Archive for January 2016

 
 

The PBoC and the Fed both lost credibility

The world’s two largest economies are facing a similar problem, a gradual loss of credibility in monetary policy.  In China, the exchange rate is artificially fixed at too high a level for macroeconomic stability.  The public recognizes this fact, and expects the Chinese government will eventually devalue.  Not surprisingly, people are trying to get their money out of China before the devaluation occurs.

The problem in the US is different.  Our government does not fix asset prices at non-equilibrium values.  The Fed does peg the fed funds rate, but they do so by adjusting monetary policy tools, until the desired fed funds rate becomes the actual fed funds rate.  So there is no disequilibrium in the sense of a shortage of fed funds, or a surplus.

But there can ben macroeconomic disequilibrium, if the fed funds rate is pegged at an inappropriate value.  In recent weeks, Fed policy has lost credibility.  In America this doesn’t show up as capital flight, but rather in terms of asset price movements:

1.  The market is increasingly skeptical that the Fed will raise rates 4 times this year.

2.  More importantly, the market is increasingly skeptical that the Fed will hit its long-term inflation objective.

In the past I’ve often discounted the usefulness of TIPS spreads from the 5-year, 5-year forward market.  This is the expected inflation rate from 2021 to 2026.  The reason I tended to discount this data is that it was being used to claim there was no problem with inflation expectations.  But a 2.3% 5-year, 5-year forward TIPS spread is a necessary condition for credibility, not a sufficient condition.  Even if the public thinks CPI inflation will eventually return to 2.3% (or 2% PCE inflation), there may be problems with monetary policy over the next 5 years.  So my past objections to the 5-year, 5-year forward data was that it ignored the short-term problem of “lowflation” and high unemployment.  It was not a sufficient condition for sound policy.

But now the Fed is not even meeting the minimal objective of market confidence that CPI inflation will run about 2.3% in the very long run.  Here’s the graph:

Screen Shot 2016-01-15 at 9.08.32 PMIt’s even worse than it looks, as the spread has fallen to about 1.58% today, which is consistent with roughly 1.3% PCE inflation. That’s a very low number for 5 to 10 years out, by which time the current problems (strong dollar, falling oil, etc.) should no longer be impacting the inflation rate.

Now admittedly there is some evidence that TIPS spreads can be distorted at times (as in late 2008), when there is an inflation risk premium in the bond yield.  But as Narayana Kocherlakota points out, that doesn’t mean there’s no loss of Fed credibility, just that the loss is spread between growth and inflation:

Let me turn then to the inflation risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.

But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low. This observation is why a decline in the inflation risk premium has information about FOMC credibility. The decline reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low – that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals.

.  .  .

To sum up: we’ve seen a marked decline in the five year-five year forward inflation breakevens since mid-2014. This decline is likely attributable to a simultaneous fall in investors’ forecasts of future inflation and to a fall in the inflation risk premium. My main point is that both of these changes suggest that there has been a decline in the FOMC’s credibility.

Marcus Nunes pointed out that this decline began at roughly the time NGDP growth began slowing, probably linked to tightening monetary policy.  I should say that Marcus, James Alexander, Lars Christensen and some other market monetarists have been ahead of me on this issue.

I’m well aware that asset prices bounce around, and that the markets may well recover from this.  But what scares me is that current asset prices already reflect the expected Fed response.  That 1.3% expected PCE inflation 5 to 10 years out is already pricing in the fact that the Fed will probably respond to this bearish news by raising rates by less than 4 times.  To boost PCE inflation up to the target, the Fed would have to do considerably more than the markets currently expect.

Perhaps in the end all will be well, but as of today the Fed has lost credibility on inflation.  The case for further Fed rate increases is much, much weaker than even 4 weeks ago.

HT:  Julius Probst

PS.  TravisV sent me an alternative view, from the Atlanta Fed.

Kocherlakota watch

Last year I made a mental note to do occasional updates of Kocherlakota’s 2015 predictions, when he strayed far, far off the reservation:

And finally, don’t forget that the other markets did provide useful information.  For instance, we know that the TIPS spreads remained quite low, which I believe supports Kocherlakota’s claim that we need a rate cut.  People laugh at how far behind Kocherlakota is on the dot graph, like the little boy that can’t keep up with his Boy Scout troop:

Screen Shot 2015-09-19 at 11.49.40 AM

Only 1% interest rates in 2017?  Yes, that’s probably too low, but it wouldn’t surprise me all that much if Kocherlakota had the last laugh.  His 1% forecast is certainly far more plausible than the official who predicts 4% in 2017.

Here’s the FT today:

A disintegrating oil price, coupled with a round of disappointing data on the US economy on Friday, has pushed back expectations to September of when the Federal Reserve will add to last month’s historic rate rise.

Fed funds futures are on Friday morning pricing a roughly 50-50 chance of US policymakers lifting rates at least once more by the end of September. On Thursday, futures implied even odds of the Fed making its next move as early as June.

Another rate increase would push rates up to 0.625% in September, 2016.  The Fed had been forecasting 4 rate increases in 2016, which most MMs thought was unlikely (because the market thought it was unlikely).  Kocherlakota was even more bearish than the markets, but they have been moving in his direction so far this year. While it’s much too soon to predict 2017, Kocherlakota must be feeling pretty good about his farewell shot at the Fed establishment.

Oh, and the 10 year yield is back below 2%.  Remember all those “experts” that said the Fed’s actions would push up mortgage rates?  I guess they don’t read MM blogs.

PS.  Kocherlakota reminds me of the little boy at the end of this music video.  He realizes that just wishing you can fly, doesn’t make it so.

PPS.  Just to be clear, while I predicted things would be worse than the Fed believed, I did not predict they’d be this bad. Some of the other MMs, however, did make this prediction.

PPPS.  And how about my claim that raising the policy target rate has the effect of lowering the Wicksellian equilibrium rate, thus giving policymakers less “ammunition”?

QE is not a policy, it’s a tool

Tyler Cowen recently linked to a post by Gerard MacDonell on QE:

Last month’s Press Release from the FOMC announcing the first rate hike in a decade contained a seemingly-innocuous and yet telling discussion of the interaction between interest rate and balance sheet policy.  It marked the end of false confidence in the efficacy of quantitative ease (QE), which can be traced to a technical error Ben Bernanke made while lecturing the Japanese on deflation in 1999.

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.

…The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.

The passages above were not a major departure or surprise to the markets, but they confirm that the Fed leadership has now abandoned its original story about how QE affects the economy and has conceded that the tool is weak.  If QE were strong, the balance sheet could not remain large even as the Fed promised to raise rates only gradually.

It has long been obvious that QE operated mainly through signaling and confidence channels, which wore off on their own without any adjustment in the size or composition of the Fed’s balance sheet. Accordingly, QE cannot be relied upon to provide much help in the next economic downturn, which means the Fed will have to tread carefully to avoid a return to the zero bound.

There’s a lot of confusion about QE, mostly because there’s a lot of confusion about virtually every aspect of monetary policy; including the most very basic aspects, such as what is it, and how we measure it.

At one level QE is nothing new, it’s just changing the monetary base to impact the macroeconomy—what the Fed has been doing for many decades.  With QE, the Fed also says that they are changing the base in order to affect interest rates on Treasury securities.  But that’s also exactly what the Fed has been doing for many decades.  And for many decades the impact of monetary shocks on long-term interest rates has been ambiguous.  So that’s also nothing new.

And monetary policy has always been 1% about concrete actions and 99% about signaling.  That’s also nothing new.  So basically the argument that QE does not work is almost no different from the argument that monetary policy doesn’t work. But of course it is slightly different.  QE is the term used for monetary policy that impacts the supply of base money at the zero bound.  So it’s possible that this type of monetary policy is less effective, although the empirical evidence suggests that QE was effective in the US, and more recently in Japan.  On the other hand future QE might not be effective, it entirely depends how it’s used.  If monetary policy is 99% signaling, then the argument should not be about the 1% (QE) it should be about the 99% (signaling.)  So the post by Gerard MacDonell isn’t so much right or wrong, as mostly beside the point.

The success of future Fed policy will depend almost entirely on the signaling element.  The Fed recently raised rates, which tells us that NGDP is about where they want it.  And by backwards induction it seems like the Fed did not want rapid NGDP growth a few years ago, as if they had wanted it then they would not have raised interest rates this past December.

Here’s thought experiment that might help.  Imagine a NGDP graph built on a large flat piece of plywood.  Drive a stake into the point where NGDP was in mid-2009.  Then drive another stake in where it was at the end of 2015.  Connect the two pegs with a string and pull it tight, so that the string is taut.  That’s the NGDP path that the Fed should have been favoring, if we assume that it was acting rationally.  That is, it behaved over the past 6 years as if it wanted NGDP to growth at a roughly stable pace between the level of mid-2009 and late 2015.  And guess what, that’s almost exactly how it did grow.

Screen Shot 2016-01-13 at 8.59.28 PM

Now you might counter my claim by insisting, “Oh no, the Fed really hoped to get a much faster recovery, a much higher growth rate for NGDP.”  Except there is just one problem with that alternative hypothesis—in that case it would not have been rational for them to raise rates in December.  Because if the market knew (back in 2009) that the Fed would raise rates in December, then the intervening NGDP growth path would have been an equilibrium solution for the economy.  (This is also approximately what New Keynesian theory says.)

Now for the curve ball.  I think the person whining that the Fed actually preferred a faster recovery might be correct.  Who’s to say?  Maybe they were sincerely upset by the long drawn out period of high unemployment.  Maybe they preferred faster NGDP growth.  But even if all that were true, then everything I previously said would still be 100% correct.  I said that if they were rational then their policy would have been consistent with the actual growth path, but I never said they were rational.

Perhaps they thought they could have their cake and eat it too—have a fast growth path then act very conservatively at precisely the moment they raised rates.  Perhaps they never read Krugman’s 1998 paper.  I can’t say.  But if we assume the Fed was rational, then we have to also assume that QE “worked”.  The Fed got exactly the recovery in NGDP that it was acting like it wanted.

When people debate whether QE “worked”, it’s not always clear what’s at stake. Obviously it worked in the sense of impacting market expectations; we know that from asset price responses to QE.  But that doesn’t tell us much about the Fed’s (or BOJ’s) broader economic goals.  I think it makes much more sense to focus on the Fed’s policy goals. What’s it actually trying to accomplish?  Why doesn’t it tell us? What should it be trying to accomplish?  Those are the issues that need to be debated, not whether QE “worked”.

PS.  It’s equally beside the point to debate whether negative IOR “works”, or changes in reserve requirements “work”, or discount loans “work”.  These are policy tools for achieving an objective, when the actual debate should be about the objectives.

Random thoughts on inflation

Over the past 7 years I’ve frequently criticized the Fed’s predictions for inflation and RGDP growth.  This is not based on my skill as a forecaster, I don’t have any.  Rather I try to infer market forecasts, by looking at things like TIPS spreads (for inflation) and TIPS yields (for RGDP growth).

I do recognize that these market predictions can be flawed, for instance TIPS spreads fell to implausibly low levels during the banking crisis of late 2008, perhaps because T-bond prices were distorted by illiquidity in the asset markets. Nonetheless, during normal times I think TIPS spreads can be useful.  Certainly the TIPS market correctly called the Fed’s earlier over-optimism about achieving 2% inflation.

But now I’m a bit torn, as the current TIPS spreads, about 1.3% on 5 year bonds, seems implausibly low to me.  TIPS spreads are based on the CPI, which tends to run higher than the PCE inflation rate targeted by the Fed.  So they are implicitly calling for barely over 1% PCE inflation.  Here’s Steve Williamson discussing a recent post by Larry Summers:

We can use inflation swaps data, as Summers does; we can look at the break-even rates implied by the yields on nominal Treasury securities and TIPS; and we can look at survey measures. What do people who do forecasting for a living, and who have access to all of that data, say? The Philly Fed’s most recent Survey of Professional Forecasters [SPF] has predictions of PCE headline inflation for 2016 and 2017, respectively, of 1.8% and 1.9%, which is pretty close to the 2% PCE inflation target. A Wall Street Journal survey shows a CPI inflation forecast that seems roughly consistent with the December FOMC projections for PCE inflation. So, it seems that “most available data,” filtered through the minds and models of professional forecasters, suggests no less optimism than the FOMC is expressing in its projections, about achieving 2% inflation in the future.

This is an interesting way to frame the issue.  Williamson talks about the fact that forecasters can incorporate market forecasts, whereas I’d tend to look at things in exactly the opposite direction.  In an efficient market, asset prices reflect all available information, including the consensus of professional forecasters.  I’d prefer the market forecast, if we could be sure that the asset prices/spreads actually reflected market expectations.  But can we?

You might wonder why I am skeptical of the TIPS spreads, which seem to imply just over 1% PCE inflation over the next 5 years, given that PCE inflation has averaged just over 1% during the past 4 years.  And indeed the trend has been downward.  But I see this as reflecting the effects of lower commodity prices, especially oil.  Since commodity prices tend to follow something close to a random walk, there’s no reason to extrapolate those declines into the future.  I have no idea where oil will be in 5 years, but the best guess is probably not too far from where it is now.  In that case, we might prefer to extrapolate the CPE core inflation rate, which has averaged about 1.5% over the past 5 years.  But even that may be a bit too low, as it includes a period where the dollar strengthened signficantly in forex markets.  On the other, other hand, maybe some of the impact of the strong dollar has not yet worked its way into core inflation, recall that PPP is a long run concept.

After reading Williamson’s post I looked up the track record of the SPF, and it looks to me like it made roughly the same sorts of mistakes as the Fed.  Here are the headline PCE inflation forecasts, with actual numbers in parentheses.  The forecasts were for Q4 over Q4 inflation, made in Q4 right before the year being forecast:

2008:Q4  1.8%   (1.2%)

2009:Q4   1.3%  (1.3%)

2010:Q4   1.4%    (2.7%)

2011:Q4   1.7%    (1.8%)

2012:Q4   2.0%   (1.2%)

2013:Q4   1.9%   (1.1%)

2014:Q4  1.8%    (0.4%) estimated based on November over November

Too small a sample to draw any conclusions, but this does support one of Williamson’s complaints about Summers’ post. Williamson criticized Summers’ claim that the Fed treats the 2% inflation figure as a ceiling, not a target.  Lots of my commenters agree on that point, partly based on the past few years.  But I’ve never been fully convinced.  Yes, the Fed has generally undershot inflation since 2008, but perhaps this was mostly an honest mistake.  The fact that the SPF tends to have made very similar errors to the Fed in recent years, strongly suggests that these were in fact honest mistakes.

FWIW, here are some predictions:

1.  Both the Fed and the SPF will continue to forecast roughly 2% inflation, in the years ahead.

2.  At some point the SPF will stop being biased (if they are currently biased) and they’ll figure things out.  At that point PCE inflation will begin averaging 2%.

3.  But not yet.  I think both the Fed and the SPF still put too much weight on Phillips Curve models of inflation, and thus I put some weight on the TIPS spreads.

4.  But the 5 year TIPS spread seems too low to me, so I will split the difference and forecast about 1.5% PCE inflation for the next couple years, and then closer to 2% after that.

5.  However when the next recession hits (and I have no idea when that will be) I’d expect inflation to again decline.  And unless the Fed moves toward NGDP targeting (which makes inflation countercyclical), this undershoot may revive complaints that the Fed treats the 2% figure as a ceiling.

PS.  If the Fed and the SPF are right about inflation expectations, then TIPS would seem like a much better investment than T-bonds.  The expected 5-year return would be perhaps 80 basis points higher on TIPS, and they are if anything lower risk than T-bonds.  The only downside is slightly less liquidity, but in an absolute sense TIPS are still a very large, deep and liquid market.  For commenters who work in finance, why would something like an insurance company hold T-bonds instead of TIPS?

A very strange interview with a BIS official

Stephen Kirchner sent me to a post by Antonio Fatás, criticizing the BIS view of monetary policy:

You probably need to read the whole interview to understand what I mean but here is a summary of the new BIS theory of inflation:

1. Inflation is a global phenomenon, not a national one. Monetary policy has very little influence on inflation, demographics and globalization are much more relevant factors.

2. The idea that monetary policy affects demand and possibly inflation is a “short-term” story that is too simple to understand the recent behavior of inflation.

3. Deflation is not that bad. The Great Depression is a special historical event that holds no lessons for what we have witnessed during the Great Recession.

4. While central banks are powerless at controlling domestic inflation, they are very powerful at distorting interest rates and rates of returns for long periods of time (decades).

5. Central banks have a problem when inflation is the only goal (they end up creating distortions in financial markets).

6. Monetary policy is a cause of all China’s problems (he admits that there are other causes as well).

In summary, central banks are evil. Their only goal is to control inflation but they cannot really control it and because of their superpowers to distort all interest rates they only end up causing volatility and crises.

What I found most bizarre was one of the questions, which didn’t seem to faze the BIS official at all:

Inflation is only 0.2% in Europe and 0.5% in the US, although the central banks are doing everything in their power to drive it up to 2%. What’s going wrong?

[Hyun Song Shin responds] Inflation is not only a domestic and short-term phenomenon – the kind of phenomenon monetary policy can influence. Inflation also depends on global and long-term factors. The most important story is global. Ultimately, inflation is falling nearly everywhere in the world.

This interview, where the reporter insisted that central banks like the Fed are doing everything in their power to raise inflation, took place on December 27, about a week after the Fed decided to raise interest rates.   I feel like I’m living in some sort of alternate reality where everyone has forgotten how to think.

I sometimes get this from commenters as well, so it’s not just one crazy reporter.  People have brains.  Use them.

HT:  Marcus Nunes