St. Louis Fed President James Bullard just delivered a speech where he claims that U.S. monetary policy has been stellar over the past four years. In fact, he says monetary policy was "close to optimal." Yes, I about chocked too after reading that line. His view is that (1) the Fed kept the price level on its long run trend and that (2) there was a reduction in U.S. potential output that undermines that case for looking at NGDP being below trend. Consequently, there is nothing to the claims of insufficient aggregate demand. It is all structural, end of the story.
This is not the first time Bullard has made claim (2), but it is the first time he has combined it with the claim that the Fed has been doing a fine job since 2008. Scott Sumner has already responded and I am sure others will too. My response to Bullard is that your theory cannot explain an important development that have been ongoing since 2008: the elevated demand for liquidity. If we are simply on a new growth path and the Fed has done a fine job with monetary conditions, then why is the demand for safe assets still so pronounced? Below are five facts about this ongoing demand for liquidity:
Fact 1Households and other retail investors have been increasing their holdings of FDIC-protected saving deposits at an usually rapid rate. This surge in saving deposit growth starts during the crisis in 2008 and still is growing. Since that time, households have acquired almost $2.4 trillion worth of saving deposits.Fact 2Households have been one of the biggest purchasers of U.S. treasuries over the past 4 years.
Through direct purchases, households have gone from holding $264 billion in 2007:Q4 to $1.3 trillion in 2012:Q1. If mutual funds purchases of treasuries reflect indirect household purchases, then household holdings have grown from $647 billion in 2007:Q4 to $2.2 trillion in 2012:Q1.This is more than doublethe Fed's increase in treasury holdings. Only foreigners have bought more. (Update: these numbers were based on SIFMA data thru 2012:Q1. The Q2 data shows major revisions such that direct household holdings went from $202 billion in 2007:Q4 to $878 billion in 2012:Q2. Including mutual fund purchasers of treasuries put household holdings at $584 billion in 2007:Q4 and $1810 billion in 2012:Q2. These combined purchasers are still more than the Fed's, but not double. Interestingly, these revision show the Fed's holdings at about 15% of total marketable treasuries. So much for the Fed buying up all the deficit)Fact 3Household holdings of liquid assets as a percent of total assets soared in 2008 and have yet to come down. Household porfolios, therefore, are still inordinately weighted toward safe, liquid assets and have yet to undergo the type of portfolio rebalancing associated with a robust recovery (i.e. a rebalancing of portfolios away from low yielding, liquid assets to higher yielding, riskier assets will spawn indirect effects on aggregate nominal spending via balance sheet and wealth effects and directly through purchases on capital. See here for evidence on this portfolio channel).Fact 4Interest rates on safe assets are at historical lows. Given the facts 1-3 above, it should be evident that these low interest rates are the result of an elevated, ongoing demand for safe assets. As noted above, the biggest purchasers of U.S. treasuries has not been the Fed over the past four years. So don't blame the Fed.Fact 5Since the start of the crisis in 2008, movements in the stock market and expected inflation have been highly correlated as seen here. This is an unusual relationship that only started during the crisis and continues to this day. Thus, whatever caused it to happen in 2008 is still with us today. The easiest interpretation that is consistent with facts 1-4 above is that spike in demand for safe, liquid assets that began in 2008 has yet to subside. Here is why: any rise in expected inflation that would reduce this intense demand for liquid assets and thereby raise the expected future nominal income, would also raise expectations of higher future stock prices. In anticipation of this development, investors buy stocks in the present (see David Glasner). Thus, expected inflation and stock prices are currently related. Since liquidity demand still remains elevated, there apparently hast not been a big enough increase in expected future nominal income to break this relationship.
Those are the facts. They all indicate there is still an elevated demand for liquidity that is slowing the economy. Now here is the thing. By changing expectations about the path of future nominal income, the Fed could reduce this demand for liquidity and spark a recovery in nominal expenditures. Specifically, by setting a NGDP level target, the Fed could increase both the certainty and expected amount of future nominal income. This would increase demand for credit today and kick start the private creation of safe assets. It also would decrease the demand for safe assets. That the Fed has not done this and, as a result, there is still elevated liquidity demand screams Fed failure, not success.
Now this is not to say there are no structural problems. Only that there still remains a sizable excess demand for liquidity that is constraining aggregate nominal spending. My hope is that James Bullard and others who share his views will wrestle with these facts that point to this safe asset demand problem.