Storytelling: Friday Chart Edition

I have not posted here in awhile, so I thought it would be good to share a few recent charts that tell interesting stories.

Central Bank Balance Sheets

First up, are two charts that show the relationship between the size of the central bank balance sheets and inflation rates. The first one shows for the 2010-2019 period the average size of central bank balance sheets as a percent of NGDP plotted against the average core inflation rate. Since larger balance sheets are typically seen as adding more stimulus to the economy, one might expect to see a positive relationship between their size and the inflation rate over this long of an horizon. Instead, we see a negative relationship:

One objection to the above chart is it may be misleading since it is the rate of change in central bank liabilities, not the level, that should drive the inflation rate. To that end, the next chart shows the change in the size of the central bank balance sheets over the same period. The same relationship holds: 

Another objection is that these charts simply show central banks responding to the low inflation environments: the lower the inflation rate the bigger the central bank balance sheets. I think that is fair, but again the horizon is an entire decade. Consequently, if the standard theories for QE such as the portfolio balance channel and the signalling channels hold, then we should expect to eventually see something different than a negative relationship. And 10 years seems long enough for 'eventually' to come to fruition. 

My explanation for these charts, forthcoming in a working paper, is that something else is driving both the low inflation and the expanding central bank balance sheets. 

NGDP Gap

Our 2020 Q3 report for the NGDP Gap came out recently. Here is the key takeaway: 

[the] NGDP gap of −4.77 percent indicates that the dollar size of the economy is still significantly smaller than prepandemic expectations. Specifically, the neutral level of NGDP was $22.22 trillion in the third quarter of 2020, whereas actual NGDP came in at $21.16 trillion. That is a shortfall of $1.06 trillion, which is a vast improvement over the previous quarter’s shortfall of $2.57 trillion, but still a sizable hole to fill in the economy. This trillion-dollar hole means that both aggregate spending and income are still falling short of their prepandemic trend levels.

Below are the relevant charts. Note, you can now get the neutral NGDP and NGDP gap measures in both Haver and Macrobond data! 

Real Interest Rates Determination

I was recently embroiled in a debate over what determines the path of real interest rates.  The debate was whether the standard desired saving - desired investment (S-I) theory of interest rates or the liquidity preference theory best explains the path of real interest rates. The former looks to the fundamentals of time preferences, population growth, and expected economic growth as the explanation for real interest rates. The latter view looks to money markets and the expected interest rate path of the central bank as the explanation. My take has been the fundamentals view is more important over the longrun while the money view is more important in the shortrun. 

Here are some charts I made that look at the longrun and show that fundamentals are, indeed, tied to real interest rate formation in advanced economies. Specifically, population growth rates and fertility rates are associated with the 10-year real yield.  I created these charts  after chatting with Matt Yglesias about his book "One Billion Americans" for the podcast. He verbally sketched out these scatterplots and I was curious to see if they held up in the data. They did! 

FOMC Humor

Finally, here is my attempt at the two choice meme as it relates to Treasury Secretary Mnuchin's decision to pull back the Treasury backstop funds for the Fed's 13(3) facilities. I joked that maybe the Secretary was attempting to force Congress to be more active on relief and rely less on the Fed. Looks like I was not too far off. Anyways, the tension between asking the Fed to do more with 13(3) facilities and asking Congress to do more is real. 

Make-Up Policy: Where Art Thou?

As we head into the second half of the year, the swift recovery many were hoping for is facing an uncertain future. The resurgence of the COVID-19 virus and concerns about dwindling fiscal support have many worried. I submit that even in the absence of these worries, the recovery would still be on shaky grounds without the Fed explicitly committing to 'make-up' policy. 

Make-up policy is an explicit framework that allows the Fed to correct for past misses in its target. In the case of a recession, this feature allows the FOMC to be fine with inflation temporarily overshooting its target while the economy bounces back. Tolerating this overshoot implies a similar surge in nominal income that would restore it to the levels expected by household and business prior to the crisis. This restoration is important since many fixed-price nominal financial obligations like mortgages, loans, and leases were made based on these forecasts of nominal income.  

Without make-up policy, the Fed may feel uncomfortable with inflation temporarily overshooting and prematurely tighten monetary policy. This would prevent nominal income from returning to its pre-crisis trend levels and trigger secondary spillover effects like mass insolvencies and other financial stress. 

Chris Condon notes that the Fed is aware of this issue and has been discussing it at the FOMC meetings this year.  For all this talk, though, members of the FOMC have given no indication in the Summary of Economic Projections (SEP) that they are taking make-up policy seriously. The SEP indicates persistent undershooting of its inflation target and consequently, a lack of make-up policy in its implicit nominal income forecasts. 

Nominal income or NGDP can be constructed from Table 1 in the SEP by combining the real GDP growth forecasts with the PCE inflation forecast plus 20 basis points (to make it GDP Deflator equivalent). This is done in a revised version of Table 1 below:

The second-to-the-last row of the table is titled "NGDP Change - 4.0" and is the forecasted NGDP growth rate minus the pre-crisis trend of 4 percent growth. The final row accumulates up these misses and reveals NGDP is still 5.3 percent below its per-crisis path even after 2022. Put differently, there is a permanent loss in nominal income according to the SEP. 

These forecasts are applied to the current NGDP levels to create a forecast in dollar level form and are presented in the figure below. The sustained drop in nominal income can be seen as the difference between the pre-crisis trend and the forecasted level of NGDP:

Note, that this forecasted loss is based on FOMC members assessing what is "appropriate monetary policy" for the SEP. The FOMC, in short, currently does not see make-up policy in the cards nor does it see it as appropriate monetary policy. Similar implications fall out of other Federal Reserve forecasts, including this one from the New York Fed. 

But it not just the Fed who thinks there will be no make-up policy and therefore a sustained loss in nominal income. First, the CBO's July update  shows a persistent gap between nominal income and its pre-crisis trend over the next decade. This forecast is conditioned on, among other things, what the CBO sees as likely monetary policy going forward.  

Second, the Blue Chip consensus forecasts of NGDP also shows a sustained drop in nominal income. The graph below shows this drop and compares it to the neutral level of NGDP, the level of nominal income needed to meet the expectations of households and businesses plans in years leading up to the crisis. The forecasted gap between these two measures is called the NGDP Gap. 

So wherever one looks, make-up policy is not being forecasted. Its absence does not bode well for the recovery and underscores the urgency of the FOMC review of its framework. I really dread repeating the slow recovery of the last decade. So please FOMC, bring this review to a vote and give make-up policy a chance during this crisis. 

Update: A reader informed me that adding 20 bps to the PCE inflation to make it equivalent to GDP deflator inflation may overstate the difference. If so, the analysis above actually understates the permanent loss in nominal income projected by the FOMC's SEP.

Why Yes, the FOMC Would Like Some Inflation Overshoot Now

The Fed claims it has a symmetric two percent inflation target. From  its 2017 and 2018 Statements on Longer Run Goals and Monetary Policy, the FOMC states:

The Committee reaffirms its judgment that inflation at the rate of 2 percent... is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored...

Numerous Fed officials have repeated this point as well. They too see the inflation target as a symmetric one, an understanding that allows for an occasional inflation overshoot. Despite these claims, however, the Fed has persistently undershoot its inflation target. If one acknowledges the Fed implicitly targeted two percent long before the explicit target was adopted in 2012, then the undershooting has lated for almost a decade.  This is not a pretty picture. 

Many observers, including myself, have taken this as evidence that the Fed's two percent target is more of a ceiling and not symmetric. This understanding has been borne out by the FOMC's own Summary of Economic Projections (SEP) forecasts for core PCE. Recall the definition of the SEP:

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

So the SEP reveals FOMC members forecasts of economic variables conditional on the Fed doing monetary policy right. And for the longest time, doing monetary policy right was not overshooting 2 percent inflation in the following year, as seen in the figure below. Keep in mind that at this horizon the Fed should have meaningful influence over inflation.

It is hard to square these revealed preferences from the SEP with a symmetric inflation target. This is a point Narayana Kocherlakota has made many times and has been a source of frustration for many Fed watchers. Ryan Avent of The Economist, for example, has been asking the Fed for years to "try overshooting for once." 

Well, ask no more. FOMC members in the March FOMC meeting finally decided it was time to give inflation overshooting a try. They did not say so explicitly, but did so implicitly via the SEP. For the first time since 2009, the SEP's central tendency forecast for core PCE inflation in the next year breached 2 percent. Specifically, this central tendency forecast for 2019 ranged from 2.0 to 2.2 percent. While this is not far above 2 percent it is progress and it is an inflation overshoot.  

The FOMC minutes for the March meeting also hinted at this new tolerance for an inflation overshoot:

A few participants suggested that a modest inflation overshoot might help push up longer-term inflation expectations and anchor them at a level consistent with the Committee’s 2 percent inflation objective. 

Maybe all complaining about the lack of an inflation overshoot has finally come to fruition. If so, the irony is that this overshoot, just like Trump's expansionary fiscal policy, is probably coming several years too late. The inflation overshoot would have been much better in the 2009-2011 period. But as seen in the above figure the FOMC in its infinite wisdom thought inflation should be closer to 1 percent during that time. FOMC officials, accordingly, seem to be calling for procyclical inflation according to the SEPs. This is not the way to do monetary policy. 

P.S. If only there were a monetary policy framework that avoided these timing problems by making inflation more countercyclical. It sure would be nice if someone would come up with a monetary policy approach that caused inflation to rise during recessions and fall during booms.  You know, kind of like Israel has done per its GDP deflator:

This countercyclical inflation has in turn lead to stable aggregate demand growth. Again, if only there were some approach to monetary policy that systematically implemented this approach.

Assorted Macro Musings

Some assorted macro musings:

New NGDP Paper

My colleague Scott Sumner and Ethan Roberts have a new primer on NGDPLT. It is a very accessible introduction to the topic, but one that also gets into NGDPLT futures targeting. Check it out.

JEC Report on the Slow Recovery

The Joint Economic Committee of Congress has a new report where, among other things, it lays out a monetary explanation for the slow recovery.  A key excerpt on why QE did not create a robust recovery (page 61):

The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program: 

"Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are        intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future." 

Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues. .

Obviously, I liked this part, but the entire report is good so take a look.

Follow Up to My Last Post

Since we are on the topic, I wanted to follow up on my last post. There I piggybacked off a recent Paul Krugman paper to note that the Fed's QE program could not generate significant nominal demand or inflation because the monetary base injections were not conditionally permanent. As a result, the Fed's QE programs became subject to the "irrelevance results" of Krugman (1998) and Eggertson and Woodford (2003). This is a widely understood point, but one that often gets overlooked.

To be clear, this understanding does not mean the QE programs had no effect. The consensus view is that the LSAPs did have some effect, lowering 10-year treasury yields somewhere around 100 basis points in total (though even this understanding is being challenged). And yes, we did not repeat the Great Depression. But again, we also did not have a robust recovery in nominal demand growth and that is a policy choice. So it seems QE was limited in what it could do.

With that said, I want to acknowledge there is a way QE could really pack a punch. And that is to make the LSAPs so large that they endanger the Fed's balance sheet via interest rate risk.  Imagine, for example, that the Fed had expanded its balance sheet 1000 times its pre-2008 size versus its almost 4 times increase that actually occurred. 

This is extreme but makes a point. If the Fed’s balance sheet were in fact 1000 times larger it could easily be set up to take a loss on its asset holdings. That is, since QE causes the Fed to hold longer-term securities on its balance sheet, the Fed in this scenario would be a lot more susceptible to interest rate risk. This is the risk where the price of a bond moves inversely with interest rates. The longer the bond, the more the bond’s value will swing in response to changes interest rates.  If rates were to go up, bond prices would fall and this would decimate the asset side of the Fed’s balance sheet. Meanwhile, the liability side of the Fed’s balance sheet (bank reserves and currency) would not have changed. So there would be fewer assets for the Fed to manage the monetary base. That means the Fed could not reign in the monetary base if inflation expectations started taking off, which they probably would in this extreme scenario.

Also, with a 1000-fold increase in asset holdings, it is unlikely the Fed's expected future seigniorage would be enough to cover the hole in the balance sheet. Without sufficient seigniorage, it could not simply pay more IOER since that would be increasing its liabilities and further expanding the hole in its balance sheet.

Now this balance sheet hole could be plugged by the Treasury Department bailing out the Fed. But since the Fed’s balance sheet is 1000x bigger in this scenario it is unlikely the Treasury could muster up enough resources to bailout the Fed without further debt monetization too. In short, the hole in the Fed's balance sheet would be so large the monetary base injection would be seen as permanent. As a result, QE would generate rapid nominal demand growth and roaring inflation in this scenario. 

This is obviously undesirable and an extreme scenario to show that QE could, in theory, pack a nominal demand punch. But it would be so costly and inefficient that it should give us pause about using LSAPs. If QE requires extremes like the above scenario to generate robust nominal demand growth, maybe it is best we look elsewhere for help. NGDPLT targeting, in my view, is the answer.

Ed Nelson Podcast
This week on the show is Ed Nelson. We had a great time talking monetary economics, Milton Friedman's legacy, and the conduct of monetary policy. Take a listen.

Paul Krugman on Temporary vs Permanent Monetary Injections

Paul Krugman looks back on the past twenty years of macroeconomic policy and finds that his 1998 paper was more prescient than he or anyone could have imagined. Back then many observers assumed that central bankers--particularly those at the Bank of Japan--need only increase the monetary base to increase the price level. It was that simple.

Ken Rogoff, for example, said the following in commenting on Krugman's 1998 article:

No one should seriously believe that the BOJ would face any significant technical problems in inflating if it puts it mind to the matter, liquidity trap or no. For example, one can feel quite confident that if the BOJ were to issue a 25 percent increase in the current supply and use it to buy back 4 percent of government nominal debt, inflationary expectations would rise.

Krugman disagreed in his 1998 paper. He showed, using a New Keynesian model, that it was more complicated than many imagined. It depended on whether the monetary injections were expected to be temporary or permanent. Here is how he summarizes his 1998 article (my emphasis):

[T]he proposition that money issuance must raise the price level was false. Or if you like, it was missing a word: permanent money issuance would raise the price level. But a monetary expansion the private sector expected to be temporary, to be wound down after the crisis had passed, would do nothing at all: the extra monetary base would just sit there. Furthermore, it was reasonable for the private sector to assume that even large increases in the monetary base in a liquidity-trap economy would be temporary, to be wound down after the crisis had passed, would do nothing at all: the extra monetary base would just sit there

He goes to note that the public should, in fact, expect large expansions of the monetary base to be temporary. Otherwise, it would imply an implausibly large jump in the price level that would not be politically tolerated. For example, if the several-hundred percent increase in the U.S. monetary base expansion under the Fed's QE were expected to be permanent then the price level would have proportionally jumped several hundred percent as well. 

Krugman notes that the actual performance of Japan's first QE program of 2001-2006 and the Fed's QE programs bore out his predictions. These large-scale asset purchase programs ultimately proved to be temporary monetary programs. 

This is an important point and one that I stress in my own work. Just to be clear, permanent means an exogenous increase in the monetary base that (1) is beyond that required to accommodate normal money demand growth and (2) is not expected to be reversed. 

To illustrate this point, I want to repeat what I showed in an earlier post. There I used the Fed's median forecast of its assets through 2025 from its 2016 SOMA Annual Report to create projections of the Fed's balance sheet. These projections show the trend growth path of currency and a series I call the 'permanent monetary base' extrapolated to 2025. The latter series is the monetary base minus excess reserves. These two measures, which reflect the liability side of the Fed's balance sheet, are plotted along side the forecasted path of the asset side of the Fed's balance sheet.

Note that the Fed's median forecast of its assets eventually converges with the trend growth of currency which historically has made up most of the monetary base. Consequently, the permanent measure of the monetary base roughly tracks currency's trend path.

The figure implies the Fed's balance sheet forecast confirms the temporary nature of the monetary expansion  under the QE programs. That is, the Fed expects most of the permanent growth in the monetary base in 2025 to have come from the normal currency demand growth. This endogenous money growth would have happened in the absence of QE. There is no sign of an exogenous permanent increase in the monetary base. 

Krugman's bigger point is that to have robustly raised nominal demand over the past decade required a permanent increase in the monetary base. This did not happen at the Fed or the ECB. Krugman thinks it sort of happened in Japan under Abenomics. Maybe so, but I am not completely convinced. In my view, the shackles of inflation targeting made such permanent increases very hard to do at most advanced-economy central banks over the past decade. 

So what would a permanent monetary base expansion look like in practice? In my paper, I argue one could look to the experience of Israel over the past decade. An even better example comes from the U.S. economy coming out of the Great Depression. It is fairly easy to see the permanent jump in the monetary base during the early 1940s:

That is what Krugman would call being credibly irresponsible. It took a war to accomplish this permanent jump in the monetary base. The same can be done more efficiently and in a rule-like manner with a NGDP level target. Credibly going to a NGDPLT, however, would require a major regime change to U.S. monetary policy. And that brings us back to Krugman's article:

Given the way experience has undermined much of the original case for a 2 percent inflation target, and given the severity of the economic crisis, you might therefore have expected some  revision – a rise in the inflation target, or a shift to some other kind of targeting – price level or nominal GDP targeting. But that hasn’t happened... This is quite remarkable. If the worst economic crisis since the 1930s, one that cumulatively cost advanced nations something on the order of 20 percent of GDP in foregone output, wasn’t enough to provoke a monetary regime change, it’s hard to imagine what will.

His pessimism is understandable. However, I am more hopeful as noted in my last post. We are making progress. We have changed the conversation and that is the first step forward. 

Abenomics Update

So a quick update on that grand monetary experiment in Japan known as Abenomics. 

Prime Minister Shinzo Abe and his party were returned to power in a decisive October election. This means the Bank of Japan will continue to expand the monetary base, peg the 10-year government bond at 0%, and strive for 2% inflation. 

I was an early fan of Abenomics, but have become a bit more skeptical over time. Others, like Noah Smith, are convinced it is working and are glad to see it continue. Mike Bird of the Wall Street Journal is also a fan. They make a reasonable argument that the real side of the economy has benefited from the Bank of Japan's policies. 

Maybe so, but what about the nominal side of the economy? Yes, we ultimately care about the real side, but the central bank can only directly affect the nominal economy. Its influence on the real economy is a by-product of this influence. Moreover, getting the nominal side of the economy to rapidly expand is needed to offset the real burden of the growing stock of nominal debt. 

So how is the nominal side of the economy doing? Okay, but not great. Inflation is above zero but nowhere near its 2% target. This is true even if we look at core measures of inflation that account for the 2014 changes in the consumption tax. Below is a chart from the Bank of Japan:

Nominal GDP (NGDP) in Japan--a measure of total nominal demand--does show more progress under Abenomics than with the original QE of 2001-2006:

This progress of NGDP is an improvement, but if we step back and look at it from a broader historical perspective it is actually underwhelming. All Abenomics has done is return NGDP to a flat trend growth path. Nominal demand growth in Japan is still far below what it was before the 1990s. This has big implication for Japan's debt burden and suggests its real growth could be higher.

So why is Abenomics failing to pack a big punch? There is both an economic and a political answer. The former is a technical one that can be summarized in the chart below. It shows the actual monetary base and its permanent portion. (The permanent portion is proxied by currency and coins in circulation since they tend to drive the long-run path of the monetary base.)

The expected path of the permanent part of the monetary base and by implication the expected path of the price level is what drives current inflation. If the expansion of the monetary base under Abenomics is expected to be unwound in the future then it should have little effect on the price level today. The permanent portion of the base suggests it will be unwound. (I have a forthcoming paper that explains in more detail why this permanent-temporary distinction matters so much.)

Another way of saying this is that market participants expect the Bank of Japan to do what it did after the initial QE program--reverse it. Michael Woodford, in his 2012 Jackson Hole speech, commented on the 2001-2006 episode:

The Japanese monetary base resumed a path that was close to a continuation of its trend prior to the QE period; hence, market participants who had continued to hold expectations about the long-run Japanese monetary base that were unchanged as a result of the QE policy would not have been that far off in their prediction (p. 241).

Woodford also notes that this experience comes “fairly close to providing an illustration of the kind of policy to which the irrelevance results of Krugman (1998) and Eggertson and Woodford (2003) should apply". This is the economic answer and the reason I have become more skeptical of Abenomics.

The political answer, in my view, is that the Bank of Japan will not make its monetary expansions permanent and significantly increase the inflation rate is because politically it cannot do so. Japan has an aging population that holds a lot of government debt and lives off of fixed income. Raising the inflation rate would harm them and create a political firestorm. I believe this is what ultimately is keeping Japan from getting robust nominal demand growth. 

Monetary Policy Analysis is Hard: Inflation Edition

I have a new article at The Hill that responds to some of the buzz created  by the Cecchetti et al. (2017) paper that was delivered at the U.S. Monetary Policy Forum:

What causes inflation? Most people believe inflation is caused by central banks adjusting monetary conditions... But is this right? A recent study by some top economists has raised questions about this conventional wisdom.  

The study found that the standard indicators... [like] economic slack, inflation expectations, and money growth were, in fact, unrelated to inflation. These findings caused quite a stir and even led the Wall Street Journal to declare that “everything markets think they know about inflation might be wrong”. 

This understanding misses, in my view, the deeper and more important point of the Cecchetti et al. paper. As the authors note in a separate blog post, the lack of a relationship between the standard indicators and inflation is actually an indication that the Fed has done a good job in managing inflation:

While the USMPF report is titled Deflating Inflation Expectations, we do not conclude that expectations are unimportant. In fact, quite the opposite: the failure of measured inflation expectations to help forecast changes in inflation is probably a side effect of monetary policy’s success in stabilizing them. 

This point, though, is a subtle one that is often missed by observers and that is why I wrote my piece for The Hill. Drawing upon Nick Rowe's work, I used the following example to illustrate the idea:

Imagine that the Fed is a driver, the economy is a car, the gas pedal is monetary policy and the car's speed is the inflation rate. The Fed’s objective here is to keep the car moving steadily along at 65 miles per hour.  

When the car starts climbing hills, the Fed pushes further down on the gas pedal. When the car starts descending from the hills, the Fed lays off the gas pedal. Over many hills and miles, the Fed is able to maintain 65 MPH by making these adjustments to the gas pedal.  

 A child sitting in the backseat of the car who was oblivious to the hills but saw the many changes to the gas pedal would probably conclude the gas pedal has no bearing on the speed of the car. After all, no matter what happened to the gas pedal the car’s speed never changed.  

 As outside observers, we know better. We know the driver was adjusting the gas pedal just enough to offset the ups and downs of the hills so that a constant speed was maintained. In terms of our Fed analogy, monetary policy was adjusted just enough to offset the ups and downs of the economy so that a stable inflation rate was maintained.

So many people have failed to grasp this point, especially over the past eight years. The Fed got the inflation it wanted over this period by pushing the gas pedal--QE and low rates--just enough to offset the drag of the Great Recession on the price level. Although the Fed wanted a quick recovery, it wanted even more to maintain stable and low inflation. This is evident in their core inflation projections in the FOMC's Summary of Economic Projections (which always saw 2% as ceiling) and in the FOMC's revealed preferences.

This meant the FOMC was not willing to allow an inflation overshoot which, in addition to making their inflation target symmetric, would have allowed more rapid catch-up growth in aggregate demand. As I have said elsewhere, this was the Fed's Dirty Little Secret: its policies were never going to create a robust recovery given the Fed's asymmetric approach to inflation targeting.

But I digress, the point of this post is to remind us that analyzing monetary policy is hard. One cannot simply draw conclusions by looking at interest rates, output gaps, money growth and comparing them to inflation Depending on how the Fed is conducting monetary policy, these indicators should be uncorrelated with inflation if the Fed is doing its job.

Given the importance of this idea, I have excerpted an earlier post on this topic below the fold.

Macro Musings Podcast: Ylan Mui

My latest Macro Musings podcast is with Ylan Muy of the Washington Post. She was the Fed beat reporter for several years and now covers economic policy at the White House. She joined me to discuss what it was like covering the Fed and what we might expect going forward from President Trump's economic policies.

This was a fascinating conversation throughout and we covered everything from the tight security of FOMC press meetings to the future of the Fed's balance sheet to whether the Fed will ever have a truly symmetric 2% inflation target. We also considered whether Trump's economic policies will truly live up to the market's expectations for them. One thing we do know for sure is that 2017 will be an interesting year for U.S. economic policy and Ylan will have much to cover for the Washington Post.

Ylan also shared that she is working with the Brookings Institute on a book about negative interest rates as a tool for monetary policy. It sounds interesting and I look forward to reading it.

Finally, Ylan and I discussed the lack of women in macroeconomics. A recent article in the Journal of Economic Perspectives reminded us that a disproportionately small share of women are in the economics profession. This problem seems to be even more pronounced in macroeconomics. Ylan shared her observation on this challenge and talked about her related work on Janet Yellen breaking barriers in macroeconomics.

This was great episode to start the new year. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Ylan Muy's articles at the Washington Post
Ylan Muy's Twitter Account

The Trump Shock and Interest Rates

I have a new piece in The Hill where I argue markets are increasingly seeing the Trump shock as an inflection point for the U.S. economy:

It seems the U.S. economy is finally poised for robust economic growth, something that has been missing for the past eight years. Such strong economic growth is expected to cause the demand for credit to increase and the supply of savings to decline 

Together, these forces are naturally pushing interest rates higher. The Fed’s interest rate hike today is simply piggybacking on this new reality. 

Here are some charts that document this upbeat economic outlook as seen from the treasury market. The first one shows the treasury market's implicit inflation forecast (or "breakeven inflation") and real interest rate at the 10-year horizon. These come from TIPs and have their flaws, but they provide a good first approximation to knowing what the bond market is thinking. In this case, both the real interest rate and expected inflation rate are rising. This implies the market expects both higher real economic growth and higher inflation. The two may be related--the higher expected inflation may be a reflection of higher expected nominal demand growth causing real growth. The higher real growth expectations are also probably being fueled by Trump's supply-side reforms.

The next figure shows the New York Fed's decomposition of the 10-year treasury into the term premium and a 'risk-neutral' nominal interest rate. Both have gone up since Trump's election. The term premium going up can be seen as investors being less risk averse and therefore demanding higher compensation for holding longer-term safe asset-bonds. The risk-neutral part can be seen as a product of the real interest rate and the expected inflation. And, as we saw in the first figure above, they are both growing:  

These figures, as well as the surge in the stock market, indicate the markets see more robust growth ahead. Given the timing of these surges, the figures seem to attribute the improved economic outlook largely to the Trump shock. 

Now markets may be getting ahead of themselves, but if these expectations come to fruition there is another big lesson to be learned from the Trump shock:

One of the big lessons from this rate decision is that the Fed cannot sustainably push up interest rates through the brute force of monetary policy. Rather, interest rates have to be pulled up by robust economic growth with the Fed following suit.  

This understanding also means the Fed did not push interest rates to zero percent in late 2008. Rather, it followed the collapsing market forces that were pulling interest rates down at the time. 

To the extent the Fed wants a stable economy, it is limited in how much it can adjust interest rates. Its interest rate adjustments have to follow the health of the economy.  

Luckily for the Fed, the health of the U.S. economy seems to have turned the corner and begun a robust recovery. This has allowed the Fed to finally break free from the chains of low interest rates.

This is a point I have repeatedly made over the past eight years. For example, see this older National Review article with Ramesh Ponnuru or this more recent piece from the Mercatus Center's Interest Rate Colloquium.[Update: See also this post to which Paul Krugman replied] My hope is that the lesson sinks in to the many Fed watchers claiming the Fed created 'artificial interest rates'.

Update: Just to make it clear, here is a figure showing both the stock market and treasury market response since Trump's election.

Macro Musings Podcast: Rudi Bachmann

My latest podcast is with Rudiger Bachmann. Rudi is an associate professor of economics at the University of Notre Dame and a research affiliate at the Center for Economic Policy Research. Rudi has published widely on macroeconomic issues in top journals and is an active member of the German Economic Association. He also blogs and write popular press articles for the German media. Rudi joined me on the show to discuss German macroeconomics as well as some of his own research. 

Our conversation begins by noting that German macroeconomics appears to be very different than Anglo-American macroeconomics. Rudi notes that is partly a misperception problem, but there is indeed something different. What is different is how macroeconomics is currently practiced in Germany: it reflects the ordoliberalism view that stresses a rules-based approach to policy. This approach to macroeconomics makes lawyers rather than economists top advisers to policy in Germany and it reflects the lasting legacy of Walter Eucken. This view not only affects Germany, but macroeconomic policy throughout the EU. 

One of the interesting issues that emerge from this discussion is that the German polity seems to worry more about repeating the mistakes of the Weimar hyperinflation in the early 1920s than the mistakes of the Great Depression in the late-1920s. The former is well known but the latter was arguably more consequential since it helped bring the Nazi to power in Germany. It is not clear why the hyperinflation experience trumps the Great Depression experience, but its experience helps shape the ordoliberalism approach to economic policy in Europe today. 

Rudi and I then shift our conversation to the future of Europe. Rudi remains hopeful that EU project will survive the Eurozone crisis and other challenges now facing it.

We conclude by discussing Rudi's work on uncertainty and the business cycle and the importance of inflation expectations for consumers. 

This was a fascinating conversation throughout. 

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

Related Links

Ruid Bachmann's homepage

Macro Musings Podcat: Andy Levin

 

My latest Macro Musing podcast is with Andrew Levin. Andy is a professor of economics at Dartmouth College and previously served two decades as an economist at the Federal Reserve Board, including two years as a special adviser to Chairman Ben Bernanke and Vice Chair Janet Yellen. Andy, in short, has a deep understanding of the history and workings of the Board of Governors and the FOMC .

During his time as a special adviser he helped spearhead the advent of the FOMC press conference, the Summary of Economic Projections, and the now infamous dot plot graph. He also was involved with the FOMC's official adoption of its 2 percent inflation target. Andy discusses these developments with me and how he would like to see them further refined. 

We also discussed what happened in 2008. The economy was contracting and yet for much of the year the Fed was signalling it was worried about inflation and wanted to raise rates. Specifically, beginning around April 2008 the market expectation of where the federal funds rate would be 12 months ahead started rising. It rose all the way to about 3.5 percent by June 2008--the market was expecting the Fed to raise rates 150 basis points in mid-2008! Although it slowly came down, the fed fund futures rate 12-months ahead still remained higher than the actual federal funds rate through September. This can be seen in the figure below:

Andy notes that the FOMC transcripts reveal that even by the September 2008 meeting Fed officials were still not grasping the severity of the crisis. Why? We discuss whether they were simply too focused on inflation or whether insular thinking and group think prevented the Fed from appreciating the severity of the downturn during 2008.   

We then moved on to Andy's proposed reforms. These have received coverage in the media and support from the 'Fed Up' campaign. Andy's reforms are driven by four key problems he finds with the Fed: (1) Regional Fed banks face a conflict of interest given their private ownership, (2) the process for choosing Fed officials is opaque and broken, (3) their is a lack of diversity at the Fed, (4) the Fed is shielded from public oversight. Andy's solutions to these problems are to (1) end commercial ownership of the regional Fed banks, (2) make Fed officials limited to a single, non-renewable 7-year term, (3) make all Fed employees public employees with a better representation of the American public, and (4) align transparency at the Fed with the standards of other public institutions. 

We close the discussion by looking at Andy's research on the anchoring of inflation expectations, the need to do periodic evaluations of the Fed's objectives, and the question of why inflation has been persistently below target for the past five years. This was a thought-provoking conversation throughout. 

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

Related Links
Andy Levin's homepage
Andy Levin's twitter account
Andy Levin's reform proposal

The Loflation Pandemic

The IMF reports in the latest WEO that the world has a low inflation problem:

By 2015, inflation rates in more than 85 percent of a broad sample of more than 120 economies were below long-term expectations, and about 20 percent were in deflation—that is, facing a fall in the aggregate price level for goods and services (Figure 3.2). While the recent decline in inflation coincided with a sharp drop in oil and other commodity prices, core inflation—which excludes the more volatile categories of food and energy prices—has remained below central bank targets for several consecutive years in most of the major advanced economies.

Here is the IMF's figure that nicely summarizes this development:

This figure shows this trend toward low inflation started around the time of the Great Recession and has only grown. Given its global nature, I am going to call this development the loflation pandemic. So what is behind it? Here is the IMF's explanation:

Economic slack and changes in commodity prices are the main drivers of lower inflation since the Great Recession.

The commodity story, in my view, is limited in how much it can explain since commodity prices have gone up and down since 2008. Moreover, as Jim Hamilton and Ben Bernanke argue, just under half of the commodity price decline since mid-2014 can be attributed to weak global demand. Weak commodity prices, in other words, are themselves partly the result of anemic demand.

That leaves economic slack, or insufficient nominal demand growth, as the main reason for the decline in global inflation. As I said before, nominal demand ain't what it used to be. This, though, begs the question as to why nominal demand growth been so weak? And why have advanced economies been so willing to tolerate it? 

The IMF does not answer these questions. All it recommends is that governments do more with fiscal and monetary policy, complemented with structural policy. This is futile. One cannot expect to change government's behavior without first knowing why they are acting as they do. 

Since the IMF seems unwilling to go there, I will. Governments in advanced economies have avoided robust aggregate demand growth--and therefore have created the loflation pandemic--because of the constraints created by their past successes with inflation targeting. Inflation targeting has become the poisoned chalice of macroeconomic policy:

Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone from the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.  

Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy...  

For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs...

Put differently, no matter what the central banks try--QE, forward guidance, negative rates--they will never push beyond the public's expectation of low inflation. Fiscal policy, including helicopter drops, will also run up against this constraint. 

This constraint also means that policymakers may not have the flexibility they need to stave off recessions:

If a trucker gets stuck in traffic jam, he will have to temporarily speed up afterwards to make up for lost time. On average, his speed for the trip will be the legal speed limit but only if he temporarily speeds up after the traffic jam. Likewise, an economy may need temporarily higher-than-normal inflation after a sharp recession to return to full employment. This also implies temporarily higher-than-normal nominal demand growth. On average, this temporary pickup will keep inflation and nominal demand growth on target. Running a little hot, therefore, is necessary sometimes. Currently, however, this policy flexibility is not possible.

This, in my view, is a key reason why the recovery from 2008-2009 was so weak. It is also why QE was set up to disappoint.

Inflation targeting was a much needed nominal anchor across the globe when it was first introduced in the early 1990s. But now it has put advanced economies into a low inflation straitjacket that is becoming a drag on economic growth. Until we recognize and act upon this observation, we can expect the loflation pandemic to spread.  

ECB Stimulus in Perspective

Today is a big day for the ECB. Mario Draghi and other monetary officials are expected to add further monetary stimulus via additional interest rate cuts and a possible expansion of the ECB's QE program. Many observers are getting excited and expecting big market moves. 

Here is the thing. Even if the ECB cuts rates and adds more QE and even if there are big positive swings in market prices, these changes will only be tolerated up to the point they push core inflation to between 1.00 and 1.25 percent. That seems to be the ECB's true inflation target range per revealed preferences. Not only is that well below the ECB's stated inflation target of being "below, but close to 2 percent", but it is nowhere near enough to create the kind of catch-up spending growth needed to restore full employment in the Eurozone. 

This is the same problem that plagues the Fed. As I recently noted in my FT Alphaville piece:

The real reason for this failure [to create a robust recovery] is the Fed’s firm commitment to low inflation. Like a governor placed on a truck’s engine to control its speed, a commitment to low inflation helps prevent the economy from growing too fast. Normally, this is a good thing. But sometimes it can backfire. A truck driver may need to temporarily go faster to make up for lost time after being stuck in traffic. Similarly, an economy may need to temporarily speed up to get back to its full potential after a recession. Neither can happen with a rigid adherence to the speed limit. 

Put differently, both the ECB and the Fed are constrained by inflation-targeting straitjackets. These straitjackets are more than the outcome of central banks actions. They are the product of what the body politic expects and so they are tough to remove. But that is exactly what is needed.

To be clear, we want to keep long-run inflation expectations anchored but allow for the temporary deviations in inflation when needed to generate catch-up growth in nominal spending. The best way to do it, in my view, is through level targeting. Here is an earlier post showing a counterfactual where the Fed adopted a NGDP level target in mid-2009. What it reveals is that inflation would have had to temporarily hit between 3 and 4 percent before settling back down to 2 percent in order to stabilize demand. Something similar would be needed in the Eurozone. But this is not going to happen anytime soon.

The world sorely needs predictable, rules-based level targeting. Until it gets some, we should continue to expect weak recoveries from recessions. 

P.S. I made this same point in a BoomBust interview this week. 

The Fed Did Not Make A Mistake In December

Many observers are now viewing the Fed's decision in December to raise interest rates as a "policy error". With volatility in financial markets, falling commodity prices, and a fourth quarter slowdown many believe the Fed got ahead of the recovery with the December interest rate hike. Some even are even calling it a "huge mistake"or a "historic rate hike mistake". One person even called it an "epic mistake".

I see things differently. The Fed did not make a mistake in December. It made a mistake all last year by talking up interest rate hikes and signalling a tightening of future monetary policy. Since markets are forward looking, this expectation got priced into the market and affected decision making. The Fed did this even though the economy was not back at full employment. The December rate hike was just a confirmation of these expectations.

The Fed, in other words, got ahead of the recovery well before December. Damage was already being inflicted on the economy by the time the actual rate hike occurred, as seen in the figures below. They all show the 12-month ahead expected federal funds rate plotted against various economic indicators. 

The first one shows the future federal funds rates alongside the trade weighted value of the dollar. Unsurprisingly, both start rising at about the same time in late 2014.

The trend growth of the stock market also began turning down about the same time as the expected tightening cycle began. 

The expected tightening also coincided with a sustained decline in expected inflation as seen below. Yes, this is not a perfect measure of expected inflation. It has a risk premium in it that could be overstating the decline. But as Narayana Kocherlakota notes, if this is the case it only underscores the point that Fed has been overly tight. For a rise in the risk premium means an increase in the demand for safe assets and a decrease in aggregate demand growth. 

The next figure show that the risk premium--as measured by the spread between BAA yield and 10-year treasury yield--did in fact coincide with the expected tightening signaled by the Fed. 

The slowdown in industrial production that began last year also roughly tracks the expected tightening by the Fed as seen below. 

Other indicators like the GDP in the fourth quarter, retail sales, or personal consumption also show a softening. In general, the point is that the Fed appears to have gotten ahead of the recovery well before December simply by talking up a rate hike. 

Though the focus of this post is on the domestic U.S. economy, it is worth briefly noting the international implications too. As shown above, the dollar rose in step with the expected tightening of Fed policy. The stronger dollar, in turn, has pulled up the Yuan with it and this can explain why problems in China first emerged last August. China is dealing with deep structural problems and is doing so by violating the macroeconomic trilemma. That is, China is pegging its currency to the dollar, is easing domestic monetary policy, and is allowing some capital flows in an attempt to stabilize its economy. This is an unsustainable policy mix and is already creating financial market volatility. 

Though it takes two to tango, the dollar surge over the past year helped push China into this predicament. China is now bleeding foreign reserves faster than ever and the timing of it can ultimately be traced backed to the expected tightening of Fed policy. 

So no, the Fed did not make a mistake at its December meeting. It made a mistake over the entire past year and now we are seeing the fruition of this error.