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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 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. 

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. 

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? 

The Sovereign Money Blues

The Sovereign Money Referendum 
Sovereign banking will not happen in Switzerland. The referendum to end fractional reserve banking and turn all money creation over to the Swiss National Bank (SNB) central bank failed by a wide margin on Sunday. This rejection is not a surprising result, given the polls going into the vote. There never was much chance the so-called Vollgeld plan would would pass. 

Still, the sovereign money referendum was useful in that it generated new discussions on the benefits and costs of opening up the central bank's balance sheet to the public. In the United States, there had already been some debate surrounding the opening up of the Fed's balance sheet to non-bank financial firms in response to the financial crisis. Depending on who you asked, this "creeping nationalization" of financial intermediation was either concerning or a step in the right direction toward safer money. The Swiss vote was good, therefore, in that it further fleshed out some of the arguments for and against central banks becoming more like a regular bank.

Among those arguing for sovereign money or something like it were Martin Wolf, Ryan Avent, Matthew Klein, Martin Sandbu, Morgan Ricks, and the positive money folks. Some of those arguing against it include Carolyn Sissoko, Jo MichellSri Thiruvadanthai, Cullen RocheScott Sumner, and George Selgin.

The appeal of deposit accounts for all at the central bank is understandable. They would be safe and end private bank runs. But sovereign money is not costless. It would bump up against some big problems that sovereign money advocates either ignore or dismiss too easily, as noted by the critics above. In this post, I want to highlight three that I think are especially under appreciated : the knowledge problem, the public choice problem, the tradeoff problem.

The Knowledge Problem
The knowledge problem, as fist noted by F.A. Hayek, is that the information needed for successful centralized economic planning is distributed widely among households and firms. It is knowledge a central planning authority needs but cannot obtain. In this context, it is the central banks inability to know where and how much money creation is needed.

Money, currently, is the byproduct of many decentralized decisions among a large number of borrowers and lenders in very different circumstances. Specifically, banks create money through loans to businesses and households in various locations based on local, idiosyncratic economic conditions. To believe this complex process could be easily replaced by a central bank committee deciding how much money should be created is incredulous.

But it gets worse. Under a sovereign money regime,  estimating the amount of money needed would actually become more complicated. This is because financial firms wanting to originate loans would need 100% reserve backing. Money, in other words, would be needed for both transaction purposes and for loan-backing purposes. So not only would the central bank need to know where and how much transaction money demand there was, it would also have to know where and how much loan-driven demand for money there was.  It would be very easy for central banks to get monetary policy wrong.

Central bankers, in short, would need near omniscience to do their job well in a sovereign money regime. Given these Herculean requirements, it is easy to understand why SNB officials were so adamantly opposed to the sovereign money proposal.

The Pubic Choice Problem
Public choice economics tells us that the fallible people who often cause problems in the private banking system are the same fallible people that work at central banks. They may mean well, but like all humans they too desire to make themselves better off and respond to incentives, sometimes unconsciously. One can, for example, look to growing Fed budgets or the Fed's influence on research as potential examples of public choice economics at work.

Now take a central bank and turn it into the sole creator of money, as sovereign money advocates desire, and see what happens to central banker incentives. This development would mean a massive expansion of the central bank's balance sheet and complete control over money creation. If, for example, the Fed opened up its balance sheet to all current retail holders of money balances--the M2 money supply--its balance sheet would expand to about $14 trillion. And once the Fed opened up its balance sheet to retail investors, it probably would not stop there. For if financial firms and households can have deposit accounts at the Fed, why not non-financial firms too? Central bank balance sheets would become super sized.

With such large balance sheets and the sole power to determine who gets money, central bankers would find it hard not to be corrupted. As Lord Acton famously said, "Power corrupts and absolute power corrupts absolutely."  Many sovereign money fans fail to grapple with this issue. They simply assume that central bankers, with all their new power, will act like saints rather than sinners. This is an incredibly naive understanding of humanity. If private bankers can behave badly, as many sovereign money advocates note, why not central bankers when given vast power?

The Tradeoff Problem
The above concerns imply monetary policy would actually get harder under a sovereign money regime. Yes, central bankers would have more control over the money supply, but they also would need near omniscience and a pure heart to get it right. It is likely, in other words, that central banking would become more destabilizing in a sovereign money regime. 

This third concern becomes even more pronounced if central banks continue to lend while opening up their balance sheets to the public. To be clear, sovereign money advocates want to avoid this very outcome--they want to separate credit creation from money creation--but it seems unlikely that central banks would cease lending in practice due to public choice reasons. If so, then, it is easy to see central banks with their now open balance sheets also expanding their financial intermediation activities and becoming the mother of all too-big-to-fail (TBTF) institutions. 

Central banks, in short, are more likely to make mistakes in a sovereign money regime than in the current system. Whether that means the wrong monetary policy or turning the central bank into a TBTF institution, the temptation will be great to paper over such mistakes with higher inflation. If so, society will have traded private bank run risk for central bank run (i.e. velocity) risk.  That is, we would be trading off running on private bank accounts for running on central bank money because of higher inflation fears. This tradeoff is depicted in the figure below.


This understanding belies a central claim made sovereign money advocates: there can be debt-free money creation. Yes, it is true a government can do helicopter drops, such as putting money into the public's deposit accounts at the central bank. But even these are implicitly a liability of the government if it cares about price stability. For it implies a commitment by the government to use real future resources—via future taxes—to keep inflation stable. This money creation, then, is a debt on future generations. 

Conclusion
For the reasons laid out above, I am not convinced that a sovereign money regime is the panacea many make it out to be. Yes, our banking system is far from ideal, but going down the sovereign money path is a step in the wrong direction.

Update: Morgan Ricks responds to my post here

PS. Brian Blackstone of the Wall Street Journal and I discuss the Swiss referendum in this week's episode of the Macro Musings podcast.  Listen below or via your favorite podcast app.



PPS. Frances Coppola makes similar observations in earlier posts on 100 percent reserve banking. 

Tuesday, May 22, 2018

What Can Argentina Teach Us about the Phillips Curve?

In the United States, there has been existential angst over Phillips curves for the past few years. Fed officials and other observers have been engaged in deep soul searching as they try to reconcile a falling unemployment rate with stubbornly low inflation. The Phillips curve says this development should not be happening--inflation should rise as the economy nears full employment. And yet, it has been happening for several years. 

Various attempts have been made to reconcile the apparent breakdown in the Phillips curve relationship. Some, like Joe Gagnon, say there is a non-linear relationship that comes into play when inflation is really low. Others, like Adam Ozimek and Ernie Tedeschi claim there is no Phillips curve mystery if one simply uses the correct measure of slack: the prime-age employment rate. Another group, including Paul Krugman, points to monopsony power as explaining the breakdown in the relationship. Still others point to a variation of Milton Friedman's thermostat argument: the Fed has been so successful at targeting inflation it has eliminated any observed relationship between inflation and slack. Nick Rowe puts it this way:
[I]nflation targeting made inflation stickier than it used to be. Which means that inflation targeting became a victim of its own success. By making inflation sticky at 2%, it destroyed the very signal of deficient-demand recessions that monetary policy was supposed to respond to. The thermostat destroyed its own negative feedback mechanism.
Minneapolis Fed President Neel Kashkari makes a similar argument in the Wall Street today.  It is also the implication of this Cecchetti et al. (2017) paper that made a splash last year. This view makes the most sense to me.

To be clear, I prefer thinking of inflation from a money supply-money demand framework along the lines of David Andolfatto and Josh Hendrickson. But if one is determined to approach inflation from a Phillips curve perspective, I see the thermostat view as the most convincing explanation for the breakdown in the U.S. Phillips curve relationship. 

Paul Krugman recently suggested we look elsewhere to get further insight on the Phillips curve. He turned to Spain which appears to show a strong Phillips curve relationship. This choice of country, however, is not a clean one since its monetary policy is set externally by the ECB. It is not obvious that we would see this relationship persist if Spain set its own monetary policy. Spain, in short, does not help us better understand the U.S. experience.

One country that might be useful is Argentina, at least if we look at the non-hyperinflation years. It has its own central bank, the BCRA, and it has periods of instability that provide data not clouded by Milton Friemdman's thermostat. Interestingly, since 2010 the BCRA has tolerated double digit inflation in Argentina and currently inflation is running near 25 percent. This run of inflation has been above the central bank's inflation target of 8-12 percent so the BCRA conveniently changed its inflation target this year to 15 percent. It might interesting to see what this run of high inflation does to the Phillips curve. 

I plotted the Argentine Phillips curve below using annual data from the IMF WEO database and Focus Economics for this period of high inflation. Most of my data comes from the former source, but for the years 2015 and 2016 the IMF does not report the inflation rate presumably because of questions about the reliability of the data. Focus Economics does provide data for those missing years. The red line below shows the estimated Phillips curve relationship leaving out the questionable 2015 and 2016 observations while the blue line shows the relationship using all the all the observations.



Yikes, we got an upward slopping Phillips curve! This is a small sample, but it is consistent with notion that inflation running too high can cause problems on the real side of the economy. We should dread this Phillips curve. 

Now to be fair, if I take the IMF data back further to earliest time where there was no hyperinflation (defined as inflation greater than 50%) we get the following figure:


Now we see a more traditional-looking Phillips curve for the period 1992-2009 (excluding the 2002 outlier, the year Argentina broke the link with the dollar) of this sample. It is depicted by the black line. Most of the observations in this earlier period have inflation lower than 10 percent. That may explain why it looks more normal. For comparison, the 2010-2018 period is again highlighted by blue. 

If we plot a Phillips curve relationship over the entire sample we get the following figure. 


The takeaway, if there is any, from these Argentine figures is that a standard-looking Phillips curve may require inflation be less than 10 percent and there be periods of instability so that Milton Friedman's thermostat is not working. But if the thermostat is not working, then, the central bank is not doing its job. The Phillips curve, in other words, may never be very informative for places where central bankers are doing a great job anchoring inflation. The United States is arguably one such place. If that is the case,  Fed officials might want to try a different approach to understanding inflation. 

Thursday, May 10, 2018

The U.S. Mortgage Market: Chart Edition

Today, I interviewed Nick Timiraos of the Wall Street Journal for the Macro Musing podcast. He is on the Fed beat now, but covered the GSEs during and after the financial crisis for the paper. Consequently, he has an encyclopedic knowledge of Fannie Mae, Freddie Mac, and the other GSEs. His knowledge and experience were the basis of our conversation today. It was a fun show and should be out in about a month.

I wanted to share some figures I collected on the U.S. mortgage market in preparation for the show. They come from an amazing monthly report on housing from the Urban Institute called Housing Finance at a Glance. These figures provide a peak into my conversation with Nick.

Consider first  the historical share of mortgage debt outstanding by type of institution. This chart is actually mine from a few years ago. There are three key takeaways from it. First, the GSEs gain most of their market share in the wake of the S&L crisis. Second, the GSEs actually lose market share to the private label security (PLS) providers during the housing boom period. These PLS providers--the red line in the figure below--gained market share during this time by tapping into the Alt-A and subprime mortgage market. Eventually, the GSEs followed suit, but its was the private label security providers who went there first and did most of the damage.  Third, the GSEs  gain market share back as the PLS supply folded in the crisis. 


Next, if we look just at the share of securitized mortgages--which today makes up about 2/3 of all mortgages today--we see the dominance of the GSEs over PLS today. This can be seen in the figure below from the Urban Institute report. 


The Urban Institute also provides the dollar amount of the mortgage market going to the GSEs and other sectors. The remarkable decline in PLS is evident here too:


 The Urban Institute also provides details on the types and sources of securitized markets:


Finally, for those curious, the Urban Institute has a nice chart summarizing the total value and equity of the U.S. housing market. This chart reports that the U.S. housing equity turned positive again in 2013 and currently stands at $15.2 trillion compared to household debt level of $10.6 trillion. Happy days are here again for U.S. housing.


Again, these charts are just a small part of my conversation with Nick. It should be out in a month or so. In the meantime check out the entire Urban Institute report.