A Failure to Act: Fed Policy and Interest Rates

Is the Fed responsible for the pernicious low-interest rate environment? Yes, but not for the reasons you think. I explain why in a new National Review article:

While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?

[...]

The Fed’s failure to adopt something like a nominal-GDP target in 2008 meant that the central bank would not be able to adequately respond to the subsequent money-demand shocks that arose over the next four years. That is, the Fed’s inaction allowed the pernicious low-interest-rate environment to develop. So while the Fed did not directly cause the low-interest-rate environment, our central bank allowed it and all of its associated problems to emerge. For that it should be blamed.

Readers of this blog will be familiar with this argument (e.g. see here, here, and here).  Here are some figures that corroborate the points made in my article. First,the figure below shows the Fed's share of treasuries over the past twelve years. It has been overall relatively stable around 15%. Observers who blame the Fed for pushing down treasury yields, though, often note the Fed's relatively large share of treasury purchases in 2011. What they ignore is the Fed also sold a similar proportion in 2007-2008. By their logic the Fed should have caused treasury yields to rise during this time. But this period is when the long decline in treasury yields actually begins.

When confronted this fact, some of these critics will then point  to long-term treasury yields and say the market is "front-running" the Fed stated plans to buy long-term treasuries. But if that is the explanation for the falling long-term yields then this next figure should not be possible. It shows the Fed's treasury holdings were relatively stable between the end of QE2 in mid-2011 and the beginning of QE3 in late 2012. It also shows that real interest rates on 10-year treasuries continued to fall. There was no front-running during this time since there were no QE programs. There were, however, ongoing global economic problems that can explain the decline.

Finally, it is worth pointing out that as the U.S. economic recovery has begun to appear more firm, long-term treasury rates have also started to gradually rise. The Fed has not changed its pace, but yields are now rising. The easiest explanation is that the long-term yields are directly reflecting the expected state of the economy. Indirectly, though, the rising yields can be traced in part to the Fed actions which under QE3 has become more closely to tied to the state of the economy. Too bad it took the Fed almost four years to get here.

Narayana Kocherlakota on Safe Assets and the Natural Interest Rate

Narayana Kocherlakota, President of the Minneapolis Fed, recently participated in a panel where he discussed the key challenges facing central banks. He viewed the safe asset shortage and the related inability of the Fed to push the actual market rate down to its natural interest rate level as problem number one. Readers of this blog know I completely agree with his assessment. I also agree with him that the reason this problem persists is that the zero lower bound is preventing the safe asset market from clearing.

Where we part ways is whether the Fed can solve this problem and its implications for financial stability. First, Kocherlakota does not seem to think there is much more the Fed can do where I believe the Fed through a "shock and awe" program could solve the safe asset shortage. The early results of Abenomics appear to support my view. The Fed, in conjunction with the U.S. Treasury Department, could also resolve this problem through a "helicopter drop". Though not my first choice, I would be fine with this approach as long as it were tied to a NGDP level target or some other nominal anchor. So the Fed is not helpless here, but has just failed to do all it can.

Second, he believes the Fed's attempt to push rates down to the neutral rate level may create financial instability. I disagree. The Fed is not causing financial instability because it is not the reasons interest rates are now low. The weak economy and resulting safe asset shortage is the reason interest rates are low. The Fed's share of marketable treasuries, for example, has been and is about 15%. That means most of the run up in public debt has been funded by you, me, and our financial intermediaries. If the low interest rates are causing an unnatural reach for yield, then blame us not the Fed. The Fed simply is playing catch up to the low interest rate environment we have created. Financial instability is more likely to emerge if the Fed were somehow able to temporarily lower the target federal funds rate below the natural interest rate as it did in 2002-2004. We are far from that situation now.

Okay, enough of my views. Here is Kocherlakota (my bold):

In my view, the biggest challenge for central banks—especially here in the United States—is changes in the nature of asset demand and asset supply since 2007. Those changes are shaping current monetary policy—and are likely to shape policy for some time to come.

Let me elaborate. The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I’ll mention what I see as the most obvious one. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.

At the same time, the supply of the assets perceived to be safe has shrunk over the past six years. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. They no longer think that. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. They no longer think that either.

The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

Great points!

Abenomics and the Supply of Safe Assets

One of the big challenges facing the global economy is the shortage of safe assets. These are the highly liquid, information-insensitive assets that function as money. The financial crisis raised the demand for these safe assets just as many of them were disappearing. This cyclically-driven safe asset shortage (or excess money demand) that emerged continues to this day and is why aggregate demand in many countries remain depressed.¹

The figure below illustrates this problem for the United States. It shows the Gorton et. al.(2012) safe assets measure along with the amount of safe assets needed to hit the pre-crisis trend growth path for NGDP as well as the CBO's full-employment level of NGDP.² It shows an ongoing gap that is preventing a robust recovery from occurring.

The big question, then, is how to restore an adequate supply of safe assets. Given the Triffin Dilemma, I have argued the only sustainable way this can happen is if the public's perception about the safety of private debt improves and thus raises investors' demand for it. In other words, the relatively high risk premium on private debt relative to treasuries must come down so that private securities can be view as more safe and used as money. But how?

My answer, which assumes that the relatively high risk premium is result of excessive pessimism, is that we need a major slap to the market's face. Something that would "shock and awe" investors into more normal portofolio holdings and along the way spur aggregate demand. I claimed an aggressive NGDP level target that significantly raised expected nominal income growth would do just that. It would both reduce the excess demand for safe assets (because of greater nominal income certainty going forward) and at the same time catalyze financial firms into making private safe assets (because of the improved economic outlook and the related increased demand for financial intermediation). 

The only problem with my story is that it seemed it would never get tested. But that was before Abenomics. Though it doesn't target NGDP, Abenomics does create a radical departure from past economic policy in Japan. Among other things, it has committed the Bank of Japan to open-ended asset purchases until inflation hits 2% and the monetary base doubles. This has provided a significant jolt to expectations, a big regime change that should catalyze the demand for and supply of privately-created safe assets if my story has merit. 

So what has happened? Is there any evidence that Abenomics is catalyzing a major portfolio rebalancing that is leading to more privately-created safe assets?  On the portfolio rebalancing front, circumstantial evidence suggests that answer is yes. The figure below shows the 10-year government yield in Japan is sharply rising. This indicates investors are, at a rapid pace, starting to move out of government debt and into other assets:

And it appears that those other assets investors are moving into include private debt. The figure below shows an average CDS spread equally weighted over 50 Japanese corporate bonds. This risk premium measure on corporate securities shows a rapid decline since the beginning of 2013, a sign that portfolios are rebalancing toward corporate debt.

But what about safe asset creation? Is there evidence that Abenomics has also catalyzed privately-produced safe assets? To answer this question we turn to the broadest measure of money, L, that is tracked by the Bank of Japan. The L money supply includes both retail and institutional money assets and is similar in scope to the U.S. M4 money supply tracked by the Center for Financial Stability. If privately-created safe assets were increasing in response to Abenomics we would expect to see it in this measure. And we do, as seen in the figure below:

This figure indicates that the right kind of QE can actually increase the supply of safe assets. Many observers think that QE simply swaps one safe assets for another with no effect. But the right kind of QE--one that leads investors to expect a permanent increase in the monetary base--can raise the supply of safe asses and help shore up a strong economic recovery for a depressed economy. It worked for FDR in 1933 and it appears to be working for Shinzo Abe in 2013.

With all that said, Abenomics is in its early stages and a lot could still go wrong. So this preliminary evidence may not be the last word.

¹There is also a structural safe asset problem that has been in play well before the crisis began. This safe asset shortage problem is the consequence of the world economy growing faster than the global capacity to produce safe assets. 

²The amount of safe assets needed to hit the pre-crisis trend NGDP path and CBO full-employment NGDP is calculated as follow. I solve for the optimal amount of money in the equation of exchange given an optimal amount of Nominal GDP (the pre-crisis trend and CBO values) and actual trend money (safe asset) velocity as estimated by the Hodrick-Prescott filter. That is, I am solving for M* in M^*_t= NGDP^*_t/V^*_t .

The Data Have a Market Monetarist's Bias

It almost seems unfair, as if the evidence is biased toward Market Monetarist's views. First it was the better-than-expected employment report last week and now it is the forecast-beating retail sales report. These developments should not be happening, especially now with sequestration, if the fiscal multiplier were large. But they are happening and underscore the case that the monetary policy can offset the drag of fiscal austerity.

This latest evidence for the Sumner Critique--the understanding that fiscal multiplier will be effectively zero when the central bank is stabilizing aggregate demand--should not be surprising since the Fed has been offsetting structural austerity since 2010, a fact lost on many Keynesian-minded folks. This post-2010 period is one of the great macroeconomic natural experiments now unfolding, pitting U.S. monetary policy against U.S. fiscal policy.¹

This multi-year natural experiment has not be lost on all observers. Jeff Spross of Think Progress takes note of it:

It hasn’t really made the front pages, but the United States recently began carrying out a massive and nearly unprecedented economic experiment, and 2013 looks to be the year when the results come in. The question is straightforward: When the economy is in a deep slump, and the government makes things worse by cutting spending, how much can monetary policy do to help? The answer could reshape the way we argue about economic policy, with profound implications for progressives’ economic priorities — and big opportunities, if they can seize them.

So far, progressives have tended to side with economists like Paul Krugman and bloggers like Mike Konczal. They argue that monetary policy is severely weakened at the zero lower bound...

But economists like David Beckworth and Scott Sumner countered that the economy’s 2.5 percent growth rate stuck around despite blows from multiple rounds of spending cuts, the European crisis, and worries about China. In fact, as Beckworth pointed out, government spending began shrinking by the start of 2010 — yet the economy just kept puttering along at 2.5 percent.

Other points in Beckworth and Sumner’s favor: Before sequestration, the latest round of across-the-board spending cuts, began, the group Macroeconomic Advisors projected growth for the first quarter below 2.5 percent if sequestration didn’t happen. Then the May 3 jobs report, which came out after Konczal’s piece, was so good it was almost shocking. Matt Yglesias and Ryan Avent, two other fans of monetary policy’s salutary effects, pointed to other data sources that suggest the Fed actually has been able to raise long-term inflation expectations. So this looks like at least a preliminary win for team monetary policy.

In my view, the most important insight from this "radical experiment" is not that monetary policy can effectively make the fiscal multiplier zero, but that it could be doing far more to shore up aggregate demand. The fact that the Fed has successfully offset structural fiscal austerity since 2010--as seen by the stable NGDP growth--suggest it could do far more. The Fed has made big strides with QE3, but has yet to unload both barrels of guns. It is time for a NGDP level target.

¹  The other, great macroeconomic experiment now unfolding is Abenomics in Japan.

Abenomics Confusion

Lars Christensen nails it on the confusion surrounding Abenomics:

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

This story is not new. The abandonment of the interwar gold standard in the 1930s by many countries spurred domestic demand and was behind the subsequent sharp recoveries, not any export growth generated by the competitive devaluations. For if everyone is devaluing, there is no place to send additional exports. That was true in the 1930s and is true today. 

With that said, the competitive devaluation arising from Abenomics may be the catalyst to kick start the ECB into more serious efforts if they care about the Eurozone's external competitiveness. The ECB may ease to keep the Euro from getting too expensive and in the process shore up European domestic demand. How ironic it would be if Abenomics were to accomplish in the Eurozone what  intense human suffering could not: moving the ECB to forcefully act. 

Balance Sheet Recessions Are Really Nominal Income Recessions

I recently lamented the Fed's ongoing dereliction of duty as seen in the sustained declined of households' expected nominal income growth:

In that post, I noted this observed decline was problematic for two reasons: (1) current nominal spending decisions are influenced by expected nominal income growth and (2) past nominal debt contracts were based on certain expectations of nominal income growth that did not happen. Here is what I specifically said on the latter point:

The figure also indicates that real debt burdens are higher than many households expected prior to the crisis. Look at the dashed line. It shows the average expected dollar income growth rate over the 'Great Moderation' period was 5.3%. Now imagine it is early-to-mid 2000s and you are taking out a 30-year mortgage and determining how much debt you handle. An important factor in this calculation is your expected income growth over the next 30 years. If you were average, then according to this data you would be forecasting about 5% growth rate. But that did not happened. Household dollar incomes declined and are expected to remain low. Nominal debt, however, has not adjusted as quickly leaving higher than expected real debt burdens for households. 

An important implication of this development is that households' deleveraging over the past few years may not be so much about their weakened balance sheets as it is about the unexpected decline in their expected nominal income growth. Josh Hendrickson and I are working on a paper where we develop this point more fully and, among other things, report the figure below. It plots expected household nominal income growth against the percent change of nominal household debt:

This figure suggests that for households, expected dollar income growth matters a lot for deleveraging. It also implies "balance sheet recessions" are a byproduct of nominal income shortfalls. One policy implication, then, is that the Fed should have maintained aggregate nominal income growth at its expected path. It failed to do so in 2008 and has yet to fully make up for this shortfall.

I bring this up, because a new paper by Kevin D. Sheedy (hat tip Simon Wren-Lewis) shows that NGDP level targeting dominates inflation targeting for this very reason. It is much better at stabilizing the real debt burdens of households precisely because it is much better at stabilizing the growth path of nominal income. Here is his abstract:

Financial markets are incomplete, thus for many agents borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating agents' nominal incomes from aggregate real shocks, this policy effectively completes the market by stabilizing the ratio of debt to income. The paper argues that the objective of nominal GDP should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.

Fed officials should take note. So should ECB officials since this finding is particularly poignant for the Eurozone. It is time to fully embrace NGDP level targeting.

The Seen and Unseen: Structural Budget Deficits Edition

On Friday I discussed the cyclically-adjusted U.S. budget deficit and asked any Keynesian to reconcile its decline with the steady growth of aggregate demand. Robert Waldman graciously replied, but he really didn't answer my question. His response focused on the pace of the recovery and changes in the overall budget balance. My question was about the structural budget balance. This distinction is an important one. So let me try this one more time.

The structural budget balance is the best way to gauge the stance of fiscal policy, as noted by Paul Krugman:

[M]easuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates, as a share of potential GDP...

Here is the IMF's cyclically-adjusted or structural budget balance for the United States:

So what does this figure tell us? It shows that fiscal policy, independent of business cycle influences, has been tightening since 2010. It has gone from a deficit of 8.5% in 2010 to an expected one of about 4.6% in 2013.  In other words, the reduction in the federal budget deficit over the past three years is more than just the government adjusting its balance sheet in response to improvements in the private sector's balance sheet. It is also the result of explicit policy choices to impose fiscal austerity. And these explicit policy changes have been relatively sharp.

Many observers have overlooked the implications of this structural austerity experiment. Three years of explicit fiscal austerity in a depressed economy should, all else equal, lead to even more economic weakness. But it has not. Nominal GDP growth--a proxy for aggregate demand (AD) growth--has been remarkably steady. There is no evidence AD over the past three years has been adversely affected by this austerity. Friday's job report underscores this point.

So what explains this development? The answer is not that fiscal policy has no effect, but rather that all else is not being held equal for U.S. aggregate demand growth. Specifically, Fed policy has effectively responded to the fiscal austerity, Eurozone shocks, China slowdown shocks, and other shocks to AD. Though this is a great accomplishment, it is far from adequate and is ultimately frustrating to watch. For it speaks to both the power and shortcomings of current Fed policy.

It is not surprising to me that Keynesians and other observers fail to see this structural austerity. The Fed has offset it over the past three years and therefore kept it out of sight, out of mind. The ECB, on the other hand, has not and so it is more apparent to observers. But just because it is not seen, does not mean it is not there.

Pushback

Despite my enthusiasm about what today's employment report means, Josh Barro says it does not vindicate the Market Monetarist's view.  Moreover, he believes we probably should not expect our view to ever be fully vindicated for political economy reasons:

Market monetarism, as advanced by [Ramesh] Ponnuru and the economist David Beckworth, among others, holds that aggressive monetary policy is a sufficient force to smooth out business cycles.And over the last year we’ve just had a mini-experiment along these lines. Congress and the president have imposed fiscal tightening by raising taxes and allowing sequestration’s haphazard spending cuts to come into effect. And the Federal Reserve has (with occasional tentativeness) gotten more aggressive in its easing, setting a specific target for unemployment and running an open-ended program of asset purchases since the fall.

The results so far are good but not great. Job growth is steady and economic growth is modest but positive. Sequestration’s human impacts are real, but a macroeconomic drag is not yet apparent. This looks a lot better than Europe, where the central bank hasn’t been so aggressive and many economies have slid back into recession. Yet we should worry about the limits of the market monetarist approach. Monetary and fiscal policy are both constrained by political forces, not just economic ones.

The political economy critique is a fair point. I remain optimistic, though, that QE3 will evolve to some kind of conditional monthly asset purchasing program where the Fed changes the size of the asset purchases to match economic developments. And once that happens we are well on the way to a nominal GDP level target.

Mike Konczal, meanwhile, pushes back on my response to his post that the Fed needs to adjust its pressure on the gas pedal:

We don’t often get a serious shift in expectations. That’s why I’m not sure how much the “gas pedal” from David Beckworth’s response is at play. Beckworth notes that the purchases in QE3 don’t automatically react to turbulence in the economy, and hopes that the Federal Reserve will buy more if the economy gets weaker. But if the expectations of where the Fed wants to end up are the real limiting factor for a robust recovery, why would a small change in purchases matter? This is partially why Greg Ip said the FOMC statement this week was “asymmetric,” even though the Fed said it might “increase or reduce” purchases: an increase is a small move, but a reduction is a genuine retrenchment.

If the public understood that the dollar size of the Fed's asset purchases were also conditional, then Fed policy should have a more meaningful effect on expectations. We may never know, however, if Josh Barro is correct about the political economy limits of monetary  policy.

Is the Fed's Able to Offset Austerity? Insights from the Employment Report

The April employment report came out today and is better than expected. The number of new jobs exceeded the median forecast, the previous two months job numbers were revised upward, and the unemployment rate fell to 7.5%. This report is not what one would expect if fiscal austerity were overwhelming the Fed's efforts to shore up the economy. But the report also is not what one would expect if the Fed were unloading both barrels of the gun at the economy. The April employment rate, therefore, reveals both the strength and weakness of the Fed's efforts.

On the first point, Mike Konczal and Paul Krugman claimed earlier this week that the contraction of U.S. fiscal policy in 2013 was trumping the Fed's QE3 program and, in so doing, undermining the views of Market Monetarists like Scott Sumner and me. The employment report and its revisions to the previous months throw some cold water on their claim. But this should not surprise anyone, since fiscal austerity has been happening from 2010 and it has yet to stop the steady progression of nominal GDP (NGDP) growth.

This can be seen in the figures below. The first figure shows that the cyclically adjusted (i.e. structural) budget balance as a percent of potential GDP has been shrinking since 2010. This is the budget balance due to policy changes, not from changes to the economy. It shows fiscal tightening over the past three years:

And what has this fiscal tightening done to aggregate demand (i.e. NGDP) growth since that time? The figure below shows it has done nothing:

This broader 3-year experiment of fiscal policy versus money policy is the one Konczal and Krugman should be examining. Instead, they focus on the first quarter of 2013 and miss the forest for the trees.

With all that said, the stable employment and AD growth is far from what is needed for the economy to reach escape velocity. Therein lies the shortcoming of QE3 and the other, previous asset purchasing programs of the Fed. They have been enough to stabilize growth, but not enough to shore up a robust recovery. And that is frustrating to watch.

This frustration led me to propose earlier this week that the Fed make the size of its monthly asset purchases under QE3 conditional on how fast the economy was reaching the Fed's targets. Ryan Avent came up with a similar proposal. And then the Fed announced later in the week that it was prepared to do something just like this:

The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

It is as if Fed officials were reading our blog posts! Okay, maybe not. More realistically, they too see the problems with QE3--it is applying the same pressure to the gas pedal irrespective of how the terrain on the road changes--and want to improve it. Unfortunately, the Fed did not get more specific than this statement so we don't know how or when this will happen. Josh Barro thinks it is unlikely it will ever happen. I hope he is wrong, otherwise we face a long journey to full employment.

Update: Robert Waldman replies to the post. Here is my response to Waldman.