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Wednesday, July 25, 2018

Closer to OCA Criteria: Eurozone or Dollarzone?

This is a quick follow-up to my recent article on the Eurozone. There I argued for more integration or separation in the Eurozone since ECB monetary policy is pushing regional economies further apart rather than together. I showed a version of the below chart in the article to illustrate this point:


ECB policy--and its response to the various shocks hitting the Eurozone--has effectively kept nominal demand growth in the core economies fairly stable while pulling it down in the periphery. This divergence suggest the Eurozone is quite far from being an optimal currency area (OCA). 

Someone asked on twitter what the chart would look like for the United States. So I made a similar chart that compares the top twenty states (ranked in terms of GDP per capita) to the bottom twenty:


While both regions are below their pre-crisis trend paths, Fed policy has at least been consistent in how it has affected nominal income growth in both rich and poor states. So the Fed beats the ECB on consistency, at least! 

Moreover, this outcome suggests there are more effective regional shocks absorbers in the United States that make the dollar zone more of an OCA than the Eurozone. That is, even if Fed policy is not optimal for all regions of the United States this is less of a problem than in Europe because the regions can better handle bad monetary policy via fiscal transfers, labor mobility, safer retail banking system, flexible prices, etc. For more on these shock absorbers see my other recent post on this topic.

Will Australia Be the First Country to Try NGDPLT?

There is a new Brookings paper by Warwick J. McKibbin and Augustus J. Panton titled Twenty-five Years of InflationTargeting in Australia: Are There Better Alternatives for the Next 25Years? Here is how they answer the question in their title:
This paper surveys alternative monetary frameworks and evaluates whether the current inflation targeting framework followed by the RBA for the past 25 years is likely to be the most appropriate framework for the next 25 years. While flexible inflation targeting has appeared to work well in Australia in the past decades, the nature of future shocks suggests that some form of nominal income targeting is worth considering as an evolutionary change in Australia’s framework for monetary policy.
Put differently, this Brookings paper argues that inflation targeting is a monetary regime whose time has come and gone. I completely agree

What is interesting, though, is that they are making this case for Australia whose economy has had a remarkable 27-year expansion. This is attributable, in part, to the Reserve Bank of Australia (RBA) who has successfully navigated through numerous shocks including the bursting of the tech bubble, the global financial crisis, commodity price collapse, and periodic bouts of China panic. The last time there was a recession in Australia it was in the early 1990s.

Along these lines, it is worth highlighting again that Australia, if any country, should have experienced a so-called 'balance sheet' recession in 2008-2009. It had a housing boom and a surge in household debt that exceeded the United States as seen below. It also faced a large negative commodity price shock in late 2008-early 2009. And yet there was no Great Recession in Australia. 


Australia, in short, was the balance sheet recession that never happened. The reason the Australian economy faired so well is because is because the RBA never hit the ZLB and, in so doing, kept aggregate nominal income on it trend growth path. Thus, there was less financial stress created for nominal debt contracts holders. So, unlike the Fed and the ECB, the RBA saw its nominal GDP stay roughly on course during and right after the global financial crisis. And that made all the difference in the world.

This gets us back to the new Brookings paper. So why do the authors argue for an explicit nominal GDP level target (NGDPLT) when the RBA's inflation target has been implicitly doing the same? The authors argue that going forward the biggest shocks likely to hit the Australian economy will be large supply shocks:
There are three main areas where future shocks can be anticipated. The first is climate change and climate policy responses. The second is the emergence of a fourth industrial revolution or a new Renaissance due to the rapid adoption of new technologies such as artificial intelligence. The third is the growth of larger emerging economies into the world economy following the experience of China.
The authors note an explicit NGDPLT is better suited to handle such shocks and thus their call for the RBA to adopt it. I agree completely on the supply shock motivation. I would, however, submit another reason for the RBA to explicitly adopt a NGDPLT in Australia. 

The RBA in the past has done a great job keeping nominal income on its trend growth path. However, in recent years it has actually slipped a bit and now it is now below trend. An flexible inflation target, apparently, is not enough to always keep aggregate demand growth stable. Moving to an explicit NGDPLT would put the focus on this emerging gap and force the RBA to take corrective actions. 


New Zealand was the first country to adopt inflation targeting. It was the avant-garde of this new monetary regime in the early 1990s. So maybe a smaller economy like Australia needs to do  same with NGDPLT before other larger economies try it. Here is hoping the RBA is willing to try it. 

Monday, July 16, 2018

The Future of the Eurozone

So we are live at NRO discussing the future of the Eurozone:
Albert Einstein is rumored to have quipped that doing the same thing over and over again and expecting different results is the definition of insanity. If he were alive today, Einstein might say this is the definition of some key euro-zone policymakers.
There I argue hard choices have to made in the Eurozone: further integrate or separate.
So where does this leave the euro zone? For now, euro-zone officials are still kicking the can down the road, but at some point they will face a fork. One path will force further integration upon the euro zone, along the lines of Emmanuel Macron’s proposal and better ECB monetary policy. The other path will lead to the separation of the euro zone. As Ashoka Mody shows in his new book, the 20-year history of the euro zone suggests the latter path is more likely. Breaking up the euro zone, though, need not end the EU. As suggested by Ambrose Evans-Pritchard and Ramesh Ponnuru, the periphery could keep using the euro while the core could exit and adopt their own currency: Call it the Deutschmark 2.0. This approach would minimize the financial stress from the breakup of the currency union.
One chart that did not make it into the final article is below showing the OCA theory. It shows that if a region’s business cycle is similar to the currency union or if there are sufficient shock absorbers in place, or some combination of the two exists, then it makes sense for the region to be in the currency union. If a regional economy does not meet these criteria, like Italy, then it would be inside the OCA frontier curve in the figure and should not join the currency union. 

My conclusion in the article effectively says that Eurozone officials are not willing or able to make the changes needed to push countries like Italy beyond the OCA frontier. Ashoka Mody makes a convincing case in his book that, if anything, the Eurozone is pushing countries like Italy farther inside, away from the OCA frontier. Better to address the inherent tensions of the Eurozone now than to keep kicking the can down the road. 



Tuesday, June 19, 2018

The Treasury Yield Curve Blues


The Fed needs to start worrying more about the flattening treasury yield curve.  Bloomberg is reporting that bond traders are getting ready for a yield curve inversion as soon as next week.  One fixed income manager quoted in the article had this to say: 
If the Fed decides to move more this year, I think it’s inevitable that the curve inverts and I think it will be a mistake,” said Colin Robertson, managing director of fixed income at Northern Trust Asset Management... He sees greater than a 50 percent chance of the 2- to 10-year spread inverting if the Fed raises rates once more this year, and if the central bank follows its projections and hikes twice more, Robertson sees inversion as a lock.
Here is what the 10-year minus 2-year spread currently looks like: 


The yield curve spread is definitely heading down, but is it truly on the cusp of an inversion? It is hard to know for sure, but there are two big clues suggesting the answer is yes. First, as noted by Robert Burgess, yield curve inversions are already happening overseas:
For much of the past year or so, investors and economists have anxiously watched the relentless shrinkage of the gap between short- and long-term U.S. bond yields to the narrowest levels since 2007. After all, an inversion —  when long-term yields fall below short term ones — preceded each of the last seven recessions. But while everyone has been so focused on the U.S, they seemed to have missed the global yield-curve inversion.   
Within the past two months, the yield on an ICE Bank of America index of government bonds due in seven to 10 years has fallen below the yield on an index of bonds due in one to three years for the first time since the first half of 2007. The strategists at JPMorgan Chase & Co. said they were seeing the same thing in indexes they manage. Although the U.S. economy is in solid shape, there have been signs of weakness in the euro zone, China and emerging markets over the past month.
Given the global integration of capital markets, it is not hard to imagine the overseas inversions working their way into the U.S. treasury yield curve. Some Fed officials are paying close attention to this possibility like Atlanta Fed President Raphael Bostic:
“I have had extended conversations with my colleagues about a flattening yield curve” and the risks of it inverting, he said at a moderated forum in Augusta, Georgia on Wednesday. “We are aware of it. So it is my job to make sure that doesn’t happen... Hopefully we won’t get to that inversion.”
That is good to know. Unfortunately, others on the FOMC are more sanguine about the flattening yield curve. From the May FOMC meeting minutes we learn the following:
[P]articipants also discussed the recent flatter profile of the term structure of interest rates. Participants pointed to a number of factors contributing to the flattening of the yield curve, including the expected gradual rise of the federal funds rate (and) the downward pressure on term premiums... A few participants noted that such factors could make the slope of the yield curve a less reliable signal of future economic activity. 
So not everyone at the FOMC is equally concerned about an inversion. This complacency may be one reason why the FOMC, as a whole, is predicting an inverted yield curve of its own making

The FOMC currently plans to have its short-term interest rate target range at 3.00% - 3.25% by the end of the 2019. Meanwhile the 10-year treasury yield has been bouncing between 2.80% and 3.00%, close to FOMC's long-run federal funds rate estimate of 2.90%. The FOMC, in other words, sees itself raising its short-term interest rate target such that the yield curve spread will become negative or inverted over the course of the next year and a half. This prediction is our second big clue that the yield curve is likely to invert.

But no big deal, says the FOMC, because this time it is different. Yes, the FOMC will be raising short-term interest rates, but the term premium is the real villain in this story. For it will not allow long-term interest rates to rise above short-term interest rates. So despite appearances, the term premium will be the real cause of the inversion per the FOMC. 

Former Fed chair Ben Bernanke similarly thought it would be different back in 2006. He said not to worry about the flatting yield curve at that time. Bernanke pointed to the term premium as the culprit even as the Fed was raising its interest rate target. But the standard yield curve recession predictions were borne out and we got the Great Recession. This recent experience should give today's FOMC pause. 

Moreover, as Michael Bauer and Thomas Mertens recently show, a negative yield-curve spread still does an amazing job predicting recessions. Consequently, the FOMC should not be aiming to raise short-term interest rates above long-term interest rates. The last thing the Fed should want to do is sing the treasury yield curve blues.  Better to play it safe than to risk choking off the expansion.

Update: I got into a twitter conversation regarding this post and my critique of Ben Bernanke's speech in 2006. As a result, I constructed the following figure using the New York Fed's estimates of term premiums. It shows the 10 year minus 1 year treasury spread decomposed into (1) an expected rate path spread and (2) a term premium spread. These two component add up to the overall spread.

The figure reveals that while Bernanke was right about a declining term premium in 2006 it was also the case that the expected path of short-term rates was declining. It was signaling recession. What this implies for today is that the FOMC should tread cautiously in interpreting the flattening of the yield curve. There may be more to the story than term premiums.

Friday, June 15, 2018

The People's Fed Chair

Ever since his confirmation hearings, Fed Chair Jay Powell has struck me as an ordinary, plainspoken person. This week I was reminded of this trait at his FOMC press conference and tweeted this statement:


This impression is consistent with reports from last year when he was being considered for Fed chair:
[F]riends and former colleagues of Powell's describe him as “annoyingly normal.” He lives in Chevy Chase, Md., and often rides his bike about eight miles from home to the Fed. He doesn't drink much, plays golf and the guitar, and has an odd ability to repeat people's sentences backward to them, a quirk former colleagues say is a reminder of his smarts — and how closely he listens.
I bring this up because Jeanna Smialek of Bloomberg has a new article that nicely captures this feature of Jay Powell. The title of her piece is Powell Styles Himself a Fed Chairman for the People. Here are some excerpts:
Alan Greenspan famously said he’d mastered the art of mumbling “with great incoherence” as Federal Reserve chairman. Jerome Powell is attempting the opposite approach. 
“Because monetary policy affects everyone, I want to start with a plain English summary of how the economy is doing, what my colleagues and I at the Federal Reserve are trying to do and why,” Powell, who took the helm at the U.S. central bank in February, said at the outset of his June post-meeting press conference on Wednesday. 
[...] 
He’s a non-economist who uses concise, simple terms -- growth is “great” and “there’s a lot to like” about low unemployment. He downplays the importance of modeled relationships and emphasizes the data in hand. He’s adding more press conferences, and the Federal Open Market Committee has already shortened its post-meeting statement under his watch.
It is a great article, read the whole thing. To be fair, though, previous Fed chairs would also consider themselves the people's Fed chair. But I do think Jay Powell brings a unique tool set to the Fed in terms of his interpersonal communication skills. I suspect these "soft" skills will prove very valuable going forward, especially as the Fed continues to navigate the politics of normalizing monetary policy. 

P.S. If Jay Powell wants to step up his 'Fed chairman for the people' game, then he might consider optimal monetary policy for the masses.

Update: Tate Lacey makes a similar point

Wednesday, June 13, 2018

Optimal Monetary Policy For the Masses: the James Bullard and Larry Summers View

James Bullard and Ricardo DiCecio have a new paper where they model wealth, income, and consumption inequality.  They also incorporate fixed-price nominal debt contracts.  They then derive the optimal monetary policy for the masses in such a model. Here is what they find:



This paper builds upon the risk-sharing view of NGDP targeting. The basic idea is that in a world of fixed-price nominal debt contracts (i.e. the real world), a NGDP level target provides better risk sharing among creditors and debtors against economic shocks than does a price stability target.  

This is because a NGDP level target makes inflation countercyclical. During recessions, inflation rises and causes creditors to bear some of the unexpected pain by lowering the real debt payments they receive from debtors. During booms, inflation falls and allows creditors to share in some of the unexpected gain by increasing the real debt payments they receive from debtors. Debtors, in other words, bear less risk during recessions but also share unexpected gains during expansions. 

NGDP level targeting, in other words, causes a fixed-price nominal debt world to look and feel a lot like an equity-world. In a similar spirit, some observers have called for a risk-sharing mortgages as a way to avoid another Great Recession. The point of this paper is that the same benefit that such risk-sharing mortgages would bring can be had by having a central bank target the growth path of NGDP.

Larry Summers is also worried about the masses and is therefore rethinking the Fed's 2 percent inflation target
My conclusion, therefore, is that in our current framework the economy is singularly brittle. We do not have a basis for assuming that monetary policy will be able, as rapidly as necessary, to lift us out of the next recession. This has a substantial cost likely in the range of at least $1 trillion over the next decade. This suggests the suboptimality of our current monetary policy framework... 
If I had to choose one framework today, I would choose a nominal GDP target of 5 to 6 percent. And I would make that choice for two reasons. First, it would attenuate the issues around explicitly announcing a higher inflation target, which I think are a little bit problematic on political economy grounds. Second, a nominal GDP target has an additional advantage in its implicit response to changing conditions. Arithmetically a nominal GDP target has the property that the expected rate of inflation rises as the expected real growth in GDP declines. This is desirable. If growth in underlying real GDP declines, neutral real interest rates are likely to decline as well. In this case allowing higher inflation to make possible even more negative real rates reduces the risk of policy impotence.
Sounds good to me, but are there any real world examples of NGDP level targeting? Probably the best example of a country following something like a NGDP level target has been Israel over the past decade. The Bank of Israel officially targets an inflation range of 1-3 percent, but in practice has made inflation so countercyclical that effectively it has been doing a NGDP level target. The figure below shows this countercyclical nature using the GDP deflator:


Note that both inflation overshooting and undershooting have been tolerated. The GDP deflator has been as hight as 6 percent and almost as low as 1 percent. Overall, its inflation rate has averaged about 2 percent, right in the center of the 1-3 percent target range. So this approach provides both a nominal anchor and short-run inflation flexibility for Israel.  

As consequence of making Israeli inflation countercyclical, the growth path of NGDP has been kept stable: 


This is what monetary policy for the masses looks like!

Monday, June 11, 2018

A Tale of Three Nominal GDP Growth Paths

Check out the figure below. It has nominal GDP plotted for three countries, normalized to 100 in 2007. The first country (black line) has kept nominal GDP on  a stable growth path over the entire period. The second country (red line) saw its nominal GDP growth path permanently decline in 2008-2009 but has since stabilized its growth rate.  The third country (blue line) had its nominal GDP growth path collapse and has only recently seen it grow past its its 2008 peak value. 


So we see three very different paths of a nominal variable that should be controlled by monetary authorities over long periods, like that depicted in the chart. Consequently, not only are we seeing a tale of three different nominal GDP growth paths, we are also see a tale of three very different central banks policies. 

Can you guess what countries are represented by the three different lines?