Archive for May 2022


Bill Nelson on Fed losses

David Beckworth has a great podcast with Bill Nelson. At one point Nelson discussed recent Fed losses due to rising interest rates (which depress the market value of bonds held by the Fed.)

Nelson: Sure. Yeah. So as you know, I send out these periodic emails on monetary policy to anybody who wants to receive them. And if they’ve your listeners who want to receive those emails, should just email me, they’re free. And I’m happy to add you. But I sent one out a couple weeks ago, pointing out that the Fed probably lost about $500 billion in the first quarter. And that we’ll know in a month or so when the Fed releases its quarterly update of its balance sheet, or maybe even sooner when the New York Fed releases its annual projection of Fed income and balance sheet. But in any case, the logic was fairly simple. The Fed’s interest rates rose very sharply in the first quarter. On average the yield curve rose about one and a quarter percentage points.

And the duration of the Fed’s securities portfolio, it indicates is about five years. And so if you just do the math, that’s a 6% loss. And a 6% loss on eight and a half trillion dollars in securities is about $500 billion. So, that’s a loss on their books. Some might argue that that doesn’t matter because they’ll never realize that loss. But I, really as any good economist, would completely disagree with that. And one way to think about it is really the same view that you were just describing that Seth articulated, which is that the present discounted value of remittances are lower by $500 billion. And you can think about that either as the loss on the securities or the rise in the IORB rate. But basically they’re going to be remitting to Treasury and therefore you and I, and everyone else are going to be paying higher taxes with a present value today of $500 billion. That’s just what the math tells you.

And the losses of course could be considerably higher as interest rates keep going up. And I agree that primarily the problem here is political. But it is a real loss. If you think about the consolidated balance sheet of the Federal Government, the Fed’s QE actions shortened up that balance sheet. They replaced long-term debt with short-term debt. They’re borrowing through the Overnight RRP Facility and through reserve balances, that’s the new debt. And they retired as it were long-term debt that they bought. So the consolidated balance sheet of the U.S. Government now has a shorter duration. Which means that the government is now more exposed to the rising short-term interest rates then they would’ve been if the Fed had not taken these actions. And that’s a real effect.

Now a hasten to add that a comprehensive view of this needs to take into account the benefits that accrued from the Fed’s actions. So, insofar as the Fed’s QE stimulated the economy, and that boosts tax revenues, and that’s something that needs to be considered as well. Now, I think you could probably make a pretty good case that the Fed’s three trillion or so of purchases around in the spring of 2020 to sort of save the financial system were extraordinarily beneficial. In terms of the long flow-based QE program that they then launched into, I am less convinced that that actually added a lot of value. But many would disagree. And so it’s that whole picture that needs to be considered.

For simplicity, I’m going to focus on the Fed’s holdings of T-bonds. They also hold some MBSs, but nothing important hinges on that distinction, at least for the purposes of this post.

How should we think about these losses being absorbed by the Fed? Let’s start with the fact that in a fiscal sense the Fed is part of the federal government. So when the value of T-bonds declines, that’s a gain for the Treasury and an equal loss for the Fed. For the consolidated federal government balance sheet it’s a wash.

Nelson suggests that the loss from rising interest rates is real. Does that contradict what I’ve been saying? Not really, it depends how one frames the question.

Image a world with a Treasury that borrows long-term, but there is no Fed. In that case, rising interest rates would benefit the Treasury in the sense that the market value of their debt would be smaller than if they had faced rising rates with nothing but short-term debt. Their previous decision to borrow long would have been wise, in retrospect.

Now imagine the Fed is created and starts buying up some of that long-term Treasury debt, and replaces it with interest bearing reserves (a short-term liability.) The Fed has effectively shifted the consolidated federal balance sheet toward shorter maturities. So the federal government gains less than otherwise from a period of rising interest rates. In that sense the Fed has imposed a loss (as Nelson suggests). The Fed’s $500 billion loss reduces the Treasury’s even larger gain that results from having the market value of its previously issued long-term debt fall by much more than $500 billion.

Given that the Treasury is a huge borrower, it might seem odd for me to claim that the Treasury gains from higher interest rates. Consider this statement by Nelson, which seems to suggest the opposite:

Which means that the government is now more exposed to the rising short-term interest rates then they would’ve been if the Fed had not taken these actions.

Once again, there is no contradiction once you understand what’s going on. Rising interest rates affect the Treasury in two distinct ways. First, the Treasury benefits from a decline in the market value of its existing liabilities. But only longer-term liabilities; T-bill prices are barely affected at all. Second, the Treasury is hurt because it has to pay higher rates on future borrowing.

Now let’s consider a scenario where the higher interest rates reflect higher inflation (the Fisher effect). In that case, the Treasury is an unambiguous winner. The real value of its existing debt declines, and the real interest rate paid on new debt does not increase. This is one way the government benefits from the inflation tax. (Others include seignorage and increased capital gains tax revenue.)

In the past year, real interest rates have risen somewhat, but remain very low. (Near zero on 5 and 10-year bonds, and negative on shorter maturities.) So I suspect that the high inflation of 2021-22 has been a net plus for the federal government, despite somewhat higher real interest rates for new borrowing.

PS. It’s possible the Fed might need a bailout (although I doubt it.) But if it does, it’s mostly a symbolic issue, sort of like the symbolic Social Security “trust fund”. Of course symbolic issues can become political, and I’d expect a Fed bankruptcy to be highly controversial.

PPS. My argument might not seem to apply to Fed holdings of MBSs, but keep in mind that those are close substitutes for T-bonds. From the perspective of the consolidated federal balance sheet, the distinction between the Fed buying T-bonds and MBSs is not that important. It has some importance for capital allocation, but even there I believe the big problem lies elsewhere (the Treasury guarantee of MBSs, for instance.)

The new axis of evil

The Guardian has a piece discussing the sort of people involved in the Putin-Trump-Orban alliance:

A notorious Hungarian racist who has called Jews “stinking excrement”, referred to Roma as “animals” and used racial epithets to describe Black people, was a featured speaker at a major gathering of US Republicans in Budapest.

Zsolt Bayer took the stage at the second day of the Conservative Political Action Conference (CPAC) Hungary, a convention that also featured speeches from Donald Trump, Fox News host Tucker Carlson, and Trump’s former White House chief of staff, Mark Meadows. . . .

When he was awarded the Hungarian order of merit in 2016 by the country’s nationalist prime minister, Viktor Orbán, the star speaker on the first day of CPAC Hungary on Thursday, the US Holocaust Memorial Museum protested, saying it “reflects the longstanding refusal of the leadership of Hungary’s ruling Fidesz party to distance itself from Bayer, in spite of Bayer’s repeated pattern of racist, xenophobic, antisemitic, and anti-Roma incitement”.

The leader of America’s Republican party sees Orban as a model:

The last featured speaker of the conference was Jack Posobiec, a far-right US blogger who has used antisemitic symbols and promoted the fabricated “Pizzagate” conspiracy theory smearing prominent Democrats as pedophiles. . . .

Addressing the conference by video shortly before Bayer’s appearance, Trump poured compliments on Orbán, who was recently elected for a fourth term as prime minister.

“He is a great leader, a great gentleman, and he just had a very big election result. I was very honored to endorse him,” Trump said.

Republicans are also addressing the issue of what to do about 13-year old girls raped by their father.

Georgia Senate candidate and former football star Herschel Walker said Wednesday he supports abortion bans without any exceptions for rape, incest or the health of the mother. 

“There’s no exception in my mind,” Walker told reporters after a campaign speech. “Like I say, I believe in life. I believe in life.”

And every time you think the GOP has hit rock bottom, we find there’s another level.

PS. You might wonder where all this “pedophilia” stuff is coming from. The NYT has a good piece on how the evangelical churches are being affected by this new culture war:

FORT SMITH, Ark. — In the fall of 2020, Kevin Thompson delivered a sermon about the gentleness of God. At one point, he drew a quick contrast between a loving, accessible God and remote, inaccessible celebrities. Speaking without notes, his Bible in his hand, he reached for a few easy examples: Oprah, Jay-Z, Tom Hanks.

Mr. Thompson could not tell how his sermon was received. The church he led had only recently returned to meeting in person. Attendance was sparse, and it was hard to appreciate if his jokes were landing, or if his congregation — with family groups spaced three seats apart, and others watching online — remained engaged.

So he was caught off guard when two church members expressed alarm about the passing reference to Mr. Hanks. A young woman texted him, concerned; another member suggested the reference to Mr. Hanks proved Mr. Thompson did not care about the issue of sex trafficking. Mr. Thompson soon realized that their worries sprung from the sprawling QAnon conspiracy theory, which claims that the movie star is part of a ring of Hollywood pedophiles.

So it’s not just Democrats; Hollywood people are also pedophiles. (And some commenters claim that I’m one too.)

Apparently, this nonsense is splitting the evangelical movement:

Across the country, theologically conservative white evangelical churches that were once comfortably united have found themselves at odds over many of the same issues dividing the Republican Party and other institutions. The disruption, fear and physical separation of the pandemic have exacerbated every rift.

Many churches are fragile, with attendance far below prepandemic levels; denominations are shrinking, and so is the percentage of Americans who identify as Christian.

The Democrats have certainly picked an inopportune time to commit suicide.


Trump elected in 2024

Newsom elected in 2028

In 2029, pot made legal and tobacco made illegal.

But of course all my political predictions end up being wrong. All I know is that the 21st century is turning out really bad (after a great 1980s and 1990s.)

Beckworth and Ireland on NGDPLT

David Beckworth’s recent interview of Peter Ireland is one of his very best podcasts—highly recommended. In this excerpt, Ireland is discussing how a policy of NGDPLT would have done better in 2021:

Ireland: You just draw a target path for the level of nominal GDP, and you base the target path in the fourth quarter of 2019. What you see is that throughout 2020, and even on into early 2021, the economy was still in a big hole.

Ireland: So you could say, wow, compared to a Taylor rule, which is focused on growth rates, even though we’re having inflation that’s above 2%, that’s just putting us back to where everybody thought they would be when implicit or explicit nominal contracts were signed, when decisions were made before the pandemic. But with that kind of target, the nominal GDP goes back to the target path in the fourth quarter of 2021. In that case, what the strategy tells you is you should be all the way back to neutral. The thing is that… I’m willing to forgive some of this, but at a minimum, a consistent strategy like that would’ve dictated an earlier start to normalization. By not making reference to the target path all along, they got caught in a very difficult situation, too, because it became clear then later on in the year that inflation was going to be a problem. But the way the Fed operates, you have to prepare markets, and you have to prepare the political system. Actually, I was worried, late last year, that what they were going to do out of fear of the political system is just hope they could get away with not even talking about anything. They had that thing, we’re not even talking about talking about this. They were-

Beckworth: Right.

Ireland: … going to try and do that until the middle of this year. That would’ve been a total disaster. But the point is that they weren’t set up to make the transition they needed to from extraordinary ease to the beginning of normalization fast enough. They would’ve been able to do it… David, you could have maintained a consistent viewpoint, and I think you did by saying like, look, I’m looking at this target path. My strategy is nominal GDP level targeting, and then you could have said as the year wore on, “well, look, my forecasts were wrong, but my strategy remains in place, and now the strategy dictates an earlier start to lift off. But that’s simply because the economy is doing so much better than I expected, coupled with the fact that the price increases seem more persistent and broad-based than I expected.”

Beckworth: Yeah, I agree with that completely. In fact, mentioning Jason Furman, he actually took my rule that I developed in a paper I did on nominal GDP targeting, and he told me in an interview last year about midway through said, “Well, David, your rule would imply the Fed needs to raise rates right now.” I was a little reluctant to embrace that implication, but he was right. I think part of it also is… for me at least, is I was doing too much looking in the rear view mirror analysis, like, well, nominal GDP still a little bit below, it’s getting close. I think what I suffered from was more… I needed to be more forward looking. What’s the forecast of nominal GDP?

This is what so many pundits miss. Having the correct regime in place makes monetary policy more effective. In 2021, a regime of NGDPLT would have helped in two distinct ways:

1. As Peter Ireland suggests, it would have made it easier to quickly raise rates without spooking the markets with an unexpected change in policy. The Fed could have stated that a stable NGDP is the policy, and rates need to adjust as appropriate to keep NGDP stable.

2. More importantly, even if the Fed were a bit late in raising rates, financial markets would have pushed longer-term rates higher in anticipation of the future Fed rate increases required to stabilize NGDP along a 4% growth path.

In 2021, I naively assumed that the Fed was serious about FAIT, and that it was sort of similar to NGDPLT. Late in the year, the financial markets gradually realized that the Fed was not serious, and hence did not push rates high enough to slow NGDP growth as we approached the trend line.

Some thoughts on inflation

Ramesh Ponnuru offers some advice to the GOP in Bloomberg:

Republicans Can Extend Their Midterm Inflation Advantage

Rising prices will help the GOP in November. Supporting monetary tightening, pursuing smart tariff and regulatory policies and restraining Democratic spending would help even more.

These are good ideas, but Ponnuru is calling on the GOP to repudiate the economic policies favored by Donald Trump, which were easy money as far as the eye can see, recklessly expansionary fiscal stimulus, and dumb tariff polices. Given that the modern GOP is little more than a Donald Trump personality cult, that seems unlikely.

I have another (albeit even more unrealistic) idea, remove the oil export sanctions on Iran:

Iran has capacity to double oil exports if there’s sufficient demand, a top official said, even as a deal on the country’s nuclear program that could pave the way for the lifting of sanctions remain elusive.

Iran will “exert maximum effort to recoup its crude oil market share and revive its customers,” Mohsen Khojastehmehr, managing director of the National Iranian Oil Co., told reporters Saturday in Tehran.

Even by the standards of US foreign policy, allowing oil exports from Russia but not Iran stands out as particularly absurd. Yes, Iran sponsors terrorism. But Russia literally invaded a European country of 40 million people. And Iran is supposed to be the bigger threat? Our sanctions policies (including Europe) have actually helped Putin (and hurt Ukraine) by driving energy prices much higher. In fairness, we have supplied Ukraine with weapons—Trump would have made them dig up some dirt on Hunter Biden before doing so.

You might wonder if my suggestions are consistent with my previous claim that the Fed is 100% responsible for any excess inflation, which is roughly any inflation caused by NGDP growth above 3% or 4%. Think of it this way. For any given NGDP growth rate, reducing supply-side constraints would have the effect of shifting growth toward RGDP and away from inflation.

Alternatively, you can think of supply-side reforms as reducing the Fed’s preferred rate of inflation for 2022. So while the Fed ultimately controls the rate of inflation, supply-side reforms can help at the margin. They can make the Fed target a lower inflation rate.

PS. You might think that I’m being a bit harsh describing the GOP as a Trump personality cult. After all, the GOP still includes moderate people like Elise Stefanik. It’s true that Stefanik was a moderate, and indeed opposed many of Trump’s policies. But that was then. Now, the 3rd ranking member of the GOP House caucus is pretending to be a wild-eyed conspiracy nut to please her voters:

I’m occasionally called a pedophile by commenters, and I always wondered where that specific insult came from. Now I know. It means they think I’m opposed to starving innocent babies.

PPS. So who is actually depriving America’s babies of milk? The usual statist grifters like Trump and Biden, and the various businessmen that who support trade barriers on milk from other countries. Oh, and Elise Stefanik:

In January 2022, following Stefanik’s advocacy, a USMCA dispute settlement panel ruled in favor of the United States that Canada is breaching its commitments under the USMCA by unfairly administering dairy tariff-rate quotas in a way that harms American dairy farmers. 

“New York Farm Bureau appreciates Rep. Stefanik’s outreach on behalf of dairy farmers in her district and across the state.

(Yes, that’s regular milk, but we also have trade barriers on infant formula.)

Rate hikes do not represent “tightening”

Yahoo recently described the views of Fed Governor Christopher Waller and St. Louis Fed president James Bullard:

Fed Governor Christopher Waller and St. Louis Fed Bank President James Bullard argued that critics don’t take enough account of the tightening of financial conditions that the Fed engineered even before it began raising interest rates in March.

“Credible forward guidance means market interest rates have increased substantially in advance of tangible Fed action,” Bullard said in remarks prepared for a conference organized by the Hoover Institution at Stanford University. “This provides another definition of ‘behind the curve,’ and the Fed is not as far behind based on this definition.”

Waller, who was previously head of research at the St. Louis Fed, made a similar point, arguing that a shift in Fed rhetoric led investors in financial markets to start pricing in rate increases in September, leading to a rise in 2-year Treasury yields that he estimated were equivalent to two quarter-point rate increases by the central bank.

I recall Fed officials making the same sort of claims in the 1970s. But higher rates don’t necessarily represent tighter money. Over the past year, higher interest rates partly reflect higher inflation expectations, and perhaps to some extent a stronger economy. The same sort of confusion occurred in the 1970s.

The Fed still has not come to grips with their policy failure—although in fairness, the Fed’s critics also misunderstand the fundamental problem. I see very few people on either side of the debate pointing out that the Fed has abandoned average inflation targeting. That’s the key policy failure, not the delayed rate increase.