Three Questions Janet Yellen Should Have Asked the Senators

Janet Yellen's confirmation hearing was today and, as expected, she got asked tough questions. It would be nice if she could return some of her own tough questions to the Senators. Here are three questions that would challenge the thinking of many and hopefully start a productive conversation on Capitol Hill. The questions are presented in graphical form, followed by a few comments:

Comment: Since most of the marketable public debt was not purchased by the Fed, it is not the main reason for the long decline in treasury yields. The Fed may have pushed down the term premium a bit, but overall the weak economy is the culprit. This can be seen, for example by looking to the decline in real interest rates that occurred after QE2 ended and before QE3 started. Even the Fed's forward guidance is itself a function of expected growth rate of the economy. So no, the Fed did not enable the large federal budget deficits with low financing costs.

Comment: If anything, the Fed has been systematically undershooting its 2% inflation target as seen above. It seems the Fed views it inflation target as an upper bound to an 1-2% target range. Yes, the Fed has been creating a lot of monetary base, but it also clearly signaled this expansion is temporary. Only a permanent, unsterilized expansion of the monetary base would make a difference. The Fed's inflation-fighting credibility is so strong that absent a major regime shift, like the introduction of Abenomics in Japan, one should not expect the current expansion of the Fed's balance sheet to create a surge in inflation.

 

Comment:  The absence of robust broad money supply growth means the economy is still starved of the monetary assets needed to restore full employment. The Fed could be doing more to correct this shortfall. No, the Fed does not directly create inside money assets, but it can meaningfully influence their production by making the right signals about the future path of monetary policy. For example, a regime change to a nominal GDP level target that required aggressive catch-up growth would do just that. It would signal that the Fed plans to allow some of the Fed's expanded balance sheet to become permanent. That matters, because it means a higher-than-expected price level in the long-run. A higher-than-expected price level in the future means investors will begin adjusting their portfolios today. The portfolio rebalancing, in turn, will mean more aggregate demand today. So yes, the Fed has not unloaded both barrels of the gun when it comes to supporting broad money supply growth. (Wonkish note: this understanding is theoretically and empirically shown here.)

If You are Going to Criticize QE...

Do not do it this way or you might face the combined firepower of Caroline Baum, Scott Sumner, Jim Pethokoukis, and Joe Weisenthal. No one could survive that onslaught. But this does not mean the Fed's large-scale asset purchasing programs are perfect. There are legitimate critiques one can make about the QE programs.

One might, for example, criticize how the QE programs have been incredibly ad-hoc and unpredictable. Even with the new "data dependent" approach of QE3, there is still confusion as to how the Fed will respond to the incoming data. A great example of this is the FOMC's decision not to taper in September. It came as complete surprise to the market. The Fed's clarity has not gotten any better since then. There is now talk of the Fed changing its "thresholds" for action. But no one knows for sure. This confusion does not help an economy struggling to get out of a slump. This is a good critique.

One could also critique the Fed for claiming it is using QE a way to restore full employment while at the same time it systematically keeps inflation below its target. The Fed's large-scale asset purchases will never gain full traction if the Fed continues to place one foot on the gas and one foot on the brake. This is definitely worthy of a critique.

One might also critique the Fed for not learning from FDR in 1933 or Abenomics in 2013 that QE can be very effective if done right. These experiences show that QE-type programs work when monetary base injections are expected to be permanent. Temporary or sterilized injections, on the other hand, are ineffective. Though QE3 can be viewed as introducing some permanence to the injections, the Fed has clearly indicated it plans to wind down most of the growth in its balance sheet. Long-run inflation forecasts indicate the public believes it. The Fed doing QE wrong is is also worthy of a critique.

But do not criticize the QE programs by saying you are sorry they ever happened. Yes, the Fed could have let the payment system crash as it did in the 1930s instead of doing QE1. And yes, the Fed could have let the economy continue to drift into deflationary territory in 2010 instead of doing QE2. And yes, the Fed could have let the economy continue to stumble in 2012 and face the sequester in 2013 alone instead of doing QE3. Very few observers would explicitly make these arguments, but one implicitly does if they question the inherent worthiness of the QE programs.

So if you are going to criticize QE do it right.

Endogenous Aggregate Supply

A recent Federal Reserve paper makes the case that potential GDP is to some extent endogenous to aggregate demand shocks:

The recent financial crisis and ensuing recession appear to have put the productive capacity of the economy on a lower and shallower trajectory than the one that seemed to be in place prior to 2007... [We] argue that a significant portion of the recent damage to the supply side of the economy plausibly was endogenous to the weakness in aggregate demand—contrary to the conventional view that policymakers must simply accommodate themselves to aggregate supply conditions. Endogeneity of supply with respect to demand provides a strong motivation for a vigorous policy response to a weakening in aggregate demand.

One example of this phenomenon would be workers who had up-to-date skills and were productive, but lost their job because of the Great Recession. Over time, their skills became obsolete and they went from being cyclically unemployed to structurally unemployed. What started as an aggregate demand problem slowly became an aggregate supply one. It is therefore important to respond to aggregate demand shocks quickly and thoroughly to prevent this from happening.

I believe another example of this endogenous aggregate supply response is the decline of expected productivity growth. This can be seen in the figure below. It comes from the Survey of Professional Forecasters and shows the expected average productivity growth rate over the next 10 years. It reveals a run-up in the expected growth rate in the late 1990s and early 2000s that corresponds to the technological advances and opening up of Asia during that period. Since 2006 it has persistently declined. This is a big deal since a decline in expected productivity growth means firms will come to expect lower returns on capital expenditures and households will come to expect lower future income growth. Firms and households will cut spending accordingly. But this expected decline in aggregate supply growth is probably an overreaction. It is hard to believe that all the productivity advances from technology and the opening up of the global economy permanently disappeared because of the Great Recession. Rather, I see it as an endogenous aggregate supply response that should largely self-correct as the economy returns to full employment.¹

The Fed paper behind this is getting a lot of attention, but it is important to note that Mark Thoma made the same point almost a year and half earlier. He does a good job illustrating the idea with the following figure. Here, Y*_SR is short-run endogenous aggregate supply, while Y*_LR is the long-run or full potential amount of aggregate supply:

Here is how Thoma describes it:

Up until the point where the line splits into three pieces, assume the economy is in long-run equilibrium with output at the natural rate...Then, for some reason, aggregate demand falls leading the economy into a recession. As AD falls, people are laid off, equipment is stored, factories are shuttered, and so on and the economy's capacity to produce falls in the short-run as shown by the blue line on the diagram.

But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen -- you get the picture -- and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.

In fact, there's no reason to think productive capacity can't return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there's nothing for policy to do. Capacity will recover...

In terms of our earlier examples, this understanding means the now structurally unemployed individuals will find it far easier to retool and get back into the labor force if the economy is humming at full employment. And the existing productivity gains will be better appreciated in a robust economy, thereby raising long-run expected growth.

There are, though, potential drags on the aggregate supply that could prove more lasting. For example, the ACA may have non-trivial effects on the labor supply according to Casey Mulligan. The question is how big of an effect developments like these will have on trend growth. Even if large, they still could be offset by further productivity gains. Ultimately, this is an empirical question.

The GOP's Golden Opportunity on Monetary Policy

One of the most remarkable developments of the past few years has been how the U.S. economy has steadily grown--albeit slower than needed--despite a  tightening of fiscal policy. This tightening has been happening since 2010, but kicked into higher gear in 2013. Many observers predicted this fiscal tightening would be disastrous. For example, some claimed the sequester in 2013 would cause anywhere from 500,000 to 700,000 jobs to be lost in 2013. And yet, as noted by Michael Darda, this has not happened because the Fed has successfully offset it:

Non-farm payroll growth surprised to the upside in October (rising 204K vs. expectations of 120K), but the data simply have returned to the 12-month average, in line with the message of a host of leading labor market indicators. The key take-away from the data so far for 2013 is that the Fed, unlike the ECB, has offset the sharpest fiscal consolidation since the 1950s, despite the zero lower bound (ZLB) on short rates and a widespread (but false) view that QE only lifts asset prices and not the real economy. Year-to-year trends in aggregate hours worked and nominal wage rates have been moderate but steady, reinforcing the argument that the Fed has thus far offset any demand side fallout from the sequester and 2013 tax hikes.

This story is a big deal, one that the GOP and other conservatives should be pushing every day in the media. They should be taking the offense and heralding its implications: U.S. government budget deficits can be easily shrunk, even at the ZLB, if we have offsetting actions by the Fed. They could note how this strategy worked before in Canada and the UK. More generally, they could make the point that if you want to minimize federal government interventions into the economy, have the Fed do its job. Just imagine how different the 1930s and the past five years would have been had the Fed stabilized total current dollar spending during these times. This is such low hanging fruit for the GOP.

Instead of running with it, however, the GOP and its thought leaders instead have fretted for five years over an inflation threat that has not materialized and now worry over asset bubbles that one has to strain to see amidst a depressed economy. This recent George Will column is a great example of this myopic vision of money. Instead of seeing how the Fed has offset fiscal austerity and therefore could stave off more if further budget cuts were made, George Will instead focuses on unfounded fears of loose monetary policy. This is why folks like Jim Pethokoukis are pulling their hair out.

The GOP needs a serious rethink on monetary policy. Some of us on the right have been trying for the past few years to awaken the GOP to this golden opportunity. We write op-eds, articles, and even travel to Capitol Hill. But sadly, the GOP continues to sabotage itself on monetary policy. It pushes for hard money policies that weaken the economy and, in turn, open door for other policies they detest. Imagine if the Fed had not allowed the sharp collapse in aggregate demand in late 2008, early 2009. It is less likely that many of President Obama's policies would have been supported and therefore enacted. As Scott Sumner once said, monetary policy is the Achilles Heel of the right.

This would be almost comical if it were not so serious. So come on GOP, run with the amazing story of fiscal austerity since 2010 and steady growth nonetheless. Do not waste this golden opportunity.