Thursday, November 14, 2013

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.)


  1. Well, first to ask aggressive questions, Yellen would have to depart somewhat from extant and sturdy Fed culture and norms. We are talking about an august independent public agency.

    Might she say,'"Volcker was lionized for getting inflation down to 5 percent, and then told to cool it. We are can take lot more heat right now, maybe run it up to 5 percent."

    Somehow I doubt it. The Fed is committed to a ceiling of 2 percent inflation, and since they are aghast at the thought at piercing that ceiling, they are really committed to a ceiling around 1.6 percent.

    I do not expect a robust exit from ZLB and near 1 percent inflation. And when the next recession hits, we will be in ZLB land nearly from the get-go....

  2. "The absence of robust broad money supply growth means the economy is still starved of the monetary assets needed to restore full employment."

    If it’s more monetary assets the economy needs, wouldn’t larger fiscal deficits be a more reliable method of creating inside money than signaling the future path of monetary policy? Fiscal deficits directly inject Treasury securities into the economy, thereby increasing net financial assets into the economy. I know you don’t equate T-securities with money assets, even with IOR (but you should - see Steve Waldman, but there’s no doubting that increasing net financial assets with T-securities improves balance sheets. And strong balance sheets mean more credit worthy borrowers and stronger appetites from banks to lend, which leads to the creation of inside money. Furthermore, the stimulatory effects of expected inflation could also be had by increased fiscal deficits accompanied by the promise of no new taxes (until inflation is above 5%). That promise is probably more credible than a promise by the Fed to tolerate even 3% inflation.

    So I think I’m actually agreeing with the theoretical implications you draw from a permanent increase in the monetary base (although I still think it’s due to the expectations of future interest rates, not the size of the monetary base), but I’m not convinced that’s the most effective way of priming the creation of inside money. It relies too much on unknowable future events. Better to directly add net financial assets and jobs now and rely on the effects of expectations when they become manifest.

  3. Jared,

    First, I do view treasuries as a type of money assets. See here. While they are definitely a medium of exchange, especially for institutional investors, they are not a medium of account. That is the key difference between them and the monetary base.

    Second, you are right that the treasury could help the monetary shortage problem. But there is a limit to how much it can help. Treasury securities have money-like characteristics because they are considered a risk-free or safe asset. But if the treasury were to issue too many of them they could lose that status if it led to higher inflation. Most money assets are privately created. The big fall was in this area and it seems unlikely to me that the treasury could produce enough treasury to fill this gap without losing its risk-free status. But even it could, it would never fly politically. So it has to be privately-produced money assets. I provide some data and graphs on this point here

    Finally, what is more important than who delivers the money--whether its expected monetary policy or current fiscal policy--is whether it is expected to be permanent. That is, at the end of the day, OMOs or helicopter drops will only work to the extent they are expected to be permanent. If the public expects policymakers to reverse itself in the future and unwind the expansion then there will be no lasting effect. Think Japan's first QE. On the other hand, if the monetary expansion is expected to be permanent both OMOs and helicopter drops are effective. Think Abenomics.

  4. Can you explain the concept of a medium of account and why it’s important? I understand a medium of exchange and a unit of account, but not a medium of account.

    By advocating for higher fiscal deficits, I’m not arguing that Treasury securities should fill the demand for safe assets all by themselves. I’m claiming that a major increase in the volume of T-securities would help repair private sector balance sheets, while maintaining incomes, which can then be leveraged in the creation of private safe assets. And I agree that inflation acts as a constraint, but that should just serve as the signal that it’s time to withdraw some of those sovereign safe assets.

    I suppose my main problem with QE is that for every dollar it creates, it extracts an equal amount of safe assets. Subsequently, it relies only on the expectations channel to encourage spending, which I still a find a bit dubious. The fiscal route can take advantage of the expectations channel as you indicate, but it’s also a direct form of increased spending that adds safe assets and income to the economy. Furthermore, I don’t think helicopter drops need to be viewed as permanent in order to function. Even if the market expects taxes to increase, those taxes can be spread out indefinitely over time and over a larger future population, thereby requiring an annual per capita tax burden that’s less than the annual per capita increase in government spending. Inflation and economic growth also lessen that future tax burden. And even if we assume Ricardian equivalence, the private sector can expand in the current period through investment intended to capture market share created by the temporary spending despite, or even because of, the expectation of future taxes.

    1. Jared, in the current context the medium of account and unit of account are the same thing. (they can be different though, like in the case of a commodity standard where medium of account would be gold, but the unit of account would certain ounces of gold). Anyway, the key issue here is that in the short-run what matters is the medium of exchange so treasuries can play a role. In the long-run, it is all about the unit of account. That is why Scott Sumner and Paul Krugman talk about banks not being important in the long-run.

      On your treasury security proposal, it sounds like we hold similar views. Effectively you are arguing for the treasury to catalyze private asset creating by injecting just enough treasury securities. That sounds reasonable to me. All this agreeing with you is beginning to scare me!

      The one area where continue to disagree is the importance of permanence. The reason I have advocated a helicopter drops tied to a NGDP level target is because it signals permanence (the level part). If the treasury did what you outlined with its current inflation target it would have very little effect. It is also the reason QEs are having limited effect. It is not just taxes in the future you have to worry about, but the expectation the central bank will rigorously enforcing its inflation target. That belief by itself is enough to prevent new treasury securities from having a lasting effect.

  5. David,
    Recall back in April and May you did a couple of posts on the University of Michigan/Thompson Reuters Survey of Consumers where households are asked how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. Well, I've been doing a lot of Granger causality tests on my own and in response to discussions in the econblogosphere and one topic that came up in the comment thread at Yichuan's most recent NoahPinion post was in fact this survey. As a result of that conversation I did some tests and I find that income expectations Granger cause 10-year T-Note yields at the 1% ("without" series) and 10% ("with" series) significance level during the period December 2008 through September 2012. This is of course consistent with term structure theory. Just thought you ought to know.