Sunday, October 30, 2011

Who Said This?

The following are some excerpts from a paper on the problems Japan faced in the 1990s. If one were to replace Japan with the United States you might think you were reading a Market Monetarist article.  Consider first, this paragraph:
As already suggested, I do not deny that important structural problems, in the financial system and elsewhere, are helping to constrain Japanese growth. But I also believe that there is compelling evidence that the Japanese economy is also suffering today from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.
Sounds very Scott Sumnerian.  But it gets better.  The author also makes the Market Monetarist claim that low interest rates can actually be a sign of tight monetary policy:

The argument that current monetary policy in Japan is in fact quite accommodative rests largely on the observation that interest rates are at a very low level. I do hope that readers who have gotten this far will be sufficiently familiar with monetary history not to take seriously any such claim based on the level of the nominalinterest rate. One need only recall that nominal interest rates remained close to zero in many countries throughout the Great Depression, a period of massive monetary contraction and deflationary pressure. In short, low nominal interest rates may just as well be a sign of expected deflation and monetary tightness as of monetary ease.
 And there is this flippant dismissal of liquidity traps like there are a walk in the park:
It is true that current monetary conditions in Japan limit the effectiveness of standard open-market operations. However, as I will argue in the remainder of the paper, liquidity trap or no, monetary policy retains considerable power to expand nominal aggregate demand. Our diagnosis of what ails the Japanese economy implies that these actions could do a great deal to end the ten-year slump.
 Finally, this critique of the uncertainty created by the vagueness of the Bank of Japan's policy objective seems almost eerily similar to the Market Monetarists' critique that the Fed lacks a clear policy objective and that in turn creates more macroeconomic uncertainty:
A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns subside”? Krugman (1999) and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.
In other words, the author is saying here that the Bank of Japan needs do price-level targeting to restore aggregate demand.  In such circumstances, that also amounts to an argument for nominal GDP targeting. But the author is no Market Monetarist. No, he just happens to be Federal Reserve Chairman Ben Bernanke, back when he was an academic.  If Chairman Bernanke ever needed a reason to adopt a nominal GDP level target it is his own work in this paper.  I encourage him to sit down, replace all the Japan references with United States in the above paper, and then ponder its implications for the Fed today.

Christina Romer Goes to Bat for Nominal GDP Targeting

And she hits a home run. Actually, if I may extend the baseball analogy a bit, she hits a grand slam.  The bases were loaded with Scott Sumner on third, Goldman Sachs on second, and Paul Krugman on first.  Coach Bennett McCallum was standing near the dugout screaming instructions.   Digging her cleats into the clay and readying her bat, Christina Romer took a hard swing at the fastball.  The ball exploded off the bat, flew over the fence, and hit baseball fan Ben Bernanke right in the gut.  After getting his breath back, Ben Bernanke picked up the ball and to his surprise found the following message on it:  "Time to man up and act like a Volker.  Initiate Nominal GDP level targeting."  Will he?  Or will he take the home run baseball and its message and throw it back on the field?

Brad DeLong gives reasons why he may not adopt nominal GDP level targeting.  Paul Krugman explains why now more than ever he should run with it.  Ultimately, Christina Romer is reminding Ben Bernanke that fortune favors the bold.  And a move to nominal GDP level targeting would be bold, the kind of bold the economy sorely needs.

Thursday, October 27, 2011

The Fed is Talking About a Nominal GDP Target

Robin Harding reports that the Fed trying to improve its communication policy:
A long and contentious debate on communications is set to occupy most of the Federal Reserve’s time when it meets on Tuesday and Wednesday next week... Three different issues are tangled together. The first is whether to clarify the Fed’s goal by agreeing on a clear inflation objective. Second is explaining how the Fed is likely to change policy in the future to reach that goal. Third is whether to use communication to ease policy now with, for example, a pledge to keep rates low until unemployment falls to 7 or 7.5 per cent.

A working group is attacking the problem from first principles, with every option – including innovations such as setting a target for growth in nominal gross domestic product over time – up for discussion.
I am glad to see them include a nominal GDP target in their discussion, but there is a more important point here. One of the key reasons behind the Fed's inability to restore robust nominal spending is its inability to clearly communicate the future path of monetary policy.  By failing to properly shape expectations about where it wants to guide the nominal economy, the Fed has created much uncertainty.  There is no way programs like QE2 and Operation Twist will have lasting power if there is no explicit and well understood target assigned to them. That is why these talks are important.  As Nick Rowe explains, the Fed is one of the worst communicators among central banks so anything would be an improvement.  

And for those who question whether expectations really do make that much difference take a look at the figure below.  Using data from the Survey of Professional Forecasters, it shows the average annualized quarterly growth rate forecasted for nominal GDP over the next year and compares it to the actual growth of nominal GDP over the next year.  It shows that a systematic and positive relationship exists between the two measures.
 

Along these same lines, Josh Hendrickson and I have a working paper that I am presenting next month at the SEA meetings in Washington, D.C. that shows shocks (or unexpected changes) to the inflation forecast causes a rebalancing of household portfolios that in turn leads to a change in nominal spending.  The importance of expectations cannot be understated. 

Hat tip Mark Thoma.

Monday, October 24, 2011

The Godfather Speaks

The Godfather of nominal GDP targeting has spoken.  Bennett McCallum, who has authored numerous academic papers on nominal GDP target and is probably the foremost expert on it, weighs in on the growing attention being given to this approach to monetary policy.  An important point that he makes is that a nominal GDP target would be easier to understand by the public than an inflation target:
It seems ironic then that, when academic economists suggested nominal income targeting to Federal Reserve officials in the 1980s, often the main objection put forth was that it would be difficult for the public to understand. But it seems likely that it would be easier for the public to understand nominal GDP growth than a target that includes an unspecified weighted average of an inflation rate and some unreported major adjustment to take account of output and/or unemployment conditions. Indeed, I would argue that “total spending” in the economy is a way of describing nominal GDP that would make that concept at least as easy to understand by average citizens as “core inflation” or even CPI inflation.
I have always believed that marketing a nominal GDP target would be fairly easy for the reasons laid out above.  Another way of framing this for the public is to say that the objective of such an approach to monetary policy would be to stabilize nominal income or wage growth (though technically that would require a nominal GDP per capita target).  The public understands their current dollar wages far better than the various CPI measures.   Thus, selling a NGDP target as a way to stabilize wage growth should have broad appeal.  And then there are good macroeconomic reasons to stabilizing nominal wage growth, but that is a topic for another post.

PS.  Lars Chrisentensen prefers to call Bennett McCallum the grandfather of Market Monetarism.  Meanwhile, Steve Randy Waldman and Kevin Drum say favorable things about nominal GDP targeting.

Friday, October 21, 2011

The Six Myths of US Monetary Policy During the Great Recession

Clark Johnson has written an article (here for smaller file size) that does a fabulous job addressing the six common myths about U.S. monetary policy since 2008. It is accessible but informed and should be required reading for anyone thinking about U.S. monetary policy.  I am adding it to my required reading list for my money and banking class.  It is really that good. 

Here are the six myths Johnson addresses:
Myth 1:  The Federal Reserve has followed a highly expansionary monetary policy since August, 2008.
Myth 2:  Recoveries from recessions triggered by financial crises are necessarily low.
Myth 3:  Monetary policy becomes ineffective when short-term interest rates fall close to zero.
Myth 4:  The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.
Myth 5:  When money policy breaks down there is a plausible case for a fiscal response.
Myth 6:  The rising prices of food and other commodities are evidence of expansionary policy and inflationary pressure.
Read the rest of the article.

Three Objections to NGDP Level Targeting

Not everyone is a fan of nominal GDP level targeting.  Here are three objections to it that I have run across recently followed by responses to them. 

1.  Further monetary stimulus is pointless since banks aren't doing much lending.
The ability of the Fed to influence total current dollar spending does not depend on banks creating more loans.  Rather, it depends on the Fed's ability to change expectations so that the non-bank public rebalances their portfolios appropriately.  Recall that a nominal GDP level target means the Fed makes an unwavering commitment to buy up assets until some pre-crisis nominal GDP trend is hit.  As Nick Rowe notes, just the threat of the Fed doing this would cause the public to expect higher nominal spending growth and higher inflation.  This change in expectations, in turn, would cause investors to rebalance their portfolios away from liquid, lower-yielding assets (e.g. deposits, money market funds, and treasuries) toward higher-yielding assets (e.g. corprate bonds, stocks, and capital).  The shift into higher-yielding assets would directly affect nominal spending through purchases of capital assets and indirectly through the wealth effect and balance sheet channels.  The resulting increase in nominal spending would increase real economic activity, improve the economic outlook, and thus further reinforce the change in expectations.

Bank lending would probably respond to these developments, but it would not be driving them.  It is interesting to note that FDR did something similar to nominal GDP level targeting in 1933 and it sparked a sharp recovery that lasted through 1936.  Bank lending, however, did not recover until 1935.  Bank lending, therefore, was not essential to that recovery.  That may be less true today, but in any event the key point here is that if bank lending does increase it would do so as a consequence of the improved economic conditions brought about by the change in expectations.  

2.  Additional monetary stimulus will only further harm savers and banks' capital position.
The concern here is that additional monetary stimulus would require a further lowering of interest rates, particularly long-term interest rates since short-term interest rates are already at the zero percent bound.   This would harm savers and banks' capital position by lowering net interest margins.  The latter is a big deal given the problems in the banking industry.  But here is the thing.  If a credible nominal GDP level target is implemented there should be real economic gains (as noted above) that would  lead to higher real interest rates.   Savers and banks would benefit.  If we can agree that primary cause of the recession is insufficient aggregate demand, then the fact that the U.S. economy is still sluggish is a sign that monetary policy has failed to do its job.  It has passively allowed the economy to weaken by failing to shore up aggregate demand.  Once it does shore up aggregate demand, as it should under a nominal GPP level target, interest rates will increase and these concerns will disappear.

3.  Nominal GDP targeting has been shown theoretically to increase volatility.
Laurence Ball (1999) demonstrated theoretically in a widely-cited paper that nominal GDP targeting can lead to increased volatility of output and inflation.  Lars Svenson (1999) later reconfirmed Ball's findings. This made some observers questions whether nominal GDP had any future.  Bennett McCallum (1999), however, said not so fast.  He showed that their conclusions were based on special backward-looking IS and Phillip curve relations that are "theoretically unattractive" (because they are backward looking)  and whose results fail to hold up with more general specifications.  Richard Dennis (2001) later confirmed that Ball and Svenson's results were fragile.  Finally, Kaushik Mitra (2003) showed that even with adaptive learning, nominal GDP targeting remains a desirable objective for monetary policy.  Thus, there have been no robust studies that show nominal GDP targeting increases volatility. 

Thursday, October 20, 2011

More Nominal GDP Targeting Links

Nick Rowe and Bill Woolsey have chimed in with some new thoughtful pieces on nominal GDP targeting.  Nick Rowe  explains how expectations management is key to nominal GDP level targeting, while Bill Woolsey responds to the nominal GDP targeting comments of Paul Krugman, Brad DeLong, and Stephen Williamson

Germany's Role in the Eurozone Crisis

I agree with Kantoos that Germany's influence over ECB monetary is problematic.  I, however, question his  his claim that Germany is not the main impediment to resolving the Eurozone crisis.  Germany's  influence over the Eurozone is vast and broad, of which its pull on the ECB is just one manifestation.  Ryan Avent sums this up nicely:
Germany, through its sheer size, its political clout, and its influence on the ECB, can make sure the money is there to end the crisis. No other euro-zone economy can. It's my understanding that Germany enjoyed its strength within the euro zone when times were good, surpluses were huge, and it was splashing out cash to the periphery. Now it seems to want to shrug and pretend it never asked for its dominant position. At a minimum, it seems willing to use the crisis and its strength to force as much of the cost of adjustment on others as possible, in a fashion that's clearly dangerous for the global financial system... Germany has a unique ability to bring the crisis to an end, and it is not accepting the responsibility that falls to it given its role, economically and politically, in the euro zone.
Germany's inordinate influence in the Eurozone has been felt since day one.  And more often than not, it has wielded its influence in a manner that best served Germany rather than the Eurozone as a whole.  This tendency is clearly seen in the figures below which show that ECB monetary policy has been rather effective in stabilizing the trend path of nominal spending in Germany, but not elsewhere in the Eurozone:




This discussion reinforces what seems obvious to me.  The Eurozone cannot go on with one nation having such a dominant role.  Even if the current debt and bank capitalization problems were to be resolved, the currency union would still have the German influence hanging over it.  That means Eurozone policies would continue to be shaped by German preferences.  For example, the real exchange rate imbalances in the currency union (that are behind many of the current problems) would be difficult to address with Germany calling the shots since it requires either painful deflation in the periphery or politically unacceptable inflation in the core.  It is hard to believe that Germany will really ever acquiesce its influence.  If I were a German leader I wouldn't want to give it up.  For these reasons, the most sustainable path going forward I see is Germany and the Eurozone parting ways.

Wednesday, October 19, 2011

Nominal GDP Level Targeting Links

Since nominal GDP level targeting seems to be really taking off now, I thought it would be useful to provide some links to past discussions here and elsewhere on the topic. Let me know in the comments section other pieces I should add to the lists.

I.  Some of my posts on NGDP level targeting
(1) A Nominal GDP Target Would Narrow the Fed's Mandate.
(3) The Case for Nominal GDP Targeting.

II.  Recent discussion by others on NGDP level targeting
 (1)  Retargeting the Fed--Scott Sumner
 (2)  Money Rules--Scott Sumner
 (3)  The Case for A Nominal GDP Level Target--Goldman Sachs 
 (4)  Hard Money--Ramesh Ponnuru
 (5)  Loose Money Will Keep the Economy--Ramesh Ponnuru
 (6)  The Case for Nominal Growth Targeting--Josh Hendrickson
 (7)  Changing Target--The Economist Magazine
 (8)  Fed Must Fix on a Fresh Target--Clive Crook
  (9) Getting Nominal--Paul Krugman

The Role of the Economics Blogosphere

Just a few days ago someone in the comment section of this blog was deriding the fact that Market Monetarist had largely emerged in the blogosphere.  How could they be taken seriously without publishing their ideas in top academic journals, this person wondered.  To make their point, the commentator questioned who will be better remembered in the future, the recent nobel laureate Chris Sims or Scott Sumner.  I replied that Sims will be remembered for his important methodological contributions.  But when it comes to shaping the broader debate about monetary policy's role in this current crisis Scott Sumner will be far better remembered.  As Paul Krugman recently noted, the blogosphere is changing how national conversations about economic issues gets shaped.  This reality was highlighted today by this Business Insider piece:
Over the weekend, Goldman came out with a report calling on the Fed to embrace Nominal GDP targeting: In other words, set as a goal for the economy that nominal GDP that we saw back in 2007, and then produce enough inflation so that we got there.

Now Bernanke is out with a new speech about monetary policy in the post-Great Recession era, and though he doesn't say that much substantive, he does talk more about trying to more clearly express monetary policy goals.

According to PIMCO's Bill Gross, that's code for... targeting Nominal GDP.  Meanwhile, Chicago Fed President Charles Evans has been making similar comments, about weighting the Fed's mandate much more towards the full employment/growth end of the spectrum, even if it means high inflation.

All of which means you should really be reading the work of Bentley Economist Scott Sumner, who has been writing forever about the benefits of Nominal GDP targeting, and who is sure to be the hottest economist in the world, as this takes off.
Academic research will always be important.  But the blogosphere seems to increasingly important for real-time discussions of important economic issues.  Scott Sumner is a testament to this development.

Tuesday, October 18, 2011

I am Not a High Profile Economist

But I do endorse this proposal.

What is Wrong with This Statement?

According to the AP, Dallas Fed President Richard Fisher believes that the Fed's policies are making it easier for Congress to avoid hard choices:
"The more we offer accommodative monetary policy," said Fisher, president of the Federal Reserve Bank of Dallas, "the less incentive they have to pull their socks up and do what's right for the American people."
What is wrong with this statement?  The answer is that Richard Fisher has the causality backward.  The very reason Congress has been running deficits in the first place that need to be addressed is because the Fed failed to first prevent and then afterwards correct the collapse in nominal spending that took place in 2008-2009.  This failure to return nominal spending to its trend path increased the cyclical budget deficit and opened the door for the structural budget deficit brought about by President Obama's fiscal stimulus.  

If Fisher really wants to create an economic environment conducive to fiscal consolidation, then the Fed must first restore robust nominal spending.  Most studies show that successful fiscal retrenchment requires an accomodating monetary policy that stabilizes nominal spending.  If the Fed were to tighten, as Fisher currently desires, then Congress will be facing an even bigger budget deficit to reign in. There is no way around this reality.

Chuck Norris is Making a Comeback

At least in the blogosphere.  Here is Nick Rowe:
Central banks run monetary policy not so much by doing things, but by threatening to do things. If their threats are credible, we never observe them carrying out those threats, and we often observe them doing the exact opposite

A credible central bank is a bit like Chuck Norris. (Apologies to Lars Christensen for stealing his metaphor.) Chuck Norris simply looks at the target variable, and it moves to wherever he wants it to go. It looks like magic. But it works because nobody wants Chuck Norris to carry out his implicit threat. So he doesn't need to.

[...]
The Fed needs to communicate its target clearly. And it needs to threaten to do unlimited amounts of QE for an unlimited amount of time until its target is hit. If that threat is communicated clearly, and believed, the actual amount of QE needed will be negative. The Fed's balance sheet is much bigger than in normal times. But in order to shrink its balance sheet back to normal, the Fed must threaten to expand its balance sheet by an unlimited amount. And be seen to be ready to carry out that threat.
Read the rest of the post here.

Greg Mankiw Answers My Questions

Back in May, 2011 I wrote the following on my blog:
Greg Mankiw recently referred to a paper where he assess which inflation rate should be targeted by the central bank.  Here is his conclusion:
[A]central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages. 
There are several good reasons laid out in the paper for targeting nominal wages.  Here I like to point out that stabilizing nominal wages is similar to stabilizing nominal income per capita.  It is not too much of a stretch to go from this to a nominal income or nominal GDP target.  In fact, Greg Mankiw and Robert Hall have a 1994 paper that sings the praises of a nominal GDP target, especially one that that targets the consensus forecast of the nominal GDP level. 
So where does Greg Mankiw stand today on nominal GDP level targeting?  If he still supports it, does he see the need to return nominal GDP back to its pre-crisis trend or at least higher than its current level?
Though I have never got a direct answer from Greg Mankiw, there is now enough circumstantial evidence to know his answers to my questions. First, he and coauthor Matthew Weinzierl have a recent Brookings Paper on the optimal stabilization policy.  They go through a menu of policy options, but reach this conclusion if monetary policy is not constrained:
The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound. In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment. A reduction in long-term interest rates may be sufficient when a cut in the short-term interest rate is not. And an increase in the long-term nominal anchor is, in this model, always sufficient to put the economy back on track. This policy might be interpreted, for example, as the central bank targeting a higher level of nominal GDP growth.
In other words, monetary policy targeting a nominal GDP level is sufficient to bring the economy back to full employment.  That sounds like a rather favorable view of nominal GDP level targeting to me.   If that were not enough, Greg Mankiw today implicitly endorses nominal GDP level targeting by linking on his blog to the Goldman Sachs paper on nominal GDP level targeting.  I'd say Mankiw has answered my questions clearly.

Now Mankiw is not just a big-time academic economist at Harvard.  He is also an economic adviser to  Mitt Romney, the likely GOP candidate for president.  That means NGDP level targeting might eventually find its way into the White House.  There are good reasons for Republicans to endorse such an approach to monetary policy.  I hope Mitt Romney is hearing them.

Monday, October 17, 2011

About That Goldman Sachs Endorsement of NGDP Targeting

Here it is and it is really good.  One might think they were reading a market monetarist policy paper.   Matthew Yglesias provides further comments on the piece as does Ryan Avent.   Here is my initial response to the piece. 

Sunday, October 16, 2011

An IS-LM Model That Almost Has It All

There is an ongoing debate in the blogosphere on the usefulness of the IS-LM model taught in undergraduate economics.  Brad DeLong nicely summarizes the problems with this model:
We really need a model with five moving pieces:
  1. Money demand equilibrium M = L(i, PY) as a function of the level of spending and the short-term safe nominal interest rate.
  2. Flow-of-funds S = I + (G-T) as a function of the level of spending and the long-term risky real interest rate.
  3. Expected inflation to get you from the nominal to the real interest rate.
  4. A term premium as a function of expectations to get you from the short-term to the long-term real interest rate.
  5. Risk spreads to get you from the safe to the risky real interest rate.
Well Brad, there actually is such an undergraduate IS-LM model that fufills most of these criteria.  It is developed by Charles L. Weise and Robert J. Barbera in this paper here.  It incorporates the short-term policy rate, the natural interest rate, the long-term risky real interest rate, the term premium, the risk premium, and the term structure of interest rates.  The model has an IS curve, an AS curve, and a TS or term structure curve.  The model can also be easily drawn in (r, Y) space. The big drawback is that money and its importance for recessions--money is the one asset one every market and thus the one asset that can disrupt every market--is ignored.  Still, the Weise-Barbera IS-LM model is still a vast improvement over the standard undergraduate IS-LM.  Do take a look.

Since When is the Fed Doing its Job Considered Going Nuclear?

Joe Weisenthal is reporting that Goldman Sachs has come out in favor of the Fed adopting a nominal GDP level target that would put it back on its long-run, pre-crisis trend.  This endorsement speaks to the growing interest and recognition of nominal GDP level targeting by the public. Even some Fed officials are speaking in favor of it.  Great news.

What is remarkable to me is that many observers in this debate describe the adoption of nominal GDP level targeting as the Fed going nuclear.  For example, Weisenthal's article above is titled "Goldman Advises The Fed To Go Nuclear, And Set A Target For Nominal GDP" and not too long ago David Wessel had an article titled "The Fed's (Gulp) Nuclear Options" where one of the options was nominal GDP targeting.  I did not realize that the Fed doing its job was considered going nuclear.  All along the Fed should have either prevented or corrected the steep fall in nominal spending that took place in late 2008 and early 2009.  The central bank of Sweden was able to do so, but not the Fed.  The best it could do was throw some ad-hoc monetary stimulus programs (i.e. QE2, Operation Twist) against the wall and hope that they would stick.  How much easier life would have been for the Fed--both operationally and politically--had it stated up front in 2008 that it was committed to maintaining trend nominal spending at any cost.  This would have better anchored nominal spending and inflation expectations that in turn would served to stabilize aggregate demand.  Instead, we have had three years of effectively tight monetary policy where it has become seen as normal so that for the Fed to do the job it should have done all along is considered going nuclear.  It should never have come to this point.

Friday, October 14, 2011

Market Monetarist or Austrian? You Decide.

Via Lars Christensen we learn of this new paper by Steven Horwitz and William Luther, two Austrian economist who take seriously monetary disequilibrium.  You might be shocked to learn that they call for nominal GDP targeting rule for the Fed.  Take a look.
The Great Recession and its Aftermath from a Monetary Equilibrium Theory Perspective
Abstract: Modern macroeconomists in the Austrian tradition can be divided into two groups: Rothbardians and monetary equilibrium (ME) theorists. It is from this latter perspective that we consider the events of the last few years. We argue that the primary source of business fluctuation is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse. Finally, we offer our own prescription to reduce the likelihood that such a scenario occurs again by better ensuring monetary equilibrium and eliminating moral hazard.
Update: paper link fixed.

Thursday, October 13, 2011

Mohamed El-Erian vs. Bruce Bartlett on the Fed

 

Bruce Bartlett  in a recent CNBC interview made the case that the Fed should be doing more.  He criticized the Fed for "sitting on its hands"  and argued it could spur aggregate demand if it adopted a nominal GDP level target.  Mohammed El-Erian was shocked to hear this claim.  He replied that most people, including himself, believe the Fed cannot do anything constructive at this point and that it probably has gone too far.  He wanted to know why Bartlett would argue otherwise.   (You can see the exchange above at about the 6:50 mark.)

I am shocked that El-Erian was shocked.  The man who seems to own a column space at the FT and a studio chair at CNBC is convinced that the Fed now is in incapable of making a meaningful dent in aggregate demand and that most observers agree with him. Apparently, he has not been reading Mike Woodford, Greg Mankiw, Ken Rogoff, Paul Krugman, Charles Evans, Scott Sumner, and others who claim the Fed could be doing more. Even Fed Chairman Bernanke has said the Fed could do more.  For example, here is Bernanke in September:
 In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus.
Now the key to the successful aggregate demand management comes from the Fed properly managing expectations.  So far the Fed has not done very well on this front and, as a result, the economy is suffering.  But it doesn't have to be this way.  FDR was able to properly shape monetary policy expectations and turn things around from 1933 to 1936 and Sweden has done  the same more recently.  So El-Erian can take comfort in knowing that this view is more than academic pipe dream.  In case El-Erian is curious, here is a short primer on nominal GDP targeting, here is how it could make a big dent in nominal spending, and here is why the Fed should adopt it.

Hat Tip: Edward Harrison

Wednesday, October 12, 2011

FOMC: We Got a Money Demand Problem


The FOMC minutes for the September, 2011 meeting were released today and the first things that stand out are the clear hawk-dove divide, the smorgasbord of additional ad-hoc monetary stimulus policy options that were discussed, and the increased economic pessimism of the members.  Something else, though, really caught my attention in the minutes.  It was this acknowledgement by the Fed staff:
 M2 surged in July and August, as investors and asset managers sought the relative safety and liquidity of bank deposits and other assets that make up the M2 aggregate. Notably, institutional investors, concerned about exposures of money funds to European financial institutions, shifted from prime money funds to bank deposits, and money fund managers accumulated sizable bank deposits in anticipation of potentially large redemptions by investors. In addition, retail investors evidently placed redemptions from equity and bond mutual funds into bank deposits and retail money market funds.
In other words, we have rapid growth in M2 coming from a surge in money demand.  This is a big deal, because money is the one asset on every market and an increased demand for it will thus affect every other market.  The more money demand there is, the less nominal spending there will be on goods, services, and other assets.  This development means the economic slump is being prolonged. 

It is great to see the Fed acknowledge this problem, but the fact is this problem has been going on for the past three years and the Fed has failed to address it in a forceful and systematic manner.  All the Fed's interventions over the past three years, including Operation Twist from this meeting, have not arrested this problem.  

How do we know this?  Well, start with the figure below.  It shows that the share of household's liquid assets (cash, checking account, time and saving deposits, money market accounts, and treasury securities) as a percent of all household's assets is closely tied to the swings in M2 velocity.  
 

Note that household's share of liquid assets never has returned to its pre-crisis level.  Due to the ongoing economic uncertainty, households still have an elevated demand for these assets and consequently money spending has fallen.  Consequently, velocity too has yet to return to its pre-crisis level.  

This next figure shows the actual dollar amounts.   From the peak of household asset values in 2007:Q2 to the latest data for 2011:Q2, households have lost around $8.8 trillion worth of non-liquid assets. Despite these large losses and the subsequent slump in personal-income growth, households have somehow increased their holdings of money and money-like assets by a staggering $1.6 trillion:


The composition of the increase in liquid assets is also interesting as seen in the next figure. Most of the increase has come in the form of time and saving deposits, though treasuries have been important too.  Money assets alone (cash, checking account, time and saving deposits, and money market accounts) have remained elevated and close to their peak value in late 2008.


Now these graphs only take us through 2011:Q2.  To get a sense of what has happened since then we can look at the weekly M2 data which shows the spike mentioned in the FOMC minutes.  A closer look at the M2 data, however, shows that main growth is in saving deposits. The next figure vividly illustrates this growth:


The growth of saving deposits is even more stark if viewed as percent of personal income:


This last figures shows us that the growth in savings is clearly not an increase in money demand from income growth.  It is all about holding precautionary money balances.  And this is why nominal spending continues to slump.

So what can be done?  My own view is that the money demand problem could be fixed by properly shaping expectations about future spending and inflation via something like a nominal GDP level target.  Unfortunately, the latest FOMC minutes indicate that is not an option.  So for now we lumber on, hoping that in absence of forceful and systematic Fed actions the market will be able to heal itself in a timely fashion.

Update:  This figure from a previous post shows that share of liquid assets has been systematically related money velocity over the past 60 years or so.  

My Journey Into Market Monetarism

When I started blogging in 2007 my writing focused on the Federal Reserve's failure to properly handle the productivity boom of 2001-2004 and how this failure contributed to the global housing boom.  This productivity boom--spawned by the opening up of Asia and the ongoing technological gains--increased economic capacity, put downward pressure on inflation, and implied a higher natural interest rate.  The Fed, however, responded to the fist two developments as if they were signalling falling aggregate demand rather than rapid increases in aggregate supply.  The Fed did this by failing to raise the federal funds rate when the natural interest rate rose and then kept it well below the natural rate level for several years.  Given the Fed's monetary superpower status, this sustained easing created a global liquidity boom  that was a key force behind the "global saving glut".  This view was what initially drove most of my blogging. 

By late 2008 my focus began to change.  I had been critical of the Fed for allowing too rapid growth in nominal spending during the first half of the decade, but by this time it seemed the Fed was erring in the opposite direction.  Nominal spending was falling fast and the Fed's seemed more focused on saving the financial system than in directly preventing the collapse of aggregate demand.  The Fed's introduction of interest payments on excess reserves in October, 2008 only served to confirm my fear that the Fed was too narrowly focused on financial stability.   This fear combined with what I was reading from Nick Rowe and Bill Woolsey (in the comments section initially) about the excess money demand problem and early posts from Scott Sumner about the Fed causing the financial crisis by failing to stabilize nominal spending in the first place convinced me that the Fed had committed a colossal policy mistake in 2008.  This failure to respond to the drop in nominal spending I later came to recognize as a passive tightening of monetary policy (something that is easy to show using an expanded equation of exchange).

As time went on, it also became apparent to me that the Fed was not forward looking enough.  For example, as early as mid-2008 breakeven inflation from TIPs was indicating an aggregate demand slowdown was ahead.  The Fed, however, at the time put more weight on backward-looking headline inflation measures as was evident in its decision to not cut the target federal funds rate in the September, 2008 FOMC meeting.  Modern macroeconomics and experience tells that one of the most effective ways the Fed can influence aggregate demand is by managing expectations. Shape nominal expectations properly and one can immediately affect aggregate demand.  As Scott Sumner likes to say, the implication of this insight is that monetary policy works with leads not lags.  

Now here we are in 2011 and the Fed has yet to, one, correct its passive tightening of the past three years and, two, properly shape aggregate demand expectations by adopting something like a nominal GDP level target.  It has been incredibly frustrating to watch the incredible amount of human suffering caused by these monetary policy failures.  Consequently, I have been blogging away at these issues along with like-minded folks such as Scott Sumner, Nick Rowe, Bill Woolsey, Josh Hendrickson, Marcus Nunes, Nicklas Blanchard, Kantoos, and David Glasner.  We all have been making the case that  the prolonged economic slump has been mostly due to passively tightened monetary policy that could easily be loosened, even at the interest rate zero bound.

Our collective efforts have been summarized in a recent paper by Lars Christensen, who labels us as a group Market Monetarists.  He argues that we are a burgeoning economic school born out of the Great Recession experience whose views have largely taken shape in the blogosphere.  What defines us, he says, is (1) our belief that this crisis has it origins in monetary policy failure rather than problems in the financial system, (2)  our emphasis on using market signals to determine the stance of monetary policy, (3) our view that monetary policy's influence on nominal spending is not constrained by the interest rate zero bound, and (4) our push for nominal GDP level targeting as way to get monetary policy back on track.

While I largely agree with Christensen's assessment of our views, there are some additional points worth noting.

First, though Market Monetarism has been largely a blogging phenomenon it has had important voices in other mediums.  Ramesh Ponnuru has been pushing the Market Monetarist view at the National Review and at Bloomberg while MKM Chief Economist Michael Darda has been promoting it in the MKM investment newletter and on interviews on CNBC and Bloomberg Radio.  And even within the blogging medium there are other prominent voices like that of Matthew Yglesias, Ryan Avent, and Brad DeLong who often are sympathetic to Market Monetarists views.

Second, Market Monetarists prescriptions are not all that different than those of prominent New Keynesians like Michael Woodford and Paul Krugman.  We all agree that when the zero bound is hit the monetary base and t-bills became perfect substitutes and so the Fed should buy longer-term treasuries or foreign exchange as part of a plan to hit some explicit nominal target.  A big difference, though, between New Keynesians and Market Monetarists is that where the former sees the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, Market Monetarist see it as simply moving down the list of assets that can affect money demand.  The zero bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument.  We approach monetary policy with much  less angst than New Keynesians.


Third, Market Monetarist stress NGDP level targeting because doing so would forcefully shape expectations. Here is why.  Under such a monetary policy regime, the Fed would announce (1) its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it.  Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.  That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause nominal spending to adjust largely on its own.  This would reduce the burden on the Fed and make it a less polarizing institution.

Finally, one critique of Market Monetarist is they lack an active research agenda and fail to take advantage of formal modeling methods like DSGE models.  While I cannot speak for all Market Monetarists, I can say that Josh Hendrickson and I have several research projects that formally evaluate the Market Monetarist  view.  For example, we have one paper where we make use of the search models developed in the New Monetarist's literature to formally develop a monetary theory of nominal income determination.  We also make use of structural VARs to examine the importance of nominal spending shocks in one paper and the portfolio channel of monetary policy in another paper.

With that said, Lars Christensen has done us a favor by documenting the rise of Market Monetarism.  It will be interesting to see what will be the long-run impact of the Market Monetarist bloggers .  I am glad to have been a part of the journey so far.

P.S. Lars Christensen is of the Market Monetarist persuasion too and now is blogging.