Archive for the Category Monetary Policy


Should the Fed worry about dollar debts?

Here is the Financial Times:

The US Federal Reserve is often buffeted by fierce cross-currents but investors caution that balancing the strong domestic economy and rising turbulence in emerging markets — and now Europe — will require a particularly adept hand at the tiller this year.

Although Argentina and Turkey have been the focus for their own idiosyncratic reasons, Urjit Patel, India’s central bank governor, argued that emerging markets are suffering a broader bout of “upheaval” caused by the “double whammy” of the Fed’s balance sheet shrinkage and the US Treasury’s borrowing binge.

“Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet,” Mr Patel wrote in the FT on Monday. “If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable.”

Borrowers in emerging markets need to understand that interest rates are volatile.  If they cannot afford to repay dollar-denominated debts when the dollar is strong, then they shouldn’t be borrowing dollars in the first place.  Borrow in your local currency.

Worries about an EM debt crisis are not a good reason to refrain from raising the target interest rate.  On the other hand, the following is not a good reason to raise interest rates:

Indeed, given the robust US economic outlook, some analysts even caution that it runs the risk of overheating. The 10-year “breakeven” rate, a market measure of investors’ inflation expectations, remains above the Fed’s target 2 per cent at 2.07 per cent, despite recent declines, and inflation is expected to continue to accelerate into the summer.

Arrgggh!  I can’t believe that in 2018, respectable publications are still making this basic error.  The Fed does not target the TIPS spread at 2%, as that spread is based on CPI inflation, not the PCE inflation rate that is the actual target of Fed policy.  When CPI inflation is running at 2.07%, PCE inflation runs around 1.8%.

NOW you want more than 2% inflation?!?!?

Reading the Fed minutes can sometimes make me want to tear my hair out.  During the long recovery from the Great Recession, the Fed frequently told us that we could not do more stimulus due to the danger of inflation exceeding 2%.  The taper tantrum was caused by Fed hints that monetary tightening was on the horizon, motivated by a fear of higher inflation.  In 2015, the Fed began raising interest rates, with the goal of preventing inflation from overshooting 2%.

And now, with unemployment down to 3.9%, we are suddenly told that the Fed would actually welcome above 2% inflation?  This makes no sense at all.

It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.

Just to be clear, it’s perfectly fine to argue that the Fed should overshoot their 2% inflation target right now.  Thus a market monetarist might favor overshooting for “level targeting” reasons.  There are good arguments on both sides of that question, but it’s certainly a defensible argument.  However these MMs that favor overshooting were also favoring more monetary stimulus during the recovery from the Great Recession.

What’s not defensible is to have have opposed additional monetary stimulus during the recovery from the Great Recession, even as inflation was running well under 2%, and then now suddenly favor above 2% inflation.

Most business cycles are caused by procyclical monetary policy.  A monetary policy that causes inflation to run below 2% during periods of high unemployment and above 2% during booms is procyclical, and hence bad.  Why does the Fed have so much trouble understanding such a basic point?  I don’t get it.

I can already anticipate commenters talking about whether money is too easy or too tight without reference to the monetary REGIME.  That’s just stupid.  Monetary policy is not about whether the fed funds rate should be raised or lowered at a given meeting, it’s about what sort of policy regime you have.  The Fed still hasn’t figured out that a procyclical policy regime is destabilizing.  It’s the primary cause of the business cycle.

PS. I have a blog post at a new AEI symposium on how the US can best compete with China.

Beckworth interviews Hamilton

David Beckworth recently interviewed Jim Hamilton on a wide variety of topics, including energy and monetary policy.  At one point they discussed Hamilton’s recent research on the impact of QE.  Hamilton discussed the March 18, 2009 QE announcement, which is sometimes cited as evidence that QE was effective.  On the day of the announcement, 10-year bond yields plunged from roughly 3.0% to 2.5%.

Hamilton pointed out that the market response doesn’t necessarily indicate that rates fell due to monetary expansion.  An alternative interpretation is that the announcement led traders to re-evaluate their view of the economy, perceiving the Fed to have relevant non-public information. Hamilton suggested that investors may have thought:

What do they know that I didn’t?  And, maybe the economy is in worse shape than I thought.

If that were the case, then you’d expect other markets to reflect this bearish perception.  In fact, exactly the opposite occurred.  Here is the NYT, from March 18, 2009:

The Federal Reserve sharply stepped up its efforts to bolster the economy on Wednesday, announcing that it would pump an extra $1 trillion into the financial system by purchasing Treasury bonds and mortgage securities. . . .

Investors responded with surprise and enthusiasm. The Dow Jones industrial average, which had been down about 50 points just before the announcement, jumped immediately and ended the day up almost 91 points at 7,486.58. Yields on long-term Treasury bonds dropped markedly, and analysts predicted that interest rates on fixed-rate mortgages would soon drop below 5 percent.

This suggests that markets treated the QE announcement as an expansionary monetary policy, which sharply lowered long term bond yields and also raised equity prices by roughly 2%.

On the other hand, I do agree with Hamilton’s claim that the big decline in interest rates (throughout the world) during the Great Recession was mostly due to other factors such as slow growth, not QE.

PS.  Let me reiterate that QE is not a policy, it’s a tool.  Thus QE is not the way to prevent demand shortfalls.  To do that you need a sound monetary policy, preferably NGDPLT.  Then QE can be used as a tool to implement that policy, in the unlikely event it is needed.

Tate Lacey on the new Fed leadership

Tate Lacey has a interesting piece over at Alt-M, which suggests that the new Fed vice chair might be amenable to NGDPLT:

Clarida now seems predisposed to three views about monetary policy that could significantly influence the Fed’s actions going forward:

1. That a central bank fully committed to reaching a nominal target is superior to one focused on mechanical operations.

2. That employing forward guidance is indeed an effective tool for conducting monetary policy.

3. That level targeting can make up for past errors in monetary policy in a way that growth rate targeting cannot.

Combined, I think these views point to Clarida being more amenable to a nominal GDP target than even he may presently admit. After all, nominal GDP level targeting requires two things of a central bank to work in practice: first a central bank must credibly pledge to keep nominal GDP growing along a stable trend line and then it must be prepared to do whatever is necessary to achieve that level of nominal growth.

Clarida has already expressed the importance of both of these elements. In addition, he has repeatedly shown a willingness to let his thinking evolve when presented with new information. Therefore, he may yet be persuaded on the shortcomings of price level targeting in favor of a superior option.

Lacey acknowledges that this is speculative, but he is right to emphasize these aspects of Richard Clarida’s thinking on monetary policy.

This is also important, and it’s the step that many modern central banks are reluctant to take:

However, the second, subtle point in his framework that should not be ignored is that Clarida recommends the central bank fully commit to an outcome rather than announce various mechanical steps.

PS.  The Hypermind NGDP contract for 2017-2018 just completed and growth came in at 4.8%. I was given the following information:

362 traders participated in this contest, and 224 (62%) made a virtual profit. This means 224 contest winners have earned a share anywhere from $4 to $1,038 from the $35,000 prize pool.

The 2018-19 NGDP futures contract is trading at 4.5%, which suggests to me that policy may be a tad too expansionary, but is still basically on course.

The market price has not been very volatile, which is perhaps disappointing if the market is viewed as a scientific experiment, but very positive if viewed as a technique for making NGDP more stable.

The government is beginning to see the light

Before getting into the main topic of the post, I’d like to point out that Mercatus has recently published a new primer on NGDP targeting, as well as futures targeting, written by Ethan Roberts and myself. I recommend it to people who want a short introduction to the concept:

The first section will clearly define monetary policy, describe the two main methods that central banks have traditionally used to carry out policy, and analyze the weaknesses of these methods. Later sections will articulate what NGDP is and how a policy of NGDP targeting works. Subsequent sections will list the most common criticisms of NGDP targeting and explain why these criticisms are misguided, and they will present arguments in support of the policy. Finally, the primer will provide specific recommendations for how to move from the current system to a system based on NGDP futures targeting.

I have a relatively low opinion of government, so I was very pleasantly surprised to see an outstanding report on monetary policy by the Joint Economic Committee.  You really need to read the entire thing, or at least the entire chapter entitled “Macroeconomic Outlook” from page 51 to 94, but here are a few excerpts:

The Report and Federal Reserve officials find low inflation rates “puzzling,” especially given the low unemployment rates. The “Phillips Curve” theory of price inflation posits that low unemployment rates drive up wages, which leads firms to raise prices to offset rising costs. The Committee Majority explores alternative explanations for below-target inflation. Notably, monetary policy may not have been as “accommodative” as commonly perceived.

The report then began describing policy in 2008, which was aimed at rescuing banks, not the broader economy:

Federal Reserve Bank of Richmond senior economist Robert Hetzel succinctly described the unusual credit policy:

Policies to stimulate aggregate demand by augmenting financial intermediation provided an extraordinary experiment with credit policy as opposed to monetary policy.

The Fed bought financial instruments from particular credit markets segments to direct liquidity toward them, which had the effect of injecting reserves into the banking system. This action alone would incidentally ease monetary conditions, but the Fed then sold Treasury securities from its portfolio to withdraw those reserves from the banking system (called “sterilization”), thereby restricting nominal spending growth.

I also get cited a few times:

Furthermore, despite the low level of the Fed’s fed funds rate target, monetary policy arguably remained relatively tight, as monetary economist Scott Sumner notes in the context of a 2003 Ben Bernanke speech:

Bernanke (2003) was also skeptical of the claim that low interest rates represent easy money:

[Bernanke:] As emphasized by [Milton] Friedman… nominal interest rates are not good indicators of the stance of monetary policy…The real short-term interest rate… 55 is also imperfect…Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

Ironically, by this criterion, monetary policy during the 2008-13 was the tightest since Herbert Hoover was President.

Then it discusses why various QE programs had little impact:

The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program:

Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future.

Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues. Furthermore as Sumner (2010), Feldstein (2013), Beckworth (2017), Selgin (2017), and Ireland (2018) note, payment of IOER at rates competitive with market rates led banks to hoard the reserve, which contributed at least partially to the collapse of the money multiplier (Figure 2-3).

And it wasn’t just right of center economists that objected to IOR:

Regarding IOER, former Federal Reserve Vice Chairman Alan Blinder advised in 2012:

I’ve been urging on the Fed for more than two years: Lower the interest rate paid on excess reserves. The basic idea is simple. If the Fed reduces the reward for holding excess reserves, banks will hold less of them—which means they will have to find something else to do with the money, such as lending it out or putting it in the capital markets.

He later observed in 2013:

If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves? Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.

I suggested negative IOR way back in early 2009.

They also point out that the Fed has ignored the intent of the Congressional authorization of IOR:

The law specifies that IOER be paid at “rates not to exceed the general level of short-term interest rates.” However, from 2009- 2017, the IOER rate exceeded the effective fed funds rate 100 percent of the time, the yield on the 3-month Treasury bills 97.2 percent of the time, and the yield on 3-month nonfinancial commercial paper 82.1 percent of the time (Figure 2-5). The Fed is including its own discount rate (the primary credit rate) in the general level of short-term interest rates to demonstrate compliance with the law.

In connection to IOER, Representative Jeb Hensarling, Chairman of the House Financial Services Committee, stated:

[It] is critical that the Fed stays in their lane. Interest on reserves – especially excess reserves – is not only fueling a much more improvisational monetary policy, but it has fueled a distortionary balance sheet that has clearly allowed the Fed into credit allocation policy where it does not have business.

Credit policies are the purview of Congress, not the Fed. When Congress granted the Fed the power to pay interest on reserves, it was never contemplated or articulated that IOER might be used to supplant FOMC. If the Fed continues to do so, I fear its independence could be eroded.

The following is also an important point—making sure than monetary policy continues to be about money:

Noting that the large quantity of reserves produced by the Fed contributed to the fed funds rate trading at or below the IOER rate, John Taylor of Stanford University’s Hoover Institution said:

[W]e would be better off with a corridor or band with a lower interest rate on deposits [IOER] at the bottom of the band, a higher interest rate on borrowing from the Fed [the discount rate] at the top of the band, and most important, a market determined interest rate above the floor and below the ceiling… We want to create a connect, not a disconnect, between the interest rate that the Fed sets and the amount of reserves or the amount of money that’s in the system. Because the Fed is responsible for the reserves and money, that connection is important. Without that connection, 63 you raise the chances of the Fed being a multipurpose institution.

Most importantly, the government is beginning to recognize that it was tight money that caused the Great Recession:

The preceding observations and alternative views merit consideration. In particular, Hetzel (2009) states:

Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.

When people like Hetzel, Beckworth and I made that claim back in 2008-09, we were laughed at.  Who’s laughing now?