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Tuesday, October 2, 2018

"Et tu, John Williams?"



Tim Duy reports that r-star, which rose to prominence over the past few years, is experiencing a Caesar-like betrayal at the Fed:
The Federal Reserve’s “r-star” has gone full supernova. New York Federal Reserve President John Williams, its key proponent, made clear in a speech late Friday that the neutral interest rate is no longer a guiding star for monetary policy. This means a federal funds rate in the range of what is considered neutral has no special significance as far as policy is concerned... 
Williams’s attachment to r-star cannot be overstated. At a professional level, it has been a key element of his research agenda. As recently as May he said that for “the moment, r-star continues to shine brightly, guiding monetary policy, but hold steady, low on the horizon.” The moment quickly passed. Last week, he tossed aside the metric, saying that it has “gotten too much attention in commentary about Fed policy.” A remarkable shift after just two 25-basis-point rate increases since his May comments... 
Williams’ speech marks the end of a transition in policy away from explicit forward guidance. It began this past August with Fed Chairman Jerome Powell’s Jackson Hole speech in which he noted the uncertainty surrounding estimates of key variables like the neutral interest rate. Fed Governor Lael Brainard pushed this point further in a subsequent speech, adding further uncertainty by differentiating between short- and long-run neutral. It continued in the September Federal Open Market Committee statement with the removal the description of policy as “accommodative.” And it ends with the primary proponent of the r-star concept — Williams — throwing it into the trash bin of crisis-era policy artifacts.
One is tempted to say "It was good knowing you r-star". However, r-star will still be around in all the models used by the FOMC and Fed staff. Just look at, for example, the policy rules on the Board of Governor's website or in its annual report. The reported change, as I see it, is more a move toward less explicit reliance on it. Implicitly, r-star will still be important to an FOMC that relies on the Phillips curve thinking in making its decisions. 

Still, these developments do indicate there is some movement towards looking at other indicators as I noted in recent post. There I suggested one useful metric the FOMC could add to its lists of monetary policy indicators is the gap between a stable benchmark growth path for nominal GDP and its actual value. I outlined in this note several ways to create this metric and note that it is in the spirit of a NGDP level target without actually adopting one. 

There are many reasons for the Fed to start following the NGDP gap. The most practical one is its ability to help the FOMC avoid falling for the inflation head fakes created by supply shocks. Here is hoping that out of the ashes of r-star's apparent demise arises an increased desire by the FOMC to pay attention to the NGDP gap.

Friday, September 21, 2018

FOMC Preview: "We Have the Nerve to Invert the Curve"

The quote in the title should be the motto for the 2018-2019 FOMC. For the FOMC is set to raise its interest rate target next week and expected to raise it several times more in 2019 despite a flattening treasury yield curve.


As seen in the above chart, the outright inversion of the treasury yield typically leads to a recession.  Despite this robust pattern, a growing number of Fed officials have become emboldened in their dismissal of it "since this time is different."  As Caroline Baum notes, 
In April, John Williams acknowledged that an inverted yield curve is “a powerful signal of recessions,” based on a significant body of research, including that by staff economists at his former bank. 
By September, Williams was already disavowing that signal. “I don’t see the flat yield curve or inverted yield curve as being the deciding factor in terms of where we should go with policy,” Williams said following a speech in Buffalo on Sept. 6. 
Next up was Fed Gov. Lael Brainard. She broke new ground in a speech last week when she... invoked the four most dangerous words in finance — “this time is different” — and applied them to the prospect of an inverted yield curve.
To be fair, President John Williams and Governor Lael Brainard are simply expressing the natural implications of the FOMC projected path for interest rates. As I noted before, the FOMC's own summary of economic projections implies a yield curve inversion over the next year or so. The FOMC, in short, is becoming increasingly dismissive of fears about inverting the yield curve. That is why the title of this post should be their motto for 2018-2019. Here is a t-shirt you can buy to commemorate this surge in FOMC boldness:


Some observers side with Fed officials arguing that "this time is indeed different" because the term premium is so low. To that I would first remind them that former Fed chair Ben Bernanke made a similar argument in 2006. As it turned out, the term premium had declined but so had the expected path of short-term interest rates. This can be seen in the figure below, which is constructed using the New York Fed's estimates of term premiums. It shows the 10-year minus 1-year treasury spread decomposed into (1) an expected rate path spread and (2) a term premium spread. These two component add up to the overall spread. The lesson here for the FOMC is to avoid falling for the siren call of the term premium excuse.


I would also remind naysayers that even if it were the case that the flattening of the yield curve is all due to a lowering of the term premium, the inverting of the yield curve still matters for financial intermediation. An inverted yield curve means smaller net interest margins for financial firms and thus less financial intermediation. That is, once the yield curve inverts, it goes from being a predictive tool to a causal agent. So even in the best-case scenario, one should not be cavalier about inverting the yield curve. Be careful FOMC.

P.S. Here is the backside of the t-shirt:



Monday, September 17, 2018

More Non-Star Metrics for Monetary Policy

In an earlier post and Bridge article, I discussed some ways to use nominal GDP (NGDP) as a cross-check on the FOMC "navigating  by stars" of r*, u*, and y*. The  motivation for these pieces was Fed Chair Jay Powell's concerns about the challenge of using these star variables when they seem increasingly in flux. Here, again, is a key excerpt from his talk:
Navigating by the stars can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly… the FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides.
The Fed chair is implicitly challenging us to find indicators that shed light on the stance of monetary policy without having to know r*, u*, and y*. The metric I suggested in the earlier pieces was the "sticky-forecast" NGDP benchmark growth path. Here I want to suggest another two measures for the Fed chair.

First, is a Phillips curve-like measure. I am not a fan of Phillips curves, but they remain stubbornly popular among policymakers and the public. They are supposed to show a relationship between the amount of slack in the economy and wage growth. However, most Phillips curves have not done well predicting wage growth (or inflation) over the past few years. Although there are many ways to measure slack in a Phillips curve, typically it is done using the unemployment rate. Attempts to salvage the Phillips curve using other slack measures have been made, like that from Adam OzimekErnie Tedeschi, and Nick Bunker who argue we should use the prime-age employment-to-population (EPOP) rate. Jason Furman, however, pushes back against this and other attempts to better define slack.

If we must stick with Phillips curve to explain wage growth as the FOMC seems intent on doing, here is my suggested approach. Take the spread between the U6 and U3 unemployment rates. This measure, unlike the prime-age EPOP, is stationary and therefore not subject to the Furman critique. Unfortunately, the U6 only goes back to 1994 so not a lot of historical analysis is possible with it. Since that time, the U6-U3 gap seems to be a fairly reliable predictor of wage growth.  The figure below plots this relationship. For purposes of comparison, it also highlights the late 1990s (blue) and the more recent years of the wage growth mystery (red).


One interpretation of this figure is that even though the U3 unemployment rate is currently low and below u*, the economy is not running as hot as it was it was in the late 1990s when the U6-U3 spread was even lower than it is now. This complements the message coming from prime-age EOP Phillips curves. This would call, all else equal, for fewer rate hikes rather than more from the Fed.

Okay, enough of Phillips curve. I want to move on to another related indicator, one that does not rely on a measure of slack but is instead tied to monetary conditions. And that is another application of my 'sticky forecast' NGDP gap measure, as explained in this note. NGDP is tied to monetary conditions for several reasons. First, it measures total money spending on the final goods and services produced in the economy. Second, it is equivalent to the velocity-adjusted money supply. NGDP, therefore, is an easy way to get a bird's-eye view of money activity in an economy. 

My sticky-forecast benchmark growth measure of NGDP can be subtracted from actual NGDP to get a NGDP gap measure. I replace the U6-U3 spread in the above figure with this NGDP gap measure to get the new scatterplot below. Once again, the late 1990s and more recent years are highlighted for purposes of comparison. And, once again, it suggests that the economy is running cooler now than in the late 1990s. Most importantly, it shows there is a strong relationship between monetary conditions and the nominal wage growth rate. Money still matters. 


Friday, September 14, 2018

The Fed's Floor System: Sayonara?

Are the days of the Fed's floor system numbered? Last month I claimed that they could be if President Trump's fiscal policy continues to spawn rapid increases in the issuance of treasury bills. His administration is relying heavily on treasury bills to finance its deficits as seen below:


This increased issuance of treasury bills matters because it implies, all else equal, a rise in treasury bill yields. Below is a figure showing the  DTCC overnight treasury-repo rate relative to the IOER rate. Lately, the treasury-repo rate has been bouncing above the interest on excess reserves (IOER) rate. This development could be a big deal.


If sustained, this rise of overnight interest rates above the IOER rate could spell the end of the Fed's floor system. 

To see why, recall that the Fed moved to a floor operating system in late 2008 by paying interest on excess reserves (IOER) at a rate higher than comparable short-term market interest rates. This pushed banks onto the perfectly elastic region of their reserve demand curve and allowed the Fed to add reserves to the banking system without causing its target interest rate to change. The supply of reserves were thus "divorced" from the setting of monetary policy (Keister et al. 2008). This divorce was seen by many a virtue of the floor system, for it allowed the Fed to manage bank liquidity and monetary policy independently, changing the size of its balance sheet to control liquidity, and the IOER rate to alter its monetary policy stance.

Maintaining this floor system, therefore, requires keeping the IOER rate at or above comparable market interest rates, so that banks will be willing to hold on to any reserves that come their way. The recent uptick in treasury bill issuance seems to be undermining this requirement and raises the possibility that the Fed could be inadvertently forced off of the floor system by fiscal policy. 

Further evidence that something may already be afoot with the rise in the overnight repo rates can be seen on the aggregate bank balance sheets from the Fed's H8 database. The figure below shows the asset category "total fed funds sold and reverse repos" as the black line. The blue line shows the same category, but just for banks transacting with other banks. This figure indicates there still is not much interbank lending, but there does appear to be a surge in nonbank lending in repos. This makes sense given the recent surge in repo rates. It may also be the first crack in the armor of the Fed's floor system as it suggest banks are beginning to invest reserves in the repo market rather than at the Fed.


Something else I showed in my piece last month was the tight fit between treasury bill issuance (normalized by the total amount of marketable treasury securities) and the IOER-Libor spread. One interpretation of this relationship is that the movement of treasury repo rates gets transmitted into interbank rates via arbitrage. 


This IOER-Libor spread, in turn, is closely tied to the percent of bank assets held in the "cash" category in the H8. (Since late 2008, this category has consisted mostly of bank reserves.) The specific pattern has been that as the IOER spread rises (falls) the cash share also rises (falls) as seen below:


Conversely, when the that as the IOER spread rises (falls) the loan share of bank assets falls (rises) as seen below:


Based on the three above charts, if the treasury-repo yield continues to be above the IOER, we should expect to see a growing share of bank assets invested in loans and fewer in excess reserves.1 That would bring the end of the Fed's floor system and rise in the inflation rate.

Some worry the liquidity coverage ratio (LCR) may complicate this story. As of 2015, the LCR started requiring banks to hold enough high-quality liquid assets to withstand 30 days of cash outflow. The LCR, consequently, has increased demand for such assets of which bank reserves and treasury securities are considered the top tier. When the IOER rate > treasury repo rates, the LCR created additional demand for reservers relative to treasuries. If, however, IOER rate <  treasury repo rates the additional reserve demand will disappear and further hasten the demise of the floor system. 

The question, then, is will the treasury bill yields continue to stay above the IOER rate? It certainly seems possible with President Trumps budget deficits. Only time will tell. 

P.S. I have a working paper on the Fed's floor system. I am beginning to wonder if it will be outdated before it gets published.

P.P.S. I see that George Selgin makes the same point near the end of this post.

1To be clear, banks cannot control total reserves, but they can control the form of the reserves. That is, banks can choose to hold excess reserves or invest in other assets like treasuries and loans that, in the aggregate, would lead to a rise in required reserves and a fall in excess reserves.

Update: One implicit assumption in my analysis is that banks are price takers, not price makers, in the overnight market. If one takes the H8 data series "fed funds sold and reverse repos" and divides it by the repo market as calculated by this New York Fed study (and updated to a more current expansion factor based on an exchange with one of the authors), one gets an average of 10 percent for the 2008:Q4-2018:Q2. Banks have been a small part of the overnight market during the Fed's floor system.

Update II: After more reflection, I am having doubts about my assumption of banks being price takers in the overnight market. I think my calculations of bank share of the repo market supports this contention, but it is hard to reconcile with the reality that overnight market rates followed movements in the IOER rate. On the other hand, if banks are able to move overnight markets then why did they fail to completely eliminate the IOER spread over comparable short-term interest for most of the past decade? 

Navigating by the Stars and Steadying the Ship Speed

I have a new article over at The Bridge where I piggyback off of Jay Powell's recent speech about the challenges of the Fed 'navigating' by the stars of  r*, u*, and y*. His concern is how to use them when they seem to be moving a lot:
Navigating by the stars can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly… the FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides.
Here is a chart I made for the piece that did not make the final cut. It shows the changing range of FOMC estimates for u* and the actual unemployment rate (u). I also added some red-lettered commentary on the chart to highlight the varying levels of FOMC concern about the gap between u and u*:


Okay, so what is the FOMC to do with all the uncertainty surrounding the navigating stars? I recommend in the article that the Fed cross check their navigational indicators by looking at nominal GDP (NGDP) relative to a benchmark growth path for it.  This growth path can roughly be thought of as the neutral level of NGDP and I show how to construct two versions of it in a recent note: a sticky forecast NGDP level and a full-employment NGDP level as seen below:


Taking percent deviations of these growth paths from the actual NGDP level gives us the following Nominal GDP gaps:


Going back to Fed Chair Powell's ship navigation analogy, looking at the NGDP gap is akin to monitoring the speed of the ship. If the NGDP gap is zero, then the ship is maintaining a steady and appropriate speed. According to the chart above, the ship is either a bit too slow per the sticky forecast measure or just about right with the full-employment measure. My preferred measure is the sticky forecast NGDP gap, so if I were Chair Powell I would currently err on the side of fewer rate hikes than more.

The main point of my note is to show how one can use NGDP as a practical way to cross check standard monetary policy indicators. I provide some other measures in the note such as a NGDP-based Taylor rule that does not rely on any of the navigational stars. I also show how a McCallum rule (which also is based on NGDP) can still be used if the monetary base is properly measured. 

Wednesday, July 25, 2018

Closer to OCA Criteria: Eurozone or Dollarzone?

This is a quick follow-up to my recent article on the Eurozone. There I argued for more integration or separation in the Eurozone since ECB monetary policy is pushing regional economies further apart rather than together. I showed a version of the below chart in the article to illustrate this point:


ECB policy--and its response to the various shocks hitting the Eurozone--has effectively kept nominal demand growth in the core economies fairly stable while pulling it down in the periphery. This divergence suggest the Eurozone is quite far from being an optimal currency area (OCA). 

Someone asked on twitter what the chart would look like for the United States. So I made a similar chart that compares the top twenty states (ranked in terms of GDP per capita) to the bottom twenty:


While both regions are below their pre-crisis trend paths, Fed policy has at least been consistent in how it has affected nominal income growth in both rich and poor states. So the Fed beats the ECB on consistency, at least! 

Moreover, this outcome suggests there are more effective regional shocks absorbers in the United States that make the dollar zone more of an OCA than the Eurozone. That is, even if Fed policy is not optimal for all regions of the United States this is less of a problem than in Europe because the regions can better handle bad monetary policy via fiscal transfers, labor mobility, safer retail banking system, flexible prices, etc. For more on these shock absorbers see my other recent post on this topic.

Will Australia Be the First Country to Try NGDPLT?

There is a new Brookings paper by Warwick J. McKibbin and Augustus J. Panton titled Twenty-five Years of InflationTargeting in Australia: Are There Better Alternatives for the Next 25Years? Here is how they answer the question in their title:
This paper surveys alternative monetary frameworks and evaluates whether the current inflation targeting framework followed by the RBA for the past 25 years is likely to be the most appropriate framework for the next 25 years. While flexible inflation targeting has appeared to work well in Australia in the past decades, the nature of future shocks suggests that some form of nominal income targeting is worth considering as an evolutionary change in Australia’s framework for monetary policy.
Put differently, this Brookings paper argues that inflation targeting is a monetary regime whose time has come and gone. I completely agree

What is interesting, though, is that they are making this case for Australia whose economy has had a remarkable 27-year expansion. This is attributable, in part, to the Reserve Bank of Australia (RBA) who has successfully navigated through numerous shocks including the bursting of the tech bubble, the global financial crisis, commodity price collapse, and periodic bouts of China panic. The last time there was a recession in Australia it was in the early 1990s.

Along these lines, it is worth highlighting again that Australia, if any country, should have experienced a so-called 'balance sheet' recession in 2008-2009. It had a housing boom and a surge in household debt that exceeded the United States as seen below. It also faced a large negative commodity price shock in late 2008-early 2009. And yet there was no Great Recession in Australia. 


Australia, in short, was the balance sheet recession that never happened. The reason the Australian economy faired so well is because is because the RBA never hit the ZLB and, in so doing, kept aggregate nominal income on it trend growth path. Thus, there was less financial stress created for nominal debt contracts holders. So, unlike the Fed and the ECB, the RBA saw its nominal GDP stay roughly on course during and right after the global financial crisis. And that made all the difference in the world.

This gets us back to the new Brookings paper. So why do the authors argue for an explicit nominal GDP level target (NGDPLT) when the RBA's inflation target has been implicitly doing the same? The authors argue that going forward the biggest shocks likely to hit the Australian economy will be large supply shocks:
There are three main areas where future shocks can be anticipated. The first is climate change and climate policy responses. The second is the emergence of a fourth industrial revolution or a new Renaissance due to the rapid adoption of new technologies such as artificial intelligence. The third is the growth of larger emerging economies into the world economy following the experience of China.
The authors note an explicit NGDPLT is better suited to handle such shocks and thus their call for the RBA to adopt it. I agree completely on the supply shock motivation. I would, however, submit another reason for the RBA to explicitly adopt a NGDPLT in Australia. 

The RBA in the past has done a great job keeping nominal income on its trend growth path. However, in recent years it has actually slipped a bit and now it is now below trend. An flexible inflation target, apparently, is not enough to always keep aggregate demand growth stable. Moving to an explicit NGDPLT would put the focus on this emerging gap and force the RBA to take corrective actions. 


New Zealand was the first country to adopt inflation targeting. It was the avant-garde of this new monetary regime in the early 1990s. So maybe a smaller economy like Australia needs to do  same with NGDPLT before other larger economies try it. Here is hoping the RBA is willing to try it. 

Monday, July 16, 2018

The Future of the Eurozone

So we are live at NRO discussing the future of the Eurozone:
Albert Einstein is rumored to have quipped that doing the same thing over and over again and expecting different results is the definition of insanity. If he were alive today, Einstein might say this is the definition of some key euro-zone policymakers.
There I argue hard choices have to made in the Eurozone: further integrate or separate.
So where does this leave the euro zone? For now, euro-zone officials are still kicking the can down the road, but at some point they will face a fork. One path will force further integration upon the euro zone, along the lines of Emmanuel Macron’s proposal and better ECB monetary policy. The other path will lead to the separation of the euro zone. As Ashoka Mody shows in his new book, the 20-year history of the euro zone suggests the latter path is more likely. Breaking up the euro zone, though, need not end the EU. As suggested by Ambrose Evans-Pritchard and Ramesh Ponnuru, the periphery could keep using the euro while the core could exit and adopt their own currency: Call it the Deutschmark 2.0. This approach would minimize the financial stress from the breakup of the currency union.
One chart that did not make it into the final article is below showing the OCA theory. It shows that if a region’s business cycle is similar to the currency union or if there are sufficient shock absorbers in place, or some combination of the two exists, then it makes sense for the region to be in the currency union. If a regional economy does not meet these criteria, like Italy, then it would be inside the OCA frontier curve in the figure and should not join the currency union. 

My conclusion in the article effectively says that Eurozone officials are not willing or able to make the changes needed to push countries like Italy beyond the OCA frontier. Ashoka Mody makes a convincing case in his book that, if anything, the Eurozone is pushing countries like Italy farther inside, away from the OCA frontier. Better to address the inherent tensions of the Eurozone now than to keep kicking the can down the road. 



Tuesday, June 19, 2018

The Treasury Yield Curve Blues


The Fed needs to start worrying more about the flattening treasury yield curve.  Bloomberg is reporting that bond traders are getting ready for a yield curve inversion as soon as next week.  One fixed income manager quoted in the article had this to say: 
If the Fed decides to move more this year, I think it’s inevitable that the curve inverts and I think it will be a mistake,” said Colin Robertson, managing director of fixed income at Northern Trust Asset Management... He sees greater than a 50 percent chance of the 2- to 10-year spread inverting if the Fed raises rates once more this year, and if the central bank follows its projections and hikes twice more, Robertson sees inversion as a lock.
Here is what the 10-year minus 2-year spread currently looks like: 


The yield curve spread is definitely heading down, but is it truly on the cusp of an inversion? It is hard to know for sure, but there are two big clues suggesting the answer is yes. First, as noted by Robert Burgess, yield curve inversions are already happening overseas:
For much of the past year or so, investors and economists have anxiously watched the relentless shrinkage of the gap between short- and long-term U.S. bond yields to the narrowest levels since 2007. After all, an inversion —  when long-term yields fall below short term ones — preceded each of the last seven recessions. But while everyone has been so focused on the U.S, they seemed to have missed the global yield-curve inversion.   
Within the past two months, the yield on an ICE Bank of America index of government bonds due in seven to 10 years has fallen below the yield on an index of bonds due in one to three years for the first time since the first half of 2007. The strategists at JPMorgan Chase & Co. said they were seeing the same thing in indexes they manage. Although the U.S. economy is in solid shape, there have been signs of weakness in the euro zone, China and emerging markets over the past month.
Given the global integration of capital markets, it is not hard to imagine the overseas inversions working their way into the U.S. treasury yield curve. Some Fed officials are paying close attention to this possibility like Atlanta Fed President Raphael Bostic:
“I have had extended conversations with my colleagues about a flattening yield curve” and the risks of it inverting, he said at a moderated forum in Augusta, Georgia on Wednesday. “We are aware of it. So it is my job to make sure that doesn’t happen... Hopefully we won’t get to that inversion.”
That is good to know. Unfortunately, others on the FOMC are more sanguine about the flattening yield curve. From the May FOMC meeting minutes we learn the following:
[P]articipants also discussed the recent flatter profile of the term structure of interest rates. Participants pointed to a number of factors contributing to the flattening of the yield curve, including the expected gradual rise of the federal funds rate (and) the downward pressure on term premiums... A few participants noted that such factors could make the slope of the yield curve a less reliable signal of future economic activity. 
So not everyone at the FOMC is equally concerned about an inversion. This complacency may be one reason why the FOMC, as a whole, is predicting an inverted yield curve of its own making

The FOMC currently plans to have its short-term interest rate target range at 3.00% - 3.25% by the end of the 2019. Meanwhile the 10-year treasury yield has been bouncing between 2.80% and 3.00%, close to FOMC's long-run federal funds rate estimate of 2.90%. The FOMC, in other words, sees itself raising its short-term interest rate target such that the yield curve spread will become negative or inverted over the course of the next year and a half. This prediction is our second big clue that the yield curve is likely to invert.

But no big deal, says the FOMC, because this time it is different. Yes, the FOMC will be raising short-term interest rates, but the term premium is the real villain in this story. For it will not allow long-term interest rates to rise above short-term interest rates. So despite appearances, the term premium will be the real cause of the inversion per the FOMC. 

Former Fed chair Ben Bernanke similarly thought it would be different back in 2006. He said not to worry about the flatting yield curve at that time. Bernanke pointed to the term premium as the culprit even as the Fed was raising its interest rate target. But the standard yield curve recession predictions were borne out and we got the Great Recession. This recent experience should give today's FOMC pause. 

Moreover, as Michael Bauer and Thomas Mertens recently show, a negative yield-curve spread still does an amazing job predicting recessions. Consequently, the FOMC should not be aiming to raise short-term interest rates above long-term interest rates. The last thing the Fed should want to do is sing the treasury yield curve blues.  Better to play it safe than to risk choking off the expansion.

Update: I got into a twitter conversation regarding this post and my critique of Ben Bernanke's speech in 2006. As a result, I constructed the following figure using the New York Fed's estimates of term premiums. It shows the 10 year minus 1 year treasury spread decomposed into (1) an expected rate path spread and (2) a term premium spread. These two component add up to the overall spread.

The figure reveals that while Bernanke was right about a declining term premium in 2006 it was also the case that the expected path of short-term rates was declining. It was signaling recession. What this implies for today is that the FOMC should tread cautiously in interpreting the flattening of the yield curve. There may be more to the story than term premiums.

Friday, June 15, 2018

The People's Fed Chair

Ever since his confirmation hearings, Fed Chair Jay Powell has struck me as an ordinary, plainspoken person. This week I was reminded of this trait at his FOMC press conference and tweeted this statement:


This impression is consistent with reports from last year when he was being considered for Fed chair:
[F]riends and former colleagues of Powell's describe him as “annoyingly normal.” He lives in Chevy Chase, Md., and often rides his bike about eight miles from home to the Fed. He doesn't drink much, plays golf and the guitar, and has an odd ability to repeat people's sentences backward to them, a quirk former colleagues say is a reminder of his smarts — and how closely he listens.
I bring this up because Jeanna Smialek of Bloomberg has a new article that nicely captures this feature of Jay Powell. The title of her piece is Powell Styles Himself a Fed Chairman for the People. Here are some excerpts:
Alan Greenspan famously said he’d mastered the art of mumbling “with great incoherence” as Federal Reserve chairman. Jerome Powell is attempting the opposite approach. 
“Because monetary policy affects everyone, I want to start with a plain English summary of how the economy is doing, what my colleagues and I at the Federal Reserve are trying to do and why,” Powell, who took the helm at the U.S. central bank in February, said at the outset of his June post-meeting press conference on Wednesday. 
[...] 
He’s a non-economist who uses concise, simple terms -- growth is “great” and “there’s a lot to like” about low unemployment. He downplays the importance of modeled relationships and emphasizes the data in hand. He’s adding more press conferences, and the Federal Open Market Committee has already shortened its post-meeting statement under his watch.
It is a great article, read the whole thing. To be fair, though, previous Fed chairs would also consider themselves the people's Fed chair. But I do think Jay Powell brings a unique tool set to the Fed in terms of his interpersonal communication skills. I suspect these "soft" skills will prove very valuable going forward, especially as the Fed continues to navigate the politics of normalizing monetary policy. 

P.S. If Jay Powell wants to step up his 'Fed chairman for the people' game, then he might consider optimal monetary policy for the masses.

Update: Tate Lacey makes a similar point

Wednesday, June 13, 2018

Optimal Monetary Policy For the Masses: the James Bullard and Larry Summers View

James Bullard and Ricardo DiCecio have a new paper where they model wealth, income, and consumption inequality.  They also incorporate fixed-price nominal debt contracts.  They then derive the optimal monetary policy for the masses in such a model. Here is what they find:



This paper builds upon the risk-sharing view of NGDP targeting. The basic idea is that in a world of fixed-price nominal debt contracts (i.e. the real world), a NGDP level target provides better risk sharing among creditors and debtors against economic shocks than does a price stability target.  

This is because a NGDP level target makes inflation countercyclical. During recessions, inflation rises and causes creditors to bear some of the unexpected pain by lowering the real debt payments they receive from debtors. During booms, inflation falls and allows creditors to share in some of the unexpected gain by increasing the real debt payments they receive from debtors. Debtors, in other words, bear less risk during recessions but also share unexpected gains during expansions. 

NGDP level targeting, in other words, causes a fixed-price nominal debt world to look and feel a lot like an equity-world. In a similar spirit, some observers have called for a risk-sharing mortgages as a way to avoid another Great Recession. The point of this paper is that the same benefit that such risk-sharing mortgages would bring can be had by having a central bank target the growth path of NGDP.

Larry Summers is also worried about the masses and is therefore rethinking the Fed's 2 percent inflation target
My conclusion, therefore, is that in our current framework the economy is singularly brittle. We do not have a basis for assuming that monetary policy will be able, as rapidly as necessary, to lift us out of the next recession. This has a substantial cost likely in the range of at least $1 trillion over the next decade. This suggests the suboptimality of our current monetary policy framework... 
If I had to choose one framework today, I would choose a nominal GDP target of 5 to 6 percent. And I would make that choice for two reasons. First, it would attenuate the issues around explicitly announcing a higher inflation target, which I think are a little bit problematic on political economy grounds. Second, a nominal GDP target has an additional advantage in its implicit response to changing conditions. Arithmetically a nominal GDP target has the property that the expected rate of inflation rises as the expected real growth in GDP declines. This is desirable. If growth in underlying real GDP declines, neutral real interest rates are likely to decline as well. In this case allowing higher inflation to make possible even more negative real rates reduces the risk of policy impotence.
Sounds good to me, but are there any real world examples of NGDP level targeting? Probably the best example of a country following something like a NGDP level target has been Israel over the past decade. The Bank of Israel officially targets an inflation range of 1-3 percent, but in practice has made inflation so countercyclical that effectively it has been doing a NGDP level target. The figure below shows this countercyclical nature using the GDP deflator:


Note that both inflation overshooting and undershooting have been tolerated. The GDP deflator has been as hight as 6 percent and almost as low as 1 percent. Overall, its inflation rate has averaged about 2 percent, right in the center of the 1-3 percent target range. So this approach provides both a nominal anchor and short-run inflation flexibility for Israel.  

As consequence of making Israeli inflation countercyclical, the growth path of NGDP has been kept stable: 


This is what monetary policy for the masses looks like!

Monday, June 11, 2018

A Tale of Three Nominal GDP Growth Paths

Check out the figure below. It has nominal GDP plotted for three countries, normalized to 100 in 2007. The first country (black line) has kept nominal GDP on  a stable growth path over the entire period. The second country (red line) saw its nominal GDP growth path permanently decline in 2008-2009 but has since stabilized its growth rate.  The third country (blue line) had its nominal GDP growth path collapse and has only recently seen it grow past its its 2008 peak value. 


So we see three very different paths of a nominal variable that should be controlled by monetary authorities over long periods, like that depicted in the chart. Consequently, not only are we seeing a tale of three different nominal GDP growth paths, we are also see a tale of three very different central banks policies. 

Can you guess what countries are represented by the three different lines? 

The Sovereign Money Blues

The Sovereign Money Referendum 
Sovereign banking will not happen in Switzerland. The referendum to end fractional reserve banking and turn all money creation over to the Swiss National Bank (SNB) central bank failed by a wide margin on Sunday. This rejection is not a surprising result, given the polls going into the vote. There never was much chance the so-called Vollgeld plan would would pass. 

Still, the sovereign money referendum was useful in that it generated new discussions on the benefits and costs of opening up the central bank's balance sheet to the public. In the United States, there had already been some debate surrounding the opening up of the Fed's balance sheet to non-bank financial firms in response to the financial crisis. Depending on who you asked, this "creeping nationalization" of financial intermediation was either concerning or a step in the right direction toward safer money. The Swiss vote was good, therefore, in that it further fleshed out some of the arguments for and against central banks becoming more like a regular bank.

Among those arguing for sovereign money or something like it were Martin Wolf, Ryan Avent, Matthew Klein, Martin Sandbu, Morgan Ricks, and the positive money folks. Some of those arguing against it include Carolyn Sissoko, Jo MichellSri Thiruvadanthai, Cullen RocheScott Sumner, and George Selgin.

The appeal of deposit accounts for all at the central bank is understandable. They would be safe and end private bank runs. But sovereign money is not costless. It would bump up against some big problems that sovereign money advocates either ignore or dismiss too easily, as noted by the critics above. In this post, I want to highlight three that I think are especially under appreciated : the knowledge problem, the public choice problem, the tradeoff problem.

The Knowledge Problem
The knowledge problem, as fist noted by F.A. Hayek, is that the information needed for successful centralized economic planning is distributed widely among households and firms. It is knowledge a central planning authority needs but cannot obtain. In this context, it is the central banks inability to know where and how much money creation is needed.

Money, currently, is the byproduct of many decentralized decisions among a large number of borrowers and lenders in very different circumstances. Specifically, banks create money through loans to businesses and households in various locations based on local, idiosyncratic economic conditions. To believe this complex process could be easily replaced by a central bank committee deciding how much money should be created is incredulous.

But it gets worse. Under a sovereign money regime,  estimating the amount of money needed would actually become more complicated. This is because financial firms wanting to originate loans would need 100% reserve backing. Money, in other words, would be needed for both transaction purposes and for loan-backing purposes. So not only would the central bank need to know where and how much transaction money demand there was, it would also have to know where and how much loan-driven demand for money there was.  It would be very easy for central banks to get monetary policy wrong.

Central bankers, in short, would need near omniscience to do their job well in a sovereign money regime. Given these Herculean requirements, it is easy to understand why SNB officials were so adamantly opposed to the sovereign money proposal.

The Pubic Choice Problem
Public choice economics tells us that the fallible people who often cause problems in the private banking system are the same fallible people that work at central banks. They may mean well, but like all humans they too desire to make themselves better off and respond to incentives, sometimes unconsciously. One can, for example, look to growing Fed budgets or the Fed's influence on research as potential examples of public choice economics at work.

Now take a central bank and turn it into the sole creator of money, as sovereign money advocates desire, and see what happens to central banker incentives. This development would mean a massive expansion of the central bank's balance sheet and complete control over money creation. If, for example, the Fed opened up its balance sheet to all current retail holders of money balances--the M2 money supply--its balance sheet would expand to about $14 trillion. And once the Fed opened up its balance sheet to retail investors, it probably would not stop there. For if financial firms and households can have deposit accounts at the Fed, why not non-financial firms too? Central bank balance sheets would become super sized.

With such large balance sheets and the sole power to determine who gets money, central bankers would find it hard not to be corrupted. As Lord Acton famously said, "Power corrupts and absolute power corrupts absolutely."  Many sovereign money fans fail to grapple with this issue. They simply assume that central bankers, with all their new power, will act like saints rather than sinners. This is an incredibly naive understanding of humanity. If private bankers can behave badly, as many sovereign money advocates note, why not central bankers when given vast power?

The Tradeoff Problem
The above concerns imply monetary policy would actually get harder under a sovereign money regime. Yes, central bankers would have more control over the money supply, but they also would need near omniscience and a pure heart to get it right. It is likely, in other words, that central banking would become more destabilizing in a sovereign money regime. 

This third concern becomes even more pronounced if central banks continue to lend while opening up their balance sheets to the public. To be clear, sovereign money advocates want to avoid this very outcome--they want to separate credit creation from money creation--but it seems unlikely that central banks would cease lending in practice due to public choice reasons. If so, then, it is easy to see central banks with their now open balance sheets also expanding their financial intermediation activities and becoming the mother of all too-big-to-fail (TBTF) institutions. 

Central banks, in short, are more likely to make mistakes in a sovereign money regime than in the current system. Whether that means the wrong monetary policy or turning the central bank into a TBTF institution, the temptation will be great to paper over such mistakes with higher inflation. If so, society will have traded private bank run risk for central bank run (i.e. velocity) risk.  That is, we would be trading off running on private bank accounts for running on central bank money because of higher inflation fears. This tradeoff is depicted in the figure below.


This understanding belies a central claim made sovereign money advocates: there can be debt-free money creation. Yes, it is true a government can do helicopter drops, such as putting money into the public's deposit accounts at the central bank. But even these are implicitly a liability of the government if it cares about price stability. For it implies a commitment by the government to use real future resources—via future taxes—to keep inflation stable. This money creation, then, is a debt on future generations. 

Conclusion
For the reasons laid out above, I am not convinced that a sovereign money regime is the panacea many make it out to be. Yes, our banking system is far from ideal, but going down the sovereign money path is a step in the wrong direction.

Update: Morgan Ricks responds to my post here

PS. Brian Blackstone of the Wall Street Journal and I discuss the Swiss referendum in this week's episode of the Macro Musings podcast.  Listen below or via your favorite podcast app.



PPS. Frances Coppola makes similar observations in earlier posts on 100 percent reserve banking. 

Tuesday, May 22, 2018

What Can Argentina Teach Us about the Phillips Curve?

In the United States, there has been existential angst over Phillips curves for the past few years. Fed officials and other observers have been engaged in deep soul searching as they try to reconcile a falling unemployment rate with stubbornly low inflation. The Phillips curve says this development should not be happening--inflation should rise as the economy nears full employment. And yet, it has been happening for several years. 

Various attempts have been made to reconcile the apparent breakdown in the Phillips curve relationship. Some, like Joe Gagnon, say there is a non-linear relationship that comes into play when inflation is really low. Others, like Adam Ozimek and Ernie Tedeschi claim there is no Phillips curve mystery if one simply uses the correct measure of slack: the prime-age employment rate. Another group, including Paul Krugman, points to monopsony power as explaining the breakdown in the relationship. Still others point to a variation of Milton Friedman's thermostat argument: the Fed has been so successful at targeting inflation it has eliminated any observed relationship between inflation and slack. Nick Rowe puts it this way:
[I]nflation targeting made inflation stickier than it used to be. Which means that inflation targeting became a victim of its own success. By making inflation sticky at 2%, it destroyed the very signal of deficient-demand recessions that monetary policy was supposed to respond to. The thermostat destroyed its own negative feedback mechanism.
Minneapolis Fed President Neel Kashkari makes a similar argument in the Wall Street today.  It is also the implication of this Cecchetti et al. (2017) paper that made a splash last year. This view makes the most sense to me.

To be clear, I prefer thinking of inflation from a money supply-money demand framework along the lines of David Andolfatto and Josh Hendrickson. But if one is determined to approach inflation from a Phillips curve perspective, I see the thermostat view as the most convincing explanation for the breakdown in the U.S. Phillips curve relationship. 

Paul Krugman recently suggested we look elsewhere to get further insight on the Phillips curve. He turned to Spain which appears to show a strong Phillips curve relationship. This choice of country, however, is not a clean one since its monetary policy is set externally by the ECB. It is not obvious that we would see this relationship persist if Spain set its own monetary policy. Spain, in short, does not help us better understand the U.S. experience.

One country that might be useful is Argentina, at least if we look at the non-hyperinflation years. It has its own central bank, the BCRA, and it has periods of instability that provide data not clouded by Milton Friemdman's thermostat. Interestingly, since 2010 the BCRA has tolerated double digit inflation in Argentina and currently inflation is running near 25 percent. This run of inflation has been above the central bank's inflation target of 8-12 percent so the BCRA conveniently changed its inflation target this year to 15 percent. It might interesting to see what this run of high inflation does to the Phillips curve. 

I plotted the Argentine Phillips curve below using annual data from the IMF WEO database and Focus Economics for this period of high inflation. Most of my data comes from the former source, but for the years 2015 and 2016 the IMF does not report the inflation rate presumably because of questions about the reliability of the data. Focus Economics does provide data for those missing years. The red line below shows the estimated Phillips curve relationship leaving out the questionable 2015 and 2016 observations while the blue line shows the relationship using all the all the observations.



Yikes, we got an upward slopping Phillips curve! This is a small sample, but it is consistent with notion that inflation running too high can cause problems on the real side of the economy. We should dread this Phillips curve. 

Now to be fair, if I take the IMF data back further to earliest time where there was no hyperinflation (defined as inflation greater than 50%) we get the following figure:


Now we see a more traditional-looking Phillips curve for the period 1992-2009 (excluding the 2002 outlier, the year Argentina broke the link with the dollar) of this sample. It is depicted by the black line. Most of the observations in this earlier period have inflation lower than 10 percent. That may explain why it looks more normal. For comparison, the 2010-2018 period is again highlighted by blue. 

If we plot a Phillips curve relationship over the entire sample we get the following figure. 


The takeaway, if there is any, from these Argentine figures is that a standard-looking Phillips curve may require inflation be less than 10 percent and there be periods of instability so that Milton Friedman's thermostat is not working. But if the thermostat is not working, then, the central bank is not doing its job. The Phillips curve, in other words, may never be very informative for places where central bankers are doing a great job anchoring inflation. The United States is arguably one such place. If that is the case,  Fed officials might want to try a different approach to understanding inflation. 

Thursday, May 10, 2018

The U.S. Mortgage Market: Chart Edition

Today, I interviewed Nick Timiraos of the Wall Street Journal for the Macro Musing podcast. He is on the Fed beat now, but covered the GSEs during and after the financial crisis for the paper. Consequently, he has an encyclopedic knowledge of Fannie Mae, Freddie Mac, and the other GSEs. His knowledge and experience were the basis of our conversation today. It was a fun show and should be out in about a month.

I wanted to share some figures I collected on the U.S. mortgage market in preparation for the show. They come from an amazing monthly report on housing from the Urban Institute called Housing Finance at a Glance. These figures provide a peak into my conversation with Nick.

Consider first  the historical share of mortgage debt outstanding by type of institution. This chart is actually mine from a few years ago. There are three key takeaways from it. First, the GSEs gain most of their market share in the wake of the S&L crisis. Second, the GSEs actually lose market share to the private label security (PLS) providers during the housing boom period. These PLS providers--the red line in the figure below--gained market share during this time by tapping into the Alt-A and subprime mortgage market. Eventually, the GSEs followed suit, but its was the private label security providers who went there first and did most of the damage.  Third, the GSEs  gain market share back as the PLS supply folded in the crisis. 


Next, if we look just at the share of securitized mortgages--which today makes up about 2/3 of all mortgages today--we see the dominance of the GSEs over PLS today. This can be seen in the figure below from the Urban Institute report. 


The Urban Institute also provides the dollar amount of the mortgage market going to the GSEs and other sectors. The remarkable decline in PLS is evident here too:


 The Urban Institute also provides details on the types and sources of securitized markets:


Finally, for those curious, the Urban Institute has a nice chart summarizing the total value and equity of the U.S. housing market. This chart reports that the U.S. housing equity turned positive again in 2013 and currently stands at $15.2 trillion compared to household debt level of $10.6 trillion. Happy days are here again for U.S. housing.


Again, these charts are just a small part of my conversation with Nick. It should be out in a month or so. In the meantime check out the entire Urban Institute report.