Monday, September 1, 2014

Another Bond Market Conundrum?

Is the U.S. economy in the midst of another bond  market "conundrum"? The last time we had one was in 2005 when former Fed chairman Alan Greenspan became perplexed over long-term interest rates failing to rise with the tightening of monetary policy. Some observers see something similar happening today. They note that the Fed has been tightening monetary policy with its tapering of QE3 and yet the benchmark 10-year treasury interest rate has been falling since the beginning of 2014. This conundrum gets even more interesting when one looks at the five-year treasury interest rate. It has hardly budged since the beginning of the year even as the 10-year interest rate has steadily declined. Jim Hamilton calls these developments the 'bond market condrum redux.

So what could be driving these developments? Robin Harding and Michael Mackenzie suggest it is the worsening economic conditions in the Eurozone and its implications for ECB monetary policy. Here is Harding-Mackenzie:
The link between US monetary policy and US bond yields has fallen apart this year, showing how fears of deflation in Europe are driving global financial markets. According to analysis by the Financial Times, the correlation between five- and ten-year Treasury yields has fallen to its lowest level on record, with US bonds appearing to track European monetary policy instead.


Five-year bond yields closely reflect the path of interest rates that markets expect from central banks. Ten-year yields normally move in tandem. But so far in 2014, the US ten-year has fallen from 3 per cent to 2.4 per cent – even as news on the economy has got stronger – while the US five-year yield has barely changed.

That is unprecedented: no other global shock going back to the 1960s has ever caused US five and 10-year yields to diverge like this. In recent months, the US 10-year yield has been more correlated with falling five-year yields in Europe.
I think Harding-Mackenzie may be on to something with the Euro zone-U.S. treasury yield connection. It is worth taking a closer look. To do so, we first need to recall that long-term interest rates can be broken down into the following components:

(1) long-term interest rate = average short-term interest rate expected over same horizon + term  

The term premium is the added compensation investors require for holding long-term treasuries over short-term ones. For example, if a financial panic causes a "rush to safety" by investors and they are more willing to hold long-term treasuries, then they will demand less compensation and the term premium will decline. The other component, the average short-term interest rate, is a nominal interest rate and via the Fisher relationship can be further decomposed into real interest rate and expected inflation terms:

(2) long-term interest rate = (average expected real short-term interest rate + average expected 
     inflation) +  term premium 

The average expected real short-term interest rate is typically tied to the expected growth of the economy.1 If the U.S. economic outlook is improving, it should increase and vice versa. Over the short-run it should track the business cycle while over the longer run it should track trend economic growth. It is also called the real risk-free interest rate and approximates what many macroeconomists call the natural interest rate.

Okay, with all that said we can now take a look at these components and assess the Harding-Mackenzie explanation for recent interest rate movements. The figure below shows these series since 2013 (It is constructed using the Adrian, Crump, and Moench (2013) term premium estimates and implied inflation forecasts from TIPs.)

This figure shows two interesting developments since the beginning of 2014. First, the term premium has been steadily falling. This decline could be explained by increasing worries over the Eurozone driving investors on the margin to treasury securities. This is not exactly the Harding-Mackenzie story, but it does provide a potential link between what is happening in Europe and long-term U.S. yields. 

Second, the real risk-free rate has been steadily climbing since the beginning of the year. This is consistent with the gradually improving U.S. economic outlook. As I have shown before, short-term swings in this real risk-free interest rate track the business cycle fairly closely. Consequently, this second development should not be surprising.

So on one hand the term premium is arguably falling because of Eurozone woes, while on the other hand the real risk-free rate is rising because of the improved U.S. economic outlook. The term premium decline, however, is larger and on net is dragging down the 10-year treasury yield (given stable inflation expectations).

But what about the 5-year treasury yield? The figure below provides the same decomposition as above and shows similar developments:

The big difference here is that changes in the term premium and real risk-free rate are much closer in size and therefore closer to offsetting each other. The graph below summarizes these differences. It shows similar increases in the real risk-free yield for both treasury securities, but much larger declines in risk premiums for the 10 year security.

In my view, then, the real bond market conundrum is why has the term premium falling more for the 10-year treasury? Has the flight to safety associated with the Euro crisis been weighted more toward long-term treasury securities? Or is it something else?

Update: See this Bruegel review of blogs for more the bond market conundrum.

 1It is technically tied to the expected growth of productivity, the expected growth of the labor force, and household's discount rates. See here for more on these points.

Sunday, August 24, 2014

About the Fed Not Trying Hard Enough To Hit Its Inflation Target

It is hard not to be cynical when you see charts like this one. It shows what appears to be a systematic relationship over the past 6 years between changes in the Fed share of marketable treasuries and PCE core inflation:

The figure indicates the Fed allows its share of marketable treasuries to change--by either engaging in LSAPs or refraining from doing so as the total share grows--so that core PCE inflation stays in the 1% to 2% corridor. Here is the scatterplot of this data:

Now this is just a reduced-form relationship, but it is highly suggestive and consistent with my claim from an earlier post that there really is no 2% target. Rather, there is a 2% ceiling to an inflation target corridor. As I showed in that post, the timings of the QE programs tend to line up with this view. The above chart provides further evidence.

P.S. For those observers who are so focused on endogenous money that they fail to see how a central bank can shape the medium-to-long run path of inflation recall what we discussed here and here. A brief excerpt:
Now to be clear, most money is inside money--money endogenously created by banks and other financial firms--and the Fed only indirectly influences its creation. However, it does so in an important way by shaping the macroeconomic environment in which money gets created. Consequently, it can have a large influence on inside money creation. For the same reason it can also influence how stable is the velocity of money. By successfully stabilizing the expected growth path of total dollar spending, the Fed will be causing this seesaw process [offsetting changes in the money supply and money velocity] to work properly.

Friday, August 22, 2014

Talking About the Past Five Years

I recently gave a talk to the Financial Planning Association of Kentucky. The slides from the presentation are below and readers of this blog with be familiar with many of them. In case you are not familiar, below is the slide outline and where to go for more information. The audience asked many questions that led the discussion beyond what was presented on the slides, including the Triffin Dilemma for US treasuries, why the Fed likes core PCE, and what is holding back the recovery. It was a lively and fun discussion.

Slide Outline
(1)  Monetary Policy Tightened During the Recession. See here, here,and here.
(2) The Fed Allowed the Money Supply to Collapse. See here, here, and chart to the right.
(3) The Fed Did Not Gobble Up the National Debt. See here and here.
(4) The Fed Did Not Artificially Lower Treasury Interest Rates. See here, here, and here.
(5) The Fed Actually Wants Inflation Between 1% and 2%. See here.

Friday, August 15, 2014

The Secular Stagnation Bug is Spreading at the Fed

Speaking of secular stagnation, it appears to be catching on at the Fed. Here is CNBC's Alex Rosenberg:
Is there something seriously wrong with the economy?
It's a scary prospect, and a concern that's gotten louder and louder over the past year. In economic circles, it goes by the alliterative name of "secular stagnation." And it's a phrase that Fed watchers are likely to hear more and more in the months ahead.
Recent comments by the vice chairman of the Federal Reserve, Stanley Fischer, indicate questions within the central bank about whether the slow growth that has followed the recent recession could reflect, or at least could potentially morph into, longer-term issues within the economy. And while Fischer avoided the phrase "secular stagnation" in his Monday speech, Minneapolis Fed President Narayana Kocherlakota is planning to host a November symposium that directly addresses the issue of secular stagnation by name, CNBC has learned.
Actually, it is worse than Rosenberg reports. The FOMC projections that are available show a pronounced downward trend in the "longer run" forecast of the federal funds rate. This projection is the expected average value of the federal funds rate over the long run. In short, its the expected long-run netural federal funds rate. Its declining trend can be seen in the figure below which shows the average of each member's FOMC "longer-run"forecast for each meeting where projections are available:

I have a hard time believing the fundamentals warrant this downward revision in the long-run neutral interest rate. Where is the optimism? Clearly, the FOMC members need to drink an elixir of readings by Joel Mokyr, Erik Brynjfolsson and Andrea McAfee, and Marc Andreessen to beef up their technology optimism. And then they could follow it up with a Bill McBride treat of demographic optimism. And to wash it all down, they should finish with a John Cochrane cocktail of secular stagnation skepticism.

Update: I stand corrected. Stanley Fischer in his speech actually leaves open the possibility of strong productivity growth going forward. Good for him! Here is an excerpt and related footnote:
Possibly we are moving into a period of slower productivity growth--but I for one continue to be amazed at the potential for improving the quality of the lives of most people in the world that the IT explosion has already revealed. Possibly, productivity could continue to rise in line with its long-term historical average10 
And here is footnote 10
For a fuller discussion, see, for example, Erik Brynjolfsson and Andrew McAfee (2011), Race Against the Machine: How the Digital Revolution Is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy (Lexington, Mass.: Digital Frontier Press); Erik Brynjolfsson and Andrew McAfee (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: W. W. Norton & Company); and Martin Neil Baily, James Manyika, and Shalabh Gupta (2013), "U.S. Productivity Growth: An Optimistic Perspective," International Productivity Monitor, no. 25 (Spring), pp. 3-12. See also Ben Bernanke (2013), "Economic Prospects for the Long Run," speech delivered at Bard College at Simon's Rock, Great Barrington, Mass., May 18. 

Secular Stagnation: Missing the Forest for the Trees

There is a new VoxEU ebook on secular stagnation. The book is a collection of essays by many prominent economists, most of whom are proponents of secular stagnation. As readers know, I am not convinced that this problem lingers over the U.S. economy and have explained why at the Washington Post and on this blog. This latest book does nothing to ease my skepticism. Many of the authors continue to mismeasure the real interest rate and ignore what I see as important technology and demographic developments that undermine the case for secular stagnation. Let's review these key issues.

First, real interest rates adjusted for the risk premium have not been in a secular decline. Everyone from Larry Summers to Paul Krugman to Olivier Blanchard ignore this point in the book. They all claim that real interest rates have been trending down for decades. The editors of the book, Coen Teulings and Richard Baldwin, even claim that this development is the 'prima facie' evidence for secular stagnation. What they are doing wrong is only subtracting expected inflation from the observed nominal interest rate. They also need to subtract the risk premium to get the natural interest rate, the interest rate at the heart of the story. For it is the natural interest rate that is affected by expected growth of technology and the labor force.

This point can illustrated by looking at the 10-year treasury yield for the United States (these graphs were first used in my Washington Post piece). The figure below shows the 10-year nominal treasury yield along with its expected inflation and term premium. The former is the annual average inflation rate expected over the next ten years, while the latter is the risk premium on treasuries that increases with the holding period of the security. The expected inflation series is constructed using data from the Survey of Professional Forecasters and the Livingston Survey.  The term premium is the average of the Kim-Wright and Adrian, Crump, and Moench estimates of the term premium. 

Note that both the expected inflation and the term premium begin to grow in the mid-1960s and peak in the early 1980s. From there, they both experience a secular decline. These developments track the increased uncertainty over the nominal anchor, inflation expectations, and economic policy that occurred during this time. Many stories are given for why this happened--LBJ trying to do Vietnam and the Great Society, beginning of  the Bretton Woods System breakdown, Fed using bad economic theory, etc.--but the big point is there was a big policy break from the past of relative price stability and this shock affected both the risk premium and inflation expectations.

Proponents of secular stagnation only account for the expected inflation term. They subtract it from the observed nominal treasury yield and behold a declining trend in real interest rates is found starting around early 1980, as seen below. 

But this is not the risk-free real interest rate, the one that best approximates the natural interest rate idea. To get that, the secular stagnationists need to also subtract the estimated risk premium. This measure, shown below, shows no clear declining trend but does show a stationary-like process that revolves around a mean just about 2%.

Now one could claim a new trend has set in over the last decade, but proving its a trend in this short of time is impossible. Moreover, there is a simpler answer: the deviations around the 2% mean are driven by the business cycle and we just happen to have gone through one of the worst in a long time. The figure below supports this view as it plots the CBO's output gap measure against the 10-year risk-free real interest rate:

To be clear, the 10-year real risk-free rate should be equal to the average of the expected path of the short-term real risk-free rates over the same time horizon. The first few years of this interest rate path are determined by the business cycle, which explains the risk-free rate's correlation with the output gap as noted above. The remaining years are shaped by expected growth of productivity and labor force and that explain the roughly 2% trend. Proponents of secular stagnation are effectively claiming the long-term 2% trend is no more. I don't buy it because one, I think they are confusing the trend for the cycle, and two, technology and demographic developments are far better than commonly portrayed. That leads us to our next point.

Second, technology growth appears to be rapidly growing but getting harder to measure. This point has been made recently by Joel Mokyr  in the Wall Street Journal and Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. Their basic point is that the economy is being radically transformed via smart machines and this will spur a period of great productivity growth, high returns to capital, and more investment. For example, imagine all the new infrastructure spending that will have to be done to support the increased use of driverless cars and trucks. Even over the past few decades there have been meaningful gains as illustrated by this hilarious spoof the show 24 being made in 1994. Noah Smith makes the case for big productivity gain even more recently. The secular stagnationists should take these developments more seriously. 

Probably one reason these developments get overlooked is that they are hard to measure. As I noted in my Washington Post piece, a good example can be found in your smartphone. It contains many items you had to formerly purchase separately--books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, dictionaries, etc.--and were counted part of GDP. Now most are free and not a part of GDP. My sense is this is not a recent phenomenon, but has been going on for sometime as the economy has become more service orientated. Measuring productivity in the service sector is notoriously hard. And it is only going to get harder.

Here is a great illustration of this measurement problem. Tyler Cowen has made the case that there has been a Great Stagnation in innovation that explains the observed slowdown in productivity data. I looked at the John Fernald TFP data and found this troubling chart. It seemed to confirm the Great Stagnation theory. It showed a sharp break in trend TFP growth starting around 1973:

Tyler Cowen approved of the chart, but Noah Smith raised some good questions about it. He observed that the Fernald TFP data can be decomposed into TFP in investment production and TFP in consumption production. TFP in investment looks better than the overall TFP:

While that is interesting, what is really striking is the TFP in consumption. It has basically flatlined since the early 1970s and is what is driving the Great Stagnation. In the spirit of Tyler Cowen, let's call this segment "The Great Flattening."

The Great Flattening does not seem reasonable. Has productivity growth in consumption really been flat since the early 1970s? No meaningful gains at all? This does not pass the smell test, yet this is one of the best TFP measures. This suggest there are big measurement problems in consumption production. And I suspect they can be traced to the service sector. I suspect if these measurement problems were fixed there would be less support for secular stagnation (and maybe for the Great Stagnation view too).

Third, the demographic outlook is not as dire as the secular stagnationists make it out to be. Bill McBride has been noting for some time that the U.S. demographic outlook is improving as the largest cohort is now found in the Millenial age group. Matt Busigin also makes this point. Globally, the United Nations also forecasts that working-age populations in many parts of the world will grow through 2050. More labor growth implies a higher return to capital and more investment demand.

These are the reason I remain skeptical about secular stagnation and optimistic about future U.S. economic growth. Maybe the secular stagnation story makes sense for the Eurozone, but at a minimum the authors of this VoxEU book should be more cautious in their endorsement of it for the United States. My sense is that they are missing the forest for the trees. They see a five-year slump, the zero lower bound, and a gloomy outlook. From these few bad 'trees' they conclude the entire forest has succumbed to the secular stagnation disease. The evidence above suggests they are wrong. They need to start looking closer at the forest.

Wednesday, July 30, 2014

Revisiting the Great Experiment of 2013

Now that the revised 2013 GDP numbers are out it is worth revisiting the debate surrounding the 'Great Experiment' of 2013. It started with Mike Konczal firing this opening salvo at Market Monetarists in early 2013:
In late 2011, the economist David Beckworth and the writer Ramesh Ponnuru wrote an editorial in the New Republic on how “both liberals and conservatives are wrong about how to fix the economy.” How were they wrong? Conservatives were wrong because, contrary to common belief on the right, the Federal Reserve wasn’t in fact doing enough to boost the economy. Liberals, however, were wrong in opposing austerity and calling for more fiscal stimulus in the form of stimulus spending or temporary tax cuts.

In Beckworth and Ponnuru’s view, the Federal Reserve still had plenty of room to boost the economy. Not only would fiscal tightening be good over the long haul, but it would force the Fed to act. And they argued that as long as the Fed is working to offset austerity, the country “won’t suffer from spending cuts.

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments -- specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction?
Paul Krugman liked Konczal's idea of 2013 being an experiment to test ideas and chimed in: 
On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
Some observers predicted that this fiscal tightening might costs as many as 700,000 jobs. Market monetarists like Scott Sumner and myself were more optimistic. I agreed at the time that this development would provide a kind of natural experiment to test whether monetary policy could offset fiscal at the zero lower bound (ZLB), but cautioned that it was only a test of how effective QE3 would be against the sequester. It was not a test of whether a NGDP level target, my ideal, could restore full employment at the ZLB. Scott Sumner made a similar guarded reply. Still, the 'Great Experiment' was on and thanks to Konczal and Krugman our views were to be publicly put to the test in 2013.

An important question that came up in this experiment was how best to measure fiscal austerity. It is not that easy since one has to control for the influence of the business cycle. Fortunately, Paul Krugman explained how to do it:
Now, measuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates
This IMF measure includes all levels of government--local, state, and federal--when calculating the government balances. It is a thorough measure. Below is a figure of it based on the latest IMF Fiscal Monitor. It shows that the cyclically-adjusted deficit as a percent of potential GDP started getting smaller in 2010. Structural fiscal policy, in other words, was contracting well before 2013.

According to Konczal and Krugman, this tightening of fiscal policy should slow down aggregate spending. So did it? The figure below shows total dollar spending in the United States as measured by nominal gross output (it includes all transactions, not just the final ones used in GDP). It shows no signs of a spending slowdown since fiscal tightening started in 2010. And none in 2013 either, the year of the 'Great Experiment.' Similar results are fond by looking at nominal GDP.

The newly revised numbers for GDP in 2013 further confirm these observations. They came in stronger than previously reported. As Scott Sumner notes,these new numbers scream "fail" for the Keynesian view. Monetary policy was easily able to offset the 2013 fiscal austerity despite the ZLB. 

So what are the lessons? First, this 'Great Experiment' of 2013 revealed the potential of monetary policy even at the ZLB. It suggests the Fed could have done more over the past five years to restore full employment. Alas, it did not! 

Second, this experiment also suggests that measuring the fiscal multiplier can be tricky. In this case, someone might think the multiplier was negative in 2013 since tightening fiscal policy was followed by sustained economic growth. Along the same lines, the true impact of the President Obama's American Recovery and Reinvestment Act of 2009 is hard to measure since had it not happened it is likely the Fed would have done more.

Third, the economics blogosphere is a great place to propose ideas and begin hashing them out. Mike Konczal's keen observation that 2013 was providing a natural experiment of sorts and the discussion that it created is a great example. I have learned a lot on many issues and am grateful for this medium.

Monday, July 28, 2014

The Other Important Legacy of World War One

One hundred years ago today World War I (WWI) began. On this anniversary there has been a lot of discussion about the war and its implications for the century that followed. Today, as I traveled, I got to listen to one such discussion on the NPR program, On Point. The host, Tom Ashbrook, interviewed several historians and a commentator about the war. It was a really interesting show and I learned a lot, like how the problems in Middle East and Ukraine can be traced in part to the boundaries that were drawn after the war. I could not have asked for a better traveling partner.

There was, however, an important point I did not hear discussed on the show and could not find on other commentaries commemorating WWI: the important legacy this war had on the international monetary system. WWI shattered the classical gold standard of 1870-1914, which had worked relatively well, and replaced it with an incredibly flawed one that is attributed by many to the severity and global reach of the Great Depression in the 1930s. And the Great Depression, according to some historians, was the key catalyst that brought the Nazis to power. Here, for example, is Barry Eichengreen and Peter Temin:
Rivers of ink have been spilled over the causes of the Nazi rise to power. Studies have championed and refuted competing hypotheses about the relationship between the German economy and the votes for the Nazi party. At some level, however, there cannot be any doubt that the Nazis were the party of the Depression. They were a fringe group in the 1920s and grew to electoral prominence only in 1930 when economic conditions deteriorated. They gained even more seats in the Reichstag in the first election of 1932, but lost seats in the second election later that year as economic conditions appeared to improve. Had that improvement come earlier, a new study using panel data shows clearly that the Nazi vote would have been smaller.18 We do not have a model of the political process that tells us how weak the electoral support for the Nazis would have had to be to significantly affect the political maneuvering among the leaders of the Weimar Republic. But almost any model would say that better economic conditions would have decreased political support for the Nazis and therefore the probability that Hindenburg would have asked Hitler to be chancellor.
So far all the problems WWI created, the flawed interwar gold standard was probably one of the the more important ones. It led to the Great Depression which, in turn, guaranteed the rise of the Nazis and another world war. The big lesson, then, is getting the international monetary system right matters a lot.

Update: Francesco Lenzi shares this interesting picture on twitter. It shows that the Great Depression, not the Weimar hyperinflation, was behind Hitler's rise.