Archive for January 2020


Megan Greene on NGDP (forecast) targeting

This FT article by Megan Greene is a sort of breakthrough:

If they are serious about achieving their mandates more effectively, the Fed and ECB should consider other strategies.

One has been circulating for decades: target the sum of inflation and total real output, or nominal gross domestic product. With NGDP targeting, a central bank automatically lowers rates as output falls, to push up inflation. That eases real debt burdens and lowers real interest rates, helping to generate growth. As output rises, rates adjust higher to bring inflation down and maintain the target.

A potential obstacle is that NGDP is reported quarterly, with a lag. But NGDP could be reported more frequently and accurately if the Fed treated it as a priority. The Fed could also target the forecast of NGDP instead, which is reported in the monthly blue-chip economic indicators survey of business economists.

There have been plenty of other pundits calling for NGDP targeting, but this is the first one I recall that advocated a “target the forecast” approach.  If forecasts are useful in monetary policy (and they are) then we obviously need to create a market-based NGDP forecast.  Hypermind has actually done so, but we need to create a much more liquid NGDP futures market.

We cannot trust the consensus forecast of economists because they consistently forecast too high, just like the Fed itself:

It’s always around 1.9% to 2.0% in the out years—a major embarrassment for the profession.  Trust markets, not economists.

PS.  The 3-month/10-year Treasury spread recently inverted.  As I pointed out a year ago, that doesn’t necessarily mean money is too tight or that a recession is imminent.  But when combined with other indicators, it seems clear that money is currently a bit too tight.

Some of this relates to the coronavirus epidemic, which has a small chance of being a major problem for the global economy and a large chance of blowing over in a few months.  The following analogy might be helpful:

Suppose you see a crazy guy load one bullet into the cylinder of a revolver.  He puts the gun to his head and pulls the trigger.  Nothing happens.

Would you say, “See, he made a wise decision, as nothing bad happened.  He just had some fun playing Russian roulette.” Or would you say that even in retrospect his decision was foolish?

That’s sort of how I think about current Fed policy.  I think there’s a 5/6 chance of no recession this year.  But I still think it would be wise to cut the IOR rate, to further reduce that risk.  I am disappointed by the Fed’s recent decision, and hope that they are monitoring events closely.  There’s a real danger that they will fall behind the curve if the coronavirus crisis gets much worse.  Indeed I think it likely they will fail to adopt a sufficiently expansionary policy in the event of a global pandemic.

If that happens, we can’t let them off the hook with excuses about unforeseen “shocks”.  The markets are very clearly indicating RIGHT NOW that money is a bit too tight.

They’ve been warned. Fix it.

PS:  I agree with this:

“The bond market is basically telling the Fed that it hasn’t done enough and will be called back to do more and that the longer they wait the more they will have to do,” said Michael Darda, market strategist at MKM Partners. “If the bond market thought Powell’s comments on wanting higher inflation were credible in his press conference, you wouldn’t have seen break-even inflation rates falling as they did.”

HT:  David Beckworth

Is Trump “coupling” with China?

In a very interesting essay, Fatih Oktay asks why China would agree to a trade deal that seems to offer it very little of value:

However, these considerations only provide breathing space for China. After the election, if Trump wins, he is likely to bring back into spotlight the more important issue of state involvement in the economy and technological development in China, and intensify the technology war. If Trump does not win, it is likely to be worse for China. Another president that can leverage the United States’ soft strengths and cooperate with allies could make life much harder for China. So, either way the conflict is likely to intensify after the U.S. elections. It is unlikely that Chinese leadership would go into this deal just for a short period of relief.

The deal, though, may have long term effects on the relationship of the two countries as well. U.S. exports of goods and services to Canada and Mexico, its top two markets, totaled about $365 and $300 billion dollars respectively in 2018. The trade expansion required by the deal will place China’s imports of U.S. goods at a level comparable to that of Mexico by the end of next year, and if the trend continues, with the expected rates of its economic growth, China may soon be the top market for U.S. exports. That would be strong coupling in a time of decoupling discussions and would make the United States a stakeholder in the Chinese economy. The other side of the coin: China’s leverage on the United States would increase immensely.

It is rather strange for the US to demand that China become much more closely integrated with the US economy at a time when the foreign policy establishment talks of “decoupling”. And it’s not just trade, we are also demanding that China become more open for foreign investment. This is an example of what can go wrong when an administration goes into negotiations with no clear idea of what it is trying to achieve.

The Trump administration is also hostile to multilateral organizations and is trying to cripple the WTO. Fortunately, a group of other nations representing a major portion of the global economy are trying to protect the global trading system:

Now you know the answer to the question: “What do the US, Russia, Argentina, Bolivia, Paraguay, Peru, Venezuela, Africa and South Asia have in common?

PS. I wonder how Trump supporters feel about their President saying how much he “loves” Xi, a dictator who presides over massive human rights abuses in Xinjiang. Personally, I find this sort of “coupling” to be disgusting. (Yes, I know he was joking, but wouldn’t you prefer he call out the Chinese on human rights? It’s nothing to joke about.)

The Fed is too inertial

In previous posts, I’ve argued that the Fed’s interest rate target should be adjusted daily, set at the median vote of the FOMC. Today provides a good example of why this reform would improve policy.

In recent weeks, the natural rate of interest has fallen sharply, and significant parts of the yield curve have inverted. US equity prices have declined over the past few days on worries about global growth. TIPS spreads are also falling, as are oil prices. (These latter two are usually correlated at high frequencies.)

[We don’t have a direct measure of the natural rate of interest.  But when market interest rates fall sharply during a time of declining NGDP growth expectations, it’s a good sign that the natural rate of interest is also falling.]

By themselves, none of these data points are decisive. But policy must be made in a world of uncertainty, based on the best information available. The data we have suggest that the Fed’s interest rate target should be reduced.

The Fed will probably not cut rates on Wednesday. This is not because they believe a rate cut would move them further from their policy goals, rather it reflects the inertial nature of policymaking. Target interest rate changes are treated as major events, which require weeks of careful deliberation.

It would be better if interest rate targets were de-emphasized. It should be no big deal to raise rates one day, cut them the next, and then raise rates the following day. That’s how things work in most asset markets; it is the Fed that is the exception. The Fed’s inertial process of policymaking makes policy more procyclical than what we would have with a more nimble, more market-based system.

Don’t be sluggish.  The Fed needs to Make Policy Changes Routine.

The actual “ammunition” issue

Pundits often make the mistake of assuming that expansionary monetary policy somehow uses up “ammunition” by reducing interest rates, which gives central banks less room to cut rates in a future recession. Actually, the reverse is true. Expansionary monetary policy boosts the equilibrium (or natural) nominal interest rate, and hence gives central banks more “ammunition” in the conventional sense of the term. This is precisely why some economists advocate a higher trend rate of inflation—to give the Fed more ammunition.

There is another sense in which conserving ammunition does make sense. For any given size of the Fed’s balance sheet, monetary policy is more expansionary when bank reserve demand is lower. Unfortunately, since 2008, the Fed has made a number of changes that boost reserve demand and hence reduce “ammunition”. (I use scare quotes because in a technical sense central banks have near infinite ammunition; the problems are legal and psychological.)

One recent change is obvious; the payment of IOR has increased demand for bank reserves. Some would argue that this isn’t really a problem, as the rate of interest paid on reserves can be reduced to zero in a crisis. Maybe, but it wasn’t reduced to zero during the worst banking crisis of the past 80 years.

A bigger problem is changes in regulation that artificially boost the demand for bank reserves, discussed in an excellent post by Greg Baer and Bill Nelson:

In September 2019, the repo market broke down because banks and broker-dealers did not step in to equilibrate a supply-demand imbalance caused by corporate tax payments and Treasury securities settlement. Banks were unwilling to use their reserve balances to lend into the repo market, in part because of a supervisor preference that banks hold reserves rather than Treasuries.  Banks also were unwilling to raise funds to lend into the repo market for two reasons: leverage requirements and GSIB surcharges generally made the resulting balance sheet expansion too expensive, and banks were reluctant to upend their capital and liquidity allocations to respond to a temporary event.

The Fed responded to the breakdown by further expanding its balance sheet and actively considering creating a standing repo facility that would mirror its standing reverse repo facility.  Reportedly, the standing facility might not just lend funds to commercial banks (which already borrow through the discount window) and primary dealers (which already participate in Fed open market operations) but also hedge funds and other participants in the FICC sponsored repo program.  In short, the Fed stepped in to solve a problem caused by its increased role in financial markets by further expanding its role in those markets and by planning to increase its role in them still further.

Their analysis leads to a policy recommendation that is music to my ears:

We encourage the Fed to . . . conduct policy in a manner similar to how it did before the crisis, with a level of excess reserves about one thousandth of its current level.

I believe that policy is more likely to avoid unexpected problems such as we saw in September 2019 if it is kept simple. Prior mid-2008, the monetary base was roughly 98% currency. That’s a very simple monetary regime. It’s true that marginal changes in the base were first implemented via adjustments in the other 2% (bank deposits at the Fed), but base injections tended to eventually impact the currency stock, as required to keep inflation close to 2%.

I acknowledge that there are potential efficiency gains associated with superabundant reserves, but I worry that the demand for bank reserves in our current system is so high and so unstable that it might make monetary policy (especially QE) less effective in a future crisis. It takes a heap of Harberger triangles to fill an Okun’s gap. K.I.S.S.

Baer and Nelson also discuss other downsides of current Fed balance sheet policy, such as the risks associated with the Fed’s much greater involvement in our financial system.

PS. This issue relates to the current debate over the floor vs. corridor system. I’m obviously with supporters of the corridor system. George Selgin has a number of illuminating posts on this issue.

PPS. Stock prices and bond yields fell today in response to one additional coronavirus case in the US. I believe the greatest risks to NGDP are to the downside, which is why the Fed should adopt a slightly more expansionary policy. We need a policy where the risks are balanced. We are close, but not quite there yet.

Where are all of the workers coming from?

In 2019, payroll employment rose by slightly over 2.1 million. That’s actually the slowest growth since 2011.

And yet it is still pretty impressive, given the low unemployment rate and the slow growth in the prime age population. So where are all these workers coming from? Why were my predictions from a few years back too pessimistic?

I’ve already discussed several factors:

1. The unemployment rate declined by more than I expected.
2. Boomers kept working longer than I expected. (Five years ago, I thought that I’d be retired by now.)
3. Illegal immigration increased by more than I expected.
4. Deportations are occurring at a lower rate than under President Obama.

And now The Economist points to another factor.  Guest workers have increased by nearly 200,000 in just the past three years:

You might object that my payroll numbers are for non-farm workers, and most of the guest workers are in agriculture.  But these two sectors are probably closely linked.  I doubt the actual amount of farm work has increased that sharply in recent years, rather guest farmworkers are doing non-farm work or they are displacing other non-guest farmworkers.  Those might be American farmworkers, but more likely they are illegal immigrants.  The displaced workers may then get jobs in the non-farm sector.

In any case, this surge in immigration helps to explain why employment and GDP growth has held up better than I expected.  It also tells us something about the actual priorities of the Trump administration:

Corporate tax cuts, deregulation, more guest workers, more illegal immigration and fewer deportations, bigger trade deficits, no infrastructure plan, obsessing about IP theft in China.

Does this look like an administration committed to helping downtrodden blue collar workers, or an administration committed to helping billionaires?

I like the corporate tax cuts and the guest workers and the lack of an infrastructure plan.  But then I’m an evil cosmopolitan neoliberal.  And even I would favor a more pro-manufacturing set of policies than Trump, notably a reduction in the fiscal deficit, which would tend to reduce our trade deficit.  Removing the steel and aluminum tariffs would also help our manufacturers.