Wednesday, January 20, 2016

Has Macroeconomic Policy Been Overly Tight?

Former Fed Minneapolis Fed President Narayana Kocherlakota believes macroeconomic policy has been overly tight the past few years. Consequently, he thinks the Fed is getting ahead of the recovery with its current tightening cycle. Is he right, has macroeconomic policy really been overly tight? To answer this question, consider the four following pieces of evidence. 

1.  Inflation has consistently fallen below the Fed's two percent inflation target for the past seven years. Here is a visual representation of this this development in terms of a shooting target:


Yes, core PCE inflation has has averaged near 1.5% over the past seven years despite a 2% inflation target. It is as if someone has been doing target shooting and persistently hits the lower half of the target. Maybe the Fed is actually aiming for something other than 2%--possibly a 1%-2% inflation corridor target--or maybe the Fed in its current form is not as powerful as we thought. Either way, inflation is being systematically kept below 2%. This suggests relatively weak aggregate nominal spending growth. This is consistent with tight macroeconomic policy. 

2. The risk-free real interest rate appears to still be cyclically adjusting. That is, the 10-year treasury interest rate adjusted for the risk premium appears to be following the prolong closing of the output gap. Some have confused the low levels of real interest rates as evidence for secular stagnation. As I have argued elsewhere, this need not be the case. The long decline in real interest that most observers invoke as the smoking gun for secular stagnation is misleading because it does not correct for the rise in the risk premium during the 1970s. Once one corrects for that you get the following figure:


The black line is the 10-year risk-premium adjusted real treasury interest rate. Note that it averages just under 2%--roughly tracking the average growth rate of the economy--but deviates around that average. Since the 1980s, those deviations closely track the business cycle as seen below: 


What this implies is that slow return of risk-free real rate to a higher level is simply a reflection of the slow unwinding of this business cycle. That it has taken this long to adjust only part way suggests that macroeconomic policy has not been very supportive.  

3.  Household portfolios still inordinately weighted toward safe assets. If one looks at the holding of liquid assets by households--defined here as cash, checking, saving, time, money market mutual funds, treasuries, and agencies--as percent of total assets it shot up during the crisis and still has yet to return to pre-crisis levels.  This indicates household demand for safe assets remains slightly elevated. This can seen in the figure below. Note that this liquidity demand measure leads the broad unemployment rate.


This measure also tracks the CBO's output gap very closely as well:


Were macroeconomic policy highly accommodative we would have expected households to adjust their portfolios faster. But they have not and this suggest macroeconomic policy has been tight. That is why this measure tracks the above measures of slack so well.

4.  Total dollar spending is still below its full employment level. This last bit of evidence is model-based and is part of a paper I am finishing where I estimate various ways to gauge the appropriate level of aggregate nominal expenditures. The key point here is that the sharp drop in nominal spending during the crisis never has been fully corrected for even after adjusting for changes in potential real GDP. It is hard to reconcile this with loose macroeconomic policy.



In short, macroeconomic policy has not been very supportive of a robust recovery over the past few years. So I agree with Narayana Kocherlakota on this point. Where people can reasonably disagree, I think, is whether this was the Fed's fault. Stephen Williamson, for example, sees little that the Fed could have done. For him, it was fiscal policy that was deficient. Specifically, he thinks there should have been more U.S. treasuries to alleviate the safe asset shortage problem.

My own view is that the bigger problem is the body politic's rigid commitment to low inflation. There is no way the Fed or Treasury could have spurred significantly more nominal spending growth without there being a temporary increase in the inflation rate. And that is simply intolerable in the current environment. The safe asset shortage problem and inability of the Fed to get much traction is simply a symptom of this problem.

That is one reason why I am a big advocate of NGDP level targeting. It would allow for temporary deviations in the inflation rate while still providing a credible long-run nominal anchor. Until we get something like this, expect regular bouts of macroeconomic policy being overly tight.

20 comments:

  1. Great post. "My own view is that the bigger problem is the body politic's rigid commitment to low inflation. There is no way the Fed or Treasury could have spurred significantly more nominal spending growth without there being a temporary increase in the inflation rate. And that is simply intolerable in the current environment." I think this is largely true, but there are some differences among individuals.

    For example, some of the Fed members have recently voted to tighten precisely because they thought inflation would shoot above target, due to QE. Conservative economists such as Cochrane, Williamson, and Feldstein all warned about inflation overheating. On the other hand, my sense is that Jeremey Stein voted to tighten because he sincerely believed that the Fed should forget its employment and inflation mandates, and focus instead on preventing asset bubbles, and furthermore, that the Fed should do this via tight monetary policy and not via regulation. This is what he said, in any case. But perhaps driven by a deep gut instinct for tight money and uneasiness with "higher inflation".

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    1. That makes sense to me. There certainly is variation on the BoG, but seeping in the background is tthis deep aversion to anything other than low inflation.

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  2. "the body politic" has many perspectives, where the one in concert with your statement would be those low risk yield seeking wealthy retirees. The part of the body politic that could be addressed equivalently using "wage growth" rather than "inflation" may have a different idea.

    Otherwise excellent thoughts. I look forward to your paper in the works.

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  3. Returns on share price should track interest rates and be on the order of maybe 3% or 4% max, but the free lunch economic theories dominant since Reaganomics argues that the way to boost gdp growth is by diverting more revenue selling gdp to capital to create wealth by inflating asset prices to get workers with declining income and fewer assets to borrow and spend more than when they had more income.

    It is Obama who will not get out of the way of lending money to bad credit risks, workers with too little income and no assets to pay to consume more to create higher gdp growth.

    The economic theory is free lunch because it looks at only supply and intentionally rejects the idea that consumers must have wage income to consume. Consumers with infinite money are the free lunch created by higher profits from paying workers less.

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  4. "Stephen Williamson, for example, sees little that the Fed could have done. For him, it was fiscal policy that was deficient. Specifically, he thinks there should have been more U.S. treasuries to alleviate the safe asset shortage problem." Are you saying that SW was advocating greater debt financing of Federal expenditures?

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    1. If you follow the links to SW in the post, it does seem SW was more debt financing. All his other work points to it.

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  5. How come fiscal policy can be responsible for low inflation if Debt/GDP is above 100% and budget deficit is still fairly large? Also, isn't inflation a nominal phonomenon, instead of a real phenomenon ?

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  6. Three questions. First, David, or anybody, why does everyone say the Fed cannot dump long bonds into the free market when clearly there could be shortages and there is massive demand for long bonds as collateral?

    Second, since there is plenty of demand for long bonds as collateral and such, is there another hidden reason why the Fed refuses to sell its bonds?

    Third, I realize that the NGDP futures market exists in the head of Scott Sumner. But, does anyone have an opinion that a futures market like he envisions could be manipulated? We know that one guy cornered the Cocoa market and that the oil futures market has been cornered from time to time. So, seriously, could the Fed say they are NGDP targeting when really they are just doing something else, if that futures market is created?

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    1. One the first question, I think the concern is that it would be disruptive to do a sudden reduction of the Fed's balance sheet. It would signal a tightening and as we've seen from the Fed's tightening so far it is not working out too well.

      I am not expert on NGDP futures. Scott has a paper on it at the Mercatus Center that may be helpful. http://mercatus.org/publication/market-driven-nominal-gdp-targeting-regime

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  7. Dave, interesting plots. What do you think of this relationship between CPI and CLF (see the plots)?

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    1. I see it as correlation not causality. Recall that in the Postbellum period of US history that there was rapid population growth and yet there was mild deflation for almost 30 years.

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    2. Was the United states on the gold standard at that time? Do you suppose that could have affected the mechanism?

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    3. The author of that simple model has updated it to model NGDP. I asked him about your postBellum comment, but no response yet. I also asked him about any counter examples: none yet he says, though he had trouble with the UK, but he suspects incomplete data may have something to do with that.

      So your postBellum example is still there... but suppose for the sake of argument there's an explanation for that which doesn't invalidate the correlation in modern economies (with fiat money).

      How does NGDP or core CPI change CLF? (I'm trying to imagine the arrow of causation running the other way). I suppose it could cause the unemployed to give up (say should a recession hit).

      Of course they could both be be caused by a 3rd unnamed cause too.

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    4. Tom, yes, the gold standard was part of the story during the postbellum period. But that underscores my point: it is monetary arrangements more than anything that determine long-run price level movements.

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    5. Correlation vs causation: what would you do to check? Granger causation analysis?

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  8. Dave, did you create that target graphic yourself?

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    1. I did, which tells you I end way too much time thinking about this stuff.

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    2. Looks good Dave! You might have a fall back career there. ;D (actually I've seen some of your other artwork and it wasn't bad)

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    3. I second that -- it's a really nice way of illustrating your point.

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