What Goes Down Must Come Up

The Mercatus Center is running a colloquium on the low interest rate environment and its implications for the economy. The colloquium runs twelve days and each day a new essay will be published. Since this is leading up to the holidays, some are calling it the "twelve days of interest".

Today the colloquium ran my essay in which I make the case that the 10-year treasury interest rate will return to the range of 4.0 to 4.5 percent. This definitely goes against the conventional view that the natural interest rate or "r-star" has permanently fallen and will keep treasury yields depressed. This view is evident, for example, in the FOMC's summary of economic projections (SEP) where members expect the long-run value of the federal funds rate to land near 3 percent. So why my contrarian claim?

My answer, as laid out in the piece, is that much of decline in the 10-year real interest rate is due to a temporary decline in the natural interest rate. In my view, this decline is tied to business cycle forces rather than structural ones. As evidence for my view, I provide Figure 5 which shows a strong relationship between the natural interest rate--the 10-year, risk-free, real interest rate in the article--and the CBO's output gap. Here is the same data plotted in a scatter plot:

And here is the output from running a regression on these two series:

As I note in the piece, these results imply that if the output gap eventually closes (i.e. goes to zero) the natural interest rate will hit 1.65 percent. Add in 2 percent for inflation and a modest amount for the term premium and one easily breaks the 4.0 percent barrier. 

I may be proved wrong, but the early bounce from the Trump shock is pushing in my direction. To be upfront, though, I was making a similar argument in 2014 when the economy early on appeared to be taking off. I still think my call was reasonable given robust growth in early 2014, but the growth quickly got snuffed out. It did so, in my view, because the Fed began talking up interest rate hikes and effectively tightening policy in mid-2014. Throw in some strains on the term premium from problems in China, Eurozone, new regulatory burdens and you get the low treasury yields since 2014. This seems to be changing now with the Trump shock but we will have to wait to know for sure. 

I encourage you to keep following the colloquium. Other contributors, often with less sanguine views about future interest rates, will follow. The next one, for example, is from Joe Gagnon who does not share my outlook on interest rates. Also, the other pieces that follow will get more into the implications of the low interest rate environment. So stay tuned!

Macro Musings Podcast: JP Koning

My latest Macro Musings Podcast is with JP Koning. JP is an economist who works in the Canadian financial industry and is a walking encyclopedia on the institutional details of central banks and money. He runs a fantastic blog called Moneyness--a must read for anyone serious about understanding money and its history. JP joined me to talk about some of the more interesting institutional arrangements for central banks and money today.

We began our conversation by talking about central banks of Switzerland, Japan, South Africa, Belgium, and Greece. They are unique in that they have stocks that are traded on the stock market. As JP notes, however, these stocks function more like a perpetual bond than an actual stock.

Another fascinating central bank story is that the Bank of England in that it used to allow personal checking. It no longer does this, but it demonstrates that the current restrictions on access to central bank balance sheets has not always been in place. And there are many advocates who would like to see a further openness of central bank balance sheets as a way to stem financial crisis. We discuss the implications of going down this path.

What happens when a central bank has internal divisions and various branches compete against each other? This happened recently in Libya and JP gives us the details. Our conversation then turned to the dollarization of the Zimbabwe economy following its bout of hyperinflation in 2008. We discuss how it happened and the influence U.S. monetary policy has on dollarized economies. We also discuss what appears to new monetary mischief being done by the government of Zimbabwe.

We also briefly touch on the latest case of hyperinflation in Venezuela. The Wall Street Journal had an interesting piece on a man who is considered by the number one nemesis of the Venezuela government for publishing black-market exchange rate of the Bolivar currency.

Our talk ends with a discussion on the Fedwire and the potential for a Fedcoin.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

P.S. Here is a slide show on the evolution of Zimbabwe's currency leading up to the hyperinflation in 2008.

Macro Musings Podcast: Mark Calabria

My latest Macro Musings podcast is with Mark Calabria of the Cato Institute. We discussed his time doing financial regulation and Fed policy as a senior staffer on the U.S. Senate Committee on Banking, Housing, and Urban Affairs. We also spent some time discussing his new paper on applying behavioral economics to Fed policy.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Related Links

Mark Calabria's Home Page

Mark Calabria's Twitter Account

Mark Calabria's New Paper

Macro Musings Podcast: Roger Farmer

My latest Macro Musings podcast is with Roger Farmer. Roger is a Professor of Economics at UCLA. He joined me to discuss his latest book, Prosperity for All: How to Prevent Financial Crises. 

This was a very fascinating conversation. Roger makes the case that modern macroeconomics as it is formally practiced has gone down the wrong path with the New Keynesian paradigm. He considers it a degenerative research agenda for several reasons. First, it is premised on the natural rate hypothesis (NRH) which he sees as incorrect. He uses the analogy of a child hitting a rocking horse to describe the NRH. The child hitting the horse will cause it to rock, but eventually it will come to rest. Likewise an economy buffeted by shocks will cause fluctuations but eventually the economy will return to its full employment level. Roger sees this view as fundamentally wrong

Roger contends a more accurate analogy would be a rudderless boat blown by various winds to new locations and staying there until new winds come along. Put differently, Roger believes in multiple equilibria for the economy that arise because of various shocks--the winds--pushing the economy to new points. The economy may stay at these equilibria for some time. Some equilibria may be good, some bad. One of the important shocks that determine these equilibria are peoples beliefs or confidence. In his work he has formally modeled this through a 'belief function' that replaces the Philips Curve in the standard New Keynesian model. This was a key theme running throughout our conversation.

Other problems Roger sees with the New Keynesian paradigm include prices being implausibly sticky, the absence of involuntary unemployment, small welfare costs to business cycles, and the inability to explain bubbles and crashes. His modeling approach aims to fix these problems and bring back the original animal spirit theme of Keynes in a formal rational expectations framework. 

Moving beyond modeling issues, Roger also believes the reason for economic volatility is not sticky prices but incomplete markets. Specifically, incomplete labor and financial markets. This was interesting because it implies price signals are not working properly and preventing markets from doing their magic. His solution is to have the government stabilize the growth of a stock market index via purchases of ETFs.

This was a fun conversation throughout. And his book is highly recommend. It really gets into the philosophy of science and its implications for the macroeconomic discipline. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can 

also listen via the embedded player above. And remember to subscribe since more shows are coming.

Related Links

Roger Farmer's Home Page

Roger Farmer's Books

Monetary Policy Rules Conference: Presentation and Paper

Back in September I was part of the Monetary Policy Rules for a Post-Crisis World conference. It was jointly hosted by the Mercatus Center and the Cato Institute. There were many interesting presentations from folks like David Laidler, Perry Merhling, Robert Hetzel, Miles Kimball, Peter Ireland, John Taylor, and Scott Sumner. The panel moderators--Ylan Q. Mui, Ryan Avent, Cardiff Garcia, and Greg Ip--were great too!

I wanted to share the working paper I presented at the conference. It was titled The Fed's Dirty Little Secret and now is posted online. This paper had its origins in an earlier blog post of mine. It was fun taking an idea sketched out on this blog and turning into a paper. Below is the paper's abstract:

Despite the Federal Reserve’s use of QE programs, the U.S. economy experienced one of the weakest recoveries on record following the Great Recession. Not only was real growth disappointingly low, but even nominal growth over which monetary policy has more control was feeble. Why did QE fail to stimulate robust aggregate demand growth? This paper argues the answer is that the Federal Reserve could not credibly commit to a permanent expansion of the monetary base under QE. Both the quantity theory of money and New Keynesian theory show, however, that a permanent expansion of the monetary base is needed to spur aggregate demand growth at the ZLB. The Federal Reserve’s inability to do so meant its QE program got consigned to ‘irrelevance results’ of Krugman (1998) and Eggertson and Woodford (2003) and were never going to spark a strong a recovery. This is the Fed’s dirty little secret. Moving forward, this inability to commit to permanent expansions of the monetary base at the ZLB will continue to weigh down on the effectiveness of Fed policy. As a result, this paper calls for a new monetary policy regime of a NGDP level target that is backstopped by the U.S. Treasury Department.  

Please take a look and feel free to provide feedback.

For those interested, the video presentation my panel at the conference is below.  As you can see, my panel consisted of Miles Kimball, Peter Ireland, and myself. Greg Ip was the panel moderator.

Macro Musings Podcast: Mark Koyama

 

My latest Macro Musings podcast is with Mark Koyama. Mark is an assistant professor of economics at George Mason University where he specializes in economic history, the roles institutions play in economics, and how culture and economics interact. Mark recently has recently written on the macroeconomics of ancient Rome and he joined me to talk about it.

This was a super fascinating conversation where we cover the history of Rome, the extent and depth of markets in ancient Rome, and the long-run growth prospects of Rome. We also discuss the the extent to which credit and financial markets were developed in Rome, including the well-documented financial panic of 33 AD that affected various part of the empire. 

Part of our conversation was motivated by Peter Temin's book The Roman Market Economy. Apparently, some ancient historians have had a hard time accepting the premise of a market economy in Rome. Peter Temin book pushes back against this view drawing upon economics, other recent work, and archaeological evidence. The evidence increasingly points to an integrated market economy that existed throughout the empire.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Related Links
Mark Koyama's web page
Mark Koyama's twitter account
Mark Koyama's posts on Rome