The Right Type of Tapering

Ramesh Ponnuru and I have a new article at the New Republic where we argue the Fed should not consider tapering unless it is tied to a NGDP level target. If the target were based on pre-crisis trends over the "Great Moderation" period, then the dollar size of the economy is about 10% too small. If it is based on the CBO's full-employment level of NGDP then it is about 6% short. Either way, there is still a large aggregate nominal expenditure shortfall. The FOMC should make tapering conditional on closing this gap.

The FOMC and Bernanke, however, signaled a different type of tapering last week that sent the markets into a tailspin.Yes, Bernanke said the tapering would be based on the pace of recovery, but he also mentioned a timetable which raised questions about whether monetary policy will truly be state contingent. There may have more than this tapering confusion that rattled markets--such as China's tightening of policy--but the Fed clearly failed to signal a future path of monetary policy consistent with supporting the ongoing recovery. This is more passive tightening of monetary policy. 

The Fed should realize it is not doing it right when The Telegraph's Ambrose Evans-Pritchard, President James Bullard, and IMF Managing Director Christine Largarde all agree the FOMC botched it last week. The Fed can make this right by talking up the right type of tapering. The kind that is conditional on closing the NGDP gap.

It's Time for the Bank of England to Adopt a NGDPLT

Evan Soltas is right. Mark Carney's arrival provides a great opportunity for monetary regime change at the Bank of England:

Mark Carney's arrival as the new head of the Bank of England on July 1 is an opportunity for the U.K. to rethink monetary policy. As a Canadian, Carney is an outsider, and he'll have a clean slate because the central bank’s two current deputy governors are leaving as well. I'm hoping the U.K. seizes the moment and embraces an idea that Carney has flirted with in recent speeches -- adopt an explicit target for nominal gross domestic product.

The Bank of England adopting a NGDP level target (NGDPLT) would be a great catalyst for other central banks considering a move to NGDPLT. The Fed is halfway there with its QE3 program and Japan's Abenomics program is not too far behind. Just like the Bank of New Zealand and the Bank of Canada were important first movers toward inflation targeting regimes, the Bank of England may be the important first mover toward a world where NGDPLT is the norm. 

As the Eurozone crisis has so vividly demonstrated, it is well past time we leave the barbaric practice of inflation targeting behind and move on to a more humane monetary policy regime of NGDPLT.

The Tapering Talk and Rising Yields Are a Sign of Recovery

There seems to be a growing consensus that the recent rise in long-term interest rates is the result of the Fed indicating it may taper its asset purchases. Fed Chairman Ben Bernanke's comments before Congress on May 22 and the subsequent release of FOMC minutes allegedly sparked concerns the Fed was going to tighten policy sooner than expected. This understanding is reflected in this Bloomberg article:

Bond prices have slumped since Bernanke told Congress’s Joint Economic Committee on May 22 the Fed could scale back stimulus efforts “in the next few meetings” if the employment outlook shows “sustainable” improvement. He stressed that any decision would depend on what the economic data showed and that a move to reduce the pace of purchases would be delayed if recovery falters and inflation falls further.

[...]

The yield on the 10-year Treasury note was 1.93 percent the day before the committee hearing and went on to trade at a 14-month high of 2.29 percent last week...The sell-off in Treasuries has triggered convulsions in capital markets elsewhere...“Central banks have given a sense of near total control, driving volatility and bond yields to historic lows and compressing risk premia,” said Michala Marcussen, global head of economics at Societe Generale SA in London. As the “countdown” to the end of the Fed’s quantitative-easing program advances, “volatility and higher bond yields are making a return.”

This is very compelling narrative, except that it is probably wrong. This popular view is so caught up in what Bernanke said that it is missing the forest for the trees. Other developments have been happening to long-term yields that suggest the tapering talk is a red herring. These can be seen in the next few figures.

First, long-term interest rates started increasing at the beginning of May. Bernanke's comments and the FOMC minutes occurred several weeks later. Therefore, the timing is way off for the tapering explanation. Something else is happening here:

Second, as noted by Jim Hamilton and Michael Darda, long-term interest rates on safe sovereign assets around the world are going up and are doing so in a similar manner. So whatever is affecting U.S. long-term interest rates is also affecting global yields.

So what could be affecting all these yields over the past few months? How about an improved economic outlook? We are now halfway through 2013 and the U.S. economy has been relatively resilient to fiscal austerity and Japan's first quarter growth has been better than expected. Maybe investors see these developments and are becoming increasingly more confident. If so, they would be rebalancing their portfolios accordingly and, in the process, driving up the natural rate of interest. This possibility is a point that Market Monetarists like Lars Christensen have been making for some time.

Note the implications of this understanding. If monetary policy does spark a robust recovery it should lead to higher interest rates, not lower ones. Higher yields mean, then, that QE3 is working. Chairman Bernanke made this very point at a prior congressional hearing:

Earlier this year, Chairman Bernanke made the point that rising interest rate reflect “The fact that interest rates have gone up a bit is actually indicative of a stronger economy,” Bernanke said in Washington today in response to questions from members of the House Financial Services Committee. That indicates the Fed’s stimulus is working, he said.

It also means that most observers have misinterpreted Bernanke's remarks on tapering. For him to even consider tapering implies he believes a solid recovery may be finally taking hold. But, by his own admission, a solid recovery means higher interest rates. Commentators, therefore, should be viewing his tapering talk and higher yields as a sign of progress, not as a sign of Fed tightening.

Some, like Gavin Davies, do see the rising yields as a sign of an improved economic outlook, but still worry about the decline in expected inflation. He notes the rising nominal treasury yields can be broken down into rising real yields and falling expected inflation:

Here too there is a benign explanation for these developments: a positive supply shock. As Ryan Avent explains, there appears to have been some growth in global productive capacity. One example would be the increased oil production in the United States. Positive supply shocks like this tend to put upward pressure on the natural interest rate and downward pressure on inflation. If this assessment is correct, then we need not worry about the declining inflation as noted by Lars Christensen.

Of course, the U.S. economy is a long way from full employment and the short-term natural interest rate may still be below zero. But these developments should give us pause and force us to recognize that once a strong recovery takes hold, we should eagerly anticipate rising interest rates.  Embrace the rates!

P.S. Count this post as my long-overdue second part of my Bernanke Friday Night Special Part I.

A Foolproof Approach to Monetary Policy For Both Fiscalists and Monetarists

Cardiff Garcia says we all need to get along. At least the fiscalists and market monetarists who believe there is still a aggregate demand shortfall. He makes the case that both sides should tolerate and even embrace each other. Here is Garcia on market monetarists:

But there is one sense in which even the monetarist position is amenable to fiscal stimulus, and it is this. A belief of the market monetarists is that if NGDP level targeting were properly embraced, then the awful outcomes characteristic of a Great Recession — a slowdown of NGDP growth, calamitous falls in asset prices, the disintegration of usable collateral — would be avoided in the first place...

As such, the very impetus for using fiscal policy to stabilise the economy and accelerate the recovery would be unnecessary...The monetarists therefore wouldn’t be inconsistent if they were to say: Sure, keep fiscal stabilisation policy at the ready in case we fail. We just don’t think it will be necessary. If it does turn out to be necessary, well, go for it.

Okay, but not all fiscal policy is equal. Fiscal policy geared toward large government spending programs is likely to be rife with corruption, inefficient government planning, future distortionary taxes, and a ratcheting up of government intervention in the economy. So I will pass on this type of fiscal policy. Fiscal policy, however, that largely avoids these problems and directly addresses the real issue behind the aggregated demand shortfall--an excess demand for safe, money-like assets--I will endorse. And that form of fiscal policy is a helicopter drop, a government program that gives money directly to households. The Fed would finance it and the Treasury Department would deliver it to each household. This idea is not new. It was originally suggested by Milton Friedman and recently discussed by the conservative AEI. So it should have appeal across both parties.

Here is how I would operationalize this policy. First, the Fed adopts a NGDP level target. Doing so would better anchor nominal spending and income expectations and therefore minimize the chance of ever entering a liquidity-trap. In other words, if the public believes the Fed will do whatever it takes to maintain a stable growth path for NGDP, then they would have no need to panic and hoard liquid assets in the first place when an adverse economic shock hits. 

Second, the Fed and Treasury sign an agreement that should a liquidity trap emerge anyhow and knock NGDP off its targeted path, they would then quickly work together to implement a helicopter drop. The Fed would provide the funding and the Treasury Department would provide the logistical support to deliver the funds to households. Once NGDP returned to its targeted path the helicopter drop would end and the Fed would implement policy using normal open market operations. If the public understood this plan, it would further stabilize NGDP expectations and make it unlikely a helicopter drop would ever be needed.

This two-tier approach to NGDP level targeting should create a foolproof way to avoid liquidity traps. It should also reduce asset boom-bust cycles since NGDP targets avoid destablizing responses to supply shocks that often fuel swings in asset prices. This approach is consistent with Milton Friedman's vision of monetary policy, would impose a monetary policy rule, and provide a solid long-run nominal anchor. Finally, per Cardiff Garcia's request it would satisfy both fiscalists and monetarists. What is there not to like about it?

P.S. I would be glad to submit this proposal to Representative Kevin Brady for consideration in his centennial commission on monetary policy. It would be great to see Congress discuss reforming the Fed along these lines.

What the Great Natural Experiment Reveals About QE

There is a great natural economic experiment unfolding. And it is not the QE3 versus U.S. fiscal austerity debate that some of us have been debating. Rather, it is the United States versus the Eurozone and the different policy "treatments" their economies are receiving. Jim Pethokoukis explains:

[W]e have an intriguing natural economic experiment. Two large, advanced economies are both undergoing fiscal austerity from spending cuts and tax increases. But one is recovering, though glacially, from a previous downturn; the other is deteriorating.

The likely difference: monetary policy. Not only did the Federal Reserve slash short-term interest rates to nearly zero way back in 2008, but it has also embarked upon a massive bond-buying program known as quantitative easing. The European Central Bank, however, only last month cut its key interest rate to 0.5 percent, still higher than the Fed-funds rate. And the ECB’s “unconventional” monetary policy has been far more modest, with bond purchases less than a tenth the size of the Fed’s. Its goals have also been more limited: stabilizing southern Europe’s debt markets and avoiding a financial crisis. At a recent speech in Frankfurt, Germany, St. Louis Fed president James Bullard said that unless Europe adopts an aggressive bond-buying program, it risks an extended period of low growth and deflation like what Japan has experienced since the 1980s.

This policy treatment explains the different NGDP trajectories in this figure: 

What is puzzling to me is how anyone could look at the outcome of this experiment and claim the Fed's large scale asset programs (LSAPs) are not helpful. Some claim the LSAPs are just helping the rich, at best, and may even be deflationary. But it is not hard to imagine how much higher U.S. unemployment would be were it not for the Fed's QE programs. Just look to Europe's unemployment rate, as noted by Pethokoukis. Yes, the LSAP programs are far from ideal but they are keeping Americans from experiencing the unemployment seen in Europe.  In other words, QE is helping the lives of ordinary working people in the Unites States. And there are many ordinary working Europeans whose lives would be much better off if the ECB were to more closely follow the Fed's actions.  

The insights from this natural experiment should give QE critics pause. And so should the fact that these these programs are helping shore up the supply of safe assets. Critics who see the slow recovery and point to the Fed's LSAPs simply are not doing the right (if any) counterfactual.

Is the Fed Squeezing the Shadow Banking System?

Some observers believe the Fed's large scale asset purchases (LSAPs) are actually a drag on the economy. They note that the Fed's purchases of treasuries is reducing the supply of safe assets, the assets that effectively function as money for the shadow banking system. They do this by serving as the collateral that facilitates exchange among institutional investors. Critics, therefore, contend that LSAPs are more likely to be deflationary than inflationary. A recent piece by Andy Kessler in the WSJ typifies this view:

So what's the problem? Well, it turns out, there's a huge collateral shortage. Global bank-reserve requirements have changed, meaning more safe, highly liquid securities like Treasurys are demanded instead of, say, Greek or Cypriot debt. And lately, Treasurys have been getting harder to find. Why? Because of the very quantitative easing that was supposedly stimulating the economy. The $1.8 trillion of Treasury bonds sitting out of reach on the books of the Fed is starving the repo market of safe collateral. With rehypothecation multipliers, this means that the economy may be shy some $5 trillion in credit...

[T]the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys, and to keep stimulating until inflation reaches 2% or unemployment is lower than 6.5%—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy. The quantitative easing policy appears self-defeating, perversely keeping economic growth slower and jobs scarce.

So is the Fed really "squeezing" the shadow banking system as Kessler claims? Are the LSAPs actually stalling the recovery rather than supporting it? In a word, no, as this view misses the forest for the trees at two levels. First, by focusing on the Fed's LSAPs of safe assets, this understanding overlooks the more important contributors to the safe asset shortage. Second, this view takes a static view. It doesn't consider the dynamic effect of LSAPs on the supply of private safe assets. Let's consider each point in turn.

First, the main reasons for the safe asset shortage are (1) the destruction and slow recovery of private label safe assets since the crisis and (2) the elevated demand for safe assets that has arisen during this time. The importance of the first develpment can be seen in the figure below. It shows the Gorton et. al. (2012) measure of safe assets broken into government and privately-created safe assets. The figure shows an almost $4 trillion dollar fall in private label safe assets during the crisis. The Fed's purchases of treasuries has no direct bearing on this private supply shortage (though I will argue below it has a positive indirect effect on it).

This reduction in the supply of safe assets occurred, of course, just as the demand for safe assets were rising in 2008. Since then, a spate of bad news--Eurozone crisis, China slowdown concerns, debt limit talks, fiscal cliff talks--has kept the demand for safe asset elevated as well as new regulatory requirements requiring banks to hold more safe assets. It is these developments that are the real stranglehold on the shadow banking system.¹ 

Still, Kessler and other critics are correct to note that the immediate effect of the Fed's LSAPs, even if relatively minor, is to reduce collateral in the shadow banking system. However, this narrow focus misses the potential for the LSAPs to catalyze the private production of safe assets. The LSAPs, if done right, should raise expected economic growth going forward and cause asset prices to soar. This, in turn, would increase the current demand for and supply of financial intermediation. For example, AAA-rated corporations may issue more bonds to build up productive capacity in expectation of higher future sales growth. Financial firms, likewise, may start providing more loans as the improved economic outlook makes households and firms appear as better credit risks. Critics like Kessler miss this dynamic effect of LSAPs.

The potential for LSAPs to spur private safe asset creation is not just theoretical. It appears to be happening already with Abenomics in Japan. And to a lesser extent, it has been happening in the United States with QE2 and QE3. Now, these two LSAPs programs are far from perfect, but even they appear to have supported some private safe asset creation. This can be seen in the figure below which shows the year-on-year growth rate of the Gorton et. al. (2012) measure of private safe assets. It also reports the year-on-year growth rate for the "M4 minus" Divisia measure from the Center for Financial Stability. This metric provides an estimate of the broad money supply, including shadow banking money assets but excluding treasuries (the "minus" part). This measure, then, is also capturing the supply of private safe assets. The figure indicates that under both QE2 and QE3, the growth rate of private safe assets increased. Unlike QE1 which was designed to save the financial system, the latter two QE programs were explicitly geared toward shoring up the economy. In so doing, they also appear to have ramped up the production of private safe assets.

QE3 is still ongoing and continues to support more private safe asset creation. The recent rise in treasury yields is another sign of this process as it indicates a rebalancing of portfolios toward, among other things, private safe assets. Now there is a long ways to go before there will be enough private safe assets to restore full employment NGDP growth. But we are on the way--the only way since there is a limit to the amount of safe assets the government can provide without jeopardizing its risk-free status--and this should not be ignored by critics like Kessler. 

The appropriate critique, then, of the Fed is not that it is squeezing the shadow banking system, but that it has failed to do enough to undo the stranglehold on it coming from the shortfall of private safe asset creation and the elevated demand for safe assets.

P.S. John Cochrane reads Andy Kessler's piece too. He wonders if the monetary base is losing its special standing as high-powered money since treasuries have become high-powered money for the shadow banking system. The answer is no because the monetary base is still the medium of account, a huge advantage. Also, though the monetary base and treasuries may be near perfect substitutes today, they won't be in the future. And investors make their decisions based largely on what they think will happen in the future. Thus, a monetary base injection today that is expected to be permanent and greater than the demand for the monetary base in the future is likely to affect spending today, even though treasuries and the monetary base are now close substitutes. The key is creating the belief that monetary base injection will be permanent, a point repeatedly made by Michael Woodford.

^{1The figure shows that government safe assets have partially offset the private label shortfall. I estimate there is still a U.S. safe asset shortfall of about $4 trillion. This shortfall can be seen in this figure which shows the amount of safe assets needed to hit full employment NGDP. The 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 .}