Allan Meltzer's Life Work

The Hoover Press and the Mercatus Center have just released a new book on Allan Meltzer's contributions to economics. The book is comprised of papers that were presented at a 2018 conference commemorating his work on the monetary transmission mechanism, the history of the Fed, and his more general work on public policy. Below is the table of contents for the book:

I happen to be the editor of the book and, as seen above, have two chapters in it: the introductory chapter and a chapter based on my podcast interview with Allan Meltzer.  So please check it out.

P.S. We had an event last week at the AEI highlighting the release of the book. It was hosted by Desmond Lachman and featured a panel discussion including John Taylor, George Selgin, Ed Nelson, and myself. I got to speculate on what Allan Meltzer would think of (1) the below-target inflation of the past decade and (2) the Fed's plans to incorporate 'make-up' policy in their monetary policy framework. You can see my comments in the video below:

New Policy Brief on NGDPLT

I have a new policy brief out on NGDP level targeting. The article summarizes in an accessible manner the key arguments for NGDP level targeting while also addressing the main concerns of this approach. The policy brief also shows how one could implement a NGDP level target in practice. The article comes out now as part of the conversation the Fed is having this year in its review of monetary policy. Please check it out. 

Related Links

The Financial Stability Case for NGDP Targeting

NGDP Targeting and the Taylor Rule on An Even Playing Field

The Repo Man Cometh

Source

The repo market hit some road bumps last week. Trading pressures in this key funding market pushed repo interest rates well above the Fed's target interest rate range. This development caused some observers to worry that it was a 2008-type run on the repo market all over again. Bill Dudley and others, however, noted this was a technical blip, not the beginning of a financial crisis. Moreover it was something the Fed could easily fix with an old fashion tool, temporary open market operations, even if the Fed got off to a slow start doing so last week. 

There have been great Twitter discussions and explanations of this repo market stress, including ones from Nathan Tankus, Bauhinia Capital, Guy LeBas, and George Selgin. There are also have been many good pieces from journalists and think tanks. Here, I want to echo a few of their points and speak to where I hope this experience takes the Fed's operating system in the long run.  Let's begin with what happened.

Stumbling Back into a Corridor System

The standard explanation for what happened has two parts. First, the Fed's quantitative tightening (QT) put the U.S. banking system close to the point of reserve scarcity given the new post-crisis regulations. Second, the Treasury recently auctioned off new securities and at the same time collected corporate tax receipts. These two developments further reduced bank reserves and pushed the banking system back into a reserve-scarce environment. Put differently, the Fed unintentionally stumbled from its floor operating system of the past decade back into a corridor operating system, the framework it intentionally left in late 2008.  

This story can be illustrated using a simple supply and demand model of bank reserves. Using this framework, the figure below on the left shows what the Fed's operating system looked like before the fall of 2008.  This was a simpler time when the Fed kept minimal reserves and banks traded for them on the interbank market. The Fed would conduct open market operations (OMOs) to adjust the supply of bank reserves so that a particular interest rate target was hit. Graphically, this meant moving the red line (reserve supply) along the downward slopping part of the blue line (reserve demand). Changes in the supply of reserves directly influenced the interest rate target. Monetary policy and money were directly linked.

This changed in late 2008 when the Fed expanded the supply of reserve such that the reserves were now on the flat (perfectly elastic) portion of the demand curve. The Fed's floor operating system had emerged. This can be seen below in the figure on the right.  Here, the quantity of reserves could change with no effect on the interest rate target. Monetary policy was now divorced from money. The Fed, in other words, could adjust its balance sheet independent of the stance of monetary policy. This was the appeal of the floor system. 

The Fed's floor system got further refined after the crisis with changes in reserve demand brought about by Dodd-Frank and Basel III. New regulations likes the leverage coverage ratio (LCR), supplemental liquidity ratio (SLR), and resolution planning for global systematically important banks (G-SIBs) increased demand for reserves. This can be seen below with the shifting out of the reserve demand curve (blue line) in the figure on the left. 

Finally, the Fed reduced bank reserves via the shrinking of its balance sheet or QT from 2017 to 2019. The goal was to keep the banking system on the flat part of the reserve demand curve, but with the lowest level of reserves possible. No one knew for sure where that would be, but if it were passed it would be made evident by overnight interest rates rising up. That is exactly what happened this past week with the Treasury sales and collection of corporate tax receipts and can be seen below in the figure to the right. The Fed's temporary OMO's is an attempt by the Fed to offset these recent Treasury actions and push the banking system back onto the flat portion of the demand curve. 

What is the Fed Doing Now?

The Fed is now engaging in temporary open market operations (OMOs) via overnight and term repos to bring the repo rate in line with its interest rate target. Some are calling this a bailout of the banking system, but these responses are what normally happens in a corridor system. It is what the Bank of Canada currently does with its corridor system and it is what the Fed did from the 1920s up until 2008. This is not a bailout, but a temporary provision of liquidity to the banking system. 

The figure below shows that $75 billion of overnight repos this past week are relatively small as a percent of the Fed's total assets. At 1.95% of total assets, they are small compared to the temporary OMOs in the decades leading up to the crisis. If we add in the additional $90 billion in term repo to be disbursed this week, it still is about where the temporary OMOs typically were as a percent of total assets prior to 2008. 

The most striking part of the figure, if anything, is the absence of temporary OMOs over the past decade under the floor system. This absence of repo activity by the Fed apparently has led many observers to forget the Fed engaged in this type of activity for most of its history. Maybe it also led to some repo atrophy at the New York Fed as discussed below. 

Why Did the Fed Stumble? 

So, why did the Fed not see this Treasury-related reduction in bank reserves coming? It should not have been a surprise and the fact that it was has some questioning the competence of the New York Fed. Some are even wondering if the absence of Simon Potter, the former head of the New York Fed's Market Group, was a reason for the misstep. 

This criticism seems off to me. Yes, Simon Potter's presence would have been nice this past week, but the Market Group is more than one person. There are other talented people in this group who are also well informed. I also find it a reach to blame the market inexperience of New York Fed President John Williams. This too puts too much weight on one person and ignores the collective wisdom of the New York Fed staff. 

I think a simpler explanation is that a floor system is just hard to run in the United States. First, no one knew for sure when the reserve scarcity point would hit because no one knew exactly how the regulations would manifest themselves in each bank. Even if they did know this regulatory part, they still would not know for certain if they had hit reserve scarcity until overnight rates shot up. 

Second, the New York Fed's slow response to the repo market stress might itself also be the fault of the floor system. The floor system has meant no need for temporary OMOs for almost a decade. Maybe the New York Fed was simply out of practice--no repo muscle memory--and caught off guard. 

Third, as noted by George Selgin, the floor system encourages the Treasury to use its TGA balance at the Fed. For a fixed Fed balance sheet, this growth in the TGA requires a reduction in bank reserves. If the Treasury had instead used the TT&L accounts this could have been avoided. But the floor system discourages their use. Maybe the Fed's choice of a floor system needs a rethink. 

Longterm Solution for the Fed

This repo market bump in the road should encourage the Fed to rethink the longterm future of its operating system. The floor system was supposed to bring greater interest rate control to the Fed, but this experience suggest that this is not the case. Moreover, as I noted in a previous post, the Bank of Canada appears to have better interest rate control with its symmetric corridor system. This, in my view, should be the longrun destination for the Fed's operating system. 

As George Selgin notes, the Fed's adoption of a standing repo facility could be a step in that direction.  There will also need to be tweaks to the regulatory front as well. The sooner we start this journey the better. 

The Repo Man Cometh

Some commentators worry these funding problems will continue to plague the Fed's floor system in the future given the Fed's desire to keep its balance sheet as small as possible while still being on the flat portion of the reserve demand curve. Since it is hard to know exactly where that sweet spot is on the curve, I agree that we may see strains again in the repo market. Eventually, this discomfort should move us toward adopting the standing repo facility, but until that time get used to seeing more temporary OMOs and Bill Dudley explainers. The Fed's repo man will come again.

P.S. There was some discussion as to who was holding the remaining reserves. This chart partly answers that question.

Source: FRED Data

Some Assorted Macro Musings

Dollar Dominance

I have been part of a dollar dominance conversation for the past few weeks. It started with my NRO article, discussions on the topic at the Jackson Hole conference, and a follow-up blog post. Later, there were twitter conversations, an interview on Bloomberg TV, and several podcast recordings. This all culminated in an article I wrote for The Bridge that summarizes what I see as the main issues of dollar dominance and what realistically can be done about it. Check it out and also see the follow-up twitter thread I provided that documents some of the claims made in the piece.

Paul Volcker is What the Public Wanted

Back in May, I interviewed Robert Samuelson about his book on the Great Inflation of the early 1970s to early 1980s. One of the claims he makes is that inflation was a bigger deal than Watergate or Vietnam for most Americans during that time. Samuelson notes most histories of this period overlook this fact even though it is supported by poll data. I finally decided to track down this poll data for myself to verify this claim. Here is the Gallup Poll data I found:

Yes, inflation was the "most important problem" for a majority of people during most of the period between early 1970s and early 1980s. This implies that Paul Volcker's war on inflation was exactly what the body politic desired at that time. It would also explain why President Reagan supported him in his efforts to fight inflation. 

Loss Functions and NGDP Targeting

I was pleasantly surprised to see Lars Svensson's updated paper from the Chicago Fed conference that took place this past June. Due to some pushback he got at the conference, he included a section in his revised paper on NGDP targeting. Here is an excerpt:

Obviously, I was thrilled to see Svensson cite my paper and recognize the financial stability argument for NGDP targeting. Ultimately, though, he rejects this monetary framework based on a loss function that assumes it is optimal to minimize the variance of output and inflation. A good central bank, in other words, is one that tries to reduce volatility in both inflation and the real economy as much as possible.

NGDP targeting, however, makes the opposite case. It explicitly aims for increased inflation flexibility in the shortrun--while still anchoring the dollar size of the economy--so that a central bank will not respond to swings in inflation caused by supply shocks. Doing so serves to minimize the variability of output and, ironically, inflation itself.

This point is vividly illustrated by the ECB in 2011. It succumbed to the siren call of temporarily higher inflation caused by negative supply shocks and, as a result, raised its target interest rate twice. This tightening helped create a second recession in the Eurozone and caused inflation to subsequently undershoot its target. In short, the ECB in its efforts to offset supply-shock induced inflation in 2011, actually increased the variability of output and inflation. 

Ideally, central bankers should be able to see through such temporary changes in inflation, but in real time this is extremely hard to do. Especially, if central bankers have in the back of their mind the kind of loss function Svensson applies above. This is the very problem that NGDP targeting helps central bankers overcome as shown by Garin et al (2016) and Beckworth and Hendrickson (2019).

More on the U.S. as a Banker to the World

I have a new article where I make the case that the U.S. financial system acts as a banker to the world: it tends to issue safer assets to foreigners while acquiring claims to riskier assets abroad. As a result, the United States’ balance sheet with the rest of the world looks like a bank’s balance sheet. This banker-to-the-world role has becoming even more important over the past few decades as the financial integration of the world economy has not been matched by a proportional deepening of financial markets.

This is not a novel idea. Charles Kindleberger first made this point in 1965. Subsequent work by Gorinchas and Rey (2007), Caballero et al. (2008), Caballero and Krishnamurthy (2009), Mendoza et al. (2009), Forbes (2010), He et al. (2016), Gourinchas et al. (2017), Matteo (2017), Krishnamurthy and Lustig (2019), and others all build on this point. Here is my own contribution to this debate. So while some may find this view surprising, it is actually a well established idea in the literature.

In my article I provided figures that show the asset and liability side of the U.S. balance sheet with the rest of the world. In these graphs, I highlighted in blue the more liquid and safe assets while I put in shades of pink the riskier assets. 

The figure below takes these groupings and divides them as a share of total assets on their respective sides of the balance sheet. This figure reveals the safe asset share of assets on the liability side (blue line) has come down some since the financial crisis, but still remains at about 60 percent of the financial assets we export to foreigners. The riskier share of assets the U.S. owns abroad has stayed relatively stable at about 70 percent. Again, this looks like a bank's balance sheet.

To be clear, one can quibble with what I define as a safe assets. Here I take a broad view that there is a continuum of safe assets. Specifically, I include currency, bank deposits, treasuries, GSEs, repos, commercial paper, money market mutual funds, trade receivables. corporate bonds, and derivatives. Some of these assets are clearly safer and more liquid than others, but the demand for them remains elevated indicating they are perceived as relatively safe by the rest of the world.  

One may also wonder if the demand for U.S. safe assets is declining since foreign holding of treasuries has flatlined since about 2015. The chart below, however,  shows that the export of safe and liquid assets to the rest of the world continues to grow in absolute dollar terms even if treasury holdings by the rest of the world has stalled.  

I noted in the article that this banker-to-world role comes at a cost: a tendency for the dollar to be overvalued and, as a result, cause the United States to run trade deficits. It also leads to U.S. budget deficits since that is only way to create more treasury securities. Finally, this role means that the U.S. economy will tend to be more leveraged than otherwise would be the case. It is not clear to me how to eliminate these costs without causing more harm to the global economy. Until there is another viable mass producer of safe assets, we are stuck with these costs. 

P.S. See Frances Coppola and Karl Smith who make similar arguments. 

Update: It is worth noting that the BIS reports just over $11 trillion in dollar-denominated debt is issued outside the United States. Between this $11 trillion and the just over $16 trillion noted above, there is almost $28 trillion of relatively liquid dollar assets abroad. This large amount of dollar assets abroad makes it unlikely Facebook's Libra or Mark Carney's SHC proposal will ever replace the dollar as the reserve currency. 

New Articles on NGDP Targeting

Just a quick note on a couple of my papers that recently got published. First,  Josh Hendrickson and I published in the Journal of Money, Credit, and Banking earlier this year with an article titled "Nominal GDP Targeting and the Taylor Rule on an Even Playing Field". Here is the abstract:

Some economists advocate nominal GDP targeting as an alternative to the Taylor Rule. These arguments are largely based on the idea that nominal GDP targeting would require less knowledge on the part of policymakers than a traditional Taylor Rule. In particular, a nominal GDP targeting rule would not require real‐time knowledge of the output gap. We examine the importance of this claim by amending a standard New Keynesian model to assume that the central bank has imperfect information about the output gap and therefore must forecast the output gap based on previous information. Forecast errors by the central bank can then potentially induce unanticipated changes in the short‐term nominal interest rate, distinct from a standard monetary policy shock. We show that forecast errors of the output gap by the Federal Reserve can account for up to 13% of the fluctuations in the output gap. In addition, our simulations imply that a nominal GDP targeting rule would produce lower volatility in both inflation and the output gap in comparison with the Taylor Rule under imperfect information.

Many of you may have  seen this article before since it has been a working paper for many years now. I am glad to finally get it published. 

More recently, I published an article in the Cato Journal titled "The Financial Stability Case for NGDP Targeting." I presented this paper at the 2018 Cato Monetary Policy Conference. Here is the abstract:

Ten years after the financial crisis there is a new appreciation for the role household debt and financial fragility play in the business cycle. As a result, policymakers are looking for tools to promote financial stability. A number of recent studies claim that nominal GDP (NGDP) targeting is just such a tool. For it can theoretically reproduce the distribution of risk that would exist if there were widespread use of state-contingent debt securities. This paper empirically test this view by exploiting an implication of the theory: those countries whose NGDP stayed closest to its expected pre-crisis growth path during the crisis should have experienced less financial instability. This paper constructs an NGDP gap measure for 21 advanced economies to test this implication and finds there is a meaningful role for NGDP in promoting financial stability.

There are a lot of other interesting papers in this Cato Journal that were presented at the conference. So take a look. For those interested, here is the video of my panel at the conference:

P.S. In my last post I asked if the Fed's floor system was about to fold. Well, the answer is no, for now. My concerns about overnight interest rates rising above the IOER have faded as they have for the most part converged back to the Fed's target interest rate range. I also said I would outline in the next post how the Fed could transition to a symmetric corridor symmetric corridor if this collapse was imminent. That promise is still good, but on hold for now. I am doing some more reading and thinking on this topic and will return to it. 

Is the Fed's Floor System Beginning to Fold?

Last December, I participated in an AEI event where I made the case that the Fed's current floor operating system could collapse into a corridor operating system fairly soon. My argument was that even without a significant reduction in the supply of reserves, a large shift in the demand for reserves could be sufficient to move the Fed off the perfectly elastic or 'flat' portion of the bank reserve demand curve. The Fed, in other words, could have a relatively large balance sheet and still end up in a corridor operating system. 

Graphically, such a development is depicted in the figures below. The figure on the left shows a floor operating system with a large supply of reserves on the flat portion of demand curve. In this system, the IOER is both the target and overnight interest rate. The second figure on the right shows what I imagined could be happening. The demand for reserves was shifting outward because of new regulatory requirements and the supply of reserves was shifting inward as the Fed began shrinking its balance sheet. As depicted, these actions together would push the Fed off the flat portion of the reserve demand curve. In turn, this would cause overnight rates to rise above the IOER and end the Fed's floor system. 

When I brought this up late last year it was pure speculation on my part, but it was informed by the Senior Financial Officer Survey and the Fed's balance sheet reduction plans. In my AEI talk, I told George Selgin, who dislikes the floor system, that if this comes to fruition Christmas will come early for him.  

Well, Christmas did not come early for poor George. He may, however, get a late gift from Santa Claus as there is some evidence my prediction may be coming true. Jeff Cox reports that interbank interest rates are rising above the IOER rate. The figure below shows the overnight bank financing rate (OBFR), the new and improved interbank interest rate measure, has started rising above the IOER. The old federal funds rate (FFR) has been above the IOER for almost a month. (The closely-related overnight Libor replacement, the Secured Overnight Funding Rate (SOFR) tells a similar story.)

To be clear, this move is small from a broader perspective as seen below. Nonetheless, this rise in both series is part of a longer-term change in their trend, where previously they were consistently below the IOER but now are bouncing above it. If they continue to rise above the IOER, the floor system's days are numbered. 

A similar story emerges if we look to the overnight treasury repo rates. The DTCC treasury repo rate has been tending up over the past month and so has the BNY Mellon treasury repo rate.

Now the DTCC repo rate has been above the IOER for awhile, but the BNY repo rate has not. This is relatively new. And like the interbank rates, the repo rates collectively have been gone from trending below the IOER to bouncing above it as seen below. Again, if this upward movement is sustained the floor system will fold.

Now, with all that said, there is something of a puzzle here: there has been no revival in interbank lending. One would expect, all else equal, that a rise in interbank interest rates above the IOER to spark some interbank lending. Instead, it appears interbank lending has been flat to declining:

One possible resolution to this puzzle is that banks are lending to the overnight treasury repo market rather than to each other. The overnight yield is slightly higher in this market and according to the Fed's H8 database there has been an explosion of reverse repo activity as seen below. 

Maybe part of the new normal is that the treasury repo market has permanently displaced interbank lending. In any event, these developments all point to some big changes taking place that could force the Fed back to a corridor system.

If that is the case, I would recommend the Fed get ahead of this transition and intentionally guide itself to a symmetric floor system like the one in Canada. In my next post, I will offer some practical suggestions for making this journey.

P.S. The technical definition for the "federal funds sold and reverse repos" in the H8 database is as follows: "Includes total federal funds sold to, and reverse RPs with, commercial banks, brokers and dealers, and others, including the Federal Home Loan Banks (FHLB)." So maybe part of the explanation for the lack of interbank lending is that bank are lending indirectly to each other via the repo market. 

Is Low Inflation Really a Mystery?

Over the past decade, inflation has persistently undershot the Fed's inflation target. The Fed's preferred measure of inflation, the core PCE deflator, has average 1.56 percent over this time compared to a target of 2 percent. The Fed officially begin inflation targeting in 2012, but was implicitly targeting 2 percent long before that time. So below-target inflation has been happening for close to a decade and for many observers it is a mystery.

There have been a spate of articles as to why the Fed has not been able to hit its inflation target. Some have wondered if the Fed really understands or even controls the inflation rate. Even Fed officials have been perplexed by the low inflation since it cannot be explained by their Phillips curve models. As a result, they sometimes attribute the persistently low inflation to developments such as falling oil prices, demographics, global competition, changes in labor’s share of income, safe asset shortage, and even the rise of Amazon.

These explanations, however, are not satisfactory since the Fed should be able to determine the inflation rate over the medium to long-run. That is, the Fed should be able to respond over time to developments that might cause inflation to drift off target. The Fed should be, in theory, the final arbiter of the trend inflation rate.

So why has inflation been so low? In my view, the answer is simple: the Fed is getting the inflation it wants. There is no mystery. One does not get a decade of trend inflation that is below target by accident. Instead, revealed preferences tell us inflation is where it is because the FOMC allowed it to be there.  Put differently, the Fed has chosen not to fully offset the shocks and secular forces listed above that have pushed inflation down. This is a policy choice.

Fed officials and others may disagree, but the revealed preference argument is hard to ignore. Moreover, there are other reason to believe that the low inflation is, in fact, the desired outcome of the FOMC. They are presented below.

SEP Core Inflation Forecasts

The first reason to believe the low inflation is a desired outcome comes from the FOMC itself. The FOMC's Summary of Economic Projections (SEP) provides a central tendency forecasts for core PCE inflation. The FOMC's definition of the SEP is as follows (my emphasis):

Each participant’s projections are based on his or her assessment of appropriate monetary policy.

The SEP, in other words, reveals FOMC members forecasts of economic variables conditional on the Fed doing monetary policy right. And up until recently, doing monetary policy right was not overshooting 2 percent inflation in the following year, as seen in the figure below. Even now, 2 is still seen largely as a ceiling. There is nothing symmetric about 2 percent in these SEP forecasts.

Most FOMC members, therefore, have treated 2 percent as a ceiling over the past decade. This is "appropriate" monetary policy for them. Keep in mind, that at this forecast horizon most of them also believe they have meaningful influence on inflation. Both of these observations point to the low inflation as a choice.

Textual Analysis

The second reason to believe that low inflation is a desired outcome comes from a recent study by the San Francisco Fed. It is titled "Taking the Fed at its Word: Direct Estimation of Central Bank Objectives using Text Analytics" and the abstract reads (my emphasis):

We directly estimate the Federal Open Market Committee’s (FOMC) loss function, including the implicit inflation target, from the tone of the language used in FOMC transcripts, minutes, and members’ speeches. Direct estimation is advantageous because it requires no knowledge of the underlying macroeconomic structure nor observation of central bank actions. We find that the FOMC had an implicit inflation target of approximately 1.5 percent on average over our baseline 2000 - 2013 sample period.

Fed officials, via their words, actually want 1.5 inflation on average. And shocker of all shockers, they are very close to getting that just that rate of inflation since 2009. 

The Neel Kashkari Counterfactual

The third reason to believe low inflation is a desired outcome comes from imagining a counterfactual FOMC. Imagine a FOMC that has twelve members that are all clones of Neel Kashkari, as seen below. In this FOMC, where interest rates were not raised over the past few years--and maybe even lowered--do we really think inflation would be the same? I find that hard to believe.

To be clear, I do think there are important secular forces pushing down trend inflation, like the demand for safe assets. But again, the Fed should be able to offset such pressures if it chose to do so. The real question, then, is why the Fed has settled for trend inflation near 1.5 percent. That is a question for a different post. This post is simply a retort to all those who think the low inflation is a mystery. Folks, it is not a mystery. It is a choice.

It is worth nothing that this choice is actually more than a choice for trend inflation. It is implicitly a choice for lower trend aggregate demand (AD) growth. As seen below, aggregate demand growth was averaging 5.6 percent in the decades before the crisis. Since the recovery started, it has averaged about 3.6 percent. That is a 2 percentage point decline in the trend. The red line in the figure shows what a naive autoregressive forecast would have predicted over the past decade conditional on past nominal expenditure history. There has been a sizable AD shortfall.

In my view, it is this dearth of aggregate demand growth rather than the low inflation that is a problem. The slowdown in AD growth has arguably contributed to problems like hysteresis and populism. If so, this policy choice has been costly.

P.S. Adam Ozimek gives us estimates of how costly this AD shortfall has been.

The FOMC Decision: A NGDP Perspective

The FOMC voted this week not to raise its target interest rate and signaled no additional hikes are planned for this year conditional on the outlook. This is a big change from last fall when the FOMC was talking up multiple rate hikes and dismissing concerns about the flattening yield curve. This 11th-hour conversion to a more dovish stance is a remarkable turnaround, one that some observers like Tim Duy are calling a "major break". 

The change is being attributed to growth concerns and a weakening of financial markets. I do not want to go through all the indicators supporting the Fed's worries, but I do want to see whether Nominal GDP (NGDP) lends support to this decision. As many readers of this blog know, I believe that properly evaluated NGDP growth is probably the best indicator of the stance of monetary policy. Okay, so what does it say?

To answer that question, I like to look at a measure called the 'sticky forecast' growth path for NGDP and compare it to the actual level of NGDP. In this note, I show the spread between these two measures--the NGDP gap--provides a good measure of the stance of short-run macroeconomic policy. Here is the intuition for the metric:

The idea behind the sticky forecast path for NGDP is twofold. First, the public makes many economic decisions based on a forecast of their nominal incomes. For example, households may take out a 30-year mortgage based on an implicit forecast of their nominal income over this horizon. The actual realization of nominal income may turn out to be very different than expected, but the households may not be able to quickly adjust their plans given sticky debt contracts and other commitments that constrain them. Therefore, the consequences of previous forecasts are often binding on them and slow to change even if their nominal income forecasts have been updated. Second, in addition to these old forecasts and decisions whose influence lingers, new forecasts and new decisions are being made each quarter for subsequent periods that will also have lingering effects. Together, this means future periods have many overlapping and different forecast applied to them that only gradually adjust.

Given the public's expectations of nominal income, the sticky-forecast path of NGDP can be viewed as the neutral level of NGDP. Unlike the unobservable u*, r*, and y*, this neutral measure is simply a weighted quarterly forecast of nominal income found in the Survey of Professional Forecasters. There is no need for guesswork. The details of its construction are in the note, but it is worth mentioning that the NGDP gap created by this measure is remarkably similar to many measures of slack. I should also note that I constructed this measure using the IMF NGDP forecasts for 21 countries in a forthcoming paper (working paper version) and find it works well cross country too.

Here are what the sticky forecast and actual NGDP paths looks like:

And here is the NGDP gap--the percent difference between the two series:

This NGDP gap shows a standard story: aggregate demand growth overheated some in the late 1990s and to a lesser extent in the early-to-mid 2000s followed by a sharp collapse in 2008. A slow recovery followed that stalled around 2015-2016 and then started rising again. Currently, the NGDP gap is slightly below the neutral level of zero percent. This graph suggest it was appropriate for the Fed to pause on rate hikes this week. It also indicates, however, that the Fed arguably should not have started raising rates in 2015.

While the NGDP gap provides a nice cross check on the stance of monetary policy, it can also be used in an explicit monetary policy reaction function. Here is one I created:

Here it is a market interest rate,  the first term measures the gap between the forecasted and targeted NGDP growth rates over the next year,  and the second term is the NGDP gap as noted above. The 1-year treasury yield is used for it and the 1-year NGDP growth forecast comes from the Survey of Professional Forecasters. The NGDP target is set to 5.5 percent for 1985-2008 and 4 percent for 2009-2018 to reflect the actual trend NGDP growth rates experience during those times.  The figure below plots the rule for different values of the coefficients:

Again, we see that if anything, the prescribed target interest rate is a little below the actual one suggesting the Fed's pause is appropriate. So overall, a smart move by the Fed and arguably one that is overdue.

Finally, I want to share one more application of the NGDP Gap that I have made before. The NGDP Gap does a decent job explaining nominal wage growth as seen in the figure below. The red dots show the portion of the scatterplot attributed to past few years. While the R² is 65 percent for the overall sample, the sample since 2016 has an R² of 85 percent. Here is hoping the Fed starts paying more attention to NGDP as a cross check for assessing the stance of monetary policy. 

Oh, the Horror of a Corridor!

The December 2018 FOMC minutes are out and reveal members continue to discuss the potential long-run frameworks for monetary policy implementation. Their discussion as to whether they should keep their current floor operating system or move to a corridor operating system can be illustrated using the figure below:

The FOMC likes the floor system since it separates the size of the Fed's balance sheet from the setting of its target interest rate. This added flexibility is possible because the reserve supply schedule is on the horizontal part of the reserve demand curve as seen above. Here, banks will take all the reserves sent their way--killing off interbank lending--as their demand for reserves is perfectly elastic. The corridor system puts the reserve schedule back on the downward slopping part of the reserve demand curve. That creates an opportunity costs for reserves and resurrects interbank lending. 

Recall that the floor system is a byproduct of the crisis. It was part of the unconventional monetary policy actions taken during that time. Consequently, the Fed is now discussing how to normalize its operating system. As I have argued in a recent paper and in various blog posts, I prefer the Fed leave the floor system and move to a symmetric corridor system. In my view, the political and economic costs exceed any benefits of a floor system. 

I do not want to rehash these arguments, but I do want to respond to a claim made by the FOMC members as reported in the December 2018 minutes. Specifically, the FOMC claims there will be much greater interest rate volatility under a corridor system. Here is the relevant part (my stress):

Reducing reserves close to the lowest level that still corresponded to the flat portion of the reserve demand curve would be one approach consistent with the Committee's previously stated intention, in the Policy Normalization Principles and Plans that it issued in 2014, to "hold no more securities than necessary to implement monetary policy efficiently and effectively." However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve.

Well, if there were any doubts as to where the FOMC is leaning in this debate over operating systems this paragraph should put the doubts to rest. FOMC members apparently love their flat reserve demand curves. So much so, they cannot handle the imagined horrors of interest rate volatility under a corridor system.

Yes, the horrors of interest rate volatility in a corridor system. I mean, how can central banks like the Bank of Canada (BoC) impose such a cruel system on their financial system? How dare the BoC leave the peaceful sanctuary of a floor system and move to the interest rate jungle of a corridor system! Just look at the all the interest rate volatility they are imposing on the Canadian financial system.

Oh wait, the BoC corridor system actually looks okay. Yes, there is some interest rate volatility for the overnight repo rate relative to the BoC's interest rate target, but the repo rate stays well within the corridor bounds.

Maybe the FOMC means interest rate volatility in a corridor system compared to a floor system, like the one it runs. After all, the FOMC is a true believer in its own operating system. The FOMC did say in the minutes that the "efficient and effective implementation of monetary policy" most likely requires providing "a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve."

With such confidence in their own floor system, it must be that the FOMC members are indeed thinking of the interest rate stability in their system. Right?

Oops, maybe not. Overnight U.S. repo rates do not look so stable compared to Canada. Maybe the scales of the above figure overstate the volatility of repo rates in the United States? How about comparing the actual spread between the overnight repo rate and target rate for the two countries and their different operating systems?

Okay, maybe the corridor system is not so bad. Maybe the FOMC is thinking of a return to an asymmetric corridor system like the one that existed pre-2008. There might be more interest rate volatility in returning to that system, but most advocates of a move to corridor system--like George Selgin, Stephen Williamson, Bill Nelson, Peter Ireland, and myself--are not advocating such a move. Instead, we want a move to symmetric corridor system where the IOER pins down the lower bound and the discount rate anchors the upper bound. 

Such a system can easily collapse into a floor system during a crisis, so the Fed could still have its desired flexibility if needed in a bind. Moreover, many other countries use some form of a symmetric corridor system. George Kahn of the Kansas City Fed has a great review of these experiences and the workings of these operating systems. 

I am glad the FOMC is debating the future of its operating system. My hope is that Fed does not get blinded by its own experience with an asymmetric corridor system and instead looks elsewhere in the world for understanding how a symmetric corridor system can work.