus the dollar fell 6 cents against the euro on the day QE1 was announced in March 2009.  We’ve also seen falls in the yen and euro on QE announcements in Japan and Europe.  But you need to know why the exchange rate has moved before drawing any conclusions about causality.

As an aside, late last year there was talk that the huge fall in oil prices would be “like a tax cut,” boosting growth in the US. I was skeptical, and still am skeptical. It’s worth noting that falling oil prices did not raise the consensus forecast for RGDP growth during 2015, indeed forecasts fell slightly between last fall and early 2015, “despite” the huge plunge in oil prices:





Will the Fed undershoot its inflation target?

Justin Wolfers has a good piece in the NYT, with a graph showing the current values of some inflation derivatives:

Screen Shot 2015-03-07 at 6.25.23 PMThe numbers actually represent ranges. Thus the 49% chance of 2% inflation means that there is a roughly 49% chance of inflation between 1.5% and 2.5%.

If we assume a bell-shaped distribution, I’d guess the median inflation estimate is around 1.75% or a bit more.  In that case there’s roughly a 66% chance that inflation will undershoot 2% over the next 5 years.  But keep in mind that this is a CPI inflation prediction market.  And the Fed actually targets PCE inflation, which runs about 0.35% below CPI inflation.  So the market currently expects about 1.4% PCE inflation over the next 5 years.  Alternatively, there is an 80% chance that inflation will undershoot the Fed’s PCE target over the next 5 years.

Does that mean money is too tight?  Not necessarily, as the Fed has a dual mandate, and employment is likely to be above average over the next 5 years (albeit only because the previous 6 were so horrible.)   Nonetheless, I’d guess that dual mandate considerations would call for no less than about 1.8% PCE inflation over the next 5 years.

Even worse, the dual mandate defense of the Fed implies they should have had inflation run above target during the high unemployment years, and of course they’ve done exactly the opposite.  So if you take the Fed’s unwillingness to run a countercyclical inflation rate into account, the current situation is even more indefensible.

Even worse, the Fed seems unaware of the fact that the current policy regime is broken, and needs to be replaced before we again slide to zero interest rates in the next recession.  Reading the 2009 transcripts, (which just came out) was a sobering experience.  The Fed pats itself on the back when it produces stable NGDP growth (as in the Great Moderation), or 2% inflation since 1990.  But when they screw up and produce a macroeconomic disaster, they discuss the situation as if it’s not their job to steer the nominal economy.   Bad things just sort of happened.  It reminds me of the transcripts from late 1937, when the Fed was unwilling to accept the fact that the higher reserve requirements (which raised interest rates by 25 basis points) contributed to the double dip depression, even though the policy was enacted to prevent inflation, and that can only be done by restraining AD.  (BTW, I’ve complained about this asymmetry for years, as has Christy Romer, and as did Milton Friedman many decades ago.)

I haven’t even come close to reading all the minutes; if any of you have more time than I do see if there is any soul searching about the foolish decision to not cut interest rates in the meeting after Lehman failed.  Or regret over the decision instituting a contractionary IOR policy in October 2008.  I was especially disappointed with Bernanke’s support for ending QE1 in late 2009, partly on the grounds that further purchases ran the risk of leading to excessive inflation.

Vaidas Urba directed me to this Bernanke comment from the April 2009 meeting:

The other perspective, however, which I think is very important and a number of people pointed out, is the medium-term constraints and dynamics that affect the economy. Unfortunately, our economy still has a significant number of very serious imbalances that need to be resolved before it can grow at a healthy pace. Just to list five. First, the leverage issue of both the financial and the household sectors. Second, wealth–income ratios are well below normal, and therefore more saving is needed to rebuild those ratios. Third, we have dramatic fiscal imbalances, which have to be reconciled at some point. Fourth, we have current account imbalances, which are at least temporarily down, but the Greenbook forecast for the medium term is that there is probably some worsening in that dimension. And fifth, as a number of people mentioned, the unemployment we are seeing is probably not mostly a temporary-layoff type of unemployment. There is a lot of reallocation going on. The financial and the construction sectors are probably not going to be as big in the future as they have been recently, so there will need to be that readjustment across sectors.

If you put all of those imbalances together and you think about what is going to support sustainable economic growth, it is a little hard to see where a robust recovery is going to come from.

How about from the Fed?

Seriously, whenever you are in a deep global slump it NEVER looks like the various components are likely to generate growth.  Why would hard up people fearing job loss consume more?  Who will we export too?  Why would firms invest when sales are slow? That was even more true in April 1933, when FDR devalued the dollar and caused industrial production to rise by 57% in 4 months.  And it was true in December 1982, right before NGDP grew at an 11% rate over 6 quarters.

In retrospect it is obvious the economy needed more NGDP in 2009, and that the Fed needed to make it happen.  But they didn’t see it.

PS.  Not to pick on Jeffrey Fuhrer, who is a fine economist, but this seems slightly off the mark:

The US inflation rate is about 1.5 percent a year, below the Federal Reserve’s 2 percent target. Too-low inflation, Fuhrer said, indicates that not all factories and businesses are humming, and more people are unemployed.

“It’s just a symptom of a poorly functioning economy that’s under capacity,” he said.

Here are some things to consider:

1.  Fuhrer is an executive vice president and senior policy adviser to Boston Fed president Eric Rosengren.

2.  The Fed is targeting inflation at 2%.

3.  The Fed is very likely to raise interest rates in the near future, which (in theory) suggests that inflation is either where they want it, or a bit too high.

Instead of saying 1.5% inflation is a “symptom of a poorly functioning economy” I’d rather he say it’s a symptom of a poorly functioning monetary regime.

PPS.  I was asked about slowing NGDP growth in Australia.  From the NGDP numbers it seems like policy is a bit too tight, but then one must also consider distortions caused by commodity price swings.  However Rajat sent me the following:

Australian workers, used to fairly solid wages rise each year for the past two decades, are faced with an economy unable to deliver the types of increases many expect.

.   .   .

The ABS reported that wages grew 0.6%, as expected but this left year on year growth at just 2.5% for 2014.

That’s only a slight dip on the recent 2.6% yoy growth rate but 2.5% is a fresh low for this wage price index series which dates back to 1997.

I’m reluctant to criticize the excellent RBA, but they do need to ease policy a bit.

PPPS.  The Boston Globe also said this about Fuhrer:

Fuhrer, a father of three adult children, lives with his wife in a historic farmhouse in Littleton. He also participates in Revolutionary War battle reenactments as a member of the Boxborough Minutemen, where he learned to play the fife.

Don’t raise rates until you see the whites of inflation’s eyes.