How we know that faster NGDP growth would lead to faster RGDP growth
A few months back David Glasner produced a fascinating paper showing how the correlation between stock prices and TIPS spreads increased sharply in the Great Recession. (And Paul Krugman commented favorably.) The implication was that when NGDP is excessively low, stock investors think higher inflation (and NGDP growth) will lead to faster RGDP growth. Recall that high inflation hurt stocks in the 1970s, by increasing the real tax rate on capital. Today, stock investors expect more NGDP to produce more RGDP.
A blog called Inframarginal Divergence has gone a bit farther:
If you want to see how bad things have gotten, you can use the beta of equities vs TIPS spreads. Loosely speaking, this beta is the amount the SPX is expected to increase for a 1% increase in TIPS spreads. If beta equals 10, then the Fed can increase equities prices by 10% by driving up the TIPS spread by 1%. Technically, I am computing the moving ratio of 6 month covariance(TIPS spread, SPX) to 6 month variance(TIPS spread) on a 1 week sampling frequency.
Now, a well-functioning monetary policy shouldn’t have a beta below 0 or above 5 against 5yr TIPS spreads (depending on your discounting any of the numbers in that range are “ideal”, meaning that real variables will be independent of inflation expectations). Well, let’s see what’s actually happening:
Good God! The data’s a bit noisy, but according to my read of this, the Fed is massively constraining real activity through its insane tight money policy. A 1% increase in inflation for 5 years (total increase in expected price level of 5%) is expected to lead to ~20% higher nominal output (integrated over time). That means that we get at least 3% real growth for 1% inflation. I want Obama to lose come Nov 2012 as much as anybody working on Wall Street because I think he’s mucked around on the AS side of the equation enough to do real damage, but I’m not willing to cut off my nose to spite my face with more unnecessary AD-induced doldrums.
So in the last few weeks the correlation has hit a new high. The stock market has never been so desperate for higher inflation expectations, higher NGDP growth. (Note, you would not expect a perfectly stable correlation, because inflation due to supply-side factors like Libya does not help the stock market.)
How can I be certain that more NGDP would help? I can’t be certain, but market forecasts are the best information we have. When policymakers ignore them, bad things usually happen.
Of course the freshwater economists would roll their eyes at this “Keynesianism”—the idea that printing money can solve real problems. They’d insist that we have 9% unemployment for year after year because investors are worried that at some future date we might have to raise the top MTR by 5 or 10 points to pay for health care. And we all know what happened when President Clinton did that. The freshwater economists are also supposed to believe in efficient markets. The strong stock index correlations with TIPS spreads just drove a dagger into their real business cycle theory.
PS. Paul Krugman has a great post showing how the eurozone’s problems are even worse.
PPS. I do think the Clinton tax increase slowed RGDP growth. But I’d also like to think I have some common sense about the size of supply-side effects.
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26. September 2011 at 05:23
Ok, you have a giant hole in your logic – a fleet armada sized hole, and it is based on beliefs others don’t have.
“Of course the freshwater economists would roll their eyes at this “Keynesianism”””the idea that printing money can solve real problems. They’d insist that we have 9% unemployment for year after year because investors are worried that at some future date we might have to raise the top MTR by 5 or 10 points to pay for health care.”
There is a SIMPLE BIT to explain:
“think he’s mucked around on the AS side of the equation enough to do real damage”
What’s that? it is Obama’s fault???
You mean that the ONLY way we can have a growing economy with Obama is PRINTING MONEY???
Ah well then, as soon as:
1. Obama gives up the goat, and changes and does what he is told.
2. Or as soon as as we’re sure he loses.
We can print money.
So let’s hope 1 come sooner than 2, because teaching Dem voters and Dem Presidents this lesson is worth it to NON-WALL STREET businessmen.
And the Tea Party SMB crowd are calling the shots, and IF the Wall Street traders don’t BEND OVER and play beta with the Tea Party, we’re going to beat them within a hair of their lives.
There is a new boss in town. The SMB job creating crowd calls the tune. Everybody else dances.
26. September 2011 at 06:03
I recall hearing an interview with one of the big RBC guys who said it wasn’t intended to explain all business cycles. I’m afraid I can’t remember who or where this was though.
26. September 2011 at 06:16
Do you agree that there can be extended recessions not due to tight money, and if so, that this could be one of them?
In the Gnome thought experiment[1], we would see similar cash hoarding and contraction of NGDP and RGDP. Would loose money from the Fed help alleviate that?
[1] Short version: Gnomes switch around all the capital goods in the country (cows, drill presses, computers) to places where they are useless, thereby rendering everyone significantly less (value-)productive.
26. September 2011 at 06:21
Right! Which is at the core of the point I made last week, here and in the following debate with Bill Woolsley and then again here . Treasuries have become negative beta vs *the whole market including treasuries*! Treasury bond QE is therefore *worse* than worthless. It’s depressing the market! I’ve been trying to make this point for awhile now, not only in your blog but also at Brad Delong, Krugman and on Nick’s blog (here and especially here for a clearer explanation). Nick is definitely interested, but there’s no question it hasn’t caught on among the talking heads in the main stream financial media. But the market certainly knows.
26. September 2011 at 06:28
While there is plenty of reasons to think that an increase in NGDP would lead to an increase RGDP, most of them have to do with reversing the damage that a far-bellow-trend NGDP does to the economy. I am quite skeptical on the tips beta argument.
The reason has to do with the structure of TIPS, which includes a put option on the real value of invested cash; TIPS will pay more interest in the case of inflation but not negative interest in the case of deflation, your capital is safe. So merely looking at the tips-treasuries break evens is not enough, a 50bp spread with the 5 year yielding 3% is a completely different story than a 50 bp spread with the 5 year yielding 1%.
To make things clearer, let’s say that the economy is in full employment and 5y treasuries yield 5%, with tips yielding 3% + expected inflation of 2%. Then the tips option structure is not relevant (the option is far out of the money) because a negative shock for inflation implies that you risk losing money. So of course as expected there is a slight correlation with equities but nothing to write home about.
However, in the present environment the option is close to being at the money, so you can replicate a “recovery” bet by being long TIPS, rather than holding a convex combination of cash and equities. For example consider that you are holding cash and equities with 0.5 weight each. The risk to your capital is substantial if the economy goes south. However, you can switch to tips and put all your money in it; then you can expect that in a recovery you will make a lot of money as inflation expectations rise, while you are 100% safe that you’ll get your capital back in case the economy goes south. Of course this is too simplistic (in practice you’d want to re-balance into equities in case of recovery) but you get the main point. So when the risk free rate is close to 0, the TIPS for same maturities should be expected to correlate closer to the market, because -unlike in normal times- they can be used to replicate a risk free position on sp500. Now this strategy, you cannot use if the economy is in full employment, because then if inflation drops you will lose money! Which should explain why the beta is higher now; the two asset classes are much closer substitutes.
So using the slope of TIPS to forecast GDP gains is deeply flawed when you put all TIPS spreads into the same time series and click “regress”, because the data from early 00s will include point estimates of the derivative of a deeply out of the money option, while present data would include point estimates of an almost at the money option. This is wrong in my opinion, it’s like regressing the s&p500 on an option that is 0.05 delta and then using the estimate to project what will happen in a world where it’s 0.5. Obviously a not very reliable approach.
Yes, there is still plenty of reasons to think that inflation is good, but the tips-beta of the market is not a proxy for what the market perceives the GDP growth will be, it’s more like a proxy of how much the market is willing to pay for an option that pays off if inflation expectations reflate.
26. September 2011 at 06:37
Scott,
You are convinced on theoretical grounds that inflation, inflation expectations, NGDP growth and NGDP expectations are monetary phenomenon, and driven by whether money is “tight” or “loose”. So, despite the fact that money is readily available for those with any good plans to put it to use, at very low interest rates, you are determined to believe money must be tight. You also believe that there is some kind of causal mechanism by which, if the CB loosens money, those other four rates will be affected. And you think that increases in those rates would be good for the real economy.
I’m skeptical about all of these claims, and think you mainly have the direction of causation backwards. Monetary authorities accommodate a rising demand for credit, if they believe it is healthy, by keeping interest rates low and creating reserves. The reserves don’t drive the lending. And the antecedent demand for credit is driven by factors outside the control of the financial sector.
But, I’m actually all for “printing money” if it could be done in the right way: not to raise inflation expectations, but to accommodate a direct boost in real economy activity through fiscal expansion not financed by tax increases or borrowing.
If a monetary authority creates new money for the treasury, and the treasury exchanges it immediately for actual goods and services, or simply gives it to those people with the highest propensity to spend or invest it right away on real goods and services, that’s a powerful, direct and efficient way of increasing effective demand for goods and services and to boost production and hiring in response.
If a monetary authority instead creates new money and exchanges it for financial assets of some kind, that is a weak, indirect and inefficient way of boosting production and hiring, at least in the present environment. I don’t think our economic problems lie on the monetary supply and credit supply side.
I also doubt the combined monetary-fiscal approach I prefer would be significantly inflationary, since we are well below capacity, and the additional money monetary transactions would be buying new consumer and capital goods and services, not just bidding up prices on existing ones.
Our Congress could generate the necessary expansion quickly by permitting the Treasury to overdraw its accounts at the Fed up to some fixed amount, and by directing the Fed to cancel those liabilities via the “printing press”. Fiscal expansion was working, and would have worked even better if it weren’t debt-driven. When they turned it off and turned toward austerity, we started to slump badly again.
I work for a company that sells books to public libraries. As you know, public library budgets are being pounded by declining state revenues combined with legislative austerity measures. Although these particular decisions do not fall inside my area of responsibility, it is unlikely that my company is going to invest in more hiring or in building up more inventory for that sector of its business – not until they see tangible indications those libraries’ budgets are going up again in a sustained way. They have invested in some capital goods to prepare for the day when things get better, and to enable more efficient purchasing within existing budget constraints. But mostly things are locked up.
Given similar market factors that are obvious to almost all businesses and standing right in front of us, it just seems ludicrous to me to try pushing on the monetary side to create monetary hot potatoes. Your approach is all about somehow forcing companies to spend and invest unwanted supplies of money to create supplies of goods and services for non-existent customers, and then hoping that the uptick in supply activity generates enough new employment and income to provide the necessary customers to buy the new stuff. I just don’t think that’s the way businesses think. “Build it and they will come” might sound good in the movies, but I’m not sure any significant number of business managers act that way.
26. September 2011 at 06:57
You’re starting to lose it, Scott. I recommend a vacation.
26. September 2011 at 07:02
If you look at the actual tax revenue figures, the practical affect of the bush tax cuts seems really, really limited. They were passed in two rounds, 2001 and 2003, but between 2003 and 04, tax revenues actually rose 100 billion dollars, half of the decline from 2000-2003. When you graph revenues vs. the trend line, the bush tax cuts look basically meaningless.
Don’t know how to do in text links here: http://imgur.com/6hwfs
26. September 2011 at 07:12
orionorbit: Whoa! Current 5-year TIPS spread is around 1.4%. But recent 5-year TIPS were issued around 105 to reduce the option value. So inflation would have to average around -1% for the option in new TIPS to have value. Back in the years before ’08 the TIPS spread was around 2.2%, but the bonds were issued at par so the option strike was at zero. So new TIPS are currently around 2.4% from the strike whereas back in ’06 we were 2.2%. And if you want an estimate without any optionality, just use some older bond that’s trading way above par and therefore has no optionality of consequence. I really doubt you are going to find anything different.
26. September 2011 at 08:10
“If a monetary authority creates new money for the treasury, and the treasury exchanges it immediately for actual goods and services, or simply gives it to those people with the highest propensity to spend or invest it right away on real goods and services, that’s a powerful, direct and efficient way of increasing effective demand for goods and services and to boost production and hiring in response._—Don .
Don- I recommend a national lottery that pays out more than it takes in. Tickets are sold in amounts under $100 per day per location per buyer, and payouts are small, in the $500 range. In other words, a lot of middling winners.
In general, middle- and lower-income people would be the buyers and spenders—and no wasteful federal programs are created.
26. September 2011 at 08:10
“If a monetary authority creates new money for the treasury, and the treasury exchanges it immediately for actual goods and services, or simply gives it to those people with the highest propensity to spend or invest it right away on real goods and services, that’s a powerful, direct and efficient way of increasing effective demand for goods and services and to boost production and hiring in response._—Don .
Don- I recommend a national lottery that pays out more than it takes in. Tickets are sold in amounts under $100 per day per location per buyer, and payouts are small, in the $500 range. In other words, a lot of middling winners.
In general, middle- and lower-income people would be the buyers and spenders—and no wasteful federal programs are created.
26. September 2011 at 08:10
“Treasury bond QE is therefore *worse* than worthless.”
K,
The Achilles heel in your argument is that the real unsterilized QE (not the Twist) programs have raised the long bond yields and steepened the yield curve. We need the real stuff, not a yield curve flattener.
26. September 2011 at 09:18
“So, despite the fact that money is readily available for those with any good plans to put it to use, at very low interest rates, you are determined to believe money must be tight.”
It certainly is. Blackstone could not secure financing on a good deal they were touting in Europe last week.
Don’t be fooled into believing low interest rates equals loose money. It doesn’t.
26. September 2011 at 09:21
@Joe2: Blackstone could not secure financing on a good deal they were touting in Europe last week.
Because it wasn’t actually a good deal.
Don’t be fooled into believing low interest rates equals loose money. It doesn’t.
Right. It’s the fact that anyone with a non-crack-induced business plan can get a loan that suggests money is loose. (Of course, Scott_Sumner would reply that this is a credit issue not a money issue.)
26. September 2011 at 09:24
Dan Kervick,
It is impossible to boost aggregate demand, either with fiscal or monetary policy, without also boosting inflation. You are asking for the impossible.
26. September 2011 at 09:32
What is really astounding is that all the information about the tightness of MP, including the one you presented is so much more clear convincing and especially easier to obtain than the results from simulations of DSGE models with different arrays of “frictions”!
26. September 2011 at 09:35
Steve: “The Achilles heel in your argument is that the real unsterilized QE (not the Twist) programs have raised the long bond yields and steepened the yield curve. We need the real stuff, not a yield curve flattener.”
You can decompose QE into to actions: 1) exchange of reserves for T-Bills and 2) exchange of T-bills for bonds (flattener).
So if the flattener is unhelpful (which is my only real arguing here), you must be arguing that the first part really works. I don’t believe that part works either though, because I agree with the argument that reserves are, for all purposes, equivalent to T-bills at the ZLB. If QE2 worked, it was because the Fed raised expectations that they were serious and willing to act, not because the actions they took were helpful. Unless they find a way to buy high beta assets (which will be pretty tricky given the Federal Reserve Act), their only tool, in my opinion, is to start announcing the contingent path of rates. E.g. “we will not raise rates until NGDP or the price level or inflation or whatever reaches some given level.” And the time to do that is short. Whenever yields drop, the market implied probability that we will get future nominal growth declines, and with it, any impact of the announced contingent path of rates.
But do you really thing that the Fed buying T-bills is going to do anything?
26. September 2011 at 09:42
This is it! Stupid-simple but (lacking a proper futures market) obviously the best monetary policy rule: Hold the SPX – TIPS spread beta at zero! This should silence Volker’s recent criticism: Now we know when inflation is bad.
26. September 2011 at 09:50
How do we know the causality doesn’t go the other way – financial panic leads to reduced liquidity in the TIPS market and hence raises TIPS spreads? The liquidity premium on TIPS may be 50 to 100 basis points so it is a non-negligible portion of the spread.
26. September 2011 at 10:04
Dan K,
Do you really not see how government overdrawing its accounts and then writing it off by law might have a negative affect on your company’s long-run investment strategy?
26. September 2011 at 10:29
Scott,
The WSJ is out with a piece today saying higher AD didn’t end the Great Depression. Ending the gold standard only produced inflation. Improved incentives for investing ended the depression. [I think the WSJ is trash. I’m just the messenger here.]
http://online.wsj.com/article/SB10001424053111904787404576532141884735626.html
“But boosting aggregate demand did not end the Great Depression. After the initial stock market crash of 1929 and subsequent economic plunge, a recovery began in the summer of 1932, well before the New Deal. The Federal Reserve Board’s Index of Industrial production rose nearly 50% between the Depression’s trough of July 1932 and June 1933. This was a period of significant deflation. Inflation began after June 1933, following the demise of the gold standard. Despite higher aggregate demand, industrial production was roughly flat over the following year.”
26. September 2011 at 10:51
Steve, Cole and Ohanian basically argue that the Great Recession is due to a negative productivity shock. This is rather bizarre. A negative supply shock in any textbook should lead to higher prices (temporarily higher inflation), but that is certainly not what we have seen in the US. Incredible that anybody seriously will make this kind of argument.
26. September 2011 at 11:02
Tom P: “How do we know the causality doesn’t go the other way – financial panic leads to reduced liquidity in the TIPS market and hence raises TIPS spreads?”
So lack of liquidity drives TIPS prices down, i.e. increases their yield, which … *decreases* the TIPS spread. That’s how we know.
26. September 2011 at 11:21
Lars- I am not sophisticated enough to argue about negative productivity shocks. I just believe in printing more money, as Friedman advocated for the Japanese (and Bernanke, and John Taylor). As you may have gathered, I prefer to live in moderately inflationary boom times than in recessionary deflations. I am not a Phd economist.
BTW, to Scott Sumner, Lars and all other friends who likes to laugh about monetary policy (with a real life edge) please read my piece that ran in the Los Angeles Business Journal.
http://www.labusinessjournal.com/news/2011/sep/26/yen-repeating-history/
26. September 2011 at 11:25
“I work for a company that sells books to public libraries. As you know, public library budgets are being pounded by declining state revenues combined with legislative austerity measures. Although these particular decisions do not fall inside my area of responsibility, it is unlikely that my company is going to invest in more hiring or in building up more inventory for that sector of its business – not until they see tangible indications those libraries’ budgets are going up again in a sustained way. They have invested in some capital goods to prepare for the day when things get better, and to enable more efficient purchasing within existing budget constraints. But mostly things are locked up.”
Libraries will survive, books won’t.
Why are you basing your view of the business climate on the assumption your company SHOULD stay open???
Just like a company that services the postal service, your days are numbered.
What MATTERS is all the newco’s that will spin up to provide library metrics / digital cataloging interfaces around Amazon’s kindle books, Goog’s book archive rip-off, etc.
It’s going to be ugly, but there will be a new form of local digital library.
The quicker your company goes belly up, the quicker the newcos can feast on your carcass!
GOV2.0. Here it comes.
26. September 2011 at 12:11
@Steve, Lars
David Glasner is any minute now releasing a post “trashing” the Ohanian (WSJ) article. It´s a gross misrepresentation of the facts, just to enable his narrative.
26. September 2011 at 13:05
Steve, Cole and Ohanian basically argue that the Great Recession is due to a negative productivity shock. This is rather bizarre. A negative supply shock in any textbook should lead to higher prices (temporarily higher inflation), but that is certainly not what we have seen in the US.
But this is exactly what occurred over the first half of 2008 (temporarily higher inflation at the outset of the Great Recession).
26. September 2011 at 13:17
The company isn’t going anywhere Morgan. They’re very big and successful on the whole, and they’re innovating to capture emerging markets as existing ones change. I was just pointing at one particular market channel. While you are right to point out that this particular part of the sales world is in flux, it is possible to make reasonable projections of what % of sales downturns in various markets are due to permanent changes in the market, and what % are due to temporary effects. (You will have to forgive me for declining to discuss any details, but I imagine my supervisors wouldn’t appreciate me discussing details of company business in the blogosphere.)
26. September 2011 at 13:35
Dan, I getcha, I just suspect you are motivated by self-interest, in both doling out social benefits and printing money, according to your career.
I’m an Internet start up guy, so I view wholesale conversion of government to less expensive digital platform with far less public employees as both moral and good for the Warstler girls.
That shift trumps any goofy money printing, fiscal stimulus noise, the future needs the past to die.
And I don’t meet many if any folks of my ilk who think efforts to SAVE the status quo are good.
But I’m honest about it. I don’t convince myself the WHOLE economy benefits from money printing and gvt. directed spending. However, you and your side do.
26. September 2011 at 13:36
MikeDC
Headline inflation crashed simultaneously with the crash in NGDP after mid 08. The higher headline inflation, unaccompanied by core inflation was a typical manifestation of a relative price shock. Until than, NGDP was kept relatively close to “target”. That was Bernankes big mistake: Tightening MP due to (headline) inflation fears in an economy that was already weakned by the house price plunge and bank “difficulties”. The Great Recession ensued
26. September 2011 at 14:10
Something I’ve been thinking about lately: Suppose that a central bank has NGDP expectations well-anchored, but then (ceteris paribus) the markets anticipate a severe negative AD shock. If the policy rate is at, say, 2%, one might think that the zero lower bound is going to prove a binding constraint. But IF expectations are well-anchored, the anticipated shock will lead the markets to anticipate a more expansionary monetary policy, raising expected future NGDP, thereby raising current NGDP, etc. This may make it unnecessary for the central bank to go all the way down to the zero lower bound, simply because NGDP expectations are well-anchored.
Why does this matter? Because it may then be the case that central banks which find themselves up against the zero lower bound for an extended period are there precisely because they’ve allowed NGDP expectations to become unanchored. And such a central bank is going to have a hard to escaping the “liquidity trap” simply because they don’t seem to know how or want to anchor NGDP expectations appropriately. So if we look at countries in liquidity traps in history, they may really look like traps because the countries seem unable to escape from them, but in fact that’s just selection bias. The countries which are using the correct method for escaping the liquidity trap may be much less likely to ever enter into one in the first place.
26. September 2011 at 14:43
Morgan, Yes, that’s your argument, and I don’t agree.
TGGP, I’m reacting to what they are saying about this cycle.
Silas, You said;
“Do you agree that there can be extended recessions not due to tight money, and if so, that this could be one of them?”
Yes, but if nominal wage grow is declining (and it is) easier money would still reduce unemployment, as wages were too high. So even if it’s 80% structural, stimulus would help. It would also indirectly lead to better public policies.
K, The problem is that rumors of QE2 in late 2010 definitely helped stock prices a lot. I’m not a big fan of QE as the best policy, I prefer level targeting, but it seemed to help stocks.
orionorbit, I don’t follow your argument. Yes, TIPS don’t fall below the original value, but you can estimate yields using an older TIPS that has already got inflation gains built in. It can lose those, and the threat of more severe deflation pushing the price below par is almost nil. In any case we are looking at changes in TIPS yields, so I don’t see where the deflation bias introduces much of a problem there. Lower TIPS spread mean lower inflation expectations. I am pretty sure you get roughly the same result using CPI futures, although I don’t have the numbers (I’m told the results are similar.)
Dan, You said;
“You are convinced on theoretical grounds that inflation, inflation expectations, NGDP growth and NGDP expectations are monetary phenomenon, and driven by whether money is “tight” or “loose”. So, despite the fact that money is readily available for those with any good plans to put it to use, at very low interest rates, you are determined to believe money must be tight.”
Please, that was the view in the Great Depression. Friedman and Schwartz totally demolished that view, it confuses money and credit. You need to talk about monetary policy, not whether credit is tight (an unrelated issue.)
BTW, I am not asking for printing money, my first choice is level targeting of NGDP, in which case no money would need to be printed.
David, Yes, I’m starting to lose it, and yes I need a vacation.
Cassander, Thanks for that info.
K, You are right about TIPS.
Ben, That would be too controversial I’m afraid.
Thanks Marcus.
Carl, The problem is that supply shocks throw it off—I still say go for the goal–on target NGDP expectations.
Tom P, I’m no expert on liquidity, but isn’t that a rather high spread estimate? The TIPS market is huge, and the bid-asked spread is tiny. I realize the market is much smaller than conventional T-bonds, but is the liquidity spread really that big?
Also, I am pretty sure you get the same results using CPI futures. Or even commodity price indices, and other indicators of inflation. I’m pretty sure the results are robust, but obviously further research would be be nice.
BTW, even if you are right, it’s an indication we need easier money.
Steve, That article is full of misleading or inaccurate data. It will be rebutted.
Ram, Exactly right, I’ve been making the same argument, but people don’t seem to pay attention. They keep talking about how I want to print money and have low rates. If we had NGDP targeting I keep insisting that rates would probably be well above zero and the base would be less than 1/2 its current size. Look at Australia.
26. September 2011 at 15:01
Right. Maybe we should stop talking about “tight” or “easy” money, and just talk about “contractionary” or “expansionary” monetary policy. The latter makes the relationships that you’ve identified seem less counterintuitive. It’s really hard to convince someone that when the Fed is printing money like never before that money is actually tight. That policy is contractionary, however, is maybe an easier sell.
26. September 2011 at 15:11
Another thing I’ve been wondering about, since reading Nick Rowe’s post on the Bernanke put, is whether Ben Bernanke himself caused the Great Recession. By that I mean, something Greenspan was doing while he was Fed chairman kept NGDP expectations anchored. Bernanke then replaces him, things are okay briefly until a negative AD shock comes in sight, and then suddenly NGDP expectations become seriously unanchored (witness the plunging TIPS spread in mid-to-late 2008). I think expectations probably came unanchored for a bunch of reasons, but maybe Greenspan had some way of signaling his commitment to stable NGDP (perhaps by way of his implicit commitment to not allow huge stock market declines), and then when Bernanke got tested, he signaled (somehow) that he had no such commitment.
26. September 2011 at 17:19
How can I be certain that more NGDP would help? I can’t be certain, but market forecasts are the best information we have.
I dont think its controversial that higher NGDP would help, except maybe to those with – gasp! – the memories of the horrible 90s inflation who are demanding austerity and tight money.
If NGDP is going up, so is personal income and wages. You’re right maybe I should care about real income, but debt is in nominal terms and housing-related debt is typically the single largest item in a homeowners budget. mortgage, auto, student loans are all ypically fixed rates in nominal terms. A little scenario analysis shows that there is a range of inflation that, by shrinking my debt, frees up income to spend on other things like an ipad 2 so I can surf the internet faster.
26. September 2011 at 21:00
Scott: “The TIPS market is huge, and the bid-asked spread is tiny. I realize the market is much smaller than conventional T-bonds, but is the liquidity spread really that big?”
Tom P wasn’t arguing for bid/ask. He was arguing that illiquidity would drive down TIPS prices. But he got the relationship between the TIPS spread and the TIPS price backwards as I pointed out above. If he is right about an illiquidity discount, the described effect would be even greater.
26. September 2011 at 21:26
Scott, I agree. Unfortunately we don’t have realtime NGDP data. A futures market would take care of that of course, but we have the stock market today and it’s already large enough for it to be reasonably resistant to manipulation if it took on an explicit role in monetary policy. At least, we have a lot of experience with it. It seems to me that getting an NGDP futures market going that isn’t vulnerable to manipulation could be fairly tricky — do you have any thoughts on that?
Supply shocks… Since I’m not an economist, I can read about things like thermoeconomics that for some reason are even less well known than market monetarism. There are strong arguments from that field to justify just targeting something like the price of crude oil. I do think there are long and variable lags in an energy supply push… I’m not sure how well they would show up in NGDP even if we had daily NGDP receipts.
But back to the market-spread beta; it has other attractive features. There’s no magic number (e.g. 5% growth) in the policy. And unlike the inflation rate itself (which, all else being equal, we’d also prefer be zero) there’s no asymmetry around the target — there’s no immediate deflationary feedback if you undershoot slightly. So you don’t need a buffer. That should please inflation hawks. And it provides a credible way to resist creating inflation around election time etc, which should please Volcker.
27. September 2011 at 00:05
The ugly monetary policy has nothing to do with Obama or Democrats. The Fed has been tightening since 2005. The financial crisis started in 2006 and just kept getting worse, with the Fed promising to step in if things got too bad. There’s a write up on it in a Sept. 2006 issue of the Economist that talks about central banks around the world sucking liquidity out of the system and going too far. Of course we know now that the Fed did nothing appropriate. It just sat and watched the crisis unfold, and then tried to fight individual fires, one financial institution at a time while Paulson went to congress begging for money – he couldn’t get it any other way. And of course, they blamed everyone but themselves.
I hate to burst the fantasy you’ve got going there, Morgan, but monetary policy isn’t going to change when/if the political guard does. It is being driven by something other than public or party interest; I really think it is just stuck on stupid.
Whatever the case, there are only two ways for this course of monetary policy to change. The first is reaching the point at which this current trajectory is unsustainable; we know that will happen because disinflation is as difficult to control as inflation, and there is no one even attempting to control it. They might have been able to shrug off the first financial crisis by pinning it on others, but a second one in less than three years should cause some serious questions to be asked about why the Fed isn’t doing its job. Hopefully that will be before it triggers our own sovereign debt crisis.
The second way is that there’s some serious housecleaning on the FOMC by congress. At the very least, congress needs to revoke the IOR, then maybe start eliminating seats on the FOMC to send a message that we’re not going to keep turning Japanese, and if one is an irrational hawk, they need not let the door hit them in the rear.
27. September 2011 at 04:30
Marcus
So there was an initial supply shock…
… followed by a massive AD shock as Bernanke and co over-reacted to it and allowed AD to plummet?
27. September 2011 at 09:49
Scott: “K, The problem is that rumors of QE2 in late 2010 definitely helped stock prices a lot.”
I’m not principally principally making an empirical argument. Mostly, I’m making a theoretical argument that 1) if bonds are negative beta (vs the whole market, not just vs SPX) then taking them away will reduce overall investment; and 2) as yields decrease towards zero, as the outlook for inflation intensifies, and as the amount of bonds outstanding is decreased by the Fed, bonds *will* necessarily become negative beta. I don’t know if we were there yet last fall (maybe not), but I think there are signs we are there now. And if things deteriorate we *will* get there.
27. September 2011 at 11:23
“as the outlook for inflation intensifies,”
Oops. Meant “deflation”
27. September 2011 at 12:53
Scott, K:
Sorry, I mistakenly typed the wrong thing, but I think my argument holds for what I meant to write.
In 2008, reduced liquidity in the TIPS market would have pushed the TIPS spread DOWN (I wrote “up”) and this would have been co-incident with the big market crash. But it wouldn’t have been falling NGDP expectations forcing both TIPS spreads and the market down, it (could) have been a liquidity crisis causing both.
The 50 to 100 bp number for the liquidity premium comes from the Fed here:
http://www.clevelandfed.org/research/data/TIPS/bg.cfm
27. September 2011 at 18:24
Ram, That’s a good idea to use “contractionary.” but “tight” requires fewer keystrokes. 🙂
I find it hard to believe Greenspan would have made much difference. His statements about the recession were very disappointing, he seemed kind of lost. The person who might have made a difference died in 2006, the same year Bernanke took over.
dwb, More NGDP helps, and debt is one way, as you say.
K and Tom, I checked that Cleveland Fed publication, and they simply assume any discrepancy with private forecasters is a liquidity problem. That’s a big assumption, and that spread seems awful large given the TIPS market runs into the $100s of billions. But I’m no expert, so all I can give you is my gut reaction.
Carl, I think it’s unlikely the NGDP futures market could be manipulated. But I’m quite willing to allow the Fed to offset any suspicious trades that they believ einvolve manipulation. As long as I’m free to get rich when I see the Fed screw up, like late 2008.
Bonnie, I think the tight money started a bit later.
K, Regarding Treasuries, there are certainly lots of ways of looking at the picture, that’s why I cited the empirical evidence. I’ve always assumed that if QE2 mattered, it mattered because it created expectations of a more stimulative policy in the future. Those sorts of arguments are psychological, and thus hard to address at the purely theoretical level. So I’m not saying your theory is wrong, I’m just not willing to buy in yet.
But I will say this, I’d vastly prefer level targeting to QE3. Especially NGDP level targeting.
27. September 2011 at 20:20
I suppose tightening has a different definition than tight. Of course you can’t get to the tight without tightening. In the same issue of The Economist is a story about the grand opening for a mortgage company hdqrs where the company had suspended mortgage origination. It went bankrupt two months later.
I’m not saying that shouldn’t have happened. Prior to its collapse, that company was hailed as an innovator in subprime lending. They were doing unsustainable things and tightening does help correct that stuff. That’s healthy. But the tightening went much farther than necessary, at least I think so since the turmoil went on for two years, culminating in the collapse of the entire financial system – under a Republican president, one month before an election to boot.
What is lender of last resort good for anyway if we end up having to borrow money from the Chinese to keep our financial system afloat? Oh no, we can’t “print” all the money to save the banks, that would be just too much even though it’s all ultra-sterilized with IOR.
28. September 2011 at 15:53
Ok this is a rather broad question and chances are you have addressed it before so if you direct me to another post or something that would be fine. I think I am starting to see why you always say that low interest rates mean tight money. I had to come at it from sort of a different direction but the way I see it is that low interest rates are an indication of tight money not necessarily a cause. Are you saying they are a cause? And more importantly are you saying that just raising them would make money “looser?” I don’t feel like that is what you are saying. But you also said that QE isn’t your preferred policy so how would you make money looser? At least how would you make it looser given the standard tools (without creating any new exchanges.)
To ask it a slightly different way, I get that you want NGDP targeting and presumably we are falling short of the target but how can the Fed increase it without QE?
29. September 2011 at 05:27
Bonnie, Well we certainly agree that money got tight by 2008.
Mike, I sometimes say “never reason from a price change.” Money could be easy or tight with low rates. But I also point out that very low rates are almost always a sign of tight money. Three famous examples are the US in the 1930s, Japanese in recent years, and the US since 2008. All three cases were associated with tight money (NGDP way below trend.)
Whether higher rates will ease policy depends how they are done. If the Fed raises rates by suddenly reducing the money supply, it will not be expansionary. If they raise rates by setting a much higher NGDP target, and do level targeting, the higher rates will be associated with an expansionary policy.
29. September 2011 at 09:17
Yeah so we’re on the same page about rates and tightness but the thrust of my question becomes the last part which is: how do they target that level without QE? Presumably in order to get higher NGDP they have to increase the money supply which means they have to buy something? Right? So what should they buy?
29. September 2011 at 17:18
Mike, No, they don’t need to increase the money supply to raise NGDP, they already have far more money in the system than we need–three times as much as in 2007. They need less demand for money. You do that by raising NGDP expectations and cutting IOR, not by QE.
30. September 2011 at 16:22
Ok, it seems to me like your approach depends mainly on the belief that if the Fed says they are targeting NGDP levels, then this would cause a change in expectations which would be self-fulfilling without the Fed really needing to do much. This may be true but I will have to think about it before I bother you any more. Thank you though, I really appreciate you taking the time to respond to all these comments, it looks like a lot of work :/.