It’s good to be the Fed

Before the recession, the Fed typically earned a profit of about $30 billion per year. After the Great Recession, their profits rose to the $70 to $80 billion range, as their balance sheet expanded.

There was a time where the Fed actually was reluctant to engage in monetary stimulus out of fear that they would take on excessive risk.  I thought those fears were completely nuts, for several reasons.  They weren’t likely to absorb particularly large losses, and even if they did they didn’t really need enough bonds to back up the monetary base, only the share held as bank reserves.  And most importantly, the Fed is essentially part of the Federal government, so when the Fed sees its assets fall due to a decline in T-bond prices, the Treasury gains a precisely equal reduction in their liabilities.  It’s a wash.

Don’t believe me that the Fed is part of the Federal government?  Where do you think all those profits go?

Here’s the latest profit report, and it’s a blockbuster:

According to figures released Friday, the Fed reported net income of $101.3 billion. That’s an increase of nearly 30% from 2013.

But the Fed sends nearly all of its profits to the Treasury. Last year, that amounted to $96.9 billion. The Fed said this was a record.

Commenter “Negation of Ideology,” who sent me this article, added this information:

Also, out of a balance sheet of $4.5 Trillion, $800 Billion will be maturing in the next two years.  Sounds to me that those who are worried about the Fed being unable to unwind and being forced to sell bonds at a loss are worried about nothing.

And $1.35 trillion of the Fed’s “liabilities” are zero interest cash.  I can’t believe people were seriously worried about the Fed’s balance sheet, and that this might have even inhibited monetary stimulus.  The Fed had similar fears in the 1930s, which were far more justified, but even those fears are widely ridiculed by modern economic historians.  Imagine what future monetary historians will think when they pour over the FOMC minutes for 2010, 2011 and 2012.

Everyone should pray each night that interest rates soon soar up to levels that put the Fed balance sheet under stress.  That would imply we get back to the sort of healthy economy that we had in the 1990s.  Unfortunately, that’s just a pipe dream.

By the way, does anyone know why the Fed has decided to raise rates before unwinding the balance sheet.  Logically you’d expect last in, first out.  They cut rates, then did QE; so why not unwind the QE, then raise rates?

Tim Worstall is just as confused as I am.

The New Yorker on monetary policy

I recall the New Yorker used to advertise itself as “the best magazine in the world.”  I think it’s fair to say that this was not based on its economics reporting.  Gordon sent me the following:

At the end of last year, when jobs and output both appeared to be growing strongly, members of the F.O.M.C. were predicting that G.D.P. growth in 2015 would be somewhere between 2.6 and 3.0 per cent. Now they have cut their prediction for growth this year to somewhere between 2.3 and 2.7 per cent. That’s not a drastic revision, but it reflects a number of recent economic statistics, such as retail sales and exports, having come in weaker than expected. Yellen pointed to a subdued housing market and a stronger dollar as restraining factors.

While Yellen was at pains to point out that other recent indicators, notably jobs numbers, have remained strong, the big rise in the dollar over the past year clearly has Yellen’s attention. Indeed, I suspect that the rally in the currency has prompted a serious rethink inside the Fed—and for good reason. The rise in the dollar means, effectively, that monetary policy has already been tightened. From an economy-wide perspective, an appreciation of the currency acts just like an actual rise in rates: it reduces the over-all level of demand and causes a slowdown in G.D.P. growth. Now that this has happened, it’s no surprise that the Fed would reconsider its next move.

To put it another way, the currency markets have already done a bit of the Fed’s work for it. By signalling to the market over the past few months that it was preparing to raise rates, the Fed prompted currency speculators to buy dollar-denominated assets, which bid up the price of the U.S. currency. Since this time last year, the value of the dollar against the euro has jumped by almost thirty per cent.

I can’t believe the Fed is downgrading its growth forecasts for 2015, who ever would have expected that to occur?  (Does anyone recall the last time they didn’t have to do that?)

More importantly, a rise in the dollar is most certainly not equivalent to a tightening of monetary policy.  If it was, then the dollar exchange rate would be the proper measure of the stance of monetary policy, not interest rates, real interest rates, the monetary base, M2, er, I mean NGDP growth expectations.

Perhaps the most incredible claim is that the dollar’s recent surge is due to the Fed signaling an intention to raise rates later this year, as if the market was not fully aware of that fact back when the euro traded at $1.35.  The new information in the last year has been monetary stimulus out of Europe (and probably some other things that I’m not aware of.)

In another New Yorker article John Cassidy suggests that, “the threat of bubbles, not inflation, should guide Fed policy.”  This despite the fact that the Fed’s last effort at bubble popping (in 1929) didn’t work out so well.  Not to mention that there is essentially no evidence as to what causes bubbles, which are not generally associated with easy money policies.  Michael Darda recently sent me a graph showing that “overvalued” markets are actually more likely to occur when money is tight:

Screen Shot 2015-03-20 at 5.13.20 PM

Conservatives are not abandoning market monetarism

Ryan Cooper has a piece in The Week on market monetarism:

During the dog days of the Great Recession, several economists developed a persuasive case that the Federal Reserve was badly bungling monetary policy. Led by Scott Sumner, these “market monetarists” argued that the Fed should be far more prepared to unleash monetary stimulus. To do this, the central bank would have to abandon its dual mandate of keeping unemployment and inflation low, and adopt a much simpler metric: a nominal gross domestic product (NGDP) growth target.

So far, so good.  But then things start to go awry:

The high-water mark of the market monetarists’ intellectual and political influence was in 2011 and 2012, when market monetarism was a key economic plank for reform conservatives, those who have been trying, with little success thus far, to push the Republican Party in a new, less dogmatic direction. Since then, however, the NGDP chorus has quieted somewhat, and the movement’s key political allies have abandoned it.

Ramesh Ponnuru, previously a strong advocate of monetary stimulus, claims that he has not abandoned the NGDP target, just that the times have changed:

I was never going to be a dove for very long. Being a hawk on monetary policy in all circumstances, or being a dove in all circumstances, makes as little sense as being either of those things on foreign policy in all circumstances… My preference would be for a steady rate of increase in nominal spending, say at 4.5 percent a year. If the Fed had pursued that policy over the last half-century, it would have been much tighter during the 1960s and 1970s, a bit tighter during 2003-06, and much looser in 2008-11. [National Review] .  .  .

There are two problems here. First is the choice of target: 4.5 percent is lower than Sumner’s typical 5 percent, and could mean enforcing unnecessarily low growth. Adopting a 4.5 percent target in the 1960s, as he suggests in his first piece, would have choked off a tremendous economic boom in which real GDP increased by 53 percent (as compared to 15 percent during the 2000s).

To quote Cooper, there are two problems here.  First, the difference between 4.5% and 5.0% is unimportant (and I’ve frequently indicated that I’d be fine with either number, or even 4.0%, level targeting.) More importantly, he’s completely wrong about the 1960s. Monetary policy has no long run effect on RGDP growth. Money is roughly superneutral, except at very low rates—far below the rates of the 1960s. The 1960s would have been booming even with a 4.5% NGDP target, and we would have avoided a painful squeeze on the economy in the early 1980s if we’d never let high inflation out of the bag.

The other problem is much more important, and it entails a truly enormous downside risk. Ponnuru argues that a return to the previous economic trend is rapidly becoming impossible. But what if he’s wrong?

If he’s wrong then the economy will find that old RGDP trend line, even with 4.5% NGDP growth.  That’s because 4.5% NGDP growth, when combined with 2% wage growth, leads to a rapidly falling unemployment rate.  It may not feel that way, but we are recovering—indeed we are doing so with less than 4.5% NGDP growth.

A permanent 1.45 percentage point decline in America’s nominal growth path would be indescribably disastrous. As Brad DeLong calculates, by 2014 the cumulative lost output of the Great Recession through that year amounted to roughly $60,000 per person. If nothing restores the trend, the amount lost could reach into the hundreds of thousands, per person.

Again, the growth rate doesn’t matter, unless you fall to very low levels.  Japan has even adjusted to a lower NGDP growth rate.  What matters is volatility.

I think some people were confused by the market monetarist message in 2009, assuming that once a dove, always a dove.  Now it’s quite possible that I’ll end up being dovish for most of the rest of my life, just as I was hawkish during the entire 1970s and early 1980s.  But that’s only if the Fed keeps missing on the low side. The model is symmetrical, and there is no reason at all for all market monetarists to agree on what the Fed should do right now, when the Fed is not even targeting NGDP.  We are in the world of second best, where opinions will differ.

No, conservatives that have adopted market monetarism are not abandoning the ship. Indeed we are still growing.

HT:  Ramesh Ponnuru

Hawks try to rewrite history

LK Beland pointed me to a new Lars Svensson post, which demolishes the Riksbank’s defense of its tight money policy:

In an interview in Bloomberg, Riksbank Deputy Governor Per Jansson again tries to defend the indefensible, the Riksbank’s sharp tightening of monetary policy in the summer of 2010. From the summer of 2010 to the summer of 2011, the Riksbank majority increased the policy rate from 0.25 percent to 2 percent.

The increases “from 0.25 percent in the summer of 2010 up to 2 percent in the middle of 2011 was really mostly about normal things that central banks look at,” given that growth at the time was about 6 percent, inflation was around 2 percent and household credit growth was about 9 percent, [Jansson] said. “There were really, in real time, no comments suggesting that it would be a stupid idea to increase the interest rate.”

But in real time, the Riksbank’s inflation forecast was below the inflation target and unemployment and the unemployment forecast were far above the Riksbank’s estimate of a long-run sustainable rate. In such a situation, easing, not tightening, is the right policy, since it shifts the inflation forecast up and closer to the target and the unemployment forecast down and closer the long-run sustainable rate. It thereby leads to better target achievement. Since tightening instead leads to worse target achievement, it is indefensible. My colleague in the Execeutive Board, Karolina Ekholm, and I indeed dissented from this tightening policy with very clear and logical arguments, namely that easier policy would in this situation lead to better target achievement.

Jansson’s claim of no opposition is extremely misleading, to put it mildly. It’s public knowledge that there was strong opposition to excessively tight money in Sweden by 2011.  The hawks were explicitly ignoring the Riksbank’s legal mandate, and several Riksbank members were pointing that out.  Here’s what was actually happening in 2011:

Ingves hire help to explain the rise in interest rates

Riksbank Governor Stefan Ingves interest rate increases has been questioned by everyone from finance minister to bank forecasters.

Express can today reveal that he hired a star consultant to defend the interest rate increases.

Cost: 140 000.

Riksbank Governor Stefan Ingves has been under fire recently.  Internally, the Bank, he has met with resistance by the so-called doves – Lars EO Svensson and Karolina Ekholm – who time and again expressed its reservations about interest rate hikes and sharp interest rate forecasts.

So the criticism of the hawks was so strong that by 2011 they were hiring a consultant to defend themselves against the dissents of several members of the Riksbank, including Lars Svensson.

For years the hawks have been telling me that monetary stimulus would lead to high inflation.  Now that they’ve been proved wrong, the new strategy is to say, “who could have known that we weren’t doing enough monetary stimulus?” Pathetic.

PS. Who could have known?  The market.

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.