Reply to Cardiff Garcia: Incrementalism is the Killer

Cardiff Garcia of FT Alphaville replies to my case for lowering interest on excess reserves (IOER):

David assumes that the the signaling effect would be enough to raise companies’ demand for loans, and that this would raise banks’ net interest margins (meaning that banks wouldn’t have to play the MMF funding/excess reserves arbitrage). Even if he is right, this would surely take time, whereas an MMF breaking the buck or a run on MMFs by nervous investors can happen extremely quickly. See: 2008, September.

As RBC analysts write, because short-term effective rates would unlink from policy target rates — ie all short-term rates would fast plunge to zero, and yes this kind of unmooring has happened before — such a move could “completely stop the volume of transactions in the Fed funds market, creating chaos in the derivatives and the floating rate note markets.”

[...]

Again these scenarios could play out very quickly, and we think it’s reasonable to assume that disfunction in these markets is unlikely to be either mild or contained. How certain can we be that the signaling effect posited by David would be so instantly accepted by markets that it would either preclude the above scenarios or otherwise mitigate the risks they present?

Note that the premise for these dire scenarios is an ongoing weak economy with few safe asset alternatives for overnight funding markets.  Lowering the IOER is not assumed to meaningfully change any of that in the near term.  The key issue, then, is whether the Fed can generate a shock big enough such that it causes firms, households, and governments to immediately start wanting more financial intermediation services.  

FDR showed that is possible in 1933 by abandoning gold.  It required, though, a radical departure from the status quo, a sharp slap to the maket's face, a regime change.  When FDR did it, it was a huge shock to market psychology as noted by Gautti Eggertson:

It is hard to overstate how radical the regime change was. “This is the end of Western civilization,” declared Director of the Budget Lewis Douglas. During Roosevelt’s first year in office, several senior government officials resigned in protest. These policies violated three almost universally accepted policy dogmas of the time: (a) the gold standard, (b) the principle of balanced budget, and (c) the commitment to small government. Interestingly, the end of the gold standard and the monetary and fiscal expansion were largely unexpected, since all these policies violated the Democratic presidential platform.

The equivalent today would something radical enough to throw the Ron Pauls of the  world into a conniption fit.  I think the abandonment of inflation targeting for something like NGDP level targeting via open-ended QE would do it.  The problem with this is that such a regime change seems politically unlikely.  And it that case, Cardiff Garcia's premise may be reasonable. Incremental policy changes may do more damage than good.

Update: Peter Ireland has the best formal treatment of IOER.

Remembering the Real Milton Friedman

Today is Milton Friedman's 100th birthday and much is being said about him. One question that continues to come up in this conversation is what would Milton Friedman do today?  I have addressed that question many times, but for the sake of those who may have missed those posts here is an edited recap:

First,  Milton Friedman advocated large scale asset purchases for Japan.  Here is an exchange he had with David Laidler in 2000:

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy. During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

Milton Friedman's call here for purchasing long-term government bonds as a way to push the Japanese economy out of its quasi-recession is similar to the Fed's justification for QE2 and Operation Twist.  The only meaningful difference is that Friedman was advocating a continual, sustained purchase of securities until a robust recovery began.  The Fed, on the other hand, has been applying a piecemeal approach (i.e. QE2, Operation Twist, long-term interest rate forecasts) that in someways creates more uncertainty.  For example, when will the Fed do the next QE?  No one, even the Fed, knows for sure.

Second, not only did Friedman call for large-scale asset purchases (LSAPs) but he also provided theoretical reasons for doing so.  His main argument was that LSAPs created portfolio effects that in turn affected aggregate nominal spending. Edward Nelson, probably the foremost authority on Friedman's monetary views, has an excellent article that summarizes Friedman's view on LSAPs and its implications for the portfolio channel.  Anyone who wants to make claims about Friedman's monetary views should read this article first.

Third, Milton Friedman was very clear that one should never look to the level of short-term interest rates as a guide to monetary policy.  Some observers point to low interest rates as indicating the Fed has kept monetary policy super loose.  Friedman called this the interest rate fallacy. In order to truly understand the implication of interest rates one needs to first know the level of the natural interest rate.  Only if interest rates are lower than their natural rate level is monetary policy stimulative. Too many observers miss this point and thus fall prey to Friedman's interest rate fallacy. 

Finally, Friedman would have preferred that monetary stimulus be done in a more systematic, rule-based manner.  Instead of announcing successive, politically costly rounds of QE the Fed could have announced a nominal level target from the start and said asset purchases will continue until the level target was hit.  There would have been no need to announce a large dollar size of the asset purchases up front that attracts so much criticism.  There would also have been no need to announce successive rounds of QE that make it appear the previous rounds did not work.  More importantly, it would have more firmly shaped nominal expectations in a manner conducive to economic recovery.  The question is what type of systematic level target would Friedman have supported?  This 2003 WSJ article indicates he might have liked a nominal GDP level target.

P.S. Even if one inovkes Milton Friedman's old keep-the-money-supply steady view, one still ends up with the conclusion that monetary policy is too tight.

Mario Draghi Shows the Power of Expectations

Last Thursday, ECB President Mario Draghi said the following:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The response was euphoric - stock markets railed, risk premiums on the Eurozone periphery fell, and the Euro strengthened - and demonstrated that expectations matters.  Without actually doing anything, the ECB was able to catalyze a shift in portfolios toward riskier assets that, if followed through, could kickstart a recovery.  It is what Matt O'Brien calls the Jedi mink trick or Nick Rowe dubs the Chuck Norris approach to central banking.  This power by central banks to manage expectations is often overlooked or dismissed by many observers.  The markets' response to Draghi's speech should give them pause.

Now the power of expectation management is nothing new.  It is the reason FDR was able to spur a rapid recovery in 1933.  It is also why some Fed officials are now promoting an open-ended form of QE.  Finally, it also why Market Monetarist have been calling for nominal GDP level targeting for some time.

If you still have doubts on the power of expectations management, imagine this counterfactual scenario.  Mario Draghi in his speech last Thursday comes out with a large chart behind him that looked like this:

He then says the following:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And for the ECB this means closing this large gap between actual and trend nominal GDP.  This gap is simply unacceptable.  We are now committed to closing it.  And believe me, what the ECB does will be enough.

Imagine how much greater the response would be to that bold message.  The economic outlook would instantly improve, portfolios would be adjusting even faster, balance sheet and wealth effects would kick in, and a recovery would be put in motion.  This would not end the need for structural reforms in Europe, but it would vastly improve government balance sheets and cause the private sector to do most of the heavy lifting in the recovery (i.e. the ECB would not need to buy vast amounts of assets).

The stakes are high.  As Ambrose Evans-Pritchard notes, we are on the cusp of another global economic crisis and Mario Draghi is the one individual who could prevent it.  All he needs to do is don his Jedi or Chuck Norris outfit.  Putting those outfits on would be a lot easier if the ECB adopted a nominal GDP level target.

P.S. Imagine how expectations would change if the FOMC came out with press release like this one at their next meeting.

Lowering the IOER is Not So Scary

Can the Fed really add more stimulus by lowering the interest paid on excess reserves (IOER)? Many observers say yes and are encouraged by the ECB's decision to do just that.  The idea behind this belief is that banks would invest their excess reserves in other assets if the IOER was below, or at least equal to, the market interest rate for safe assets.  This rebalancing of banks' portfolios would in turn cause a rebalancing of the non-bank public's portofolio and help kickstart a recovery.

The folks at FT Alphaville, however, are not so sure.  They see problems with lowering the IOER.  They are concerned that doing so would eliminate the net interest margin for money market funds (MMFs) and drive them out of business.  The funds sitting at MMFs would then move directly to banks, which also face low net interest margins and increasing FDIC fees.  Banks, then, might start charging customers for deposit accounts and this, in turn, might cause the public to want to hold more cash.  As a result, financial intermediation would further weaken and the economy would sink even more. 

That is a scary story.  The folks at FT Alphaville say the only way to avoid this outcome is if fiscal policy complimented the lowering of IOER by providing more safe assets in which financial firms could invest their would-be costly excess reserves.  Cardiff Garcia of the FT Alphaville wants to know what the Market Monetarists, long-time advocates of lowering the IOER, think of this scary scenario. 

Here is  my take.  The FT Alphaville story fails because it ignores the broader effect of the Fed lowering the IOER.  Such an announcement, if credible, would send a loud signal to markets of more monetary stimulus.  And if done right, this signal would have a huge impact because lowering the IOER is tantamount to saying the Fed is going to permanently increase the monetary base.  A permanent increase in the monetary base implies a permanently higher price level and permanently higher NGDP level down the road.  In other words, lowering the IOER would permanently raise expectations of future nominal spending and income.  As a result, demand for financial intermediation services would increase today as firms, households, and governments planned for the higher level of NGDP.  The increased demand for credit would raise financial firms' net interest margins and more privately-produced safe assets would appear.  No doomsday for MMF and a recovery ensues.

Now I do think that the signal from lowering the IOER would be even more effective if it were done in conjunction with the announcement of a NGDP level target.  It would provide a destination point for nominal spending and nominal income that would better focus the public's expectations.  

The folks at FT Alphaville are correct, tough, that fiscal policy could be a part of the NGDP recovery process if it created more safe assets.  Treasuries and GSEs function as money for many institutional investors and thus are an important part of the money supply and any NGDP recovery.  However, the amount of safe assets needed for a full recovery of aggregate demand seems far too large to be met by publicly-created safe assets alone.  

The figures below illustrate this point.  The first one shows the total stock of safe assets broken down into privately-produced safe assets and publicly-produced safe assets.  (The safe asset series is constructed according to Gorton et al. (2012) and the figures come from a paper on transaction assets I coauthored with Josh Hendrickson.)  Note that most safe assets are privately produced.

Privately-produced safe assets have fallen since 2008 and have yet to return to their peak value, let alone their pre-crisis trend.  Publicly-produced safe assets have somewhat compensated for the collapse, but not enough.  This is self evident from the ongoing slump in nominal spending, but also can be seen in the figure below which shows the deviation of the two series from their Great Moderation (1983-2007) trend in dollar terms. 

Publicly-produced safe assets as of 2011:Q4 are approximately $4.7 trillion above trend while privately-produced safe assets are about $7.3 trillion below trend.  To fully make up for the collapse of private safe assets, the public sector would have to create another $2.6 trillion in debt. That is not going to happen in this political climate.

But then it is not needed.  As outlined above, lowering the IOER and adopting a NGDP level target should incentivize the private production of safe assets and spark a robust recovery in aggregate demand.  Lowering the IOER need not be scary.

P.S. I first raised concerns about the IOER back in October, 2008.
P.P.S. Here is a similar comment for Izabella Kaminska at FT Alphaville.

Update: David Glasner also weighs in on lowering the IOER.

Chuck Norris Central Banking Promoted by Fed Official

San Francisco Fed President John Williams is finally coming to the view that Market Monetarists have advocating for some time: the Fed should do open-ended QEs tied to some explicit economic objective.  Here is Williams:

He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2” programme launched in November 2010 but rather adjusted according to economic conditions.

“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.

This is encouraging that Fed officials are beginning to see the wisdom of this approach.  The irony of  an open-ended QE program, however, is that it should actually reduce the burden on the Fed to buy up assets while at the same time keep long-run inflation expectations anchored. Here is how I explained this approach to Jim Hamilton in an earlier post.

Safe Assets, Money, and the Output Gap

In the past, I made the case that the shortage of safe assets is really just an excess money demand problem.  That is, the sharp decline in the stock of safe assets that began in 2008 matters because it means there are fewer assets that can facilitate exchange relative to the demand for them.  This relative shortage of transaction assets or money implies a deficiency of aggregate nominal expenditures and can explain the ongoing slump.  This notion of excess money demand is not novel, but what is new and makes this view a compelling narrative of the crisis is our expanded understanding of what constitutes money.

Prior to the crisis, most observers thought of some measure of retail money assets like M2 as an appropriate measure of money.  Thanks to efforts of Gary Gorton (2008), Wilmot et al. (2009), Sing and Stella (2012), and others we now know that a more accurate measure of money should also include institutional money assets that facilitate exchange for institutional investors.  One attempt to measure this broader notion of money comes from the Center for Financial Stability (CFS).  Using their data, one can show that the supply of money has fallen sharply since 2008 and has yet to recover.  By itself, this decline in the stock of money assets implies an unsatisfied demand for money.  Throw into this mix the heightened demand for safe assets arising from economic fears and you have a pronounced excess money demand problem.  One would never know this, though, by looking at traditional measures of money.

The nice thing about this excess money demand view is that it helps shed light on the ongoing debate as to whether there is a large negative output gap.  Since money assets are on every market, excess money demand implies a general glut that in turn should create a negative output gap.  Thus, relative money shortages should be correlated with the output gap.  So is there any evidence for this view? 

Michael Belongia and Peter Ireland provide a clever technique in a recent paper that can answer this question.  They solve for the optimal amount of money assets by plugging in potential Nominal GDP (as estimated by the CBO) and actual trend money velocity (as estimated by the Hodrick-Prescott filter) into the equation of exchange (i.e. M^*_t= NGDP^*_t/V^*_t ).  I reproduce their procedure here using the CFS's M4 divisia money supply¹ and come up with the following figure:

The figure shows that the quantity of money assets is currently about 7% below what is needed to generate full potential NGDP growth.  Now if one takes the percent difference between the actual and needed M4 divisia in the figure above--the M4 divisa gap--and plots it against the the output gap you get the following figure:

I find this figure striking.  With a R² of about 60%, it shows that the output gap typically tracks the M4 gap.  For the recent crisis in particular, it shows the acute shortage of money assets (or excess money demand) is matched by the large output gap.  This figure, then, indicates the excess money demand explanation for the recent crisis is a compelling one.

Now some observers like James Bullards and Stephen Williamsons believe that the shortage of safe assets or money is the consequence of real shocks to financial intermediation that have permanently lowered the productive capacity of the U.S. economy.   The relationship evident in the figure above, however, suggests that there is in fact a large output gap given the significant shortage of money assets.  And even if the shortage were caused by a real shock, there are still policy options that could close the M4 gap.   

First, the government could create more safe assets in the form of treasuries.  This approach, however, is politically controversial as it requires more budget deficits.  It is also not clear to me that this approach would be able to create enough safe assets to completely close the M4 gap.  Second, the Fed could create the incentive for the private sector to start producing more safe assets by adopting a NGDP level target.  Such a target would raise the expected level of future NGDP and, in turn, raise the current demand for financial intermediation services.  That would lead to more privately-produced safe assets and ultimately a recovery. There are ways out of this economic morass.

¹I specifically use the CFS' "M4 minus" money supply measure. It had a better fit than the regular M4.

I am Back

My apologies for the month-long blogging hiatus.  Among other things, I have been busy with moving to a new job, taking a family road trip, and working on some papers.  I never stopped reading other blogs and often wanted to jump in and join the discussions.  Now that I have more time I plan to start blogging regularly again.  I will see you in the blogosphere!