Archive for March 2016


Fed policy options

The Fed has three primary ways to impact NGDP:

1.  Change the supply of base money–primarily through open market purchases (OMPs), or sales.

2.  Change the demand for base money through adjustments in interest on reserves (IOR)

3.  Change the demand for base money through adjustments in the Fed’s target (inflation, NGDP, etc.), or making it more credible though actions such as level targeting, or currency depreciation in the forex market.

Most pundits think and talk in terms of binaries, and thus underestimate the policy options available to the Fed.  Thus a pundit might say we need to ban currency and break the zero bound, because OMPs are ineffective at the zero bound—forgetting the option of impacting base money demand by adjusting the policy target.

For each of the three options, it’s useful to treat one as a given, and think about the other options in a two dimensional space.  Thus if we have a given policy target, say a 4% NGDP target path, then the Fed has two tools to get there, OMPs and adjustments in IOR.  Then you can think about how much weight the Fed should put on each tool, by considering other objectives, such as size of the balance sheet.  For any given NGDP target, the higher the IOR the larger the balance sheet, and vice versa.  If the Fed wants banks to hold lots of liquidity, they might opt for a higher IOR.  If they are worried that they’ll need to do a lot of QE to hit their target, and that this QE will be politically unpopular, they’ll go for negative IOR.  (That’s where the ECB is right now.)

But we don’t have to think of the policy target as a given.  Japan recently raised their inflation target from 0% to 1%, and then later to 2%.

Or we could assume that for some reason IOR is fixed at zero, as it was during the Fed’s first 95 years. Then the trade-off would be between steepness of target path and size of balance sheet.  The faster the desired rate of NGDP growth, the smaller the ratio of base money to GDP, and hence the smaller the central bank balance sheet.  Australia chose a high target path, and got a very small RBA balance sheet as a result.

And finally, the balance sheet itself might be a key objective.  For instance, the Swiss National Bank recently became concerned about their ballooning balance sheet.  Suppose central banks are averse to a large balance sheet.  In that case the target path and IOR become the two policy options.  The Swiss could opt for a higher rate of inflation, or they could opt for a lower rate of IOR.  In fact, they’ve opted for negative 0.75% IOR, an especially low rate.  In my view they should have changed the (effective) inflation target, by not revaluing last year.

Even within a category such as OMPs, there are several possible options.  Thus the central bank could buy Treasury bonds, or they could buy a riskier asset.  Generally speaking, the riskier the asset the more “bang for the buck”, but not as much more as you might imagine (in my view.)  Monetary policy primarily works by impacting the liability side of the Fed’s balance sheet; the asset purchases are not very important.  However when we are at the zero bound, or when the market rate equals the interest rate on reserves, it’s quite possible that the asset side becomes relatively more important.  It’s hard to say how much more, because policy at the zero bound is especially sensitive to expectations of future policy.  But if we hold the NGDP target path constant, then the specific type of assets being purchased might make some difference.

Here’s a question from Eliezer Yudkowsky:

Should market monetarists be pushing heavily to have the Fed be buying higher-priced bonds, foreign assets, or non-volatile shortable equities, instead of US Treasuries?

It seems to me intuitively that buying Treasuries with money might itself be a wobbly steering wheel, because as the Treasuries have lower yields and especially as you foolishly start to pay interest on reserves, you’re substituting two very similar assets. As the two assets get *very* similar you might be approaching a division-by-zero scenario where it takes unreasonably large amounts of money creation to change anything. And yes, there’s still an amount of money that’s enough. But maybe you would literally have to run out of short-term Treasuries to buy. Maybe you’d need to print far less money if you were buying a basket of low-volatility stocks or something. So maybe this is one of the things that market monetarists should push for, for the same reason we push for not using interest rate targeting because the meaning of the asset keeps changing? Like, if we try to create money and exchange it for Treasuries, does the meaning of that act change and diminish even as the Treasury yields get closer to zero.

If printing more of the unit of account or unit of exchange is supposed to have a mode of action that doesn’t interact with the similarity of that currency to the Treasuries that it’s replacing, then I confess that this is something I still don’t understand myself and definitely couldn’t explain to anyone else. It might need to be explained to me with some kind of concrete metaphor involving apples being traded for oranges in a village that prices everything by apples, or something. Right now, the only part I understand is the notion that people have a price/demand function for things-like-currency, which implies that if a Treasury has become a thing-like-currency, creating currency and removing Treasuries will be a wash in terms of the demand function.

I think this question needs to be broken down into pieces.  First, are we happy with the policy target?  In my view the ECB and BOJ should not be happy with their policy target, as it leads to such low NGDP growth expectations that they are forced into unpleasant decisions on IOR and/or QE.  They’d be better off with another target, say level targeting of prices, which would lead to faster expected NGDP growth and less need to do negative IOR or QE.

But let’s say the target is carved in stone, then what are the options?

I prefer starting with buying Treasuries, even if it is less effective than other assets. Recall that seignorage is basically just a form of tax revenue, which ultimately goes to the Treasury.  Unless you specifically want to build sovereign wealth fund, it’s not clear why you’d want the Fed to buy stocks.  And if you do want to build a sovereign wealth fund, it seems like it should be the Treasury’s decision.  In other words, the Treasury could borrow a trillion dollars and use it to buy index stock funds. Then the Fed would have lots more T-debt to buy.  This combined operation has the same ultimate effect as Eliezer’s proposal, but the lines of authority are clearer.

The next question is how much T-debt should the central bank buy?  I don’t really know.  I’d probably ask the Treasury how much they’d like to leave in circulation to give liquidity to the markets (which might be $5 trillion), and then stop at that red line.  At that point I’d have the Fed buy other assets, such as Treasury-backed GSE debt (i.e. MBSs), foreign bonds, AAA corporate debt, etc.  I suppose at some point you might end up buying stock, but I can’t really envision that happening.  On the other hand, a decade ago I couldn’t envision where we are right now—-6 1/2 years of nearly 4% NGDP growth and interest rates at 0.5%.  So who knows?

To summarize, I have several objections to the Fed buying stocks right now:

1.  I doubt it provides much more bang for the buck, as it’s the liability side of the Fed’s balance sheet that really matters.

2.  Even if they do need to buy more Treasury debt (relative to stocks), buying that debt is not costly, indeed the Fed usually makes a profit.

3.  Any decision to build a sovereign wealth fund should be made democratically, i.e. by the Treasury.

I could add other objections, such as that it’s “socialism”.  However I’m actually not all that worried about the Fed meddling in the management of companies.  But lots of other people would be.

Eliezer’s right that base money and T-debt are much closer substitutes at the zero bound, but I don’t see that as a problem.  So do more!

I prefer to work back from the target.  What percentage of GDP does the public want to hold in the form of base money, if the central bank is expected to hit its target?  Right now people are confusing two issues, a desire to hold base money because rates are low, and a desire to hold base money because the central bank is not expected to hit its target (as in Japan and the eurozone).  If credibility is the problem, then you need a mechanism to restore credibility.  I like my “whatever it takes” approach and/or level targeting, but other options are available.  Thus small countries like Switzerland can simply devalue their currency.

Until we get clear thinking from the central banks about the three policy levers discussed above, it’s hard to give good policy advice.  For instance, if the ECB actually has big problems hitting its inflation target at the zero bound, then the asymmetry built into their target is obviously exactly backward.  In a world where the zero bound is a big problem, the target should be “close to but not below 2%”. Right now, they have a policy target that conflicts with their operating procedure. The target reflects the assumption that it is high inflation that is difficult to control. And yet exactly the opposite seems to be true.

Then central banks need to think clearly about the inflation rate/size of balance sheet trade-off (at each IOR).  They don’t seem to know whether they are more averse to higher inflation or to a very big balance sheet, and hence end up in the worst of both worlds—missing the inflation target and thus getting an even bigger balance sheet.  Of course the lack of clear thinking might actually reflect very clear thinking by each member of the ECB, but no agreement on which of those clear paths is best.  But I think it’s worse than that, you have central bankers saying we need to raise rates so that we can cut them in the future, an EC101-type error.  So I’m not willing to give them the benefit of the doubt.

I don’t think Eliezer will be happy with this post–it’s too long to be an “elevator pitch”

The global shift to services and high tech

One of the popular theories of low interest rates is that demographics are reducing the need for physical investment, and that investment which does occur is skewed more and more toward high tech.  Because prices of high tech investment goods are falling fast, growth in dollar spending on investment is reduced below what people want to save at “normal” interest rates, which puts downward pressure on interest rates.  The Economist has a recent article on a major industrial power in East Asia, which seems to be rapidly shedding its heavy industry.  See if you can guess the country:

FOR an export juggernaut, XXXXX’s losing streak is alarming: for 14 straight months its exports have fallen in value terms compared with a year earlier. In January they plummeted by 18.8% to just under $37 billion—the steepest drop since 2009. Petrochemical products are a key XXXXXXX export, so low global oil prices partly explain the numbers. Still, the country’s longtime engines of growth, including steel mills, shipyards and car plants, appear to be running out of puff.

Now suppose I told you that this country was expected to grow in 2016 at roughly the same pace (2.6%) as it has over the past decade.  Might you be skeptical of the official figures?

The country is South Korea, and I’ve never heard anyone question the accuracy of their GDP numbers.  Here’s why they keep growing, despite the depressed conditions in heavy industry:

Other businesses are thriving despite the downturn. Seven of the ten best-performing stocks last year in the MSCI Asia Pacific Index, a benchmark followed by big investment funds, were South Korean, among them pharmaceutical, cosmetics and aerospace firms.

Media stocks have been buoyed recently by the success of CJ E&M, a subsidiary of CJ Corp, another chaebol.

Do we have any evidence that this is also occurring in China? If high tech were booming, it ought to show up in housing prices in the centers of high tech, especially Shenzhen—which is the Silicon Valley of China.  Here are recent trends in housing prices:

Screen Shot 2016-03-28 at 9.39.00 AM

Hmmm, Shenzhen looks kind of like Palo Alto. I suspect that much of what we see in global trade figures is part of a general worldwide trend from producing things to producing experiences.  That China recession people have been predicting?  Maybe 2017.

PS.  The Economist article on house prices is entitled “For Whom the Bubble Blows”.  Let me know when the Palo Alto bubble bursts, I’d like to buy a house there.  I’m willing to pay prices from the peak of the 2006 housing “bubble”. Here’s Zillow:

Screen Shot 2016-03-28 at 9.46.42 AM

Fiscal multiplier studies—it’s far worse than I thought

I was stunned to see a recent paper on fiscal multipliers use a 90% confidence interval, which seemed far too lenient.  After all, economics and many other sciences suffer from problems such as data mining, publication bias, and inability to replicate findings.  I’d like to see the standard statistical significance cut-off point raised from 95% to something stronger, maybe 98%.  When I did this recent post I wondered if I was making some elementary error, as econometrics is not my strong suit.

It turns out the problem is even worse than I assumed.  Indeed Ryan Murphy recently published a study of fiscal multiplier research (in Econ Journal Watch), and found that many studies use 68%!!

In recent decades, vector autoregression, especially structural vector autoregression, has been used to study the size of the government spending multiplier (Blanchard and Perotti 2002; Fatás and Mihov 2001; Mountford and Uhlig 2009). Such methods are used in a significant proportion of empirical research designed to estimate the multiplier (see Ramey 2011a). Despite being published in respected journals and cited by prominent members of the profession, much of this literature does not use the conventional standard of statistical significance that economists are accustomed to in empirical research.

Results in the literature on the fiscal multiplier are typically communicated using a graph of the estimated impulse-response functions. For instance, the effect of government spending on output may be reported by reproducing a graph of an impulse-response function of a one-unit (generally, one percentage point or one standard error) change in government spending. The graph would show the percent change in output over time following the change in government spending. To report statistical significance, authors of these studies may then draw confidence bands around the impulse response function. Ostensibly, if zero lies outside the confidence band, it is statistically distinguishable from zero. But very frequently in this literature the confidence bands correspond to only one standard error. In other words, instead of representing what corresponds to rejecting the null hypothesis at a 90% level or 95% level, the confidence bands correspond to rejecting the null hypothesis at a 68% level. By conventional standards, this confidence band is insufficient for hypothesis testing. Not every useful empirical study must achieve significance at the 95% level to be considered meaningful, of course, but a pattern of studies which do not use and reach the conventional benchmark is a cause for attention and perhaps concern. Statistical significance is not the only standard by which we should judge empirical research (Ziliak and McCloskey 2008). It is, however, a useful standard, and still an important one. Here I examine papers in the fiscal multiplier literature which apply vector autoregression methods. Sixteen of the thirty-one papers identified use narrow, one-standard-error confidence bands to the exclusion of confidence bands corresponding to the conventional standard of 90% or 95% confidence. This practice will often not be clear to the reader of a paper unless its text is read rather carefully.

I can’t even fathom what people are thinking when they use 68%.  It seems like something you’d see in The Onion, and yet apparently this stuff gets published.  Can someone help me here, what am I missing?

In praise of President Obama

Because I focus on economics, and because I don’t agree with Obama on many economic issues, I often end up being critical of his policies.  (Although less critical than most conservatives; for instance I thought Obamacare was mostly a missed opportunity.)  But this WSJ story made me appreciate Obama’s cool, cerebral style:

Tuesday’s coordinated terrorist attacks in Brussels have left at least 30 people dead and more than 200 wounded, shut down the capital of Europe and raised security alarms from Frankfurt to London to New York. (See above.) So maybe it’s time we all get over our inordinate fear of Islamist terrorism.

Believe it or not, that’s the not-so-subliminal message we keep hearing from President Obama, even as he condemned the attacks during his visit to Cuba. “Obama frequently reminds his staff that terrorism takes far fewer lives in America than handguns, car accidents and falls in bathtubs do,” reports Jeffrey Goldberg in a lengthy profile of the President’s national-security thinking in the Atlantic magazine. Islamic State, Mr. Obama is quoted as telling adviser Valerie Jarrett, is “not coming here to chop our heads off.”

When I first started to closely follow public affairs (in the 1970s), right-wingers seemed more rational, whereas the left frequently seemed to ignore cold hard logic, as when considering the costs and benefits of EPA or OSHA regulations.  The WSJ editorial page would tell us “Yes, this EPA regulation will save 15 lives, but at a cost of 3 billion dollars.  Not worth it.”  Now things almost seem to have reversed.  Now conservatives increasingly seem to rely on the “reptilian brain” (and a leading GOP candidate who will not be named (to avoid a horror show in the comment section) seems to rely on almost nothing but his reptilian brain.)

Some commenters will tell me that even if (objectively) terrorism is not a big problem for the West, fear of terrorism creates bad policies.  I agree, but that fear is fixed in quantity.  Triple the annual number of deaths from terror, or cut them by 2/3rds, and it has no effect on the level of fear.  (Perhaps there is a homeopathy analogy here.)  America has had almost no problem with Islamic terror in the past decade (just two sizable attacks in the US, AFAIK), and yet the hysteria is just as bad as ever.  Jet travel is 10 times safer than in the 1960s, but people are just as terrified of flying as in the 1960s.  I feel safer in a car, in my reptilian brain, even though my rational side knows I’m in much more danger.

So while terrorism leads to bad things like NSA overreach, and the Keystone cops antics of the TSA, we can’t prevent that problem by stopping terrorist attacks.  We’ll never get the attacks down to zero, meaning we’ll always be petrified of terror.  Our brains want to be terrified; if it’s not one thing, it will be another.  In the 1950s it was the Cold War.

After I wrote this, Tyler Cowen directed me to some data on the amount of terrorism in Europe.  Notice that as more Muslims have moved to Europe, the rate of terrorism seems to have declined:

Screen Shot 2016-03-24 at 10.48.26 AM

Even if you just focus on Islamic terrorism, which can strike unexpectedly at any place, the 1980s were worse than the 1990s, the 2000s, or the 2010s.  And yet the fear is greater than ever.

When I was young, I recall WWII vets saying that Vietnam was no big deal; the death toll was barely a 10th of WWII. And the Iraq War’s death toll for Americans was less than a 10th of Vietnam.  Yet many pundits viewed Iraq as America’s greatest foreign policy disaster.  Each year, unnecessary deaths bother us more than they did the year before. This trend has been going on for decades, and will continue until some huge catastrophe once again makes us numb to massive death totals.

I hope we keep becoming softer.

PS.  I just noticed that David Henderson also has a post praising Obama, very much worth reading.  I wonder if Obama will end up being like Clinton, where (after the fact) we realize that things could have been much worse, and eventually did become much worse.  Let’s hope not.

PPS.  To say that terrorism is not now a major problem in America or Europe, is not the same as saying it’s a problem to be ignored.  It’s quite possible that it will become a major problem in the future.  I’m agnostic on the proper response to ISIS, for example.




Bernanke and Mishkin on helicopter drops

There are two serious approaches to dealing with the zero bound, and one deeply unserious approach.  The two serious proposals are:

1.  Unconventional policy tools (quantitative easing, qualitative easing, negative IOR)

2.  A new policy target (price level targeting, NGDPLT, 4% inflation, etc.)

And one deeply unserious proposal:

1.  Helicopter drops

In this video, Frederic Mishkin points out that the Fed is not even authorized to do helicopter drops.  And the idea that the GOP Congress would go along with this sort of scheme is ludicrous.  (And people somehow think I’m unrealistic for talking about NGDP futures markets.)

And yet helicopter drops seem to be all the rage at the WSJ, the Economist, and Bloomberg.

Back in 2004, Ben Bernanke (in a paper with Vincent Reinhart and Brian Sack) discussed the real issue:

The greater the confidence of central bankers that tools exist to help the economy escape the ZLB, the less need there is to maintain an inflation “buffer,” and hence the lower the inflation objective can be.

Helicopter drops are not even an option.  Either you use unconventional tools aggressively enough to hit your target (and there is no limit to how aggressively they can be used) or you set a policy target where the zero bound does not occur (or does not create problems if it does occur, as with level targeting).

It’s a sad commentary on the media that they are buying into this notion that central banks are out of ammo, even as central bankers insist they are not out of ammo, and the Fed is raising interest rates despite inflation being below 2%, and expected to remain below 2%.

Also note this suggestion from the same paper:

Despite our relatively encouraging findings concerning the potential efficacy of nonstandard policies at the ZLB, we remain cautious about making policy prescriptions. Although it appears that nonstandard policy measures may affect asset yields and thus potentially the economy, considerable uncertainty remains about the size and reliability of these effects under the circumstances prevailing near the ZLB. Thus we still believe that the best policy approach is one of avoidance, achieved by maintaining a sufficient inflation buffer and easing preemptively as necessary to minimize the risk of hitting the ZLB. [emphasis added]

The Fed obviously ignored that advice in 2008, and they are ignoring it today.  The question is why?

HT:  Ben Klutsey, Patrick Horan