Archive for April 2015


Interesting links

Jim Glass sent me a very good piece by Greg Ip of the WSJ:

The U.S. economy has downshifted rather abruptly in the last few months, prompting new discussion within the Federal Reserve about delaying its first interest-rate increase. Yet the growth deceleration should not come as a surprise, because the Fed has already tightened.

True, the Fed’s interest-rate target remains close to zero. But the Fed tightens through its words, not just its actions, and the drumbeat of chatter from the Fed in the last year has made it clear that officials plan to start raising rates sometime this year.

That chatter has made itself felt in stock, bond, and most important foreign exchange markets. The dollar’s sharp rise in the last six months is not due not just to the European Central Bank‘s dramatic easing of monetary policy through quantitative easing (QE, the purchase of bonds with newly created money), but to the juxtaposition of the ECB’s action against anticipation that the Fed will soon tighten.

.  .  .

This is a reminder of something investors and Fed officials routinely forget: Markets discount the Fed’s actions long before they actually occur, in ways that are not obvious at the time. We saw that with the 2013 “taper tantrum” that sent mortgage rates up sharply and soon produced a notable slowing in housing and other interest-sensitive parts of economic growth.

The Fed should therefore respond to this in one of two ways. First, the tightening in financial conditions has already done much of the work that its first interest-rate increase was supposed to accomplish. This is a good reason to either delay the start of tightening, tighten more slowly, or both.

Second, if Fed officials feel the tightening in financial conditions is excessive, they should change how they talk. The dovish message of the March Fed meeting arrested the rise in the dollar, and more officials are expressing concern about the tone of recent data.

Some economists think of the stance of monetary policy as the future path of the target rate, relative to the future path of the Wicksellian equilibrium rate.  But it’s easy to lose sight of the fact that changes in the stance of monetary policy generally involve changes in the future path of the Wicksellian rate far more than changes in the future path of the actual rate.

Here’s a good piece by Tim Worstall:

Much as I enjoy seeing people shouting at the EU and the ECB for the near idiot manner in which they have conducted monetary policy in the past few years, for I yield to no one except Scott Sumner in my estimation that their performance has been terrible, I can’t let this from Paul Krugman pass. For he appears to be rewriting economic history on the hoof over this idea of expansionary austerity.

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That the ECB and the EU Commission screwed up I’ll accept, even fervently endorse. But that’s not the same as being able to show that expansionary austerity doesn’t work: because the EU and the ECB didn’t actually try it. For the poster child for expansionary austerity is actually my native UK in the 1930s. Yes, it involves reducing the deficit and it can thus be described as austerity. But what is really being done is that austere fiscal policy along with a riproaringly expansionary monetary policy. Rather like, umm, doing QE in fact. What Britain did in the 1930s was to come off the gold standard and devalue the pound by 25% or so. We thus got the expansion through that monetary policy and it worked: two years later we were back above pre-recession levels of output. The other examples of the idea also had significant devaluations of the currency in question. Such a devaluation being an important part of the overall policy.

All of the successful examples of expansionary austerity that I know of involve monetary stimulus.  And that includes the massive $500 billion decline in the US budget deficit between calendar 2012 and 2013, which was accompanied by a speed up in GDP growth, a speed up in job creation, and a speed up in the rate of decline in the unemployment rate.  Of course in early 2013 Paul Krugman thought the austerity would slow the recovery.

In early 2014 Krugman suggested that we would soon get a test of the hypothesis that extended unemployment benefits had raised the unemployment rate, as the benefits were being scaled back.  More recently, he seems to have gone quiet about that test, just as he did after the 2013 test of market monetarism.  The Economist explains why supply-side economics matters, even at the zero bound:

A research paper from the Federal Reserve Bank of Chicago estimates that, if real wage growth had followed its historical relationship with the unemployment rate, by mid-2014 it would have been 3.6 percentage points higher than it actually was. Three big things, though, have held back pay: changes to America’s unemployment-insurance system, the behaviour of firms, and the persistence of labour-market “slack”.

America’s unemployment-insurance system underwent a big change at the end of 2013. Before then, the average American could get 53 weeks’ worth of unemployment benefits; in three states they could get 73 weeks’ worth. Congress then decided to make benefits stingier: the average limit dived to 25 weeks, cutting off 1.3m Americans immediately. With nothing to fall back on, the wage expectations of many unemployed people fell, says Iourii Manovskii of the University of Pennsylvania. Employers in some sectors quickly took advantage of this newly cheap pool of workers. A big chunk of the 3m extra jobs created during 2014 were in poorly paid industries (see chart 3).

And here’s one on Neo-Fisherism in Turkey:

Mr Erdogan claims””against all the evidence and in complete contradiction to orthodox economics””that cutting rates will somehow lower inflation. As a devout Muslim, he may also be uncomfortable with usury; he says a rate of zero is the ideal. And the small businessmen who are loyal AK voters tend to borrow domestically in liras, not abroad in dollars.

If Mr. Erdogan thinks zero is ideal, then he presumably regards Switzerland as having the West’s most Islamic financial system. On the other hand, given the speed at which the Turkish lira is losing value, I wouldn’t look for zero rates in Istanbul anytime soon.

Lost in translation

This piece in the NYT made me smile:

While Mr. Bernanke will remain a full-time fellow at the Brookings Institution, the new role represents his first somewhat regular job in the private sector since stepping down as Fed chairman in January 2014.

His role at Citadel was negotiated by Robert Barnett, the Washington superlawyer who also negotiated a deal for his book, “The Courage to Act,” which Mr. Bernanke recently submitted to his editor and will be published in October.

Mr. Bernanke’s insights are already much in demand.

At a gathering at the Bellagio Hotel in Las Vegas last May, several hedge fund managers said they had attended dinners with Mr. Bernanke in the first months after he stepped down from the Fed.

“At those dinners he gave credence to the idea that the Fed believed in lower potential G.D.P. and lower potential inflation,” Mr. Novogratz told the audience of money managers. For many, that advice was well worth the cost of a seat at the time.

But one hedge fund manager missed out.

“He gave this stuff out,” Mr. Tepper said, “but I didn’t realize what he was saying at the time, so I didn’t do a great trade.”

I’m quite certain that Bernanke did not suggest that we were in an era of “lower potential inflation”, as there is no such thing as potential inflation.  Looks like Mr. Tepper is not the only one who “didn’t realize what he was saying at the time.”

(I’ve been telling finance audiences that rates would stay low ever since I started blogging in 2009.  Of course they don’t pay me as much as Bernanke (nor should they), indeed the London HSBC group I spoke to last year never paid me a dime.)

Bernanke on monetary reform

Well this is the post we’ve all been waiting for, isn’t it?  Ben Bernanke has a post discussing options for monetary reform. As you’d expect, it’s a really well thought out post—first rate.  And as you’d expect, I am still able to find a few points where I disagree.  But let’s start with the good stuff:

Of course, no policy framework is without drawbacks, as attested by the difficulties the FOMC has faced in dealing with the zero lower bound on interest rates. If the Committee were to contemplate changing its framework, there are two directions it might consider.

He’s open to alternatives, and recognizes that policy has been less effective since 2008.  The first alternative is a Taylor-like instrument rule, which Bernanke finds useful but a bit too rigid to rely on completely.  Ben shows he’s a natural blogger by providing a long quote explaining why policymakers cannot rely too rigidly on a mechanical rule, before telling us:

As some will have guessed, the quote is from John Taylor’s classic 1993 paper introducing the Taylor rule, “Discretion versus Policy Rules in Practice” (pp. 196-7).

A little bit of teasing from the former Fed chair to (perhaps) the next Fed chair if the GOP retakes the White House. Then the second alternative:

The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP. Some of these approaches have the advantage of helping deal with the zero-lower-bound problem, at least in principle.

That’s good.

My colleagues at the Fed and I spent a good deal of time during the period after the financial crisis considering these and other alternatives, and I think I am familiar with the relevant theoretical arguments.

I’m sure that’s right, and I’m certain there is nothing theoretical that I could have added that would have carried much weight at the Fed.  They’d be better off talking to people like Michael Woodford.  Nonetheless, later I’ll argue that the Fed was not fully aware of the political implications of these alternatives.

Although we did not adopt one of these alternatives, I will say that I don’t see anything magical about targeting two percent inflation. My advocacy of inflation targets as an academic and Fed governor was based much more on the transparency and communication advantages of the approach and not as much on the specific choice of target. Continued research on alternative intermediate targets for monetary policy would certainly be worthwhile.

One of Bernanke’s good qualities is that he’s open-minded.  He obviously sees that given what’s happened since 2008, in retrospect a slightly different approach might have been better.  But of course we can’t rewrite history, and there are credibility issues that constrain policy, as they should.  The italicized phrase may surprise some readers who don’t play close attention.  I’ve always argued that it would have been quite difficult for the Fed to abandon its 2% inflation target right after formally adopting it in 2012.  A central bank that is so cavalier with previous promises would not be trusted any more than the Argentine central bank.

Finally we get to the key three paragraphs:

That said, I want to raise a few practical concerns about the feasibility of changing the FOMC’s target, at least in the near term. First, whatever its strengths and weaknesses, the current policy framework, with its two explicit targets and balanced approach, has the advantage of being closely and transparently connected to the Fed’s mandate from Congress to promote price stability and maximum employment. It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate. For example, any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge, and concerns about the public or congressional reaction would reduce the credibility of the FOMC’s commitment to the alternative target.

Second, proponents of alternative targets have to accept the fact that, for better or worse, we are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility, even though the very fact that the target is being changed could sow some doubts. At a minimum, Congress would have to be consulted and broad buy-in would have to be achieved.

Finally, a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy. I think though that the probability of getting Congress to accept larger automatic stabilizers and the probability of their endorsing an alternative intermediate target for monetary policy are equally low.

There’s much that can be said here, and I’m going to consider the question of Congressional authorization in another post, over at Econlog.  But let me just say here that I think he’s wrong about price level and NGDP targeting, I don’t think they would require Congressional authorization.  A 4% inflation target perhaps would.

Obviously I don’t think fiscal policy would be better than monetary reform, but it’s a moot point as we both agree that Congress is not about to start using fiscal policy to stabilize the economy at the zero bound.  Nor are the Europeans or the Japanese.  Indeed the Japanese sharply tightened fiscal policy in 2014 (and unemployment fell).  So with fiscal policy off the table we need to improve monetary policy to make it more effective.

Reading between the lines, and based on what I’ve read from various insider sources, Bernanke may have the following concerns:

1.  Congress would not like a 4% inflation target.

2.  The Fed establishment hates (price or NGDP) level targeting.  It puts them right in the spotlight, with “ownership” for adverse moves in the nominal economy.  They’d rather be one of many factors making our economy work better.

Here are a few areas where I disagree with Bernanke’s pessimism.  Let’s start with communication.  It’s often claimed that it’s easier to communicate an inflation target than a NGDP target.  “The public understands inflation.”  No they don’t!!! They don’t have a clue as to what inflation means.  Most of my students were far above average, and yet when I would ask them the following question (as economics major seniors), 90% would get it wrong:

If all prices rise 10% and all wages and salaries also rise 10%, has the cost of living actually risen?

Most say no, whereas the correct answer is that the cost of living rose 10%.  Bernanke discovered this in 2010 when core inflation fell to 0.6% and the Fed announced it was going to try to raise the cost of living for Americans, to help the economy.  Talk radio went nuts, and Bernanke ran into a firestorm of criticism.  It sounds “bad.”  The Fed may correctly view 2% as a symmetric target, where misses in either direction are bad, but the public sees it more like the ECB, the lower the inflation the better.  That’s because the public thinks their own nominal income is unrelated to changes in the cost of living, whereas the Fed believes that monetary stimulus will boost RGDP, and this causes the average American’s nominal income to rise even more than inflation rises.  Inflation targeting is a communication nightmare.

Second, Bernanke seems to overlook the fact that even with its current dual mandate there are times where the Fed must pursue an inflation rate higher than 2%.  Indeed if it were not true, if they always focused like a laser on 2% inflation, then they’d have a single mandate, and their policy would be indistinguishable from a central bank with a single mandate.  In fact, when there is a severe adverse supply shock, such as an oil embargo, the Fed does aim for above 2% inflation.  In this respect, NGDP (growth rate) targeting is very similar to current Fed policy.  As far as price level targeting, the Fed could easily argue that aiming for a long run 2%/year rise in the price level is more consistent with their Congressional mandate, as it provides more long price level predictability that inflation targeting (where the price level has a random walk element.)

I’ve already indicated that the “blank slate” argument is a genuine concern.  But I also have argued that there are creative ways of addressing this issue.  A likely compromise would involve the Fed setting intermediate NGDP target paths every 5 years, where the target growth rate was the Fed’s estimate of trend RGDP growth, plus 2% inflation.  That would keep inflation close to 2% in the long run, while gaining some of the advantage of NGDPLT over the business cycle.  For those who worry that inflation would vary somewhat, recall that under current policy inflation reached almost 5% in mid-2008, and then fell into negative territory over the next year.  That doesn’t seem very stable to me.

As far as communication, the Fed should continue to communicate to the public that it has a 2% inflation goal (if that’s indeed what Congress wants) but communicate to the markets that it has an intermediate NGDP target that it thinks is most consistent with its combined inflation/employment goals.

And finally, I think some of the concern that NGDPLT might be inflationary was due to the fact that the issue happened to gain traction at a very unusual point in US history, where trend RGDP growth was falling from 3% (over more than a century) to 2% or even slightly less.  But that’s likely to be a fairly rare occurrence.  God help us if the rate keeps falling to zero.  In that case monetary policy will be the least of our concerns.  We’ll be broke.

HT,  Patrick Sullivan, Ken Duda, Britonomist

Is modern macro to blame?

There are some recent posts by David Andolfatto, Mark Thoma and Noah Smith, discussing whether modern macro failed us in 2008.  I don’t disagree with claims that we should not have been expected to predict the financial crisis (if these crises were predictable then they would not occur.)  Rather I’d like to approach the issue from a different perspective. When economists discuss the state of macroeconomics circa 2008, they generally take one of two positions:

1.  Macro is fine, it’s not our fault.

2.  Macro screwed up because they didn’t pay enough attention to ________, where the missing name is the person judging the condition of macro.

I’m sort of in the second group.  But I’ll make things a tad more interesting by claiming that they didn’t just ignore my advice; macroeconomists ignored their own theories.  Here are some parts of mainstream macro, circa 2007, that were almost totally ignored a year later:

1.  Monetary policy continues to be highly effective at the zero bound.

2.  Interest rates and/or the money supply are not good indicators of the stance of monetary policy.

3.  The Great Depression was caused by tight money, not banking distress.

4.  Fiscal stimulus is mostly ineffective due to monetary offset.

5.  Extended unemployment benefits raise the unemployment rate.

If economists had kept believing in 2008 what they believed in 2007, the Great Recession would have been the little recession.  In Europe it was even worse, as economists didn’t even seem to recognize that Great Recessions are caused by adverse demand shocks.  On the other hand European economists seemed to be a bit more skeptical about fiscal stimulus, AFAIK.

PS.  I have a post over at Econlog looking at the question of whether the Fed is allowed to create NGDP futures markets, a question recently raised by David Andolfatto.

HT:  Gordon



The ECB has expected AD growth right where it wants it

Vaidas Urba sent me the latest ECB report:

The March 2015 ECB staff macroeconomic projections for the euro area foresaw annual HICP inflation at 0.0% in 2015, 1.5% in 2016 and 1.8% in 2017. In comparison with the Eurosystem staff macroeconomic projections published in December 2014, the inflation projection for 2015 had been revised downwards, mainly reflecting the past fall in oil prices. In contrast, the inflation projection for 2016 had been revised slightly upwards, also reflecting the expected impact of recent monetary policy measures.

As regards measures of longer-term inflation expectations, the ECB Survey of Professional Forecasters for the first quarter of 2015 indicated that the expected five-year-ahead inflation rate was 1.77%. Medium and long- term market-based measures, such as forward inflation-linked swap rates, had broadly stabilised since the previous monetary policy meeting.

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With regard to the monetary policy stance, the members generally shared the assessment that significant positive effects from the monetary policy decisions taken on 22 January 2015, in conjunction with the package of measures decided in June-September 2014, could already be seen, namely an easing in financial market conditions and in the cost of external finance for the private economy. Moreover, recent data on economic activity had been somewhat positive and there were signs of a turnaround in inflation dynamics, including a stabilisation in market-based measures of inflation expectations. This provided grounds for “prudent optimism” regarding the scenario of a gradual recovery and a return of inflation rates to levels closer to 2%. It was recalled that the March 2015 ECB staff macroeconomic projections were predicated on the full implementation of all monetary policy measures taken by the Governing Council, including the expanded APP comprising monthly purchases of €60 billion, which were intended to be carried out until the end of September 2016 and, in any case, until the Governing Council saw a sustained adjustment in the path of inflation consistent with the aim of achieving inflation rates below, but close to, 2%. The March 2015 projections should therefore not be interpreted as suggesting that the latest monetary policy measures were less necessary. On the contrary, they confirmed that full implementation of these measures was required to deliver on the Governing Council’s mandate. At the same time, the Governing Council would continuously assess the effectiveness of the measures and would regularly review progress towards the attainment of the objectives as evidence accumulated over time.

The ECB thinks the current stance of monetary policy is just right.  (I think that’s crazy, but it doesn’t matter what I think.) The ECB also called for structural reforms, but pointedly did not ask for fiscal stimulus, indeed cautioned against slacking off on the deficit reduction targets.  Given their insane monetary policy, their stance on fiscal policy makes sense.

For instance, suppose the Germans were suddenly to do lots of fiscal stimulus, what effect would that have?  Both theory and empirical evidence suggest it would be a beggar-thy-neighbor fiscal policy.  The ECB believes it would have to tighten monetary policy to avoid overshooting their 1.8% inflation target.  Yes, the German stimulus would boost NGDP in Germany. However since overall eurozone NGDP would be stabilized via monetary offset, non-German NGDP would have to decline. This might occur through a stronger euro, for instance.

Indeed this is exactly what happened in 1992, when German fiscal stimulus associated with reunification led to a stronger ECU, which drove countries like Britain and Sweden deeper into recession and eventually out of the EMS.

The ECB may be completely incompetent at monetary policy, but give them credit for opposing the type of fiscal policies that caused all sorts of problems in 1992.

PS.  Also give the ECB credit for understanding the circularity problem—note the last portion of the third paragraph quoted above.

PPS.  I don’t know if anyone’s trademarked “beggar-thy-neighbor fiscal stimulus” yet, but if not I get first dibs.