Some Thoughts on David Altig's Question

David Altig has a post that summarizes the differing views on what the Taylor Rule is saying about the current stance of monetary policy. He notes that economists from Goldman Sachs, Macroeconomic Advisers LLC, Deutsche Bank Securities Inc. and the San Francisco Federal Reserve Bank view the Taylor Rule as indicating monetary policy is tight while John Taylor, on the other hand, sees the rule as showing the Fed's stance is just about right. Altig suggests that one of the problems in this debate is that the Taylor Rule is based on assumptions about the monetary transmission mechanism that may not hold in the current crisis. Given this possibility, Altig concludes with the following question:

Is the Taylor rule the right tool for discussing the stance of monetary policy at present?

My guess is probably not. For starters, it assumes the parameters defining the relationship between the macroeconomic variables (inflation gap, output gap) and the appropriate federal funds interest rate are constant and linear. While these assumptions worked for the relatively stable 25 or so years during the Great Moderation they seem suspect now given the severity of the economic downturn. Another problem in using the Taylor Rule is that one has to know what is the neutral federal funds rate and the output gap. These metrics are hard to know with precision even in normal times, let alone turbulent economic times as we have now.

Given these challenges with the Taylor Rule, let me suggest an alternative, simple metric for determining the stance of monetary policy. This metric is difference between (1) the growth rate of nominal spending in the U.S. economy and (2) the federal funds rate. Using this metric, the federal funds rate should not deviate too far from the nominal spending growth rate otherwise monetary policy is either too loose (the federal funds rate is significantly below the nominal spending growth rate) or too tight (the federal funds rate is significantly above the nominal spending growth rate). This measure is similar to the one used by The Economist magazine where they gauge the stance of monetary policy by looking at the difference between the nominal GDP growth rate and the federal funds rate. The Economist explains the way to “interpret this [metric] is to see America’s nominal GDP growth as a proxy for the average return on American Inc. If the return is higher than the cost of borrowing, investment and growth will expand [and vice versa].

I however, think, a better way to think about this measure is to view it in terms of nominal spending rather than the return on American Inc. Here is why: stabilizing nominal spending is the key to stabilizing macroeconomic activity. If an economy is running near full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that cannot be sustained. This is because there are numerous nominal rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending and not have real economic activity move as well. Note, that key here is not to aim for price stability, but to aim for nominal spending stability. As I noted before,

Nominal spending shocks, after all, are the real source of macroeconomic volatility while inflation is merely a symptom of these shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high(low) inflation due to positive(negative) aggregate demand shocks or negative(positive) aggregate supply shocks?--and as a result monetary policy that targets inflation may make the wrong call.

The good news is that the Fed can largely shape nominal spending and keep it growing around some target. But to do so means the Fed must not let its federal funds rate be low relative to the growth rate of nominal spending or vice versa.

So what does this policy rate gap look like? Using final sales to domestic purchasers as my measure of nominal spending, I have constructed it two ways: (1) the year-on-year percent change in nominal spending minus the federal funds rate and (2) the annualized quarterly percent change in nominal spending minus the federal funds rate. I have graphed both series below with the NBER recessions in gray bars. The figure goes through 2009:Q1. (Click on the figure to enlarge.)


This figure indicates this measure is consistent with commonly held views about the stance of monetary policy historically. For example, the easing of policy in the 1970s is apparent as is the tightening in the early 1980s. This figure also shows a very accommodative monetary stance in the early-to-mid 2000s. Finally, it shows that through the last few quarters ending in 2009:Q1 monetary policy appears to have been effectively tightening. This is because even though the federal funds rate did not change, nominal spending collapsed creating a large gap between the two series. The fall in nominal spending can seen in the figure below. (Click on figure to enlarge.)

While the policy rate gap is probably not a perfect measure of monetary policy's stance, it is simple to construct and has some predictive power as seen in the figure below. In this figure, the policy rate gap is graphed along with the CBO output gap 3 quarters ahead.

The policy rate gap appears to granger cause the CBO output gap. Such a pattern in the data could easily be explained by macro model where nominal spending shocks that encounter nominal rigidities create create output gaps. I find this to be a promising way to evaluate the stance of monetary policy and hope to do more with it.

The Future of the Euro (Part VII)

Speaking of optimal currency areas, Barry Eichengreen has a new article on whether some Euro countries may abandon the currency union:

Although housing prices have fallen euro area wide, they have fallen more dramatically in some countries than others. Although the crisis has meant large losses for banks throughout the euro area—often on those same housing-related investments—it has produced larger losses in some countries than others. It has led to rising unemployment throughout the euro area, but more in some countries than others. The result is more deflationary pressure, actual or potential, in some euro area countries than others. There are also more strains on the public finances of some euro area countries, as reflected in the widening of spreads on sovereign bonds and their associated credit default swaps.

Under these circumstances, different euro area countries presumably would prefer a different monetary policy response. But the members of the euro area are necessarily subject to a one-size-fits-all policy, such being the intrinsic nature of monetary union. This tension has revived the pre-1999 debate over whether monetary union in Europe is a good idea. It has also given rise to chatter and speculation about the possibility that one or more euro area countries might now choose to abandon the euro. This article weighs the implications of such a move and, although finding it risky, costly, and complicated, concludes that it is not inconceivable.

Read the rest of the article here. Here is the intrade contract on whether "any country currently using the Euro to announce their intention to drop it on/before 31 Dec 2010." (Click on figure to enlarge.)

This figure indicates the probability is only about 15% now, a big drop from the 40% high last year.

Roubini, Ferguson, and Zuckerman on CNN

Is One Currency Enough for the United States?

Marshall Auerback recently had an interesting post on California's IOUs becoming a form of money. Mark Thoma responded to that post by noting the following:

Having fifty different currencies isn't necessarily bad, there are pros and cons to having a single currency across all fifty states, i.e. to forming currency union. With a currency union, individual members lose the ability to conduct independent monetary policy - there is one money and one policy so everyone in the group gets the same treatment - but that is less costly when the the economic differences among the members of the union is small and the same policy is generally applicable...

Another way of saying that is to ask whether United States truly is an optimal currency area. This is a question I asked in a recent paper:

Is the United States best served by a single central bank conducting countercyclical monetary policy? According to the optimal currency area (OCA) criteria, the answer is yes if the various regions of the United States (1) share similar business cycles or (2) have in place flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a national monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a national monetary policy destabilizing—it will be either too stimulative or too tight—for some regions unless they have in place the above listed economic shock absorbers.

[...]

Consider, for example, a region in a currency union whose economy is not well-diversified and is slowing down because of a series of negative shocks to its primary industries. If the monetary authorities in this currency union decide to tighten because the other regional economies are expanding too fast then the region slowing down needs price flexibility, labor mobility, and federal fiscal transfers in order to offset the effects of the contractionary monetary policy. If these economic shock absorbers are absent, then this region would find this tightening of monetary policy to be further destabilizing to its economy. In general, the greater the dissimilarity of a region’s business cycle with the rest of the currency union the more important these economic shock absorbers become for the region to be a successful part of an OCA.

Graphically, this understanding can be illustrated as follows (click on figure to enlarge):

So are there any regions of the United States that fall outside the dollar OCA area? I find some evidence that the rustbelt and the energybelt might have benefited from having their own currency over the period 1983-2008. What I do not show--as is the case with most OCA studies--is the (1) added transaction costs and (2) potential political economy problems that would emerge had these regions formed their own currency unions. So it is hard to know whether these regions would have on balance benefited from having monetary autonomy. You can read the paper here.

6.5 million job losses later...

Here are the job numbers.

Worth Repeating

Larry White has some great comments on the petition signed by a number of prominent economist for maintaining Fed Independence. Here are some excerpts:

...The letter continues:

We urge Congress and the Executive Branch to reaffirm their support for and defend the independence of the Federal Reserve System as a foundation of U.S. economic stability.

If “independence” means discretion, then independent Fed policy in 2001-07 did not deliver stability, but fueled an unsustainable path in mortgage volumes and housing prices. The key to stability is not the independence but the restraint of the Fed, self-adopted or externally imposed. Failing self-adoption, external imposition is surely reasonable.

First, central bank independence has been shown to be essential for controlling inflation.

Actually, the correlation between measured independence and low inflation has been shown to disappear with a widening of the sample of countries...

Second, lender of last resort decisions should not be politicized.

Consider cases where the Fed has intervened to stave off the resolution of an insolvent firm or to sweeten the deal for its acquisition, e.g. the cases of AIG and Bear Stearns. The Fed or its defenders may call those “lender of last resort” operations, but they weren’t. They had nothing to do with the standard historical (Bagehot) understanding of the LOLR role, which is to lend liquid reserves to solvent commercial banks facing temporary liquidity problems. The LOLR role does NOT include lending to insolvent firms, or lending to non-banks. The Fed’s actions in those cases had even less to do with the modern understanding of the LOLR, which is to prevent the money stock from shrinking. Likewise the Fed’s decisions to create new “loan facilities” for broker-dealers and money-market mutual funds had nothing to do with acting as a LOLR.

The Fed’s decisions in those cases were actually the sort of decisions that were traditionally left to Congressional appropriations (as in the Chrysler bailout of the 1970s). Congress should not be blocked from questioning (“politicizing”) the Fed’s fiscal-policy decisions simply because the Fed mislabels them or self-finances them.

Finally, calls to alter the structure or personnel selection of the Federal Reserve System easily could backfire by raising inflation expectations and borrowing costs and dimming prospects for recovery. The democratic legitimacy of the Federal Reserve System is well established by its legal mandate and by the existing appointments process. Frequent communication with the public and testimony before Congress ensure Fed accountability.

If the Fed’s legitimacy is established by mandates that the Congress gave it, how is it improper for Congress to revisit that mandate, for example to improve Fed accountability? We don’t want changes that raise inflation expectations, agreed. For that very reason we should welcome a new mandate that better restrains the Fed from inflating.

As I mentioned before, an audit or investigation properly conducted--that is one without the gotcha-type moments seen in the recent Bernanke testimony--could actually strengthen the Fed's independence. Read the rest of White's post here.

Assorted Musings

Some more assorted musings.

1. This Economist article on the state of marcoeconomics has attracted a lot of attention. Paul Krugman and Brad DeLong both note that the article is not entirely accurate in that some economists, including themselves, did see problems emerging. However, the problems they focused on were the wrong ones:

   The prevailing view was that the truly dangerous financial crisis would be one produced by the unwinding of "global imbalances"--a collapse in the dollar and a panicked flight not toward but away from dollar-denominated cash--that could not be handled by the Federal Reserve because in such a crisis the assets that it would create would be assets that nobody wanted to hold. So I think--surprise, surprise--that Paul Krugman is right here: Pragmatists weren't ignoring the risks of crisis, but they were watching out for the wrong crisis because we had no clue how bad the state of risk management in America's investment banks had become...

   Even this assessment, however, is not completely fair. As I noted previously, the folks at the BIS (1) saw the problems emerging and (2) saw the correct ones. See here for more.


2. The New York Times has a great article explaining the various ways of rationing health care. It shows that no matter how we ration health care--through price, quantity, or quality--tough choices have to be made.


3. NPR did an interesting story on research by Ben Olken and Benjamin Jones that shows temperature negatively affects economic activity:

   They found that for poor countries, an increase in annual average temperature by 1 degree centigrade corresponded to a 1.1 percent drop in per-capita gross domestic product...It's unclear exactly why temperature would have this effect. It might be that crop yields go down, or that disease is more of a problem. Or it might just be what you could call the "sloth" theory — it's hard to work when it's hot out. Who wants to mow the lawn in August?

   I will vouch for sloth theory when it comes to running. When I moved to Michigan I found it relatively easy to acclimate to running in very low temperatures. After moving to Texas, though, I found adjusting to running here to be far more challenging. ( I still marvel at those folks who go for runs in early afternoon here in Texas when temperatures are 100+; my runs are always early in the morning when it is cooler.) I am only one data point, but from my experience I am open to notion that economic geography and climate can influence economic activity. Here is their paper.


4. Finally a U.S. monetary policy official admits the Fed contributed to the housing boom. Bloomberg is reporting that the president of the Atlanta Federal Reserve , Deninis Lockart, said the following:

   “Among the causes of the financial crisis was a long period of low interest rates,” he said. It is clear low rates “had something to do with the housing bubble.”

   Lockhart was not around when this happened, so it is easier for him to make theis statement--there is no blood on his hands. It is worth nothing that back in 2003 that Gary Stern, Minneapolis Fed president and voting member of the FOMC did raise questions about the deflation scare of the time. He was not convinced they were truly a threat to macroeconomic stability. Had his views been more widely shared at the Fed maybe the federal funds rate would not have been held so low for so long. [Update: Here is a Stern speech where he questions the conventional wisdom on deflation in 2003.]
   

What Fed Indpendence?

Responding to criticisms of the Federal Reserve, a number of prominent economists have signed a petition that calls for Congress and the Executive Branch to "reaffirm their support for and defend the [Fed's] independence as a foundation for U.S. economic stability." While I support the Fed independence, I also recognize the Fed is ultimately a creation of Congress and is therefore subject to political pressures. These political pressures are bound to get stronger in times of economic crisis. In the current crisis these political pressures have become pronounced for the following reasons: (1) the Fed has made large scale interventions into the economy that involve picking winners and losers; (2) some of its interventions will generate quasi-fiscal costs; and (3) many observers believe the Fed played an important role in creating the crisis. To hope that Congress will embrace the petitioners' call for maintaining the Fed's independence given these developments is naive at best and counterproductive at worst. Some members of Congress and other observers may see this petition as a call to maintain Fed secrecy by a bunch of economists associated with the Fed. For example, see this post and this follow-up one at Zero Hedge. Will Wilkinson suggests that the advocates of the Fed's independence would actually strengthen their case by actually embracing the calls for an audit of the Fed:

One reason to want an audit of the Fed is to establish whether or not it has actually been acting with sufficient independence. The question is already in the air. To attempt to impede an inquiry into the question by stressing the high value of independence is obviously to beg the question. Those who prize independence, if they really do, ought to be all the more keen on an inquiry.

Given the three developments mentioned above I think Wilkinson is correct. Increased transparency will only help the Fed moving forward.

What if the Federal Reserve Had Listened to the BIS?

What do you get when the key insights of Hyman Minsky--prolonged macroeconomic stability can actually be destabilizing if it causes observers to take for granted the "good times" and underestimate risk going forward--and Frederick Hayek--price stability is not a sufficient condition for macroeconomic stability--are accepted by a group of mainstream economists? You get economists who were able to foresee as early as 2003 the current economic crisis and issue a warning. And just who are these economists? They are the research staff at the Bank for International Settlements (BIS), formerly led by William White. Der Spiegel has a great article on William White and his colleagues that highlights how they repeatedly warned central bankers of the dangers lurking ahead but to no avail. What is amazing, is that the BIS is the bank for central banks and had the ear of Alan Greenspan and other central bankers. In other words, these were not a bunch of economic cranks, but serious research economists at a top economic institution who were given a hearing but ignored by top policymakers. Here is Der Spiegel:

[William] White and his team of experts observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market. To give all this money somewhere to go, investment bankers invented new financial products that were increasingly sophisticated, imaginative -- and hazardous.

As far back as 2003, White implored central bankers to rethink their strategies... The prevailing model [at central banks] was banal: no inflation, no problem. But White wanted central bankers to take things a step further by preventing the development of bubbles and taking corrective action. He believed that interest rates ought to be raised in good times, even when there is no risk of inflation. This, he argued, counteracts bubbles and makes it possible to lower interest rates in bad times. He also advised the banks to beef up their reserves during a recovery so that they would be in a position to lend money in a downturn.

William White and his crew took this message directly to key players time and time again. Among other publications, they did so with this paper presented at the Fed's Monetary Policy symposium at Jackson Hole Wyoming in August 2003 (Greenspan was in attendance), as well with this paper titled "Is Price Stability Enough" in 2006, and in many of the popular BIS Annual Reports. My favorite article of the bunch is the second one above which happens to have been written by White himself. Here are some excerpts:

It will be argued in this paper...that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term. Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits. The core of the problem is that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms – whether in terms of debt levels, saving ratios, asset prices or other indicators of “imbalances”. The historical record indicates that mean reversion is a common outcome, with associated and negative implications for future aggregate demand.

[...]

One implication of positive supply side shocks is that they call into question whether monetary policy should continue to pursue the near-term [monetary policy] target of a low positive inflation rate... Failure to adjust the [monetary policy] target downward (whether explicitly or implicitly) in the face of positive supply shocks would result in lower policy rates than would otherwise be the case... Paradoxically, taking out insurance against a benign deflation might over an extended period increase the probability of the process eventually culminating in a “bad” or even “ugly” one.

This is the same point I have made here on this blog: by avoiding the benign deflationary pressures of 2003 the Fed help put in motion the developments that created the malign deflationary pressures of 2009. If only the folks at the BIS had been taken more seriously. One can only imagine how different the current economic crisis would have been.

Update: Presto Pundit in the comments points us to an article that chronicles the ongoing debate between William White and Alan Greenspan.

Another Way to View the Crisis: A Boom-Bust Cycle in Global Nominal Spending

Many observers, including myself, have spent many hours thinking about the source of the current economic crisis. Much of the discussion in this debate has centered on the role played by the list of suspects rounded up so far: a saving glut in emerging economies, excessive fiscal and monetary policy stimulus in advanced economies, the securitization of finance, underestimating aggregate risk, the lowering of lending standards, the failings of rating agencies, aggressive lending tactics, and poor choices made by lenders. The truth is some mix of all of these played a role. That makes it difficult to apportion responsibility (or blame) accurately and, thus, makes it challenging to draw the appropriate lessons from this crisis moving forward. So in an attempt to simplify matters, this post presents the economic crisis from a different perspective.

So what is this perspective? This approach begins with the understanding that the key to macroeconomic stability--whether nationally or globally--is to stabilize nominal spending. If an economy is running near full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that fall outside its natural rate area (i.e. is unsustainable). Why? Because there are numerous nominal rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending and not have real economic activity move as well. Note, that key here is not to aim for price stability, but to aim for nominal spending stability. As I noted before,

Nominal spending shocks, after all, are the real source of macroeconomic volatility while inflation is merely a symptom of these shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high(low) inflation due to positive(negative) aggregate demand shocks or negative(positive) aggregate supply shocks?--and as a result monetary policy that targets inflation may make the wrong call.

Now apply this thinking to the global economy. From 1980-2002 global nominal spending (as measured by world nominal GDP) in current U.S. dollars grew about 5.0% a year. In PPP current international dollars it grew 6.1% a year. Suddenly, in the period 2003-2007 those numbers jumped to 10.7% and 7.5%. (Data from WEO databse April 2009.) This surge in global nominal spending was sudden and most likely unexpected given the trends for the 1980-2002 period. These developments can be seen in the figure below: (Click on figure to enlarge.)

In short, the world experienced a nominal spending boom over the years 2003-2007 that was unsustainable. Today, the excesses related to that boom are being worked out.

Now why bring up this perspective? Because I believe it has clear policy implications: policy makers should be watching nominal spending both at home and across the globe. Focusing too narrowly on inflation caused policymakers to miss this surge in nominal spending. Two institutions in particular should be watching global nominal spending. First, the IMF should be monitoring global nominal spending given its objectives for global financial stability. Second, the Federal Reserve should also be closely monitoring global nominal spending because (1) it is a monetary superpower and can currently shape to some degree global nominal spending and (2) it has also an enhanced mandate for financial stability. Stabilizing global nominal spending will not eliminate all financial risk, but it will go along way in preventing the buildup of economic imbalances.

Assorted Musings

More assorted musings:

1. The saving glut smackdwon continues. First Menzie Chinn dealt it a back-breaking blow, then I pounded it with some monetary superpower, and now Asian officials are pushing back as well.
2. Apparently the Swedish central bank has been reading Scott Sumner's blog. They are now penalizing banks for holding excess reserves. This move is a part of a package where they are effectively cutting interest rates to minus 0.25 percent.
3. Josh Hendrickson has a great post where he reminds us that yes, "inflation is a monetary phenomenon, but this isn't inflation." I hold a similar view.
4. Nick Rowe baits me in for more discussion on whether the Fed actually pushed its policy rate below the natural interest rate in the early-to-mid 2000s. I am convinced it did, Nick is not so sure. See our exchange in the comment's section.
5. Speaking of the natural interest rate here is a graph from an ECB paper that rigorously shows the actual interest rate (red line) did drop below the natural interest rate (black line). Click on figure to enlarge.
6. Here is a great article on Mark Thoma and how he influences the national debate through his blog the Economist's View. The economic blogosphere really has become a force in shaping economic policy. I had a conversation about this with Tyler Cowen and he pointed to, among other things, how the original plans for the TARP were scrapped because of negative feedback from the blogosphere.