Archive for the Category Monetary Policy


Evidence that central bankers cannot be trusted

There’s a great new Wall Street Journal article that begins as follows:

In the seven years since the world’s central banks responded to the financial crisis by slashing interest rates, more than a dozen banks in the advanced world have tried to raise them again. All have been forced to retreat.

But it’s never their fault:

Riksbank Deputy Governor Per Jansson, in a 2014 speech, responded to critics saying, “with hindsight, it is clear that monetary policy could have been somewhat more expansionary if we had known that inflation would be as low as it is now.” But, he said, “This is a natural and unavoidable consequence of the fact that monetary policy has to be based on forecasts, which are uncertain.”

Former ECB President Jean-Claude Trichet, who pushed eurozone rates up in 2011, said he needed to react to rising inflation driven by commodity prices and a threat that households and businesses might expect higher inflation rates in the future. The ECB’s mandate was for inflation near 2%, and the ECB delivered “exactly what we promised” during his term, he said in an interview. Subsequent rate reductions happened after he left and the inflation backdrop shifted, he said. Mr. Trichet said he used other measures to combat financial turmoil, including bond purchases and emergency loans to banks.

Per Jansson doesn’t tell the WSJ readers that the Riksbank’s own internal inflation forecast predicted failure, as inflation was expected to remain below target even without a rate increase.  Lars Svensson was so exasperated he resigned in protest. The Riksbank was clearly violating its legal mandate to target inflation.

Regarding Trichet, I don’t know whether to laugh or cry.  Imagine someone named Trichet racing to the edge of the Grand Canyon at 100 mph. Besides him sits Mr. Draghi.  Just before he reaches the edge of the canyon, Trichet rips off the steering wheel and hands it to Draghi.  Here, you drive.  And then he jumps out the window.

Heh, we hit the inflation target under my watch, it was my replacement who fell short.  Don’t blame me.

For years, the Paul Krugmans of the world have been telling us the Eurozone Depression is so deep that monetary policy isn’t enough, we also need fiscal stimulus. At the same time the Trichets of the world are raising rates to prevent eurozone overheating.  You can’t make this stuff up, it’s just too bizarre.

Who am I to question the wisdom of the central bankers of the world?  They are often much more distinguished than I am.  In fact, I don’t trust my own judgment; I presume that Yellen and Fischer are much better monetary economists than I am. But it seems the markets also think the Fed is wrong:

Fed officials now say they plan to move gradually. But their expectations for rates could still be too high. Officials in June estimated the Fed would raise the short-term federal-funds rate from near zero now to 1.625% by the end of 2016 and to 2.875% by the end of 2017.

Investors have a different view. Fed-funds futures markets, where traders place bets on the outlook for the central bank’s benchmark interest rate, put the Fed target at under 1% at the end of 2016 and under 1.5% at the end of 2017. In anticipation of the Fed’s next policy meeting, some officials have said they expect to reduce their projections for rates in the future. Their projections for where rates will end up in the long run have drifted down by a half percentage point in the past three years.

Yup, they’ve “drifted down” and they’ll keep drifting down, as long as central bankers think they are smarter than the markets.

As you read the following, think about how the real risk free interest rate is determined in global markets.  Then ask yourself how much success the Fed is likely to have against this backdrop:

Mario Draghi’s promise that the European Central Bank is willing to step up its stimulus if needed is resonating with economists, who see the euro-area recovery as too shallow to be sustained.

More than two-thirds of respondents in a Bloomberg survey predict the ECB’s president will expand or extend the 1.14 trillion-euro ($1.3 trillion) quantitative-easing program, and almost all of those say he’ll do so within nine months. While an increasing number of respondents see the economy improving for now, they’re also fretting that the upturn won’t last long.

The ECB’s Governing Council has already shown concern that a slowdown in global trade will erode exports, a pillar of the regional recovery, before domestic demand is strong enough to compensate. The central bank this month cut its growth and inflation forecasts and Draghi told reporters that QE is flexible in size, duration and composition. In contrast, the Federal Reserve may raise its interest rates as soon as this week.

“QE risks becoming a semi-permanent feature,” said Gianluca Sanna, a portfolio manager at Banca Monte dei Paschi di Siena SpA in Milan. “While it’s certainly true that the euro zone is indeed going through a phase of decent, maybe even above-potential, output growth, chances are that there is nothing self-sustaining in what we are seeing right now and the euro zone ends up again in a low-growth environment with inflation dangerously close to zero.”

I very much hope I’m wrong, just as I hope I’m wrong in my prediction that Chinese growth will come in well below the consensus.

HT:  Foosion

Andrew Levin on Fed policy

Soon after I finished reading Larry Summers’ powerful argument against monetary policy tightening, Marcus Nunes sent me an equally powerful piece by Andrew Levin, who previously was a special adviser to Bernanke and Yellen (2010-12), and recently joined the faculty at Dartmouth.  The intro paragraph lays out four arguments against tightening policy now.

The Federal Reserve is on the verge of triggering the process of monetary policy tightening. In particular, a number of Fed officials have indicated that the Federal Open Market Committee (FOMC) is likely to start raising its federal funds rate target within the next few months—and perhaps as soon as its upcoming meeting next week. Unfortunately, the rationale for that policy judgment rests on faulty analytical assumptions about the labor market, inflation dynamics, the stance of monetary policy, and the balance of risks to the economic outlook. Consequently, initiating monetary tightening at this juncture would be a serious policy error.

These four arguments are then developed in more detail.  For instance, here are some comments on the balance of risks:

Over the past eighteen months, FOMC statements have regularly characterized the balance of risks to the economic outlook as “nearly balanced.” Of course, that assessment has recently come into question due to a bout of financial market volatility in conjunction with shifting prospects for major foreign economies (most notably China). Regardless of how financial markets may evolve in the near term, however, it seems clear that the balance of risks remains far from symmetric. If the U.S. economy were to encounter a severe adverse shock within the next few years (whether economic, financial, or geopolitical in nature), would the FOMC have sufficient capacity to mitigate the negative consequences for economic activity and stem a downward drift of inflation? For example, if safe-haven flows caused a steep drop in Treasury yields along with a sharp widening of risk spreads, would a new round of QE still be feasible or effective? Alternatively, would the Federal Reserve implement measures to push short-term nominal rates below zero, as some other central banks have done recently? In the absence of satisfactory answers to such questions, it is essential for the FOMC to maintain a highly accommodative stance of monetary policy as long as needed to ensure that labor market slack is fully eliminated and that inflation moves back upward to its 2 percent goal. Such a strategy will help strengthen the resilience of the U.S. economy in facing any adverse shocks that may lie ahead.

This may be the strongest argument against a rate increase now.  I can understand both sides of the argument on the labor market—maybe wages will start rising more rapidly.  But I really can’t see any good arguments on the other side of the balance of risks issue.  The risks of waiting until 2016 are very low in terms of overheating and inflation.  And I’ve never accepted the “financial” argument (bubbles, etc.) as having any validity at all.  Everywhere it’s been tried (America 1929, Sweden 2010, etc.) it’s failed. Are there any successes?  Does the Fed even have any Congressional mandate to go after bubbles?  Is there a model they can point to that explains how monetary policy should prevent bubbles? Marcus also sent me a good paper on bubbles by Gadi Barlevy of the Chicago Fed.  This is from the conclusion:

Finally, with regard to policy implications, my discussion highlights various difficulties in using greater-fool theories of bubbles to justify action against potential bubbles. Although these theories can provide some justifications for why policymakers should intervene, these rationales come with many caveats. For example, policymakers may have to know that traders have incorrect beliefs, even though policymakers would not necessarily be any better at forecasting future dividends than members of the private sector. Other justifications for intervention require policymakers to be perfectly attuned to when bubbles arise—a condition that seems implausible in practice. In fact, greater-fool theories of bubbles naturally suggest the opposite, that is, that detecting bubbles is likely to be difficult. Recall that in asymmetric information models, bubbles can arise only because there is the possibility of mutual gains from trade. Thus, there may be plausible reasons for why agents trade assets beyond trying to benefit at the expense of others. Finally, the social welfare implications that emerge most clearly in these models do not seem to capture the main issue policymakers are concerned with in regard to bubbles. For example, those who argue for a more forceful policy response to potential bubbles typically expect this response to come from central banks. This reflects a view that bubbles are fueled by loose credit conditions, as well as the idea that the collapse of a bubble causes the most harm when assets were purchased on leverage and a collapse in their price would trigger a subsequent round of defaults. Yet in most models of the greater-fool theory of bubbles, credit plays only a minor role or is missing altogether.

If the FOMC wants to go chasing after bubbles, that’s their decision.  But don’t think there’s any scientific evidence supporting this quest.  In contrast, there’s lots of scientific evidence that it would cost thousands of jobs, maybe hundreds of thousands.

I’m baffled that Greenspan is baffled

I’m certainly an optimist.  I think the expected interest rate increase is a mistake, but on balance I don’t think it will push the US back into recession.  I suppose I’d say I’m 80-20 growth in 2016.   But even that is an unnecessary risk in my view, with essentially no upside from raising rates:

1.  It will hurt the unemployed.

2.  It will move the Fed further from its 2% PCE inflation target.

3.  If you are worried about savers (I’m not) it will lead to lower interest rates in years 2 through 20 than would an easier money policy that led to faster NGDP growth.

The only argument in favor seems to be that rates for savers would be 1/4% higher for a year or two.  And that gain is worth all the downsides?

I’m 80% sure this will not push us into a double dip recession, despite the fact that history shows exactly the opposite.  Of the 5 previous attempts to exit the zero rate bound (or perhaps I should say what Keynesians regard as the zero bound) 4 were failures, which pushed the economy back into recession and/or deflation.  The failures were the US in 1937, Japan in 2000 and 2006, and the ECB in 2011.  (That 2011 rate increase wasn’t quite at the zero bound, but generally regarded as close.)  In three cases it was a 1/4% increase, and in 2011 a 1/2% increase.  The only success was in 1951, when the Treasury-Fed Accord ended the low interest rate pegging policy.

And yet despite all of this history, Alan Greenspan is “baffled”:

Greenspan also said he’s “baffled” that a 25 basis point hike by the Fed would have a major impact on economic conditions around the world.

So almost every previous time central banks do a tiny interest rate increase at the zero bound, it blows up in their face.  And yet we are shocked that markets might be a tad worried?

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What’s the downside of waiting until the Fed actually needs to raise rates to achieve its target path?

It’s really very simple.  Basic monetary theory says that interest rate pegging makes the price level indeterminate.  A peg slightly above the natural rate eventually sends you into deflation.  A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation. Monetary theory says that a 1/4% can make a massive difference, or it might make very little difference at all (it depends what happens next).  If you read any news or opinion articles where the writer wonders how a 1/4% change can be such a big deal, just stop reading.  You are wasting your time.

PS.  Just as I am a US economy optimist, perceived as a pessimist, I’m a China pessimist perceived as an optimist.  I’m currently more pessimistic about China’s growth prospects for 2016 than every single member of The Economist’s expert panel.  Every one of them expects at least 6.3% growth for China in 2016.  What a bunch of pollyannaish apologists for the Chinese Communist Party!

Say goodbye to the “discouraged workers”

For the past few years I’ve been suggesting that the labor force participation rate is not going to bounce back.  Commenters have insisted that the workers were just “discouraged”, and that they’d come back in and start looking for jobs when the labor market got somewhat better.

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Today the unemployment rate fell to 5.1%.  If that’s not the natural rate, it’s pretty close. Close enough so that if you really wanted a job you should at least be looking by now.  And yet the Labor force participation rate is 62.6%, the lowest level since the 1970s. No, I’m afraid the discouraged workers are gone for good.  Indeed the Fed wants to tighten now to prevent the job market from overheating!

I watched CNBC this morning during the jobs report, and the commentary was pretty funny.  They didn’t seem to think a quarter point was a big deal, and suggested that it might mean about 10% off the Dow.  But 10% corrections happen quite often, so it’s no big deal!  They were genuinely puzzled by why the stock market thought it was a big deal.  “Just a quarter point.”  One Tea Party type bragged that he’s been for a rate hike for 4 years.  I’ve noticed recently that people don’t seem at all embarrassed when their previous policy recommendations turn out to be totally wrong in retrospect.  Even worse, they don’t seem aware of the fact that they were wrong.  Monetary policy commentary is just free floating atavistic urges, completely untethered from any sort of model of policymaking, or economic data.

Over at Bloomberg there’s a new editorial today calling for the ECB to abandon its 2% inflation target and replace it with . . . with . . . with . . . I get to the end of the article and there’s just nothing.  Just get rid of the 2% inflation target.  That’s all. It would be like the captain instructing the pilot “don’t steer east by northeast.”

PS.  In my previous post I erroneously stated that the Neo-Fisherians believe in short run monetary superneutrality.  David Andolfatto pointed out that this claim is not correct.  Mea culpa.  Fortunately it did not affect any of the substantive points I was trying to make.  (I think what confused me is that short run superneutrality will also get you to Neo-Fisherism.  But it’s not a necessary condition, as I should have realized.)

The long run is now

I recently criticized the view that the Fed might want to consider raising interest rates because a long period of low rates could lead to financial imbalances, such as “reaching for yield.”  I actually have several problems with this view, but focused mostly on the implicit assumption that tighter money would lead to higher interest rates.  That’s not true over the sort of time frame that people are worried about.

Tyler Cowen linked to the post and offered a few comments:

Scott Sumner dissents on reach for yield.  I don’t think easier money will boost the American economy right now.  So I think you just get a loanable funds effect and then possibly a reach for yield.

A few reactions:

1.  I have a rather unconventional view on the question of policy lags, which Tyler is probably referring to in his “right now” remark.  I believe that monetary policy affects RGDP almost immediately, or at least within a few weeks.  This is based on three interrelated claims, which may or may not be true:

a.  Monetary policy immediately affects expected future NGDP growth.  That can be defended either as a definition (I define the stance of policy as expected NGDP growth) or if you prefer it can be defended on EMH/Ratex grounds.  If it affected growth expectations with a lag, then there would be lots of $100 bills on the sidewalk.  I don’t see many.

b.  Changes in expected future NGDP have an almost immediate impact on current NGDP growth.  I can’t prove this, and it’s the weakest link in the chain.  But I strongly believe it to be true.  Someone should do a study correlating changes in expected future NGDP (perhaps 4 quarters forward, consensus forecast) with changes in current NGDP.  I expect a strong correlation.  Thus during periods where the expected future NGDP falls sharply, such as the second half of 2008, current NGDP also falls sharply.

c.  Changes in current NGDP are highly correlated with changes in current RGDP. This is one of those “duh” observations, at least for anyone who pays attention to the data.

Most people believe in long and variable lags, because they associate “monetary policy” with changes in interest rates.  If the Fed created and subsidized trading in a NGDP prediction market, I believe we would quickly discover that my view of policy lags is correct, and the consensus view is wrong.  But even if I were wrong, wouldn’t it be useful to pin down this sort of stylized fact? You’d think so, but my profession seems surprisingly uninterested in these sorts of things.

2.  The loanable funds effect is exactly why I think I’m right.  Faster growth would lead to more demand for loanable funds, and thus higher interest rates.  I wonder if Tyler is referring to the “liquidity effect”, the tendency for monetary injections to lower interest rates in the short run.  If so, I don’t think this effect lasts long enough to justify distorting Fed policy with tight money in order to stop people from “reaching for yield.”

3.  I don’t like the term “reach for yield.”  When the interest rate falls, it’s rational for people to value any given future cash flow at a higher level.  So if rates fall for reasons unrelated to corporate profits or returns on apartments, then stock and real estate prices should rise.  That’s markets working the way they are supposed to.  I believe low interest rates are the new normal of the 21st century (partly but not entirely for Cowenesque “Great Stagnation” reasons), so I’m not at all concerned by higher asset prices.

4.  Tyler is on record predicting a very bad recession in China, and also for being open to arguments that the Fed might want to consider raising interest rates this year.  Each is an eminently reasonable and defensible view.  But surely they can’t both be true?  If China is going into a very bad recession, I can’t even imagine a scenario where the Fed raises rates and then a year later looks back and says, “Yup, we’re sure glad we raised rates.”  Stocks plunged earlier today on just a tiny, tiny piece of bad manufacturing news out of China.  How tiny? Notice that the same low PMI occurred three other times in the past 4 years, without RGDP growth ever falling below 7%.

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What would that index look like if Chinese RGDP growth was actually about to turn negative?  What would US stocks look like?

5.  I strongly agree with Lars Christensen’s post, which suggests that the Chinese are making a mistake by trying to prevent the yuan from falling.  I also agree with those who claim that recent events show the Chinese leadership to be less competent in economic affairs than many had imagined.  This is a consequence of development; the problems become trickier than when you are just cleaning up after the Maoist disaster.  They don’t seem to be any better at monetary policy than we are.

6.  Off topic, I probably erred in saying Trump has no chance.  That’s my personal view, but maybe I’m just an old timer who is out of touch with changes in America. After all, Berlusconi was elected three times in Italy.  I saw Trump as just another example of a rabble-rouser like George Wallace or Patrick Buchanan, who rose up and then faded.  That’s still my gut level view, but commenter “John” points out that Trump does have a non-zero chance in prediction markets, and I do claim to be an EMH guy.  More importantly, even though Trump and Sanders are unlikely to even be nominated, I see their rise as bad news for American politics.  I could even see their limited success hurting the stock market slightly, as the prospect for sensible economic and immigration reforms seems ever more distant.  Historically, markets do worse in times when the political situation is adrift.  And at the moment China, the US and Europe all seem to be a long way from the almost effortless competence of the Reagan/Clinton era.

PS.  Japan 2014, Canada 2015.  Another fake “recession” call.  Read about it at Econlog.