The Decline of the 10-Year Treasury: Implications for Fed Policy

The 10-year treasury yield reached an historic low this week, crossing the 1% barrier. For many observers, this was a troubling development that confirms the U.S. economy is being sucked into the mire of secular stagnation. For others, it was an unsurprising outcome given the long-run trajectory of interest rates and the ongoing safe asset shortage problem.

Both views have some merit. The decline of the 10-year treasury yield does create problems for the U.S. economy, but it has been happening for some time. There is nothing magical about crossing the 1% barrier, though it does brings closer the day of reckoning for the Fed's operating framework.

The decline of the 10-year treasury yield, if sustained, means the entire yield curve may soon run into its effective lower bound. This will render useless much of the Fed's toolbox. Fortunately, there is a fix for the Fed's operating framework that makes it robust to any interest rate environment. This fix, ironically, ties the Fed more closely to fiscal policy while making it more Monetarist in practice. 

This post outlines the proposed fix, but first motivates it by explaining how the decline in the 10-year treasury yield creates problems for the U.S. economy.

Why The 10-Year Treasury Yield Decline Matters 

The are three reasons why the fall in the 10-year treasury yield matters. First, it implies there is an excess demand for safe assets. These are securities that are expected to maintain their value in a financial crisis and, as a result, are highly liquid. The biggest sources of safe assets are government bonds from advanced economies, especially U.S. Treasuries. The global demand for them has far outstripped their supply and this has led to the global safe asset shortage problem. The 10-year treasury yield falling below 1% is the latest manifestation of this phenomenon.

The safe asset shortage is problematic because it amounts to a broad money demand shock that slows down aggregate demand growth. One solution is for safe asset prices (interest rates) to adjust up (down) to the point that safe asset demand is satiated. The effective lower bound (ELB) on interest rates prevents this adjustment from happening and causes investors to search for safe assets elsewhere in the world. Other economies, as a result, are also affected by the safe asset shortage problem and experience lower aggregate demand growth.¹

The demand for safe assets, as noted above, is closely tied to the demand for liquidity. This can be seen in the figure below which shows that the use of money assets (i.e. money velocity) closely tracks the 10-year treasury yield. Over the past decade, this has meant the public's desired money holdings have increased as the 10-year treasury yield has fallen. All else equal, this implies slower growth in aggregate spending.

Below is a chart from an upcoming policy brief of mine that illustrates this point from a global perspective. It shows the average 10-year government bond yield between 2009 and 2019 plotted against the average growth rate of domestic demand over the same period. The government bond yield can be viewed as the safe asset interest rate in these advanced economies. The figure reveals a strong positive relationship between the safe asset yield and the domestic demand growth rate.

One has to be careful interpreting the causality here, but I do further analysis in the policy brief and find shocks to the bond yields do influence domestic demand growth. The safe asset shortage, therefore, appears to be a drag on global aggregate demand growth. The first reason, then, why the decline in the 10-year treasury yield matters is that it portends weaker aggregate demand growth. 

The second reason the decline matters is that it leads to a flattening of the yield curve. Financial firms that fund short term and invest long term rely heavily on a positive slopping yield curve to make this business model work. A flattening yield curve undermines it and may lead to less financial intermediation. This is one reason an inverted yield helps predict recessions. In this case, however, the  effect may be longer lasting than the business cycle as the decline in treasury yields appears to be on a sustained path.

The third reason the decline matters is that it impairs the Fed's current tool box. The Fed's target interest rate is now down to a 1-1.25% range, a small margin for a central bank that normally cuts around 5% during a recession. The Fed could turn to large scale asset purchases once it hits the ELB, but with the 10-year treasury now near 1%, there is not much space here either. Consequently, the Fed's toolbox is shrinking and soon could be rendered useless. 

Now the Fed can add to its toolbox and indeed the Fed is exploring new tools--such as negative interest rates and yield curve control--under its big review of monetary policy. Even these tools, however, are limited since the declining 10-year treasury yield is compressing the yield curve. 

The Fed's current toolbox, in short, is premised on a positive interest rate world that is slowing fading. The Fed, therefore, may soon face a day of reckoning for its current operating framework. That possibility and what the Fed could do in response is considered next.

Revamping the Fed's Operating Framework

The Fed’s operating framework--defined here as the instruments, tools, and targets the Fed uses in its conduct of monetary policy--has been geared toward a positive interest rate environment. This framework has been increasingly strained by the downward march of interest rates. The 10-year treasury yield dropping below 1% underscores this challenge.

The Fed needs, consequently, an operating framework that is robust to any interest rate environment and one that is capable of stabilizing aggregate demand growth. I have proposed a fix to the Fed's operating system that addresses these challenges in a forthcoming journal article. Here I want to briefly outline that proposal. It has three parts: (1) the Fed adopts a dual reaction function, (2) the Fed adopts a NGDP level target, and (3) the Fed is empowered with a standing fiscal facility for use at the ZLB.  The three parts are explained below. 

Part I: A Dual Reaction Function. To make the Fed’s operating framework robust to both positive and negative interest rate environments, I call for a two-rule approach to monetary policy. Specifically, the Fed would follow a version of the Taylor rule when interest rate are above zero percent and follow the McCallum rule when interest rate are at zero percent or below. The former rule uses an interest rate as the instrument of monetary policy while the latter rule uses the monetary base as the instrument.  Consequently, the Fed would have effective instruments to use no matter what happens to interest rates. 

Part II: A NGDP Level Target. A level target provides powerful forward guidance since it forces the central bank to make up for past misses in its target. For reasons laid out here, I prefer a nominal NGDP level target (NGDPLT) and specifically, one that targets the forecast. This combined with the first feature implies the following dual reaction function system for the Fed:

Here, iⁿ is the neutral interest rate, the NGDP^Gap is the percent difference between the forecasted level of NGDP and the NGDPLT for the period of t to t+h, Δb is the growth rate of the monetary base, Δx* is the target NGDP growth rate, and Δv is the expected growth rate in the velocity of the monetary base for the period of t to t+h.

Part III: A Standing Fiscal Facility. The final part of the proposal establishes a standing fiscal facility for the Federal Reserve to use when implementing the McCallum rule. That is, when the Fed starts adjusting the the growth of the monetary base according to the McCallum rule, it will do so by sending money directly to the public. My proposal, then, incorporates 'helicopter drops' into the Fed's toolkit in rule-like manner. 

I provide more details in the paper, but here are the advantages of this proposed operating framework. First, it keeps countercyclical macroeconomic policy at the Federal Reserve. This provides continuity with the existing division of labor between the U.S. Treasury Department and the Federal Reserve.  Second, it enables the Fed to provide meaningful countercyclical monetary policy no matter what happens to interest rates. Third, it provides credible forward guidance since it combines a NGDPLT with helicopter drops. Finally, since this operating framework would require the Fed to be much more intentional about the rules it follows, it would make the Fed more rules-based and predictable. 

This proposal would require approval from Congress. Given the Fed's shrinking toolbox and the ongoing expectation that it deliver countercyclical policy, this may not be as big an ask as some imagine. Moreover, it could easily be seen as return to a more Monetarist Federal Reserve since it would be relying more explicitly on the monetary base to implement monetary policy. 

Conclusion 
Some commentators have speculated that the corona virus might be a shock that forces us out of our complacency and spawns many unintended innovations. To the extent this shock leads to ongoing declines in the treasury yields and exhausts the Fed current toolbox, it might also lead to innovations in U.S. monetary policy. Here's hoping it does along the lines suggested above. 

¹ The safe asset shortge can also become self-perpetuating and lead to what Caballero et al (2017) call a ‘safety trap’. This problem emerges when the excess demand for safe assets pushes down safe asset yields to the effective lower bound (ELB) on interest rates. If the excess demand for safe assets is not satiated at that point (i.e. the equilibrium real safe asset interest rate is below the ELB), then aggregate demand will contract and push down inflation. Via the Fisher relationship, the lower inflation will drive up the real safe asset interest rate and increase the spread between it and the equilibrium real safe asset interest rate. As a result, aggregated demand will further contract and the cycle will repeat.  This is the safety trap.

More Non-Star Metrics for Monetary Policy

In an earlier post and Bridge article, I discussed some ways to use nominal GDP (NGDP) as a cross-check on the FOMC "navigating  by stars" of r*, u*, and y*. The  motivation for these pieces was Fed Chair Jay Powell's concerns about the challenge of using these star variables when they seem increasingly in flux. Here, again, is a key excerpt from his talk:

Navigating by the stars can sound straightforward. Guiding policy by the stars in practice, however, has been quite challenging of late because our best assessments of the location of the stars have been changing significantly… the FOMC has been navigating between the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting navigational guides.

The Fed chair is implicitly challenging us to find indicators that shed light on the stance of monetary policy without having to know r*, u*, and y*. The metric I suggested in the earlier pieces was the "sticky-forecast" NGDP benchmark growth path. Here I want to suggest another two measures for the Fed chair.

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

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

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

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

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

Assorted Macro Musings

Some assorted macro musings from the week

A Monetary Correction

Ramesh Ponnuru and I have a new article in the National Review where we make the contrarian case that monetary policy was actually tight over the past decade relative to its own inflation target and past trends in the growth of aggregate nominal spending. We note the following:

The economy seems largely to have adjusted to the new, lower pace of spending growth. The problem now is not that monetary policy is erring on the side of tightness and thus holding back the economy’s potential. It’s that the Fed’s apparent bias against letting spending and inflation drift higher, even temporarily, makes it more likely that the next economic downturn will again be severe and the next recovery will again be sluggish.

As evidence for our claim on a trend decline in the growth of nominal spending, we show the following figure:

Asymmetric Inflation Fears

I often chastise the Fed for effectively having an asymmetric 2% inflation target. The truth is, though, that the Fed's undershooting of its inflation target is mild compared to the asymmetric inflation fears many of financial commentators. When the CPI hit 2.1% last week the financial pundits began to freak out like it was the 1970s all over again.  The Wall Street Journal OpEd shown below is a good example of this thinking:

Where was this concern when inflation was undershooting for so long? Recall that the official target of the Fed, the PCE deflator inflation rate, has been running about 50 basis points below its target for almost a decade. (Yes, the Fed was implicitly targeting 2% before 2012 so it has been a decade.) 

Comments on January's FOMC Minutes

The January FOMC minutes came out this week and I had a few things to say about them on twitter. Below is a screen shot of my first tweet. I also did a quick write up of these points at The Bridge.

Israel Monetary Awesomeness Update

In the past some of us have pointed to the Bank of Israel(BoI) as a central bank that does flexible inflation targeting right.  We noted that the BoI allows for truly flexible countercyclical inflation that on average hits its inflation target. It does it so well that nominal demand growth has been relatively stable. Below are a few pictures to illustrate this point

Consider first Israel's inflation rate, as measured by the GDP deflator. Since 2007, this inflation rate has moved in a countercyclical fashion. The BoI officially targets inflation within a range of 1%-3%, but has allowed inflation to touch 5% two times over the past decade when real GDP decline. It also has allowed inflation to fall when GDP has soared. Over this sample period, the GDP deflator inflation rate has average just over 2%. Imagine that: a symmetric inflation target over the business cycle!

As a result of this inflation flexibility, nominal demand has been relatively stable. Well done BoI. Here's hoping that some at the Fed are taking notice.

Floors vs Corridors: Fed Edition

This week on the podcast I interviewed George Selgin. We discussed the difference between a corridor and floor system and what that means for the Fed. Among other things, we discuss how a floor system can create a liquidity-trap like situation above the ZLB, what a car in neutral can tell us about a floor system, and what we know about the legality of IOER. Take a listen.

Monetary Regime Change Update

I recently made the case that we got a monetary regime change in 2008 that explains the stubbornly low inflation since that time:

A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.

The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  

Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path.  

Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. 

I went on to say this is the monetary regime change no one asked for. It is also one that many observers seem to miss in their analysis of Fed policy since the crisis.  

Well, I was on twitter discussing long-term treasury yields and monetary policy with Tim Duy and Joel Wertheimer. I decided to whip up some charts comparing 1-year head NGDP forecasts from the Philadelphia Fed's Survey of Professional Forecasters against 10-year treasury yields. The results, in my view, are consistent with the claim that there was a monetary regime change in 2008. 

First, here is the chart for the 1980:Q1-2007:Q4 period. It shows a fairly strong relationship between expected NGDP growth and long-term treasury yields:

The next figure shows the relationship for the period since 2008:Q1. Say goodbye to that relationship:

Just to be robust, I took out the outliers in the above chart (which are for the periods 2008:Q4-2009:Q2) and got the following chart:

So something has changed in the relationship between expected NGDP growth and long-term treasury yields. The monetary regime change story outlined above coincides closely with this breakdown. Here is one way to connect these two developments. Before 2008 the Fed allowed its tightening to follow the pace of recovery, whereas afterwards the Fed has tended to get ahead of the recovery in its desired and actual rate hikes. If so, the Fed's tightening post-2008 would have slowed down the recovery and lowered the expected future path of short-term interest rates. This overreacting by the Fed would have kept long-term interest rates from rising with expected rises in NGDP growth. This type of behavior would also be consistent with a monetary regime change where only low rates of NGDP growth and inflation are tolerated. This is what appears to have happened in 2008. 

Monetary Regime Change: Mission Accomplished

Christina Romer, former CEA chair, called for a monetary regime change several times between 2011 and 2013. It is now several years later and it appears we did finally get a monetary regime change. Unfortunately, it is not the kind of regime change Christina advocated and actually goes in the opposite direction. 

Christina called for the Fed to adopt a nominal GDP level target that would restore aggregate demand to its pre-crisis growth path. Instead, we got a regime change that has effectively lowered the growth rate and the growth path of aggregate demand. This regime change, in my view, is behind the apparent drop in trend inflation that Greg Ip recently reported on in the Wall Street Journal. 

It is not easy to change trend inflation--just ask Paul Volker--but the Fed and other forces seemingly accomplished just that over the past decade. Since the end of the crisis, the average inflation rate on the Fed's preferred measure of inflation, the core PCE deflator, has fallen to 1.5 percent The headline PCE deflator average has fallen to 1.4 percent over the same period. Both are well below the Fed's target of 2 percent. 

This persistent shortfall of inflation has received a lot of attention from critics, including me. Lately, some Fed officials are also beginning to see the inflation shortfall as more than a series of one-off events. Governor Lael Brainard's recent speech is a good example of this change in thinking with her acknowledgement that trend inflation may be falling.

Still, there is something bigger going on here that is being missed in these conversations about the inflation rate. A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.

The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  

Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path. 

Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. So this is a joint monetary-fiscal problem that has effectively created a monetary regime change.

So yes, we got a monetary regime change, but no it is not the one Christina Romer and most of us wanted. 

An Alternative to Raising the Inflation Target

Ramesh Ponnuru and I have a new article in the National Review where we make the case that a better alternative to a higher inflation target is a NGDP level target:

Does the U.S. economy need more inflation? A group of 22 progressive economists has written a letter to the Federal Reserve urging it to appoint a blue-ribbon commission to study whether the central bank should raise its target for inflation above its current 2 percent. Fed chairman Janet Yellen, in her press conference following the latest interest-rate increase, called it “one of the most important questions” facing the organization. The economists’ advice shouldn’t be rejected out of hand, but it should be rejected. They make some valid points in their diagnosis of the ills of the current monetary regime. But the Fed can and should address these problems without raising inflation...  

These arguments for a higher inflation target are reasonably strong if you accept the premise that keeping inflation stable should be the Fed’s principal task in the first place. There is, however, a superior alternative. That alternative would stabilize the growth of nominal spending: the total amount of dollars spent throughout the economy...  

This policy would capture the benefits of inflation targeting...A key difference between the two policies is that a nominal-spending target would allow inflation to fluctuate over the short term in response to movements in productivity. 

In general, a nominal GDP level target allows for more inflation flexibility than is currently seen in practice while keeping the growth path of nominal demand stable. This rule would also improve over  current approaches by better risk-sharing in the financial system, better aligning of the Fed's interest interest rate with the natural interest rate, and better maintenance of money neutrality. Finally, its an target that invokes the imagery of Chuch Norris and Jean-Claude Van Damme.

Talking Monetary Policy with Paul Krugman

Paul Krugman joined me for the latest Macro Musings podcast. It was a fun show and we covered a lot of ground from liquidity traps to secular stagnation to fighting the last war over inflation. Paul and I have had conversations in the blogosphere since the 2008 crisis so it was real treat to finally chat with him in person.

In our conversation there were two issues brought up that deserved more time, in my view, than we could give on the show. So I want to address them in this post.

The first one is the important distinction between temporary and permanent monetary base injections. This distinction came up up in our discussion on what it takes to reflate an economy in a zero lower bound (ZLB) environment. Krugman's 1998 paper showed that to do so requires a permanent increase in the monetary base whereas a temporary one will not work. This 'irrelevance result' was further developed by Eggertson and Woodford (2003) who showed that QE programs that are temporary in nature will not spur rapid aggregate demand growth. Others have since built upon this point and there is also earlier monetarist literature that makes a similar argument (source). Here is an excerpt from a Michael Woodford FT piece in 2011 that nicely summarizes this view¹:

The economic theory behind QE has always been flimsy. The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank's supply of base money. Because of this, at least in the long run, any increase in supply must raise prices proportionally. It followed that, in the short run, QE must also have an effect on spending levels, that will eventually tend to raise prices, even if the channels by which this occurs are obscure.  

The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan's experiment with QE, the added reserves were all rapidly withdrawn in early 2006. More worryingly for Mr Bernanke, whatever the long-run effects would have been, there was no increase in nominal growth over the five years of the experiment.  

The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.

Woodford acknowledges the Fed's large scale assets purchases can help when financial markets freeze up like during QE1, but beyond that will not create the kind of robust aggregate demand growth required to quickly escape a ZLB environment.

For me, the implication of this understanding is that the Fed should have aimed to return the price level (or nominal income) to its previously-expected growth path following the crisis. Krugman, on the other hand, is worried that might not be enough if secular stagnation is real. He, consequentially, prefers a permanently higher inflation rate whereas my approach would imply only a temporary one. In short, I want a level target for monetary policy whereas Krugman wants a higher inflation target.

I also want to be clear as to exactly what is a permanent monetary base injection. First, it is an (exogenous) injection beyond that warranted by normal money demand growth. That is, an increase above the regular growth created by currency demand, required reserves, and other normal (endogengous) sources of monetary base growth. Second, the actual permanent increase need not be very large given the long-run unitary relationship between the monetary base and the price level (after controlling for real growth). Third,  the permanent increase does not mean the monetary base injection is permanent throughout eternity. Only that it is permanent to the extent the current economic conditions that warranted the injection continues to hold. New economic developments may call for additional permanent changes to the monetary base. Finally, most central banks cannot credibly commit to such permanent increases in the monetary base, as evidenced by the record-low inflation in advanced economies since the crisis.  For more on these points see this recent paper of mine.

The second issue is my suggestion that fiscal policy could be used to stabilize the money supply. This came up near the end of the podcast when we started discussing the safe asset shortage problem. The key idea here is that the money supply properly measured includes both retail and institutional money assets. The Center for Financial Stability (CFS) has estimated such a measure. It is the Divisia M4 money supply which includes athe retail money assets in M2 plus institutional money assets. The latter include repos, commercial paper, institutional money market funds, and large-time deposits. 

As Gary Gorton and others have shown, there was a bank run on these institutional money assets during the financial crisis that led to a sizable and persistent reduction in their supply. This can be seen in the figure below which uses the M4 component data from the CFS:

This persistent shortfall in the privately-produced institutional money assets seen above was partially offset by the rise in treasury bills.  More of the shortfall could, in theory, be offset by the issuance of additional treasury bills. That was the point I was trying to make. The big question here is could the U.S. Treasury issue enough treasury bills to fill the institutional money asset shortfall without jeopardizing its risk-free status? I do not know. But it is one possible solution to the safe asset shortage problem.

The chart below builds upon the last figure by plotting the institutional money assets along side the retail money assets (or M2). Together they make up the M4 money supply. The figure reveals that even though the M4 money supply is now past its pre-crisis peak, is still far below its pre-crisis trend path. It never has fully recovered from the Great Recession. This could be part of the story for the weak recovery and, arguably, treasury could help.

Related Links
Permanent versus Temporary Monetary Base Injections: Implications for Past and Future Fed Policy
Scott Sumner on Paul Krugman's podcast

¹ The Michael Woodford article ran in the Financial Times on August 26 and was titled "Bernanke Should Clarify Policy and Shrink QE3"

Dollar Domination, Robot Monetary Overloads, and Closing the AD Gap

Some assorted musings:

1. From this week's podcast with Ethan Ilzetzki comes this amazing figure. It shows that approximately 70% of world GDP is tied to the dollar. The implication is staggering: the FOMC is setting monetary conditions for much of the world.

Source

2.  Greg Ip argues our robot fears are misplaced. If anything, we do not have enough robots destroying jobs:

From Silicon Valley to Davos, pundits have been warning that millions of individuals will be thrown out of work by the rapid advance of automation and artificial intelligence. As economic forecasts go, this idea of a robot apocalypse is certainly chilling. It’s also baffling and misguided. Baffling because it’s starkly at odds with the evidence, and misguided because it completely misses the problem: robots aren’t destroying enough jobs...  

This calls for a change in priorities. Instead of worrying about robots destroying jobs, business leaders need to figure out how to use them more, especially in low-productivity sectors.

Okay, what industries fit this description? Greg mentions the usual suspects: education, healthcare, and leisure and hospitality. Here is another one: central banking. It has not changed much in many decades and probably has low productivity. So maybe the hidden message of Greg's article is we need to get robots running the Fed?  My answer: sure, but only if they are targeting a NGDP futures market as proposed by Scott Sumner. This approach, after all, is fairly automatic by design and therefore conducive to our robot overlords taking over the Fed.

3. The CBO estimates the full-employment level of aggregate demand. They unfortunately call it "potential nominal GDP' which is horrific since the potential is truly infinite--think Zimbabwe's NGDP in 2008--so ignore the official name. The idea behind the measure is reasonable: what level of aggregate nominal spending is consistent with full employment. Here is the series lined up against actual aggregate demand as measured by NGDP. 

Source

The figure indicates there was a sharp collapse in aggregate demand during the crisis and the full-employment level has only slowly converged to it. Therefore, there was both a sharp decline in aggregate demand (a cyclical shock) and a downward adjustment in the full-employment trend level of aggregate demand (a structural shock). This understanding is consistent with the recent Fernald et al. (2017) BPEA paper that found that there was both a demand shortfall (that ended by mid-2016) and a decline in potential real GDP. So the CBO's full-employment level of aggregate demand seems quantitatively reasonable.  

For fun, I plotted the difference between the full employment level and actual aggregate demand--the AD gap--against the latest hip labor market indicator. It is the working-age employment rate (a termed coined by Jordan Weissmann) which is more commonly known as the employment-to-population rate for prime-age workers (25-54 year olds). Nick Bunker has been a tireless advocate for using this measure to replace the unemployment rate as the headline labor market indicator. 

So how does the working-age employment rate measure up against the AD gap? Not too bad according to the figure below. The relationship is not perfect, but it is strong enough to indicate that the continued upward recovery of the working-age employment rate over the past few years has been largely due to cyclical factors. 

Source

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: Jesus Fernandez-Villaverde

 

My latest Macro Musing podcast is with Jesus Fernandez-Villaverde.  Jesus is a professor of economics the University of Pennsylvania, a research associate with the National Bureau of Economic Research, and a research affiliate with the Centre for Economic Policy Research. 

Jesus does theoretical macroeconomic modeling, econometrics, and economic history. He has several books coming out on those topics and recently coauthored a chapter in the Handbook of Macroeconomics titled "Solution and Estimation Methods for DSGE Models". He joined me to talk about European economic history and macroeconomic modeling on the show. 

Most of our conversation focused on German monetary history in the 20th century since it has been so consequential for the rest of the Europe. We began by discussing the Weimar hyperinflation of the early-to-mid 1920s and the Great Depression of the late 1920s-early 1930s. It is hard to appreciate the fact that Germany went from hyperinflation to painful deflation in a decade. Several interesting questions come out this experience. First, which is worse: hyperinflation or depression? Second, why do the Germans seem to remember the former more than the later? Third, is it true that the Great Depression brought the Nazis to power? Jesus provides good answers to these in the interview. We also touch on Bretton Woods, the EMS crisis in 1992, the advent of the Eurozone, and the best path forward for this currency union.

Jesus and I then turn to the current debate over DSGE  modeling in macroeconomics. He responds to recent criticism of this approach and also considers the the future of monetary search models in this field.

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 episodes are coming.

Update: Since we talked about it in the podcast, here is a chart I created some time ago on the EMS crisis in 1992 . It shows Germany's tightening of monetary policy pulling down (via the peg) nominal demand in other European countries.  It is also shows a recovery in UK nominal spending once the peg was broken.

Related Links

Jesus Fernandez-Villaverde's home page

Macro Musings Podcast: Gauti Eggertsson

My latest Macro Musings is with Gauti Eggertson. Gauti is a professor of economics at Brown University and formerly worked in the research departments of the International Monetary Fund and the Federal Reserve Bank of New York. He has written widely on liquidity traps, deflation, and the zero lower bound (ZLB) and joined me to talk about these issues.

This was a fun conversation and a good look back at the challenges and shortcomings of macroeconomic policy since the crisis in 2008. One of the big takeaways from our conversation, at least for me, is that central banks during this time ignored many of the key findings in the literature when it comes to best practices at the ZLB.

Before getting to these missed opportunities, it is worth recalling the nature of the ZLB problem. It emerges when there has been a severe recession that forces down the 'natural' or market-clearing level of short-term interest rates to a level well below 0%. The Fed's normal response, lowering interest rates to the level of the natural interest rate, does not work here because the Fed will run up against a lower bound where people would rather hold cash than earn a negative interest rate on their deposits. This lower bound is effectively a price floor that prevents the economy from properly healing and quickly returning to full employment. 

So what can policymakers do? Gauti's work gives an answer. Specifically, his 2003 paper with Michael Woodford (which builds upon Paul Krugman's 1998 paper) shows that policymakers need to credibly commit to an expected path of interest rates that will restore the pre-crisis path of the price level. Put differently, Gauti's work implies the best defense against and escape from a depressed economy is some kind of level targeting. Gauti favors an output-gap adjusted price level target. As Michael Woodford noted in his 2011 talk, this effectively amounts to a nominal GDP level target or restoring the growth path of nominal spending. 

One implication of this understanding is that if there is any disinflation or deflation from a collapse in aggregate demand during a recession there needs to be an offsetting period of reflation to restore the aggregate demand growth path. This did not happen after 2008 and implies aggregate demand growth was persistently weak. This was a missed opportunity by the Fed.

The Fed, instead, tried various rounds of QE. And it did so in exactly the manner that Eggertson and Woodford (2003) and Krugman (1998) said would lead to the famous  'irrelevance results'. That is, the Fed did these programs using temporary monetary base injections, whereas only permanent injections matter. 

What is truly surprising about this observation is that the permanent injections point is widely understood. For example,  here is a list of prominent New Keynesians who acknowledge it (including former Fed chair Ben Bernanke). And here is a list of quantity theory advocates making the same point.

To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment. 

So why did the Fed ignore the literature and fall right into the irrelevance results trap? I have a working paper that takes a stab at this question. I argue there were both external forces (public's fear of inflation vented via Congress) as well as internal ones (Fed still fighting the last battle and suffering from loss aversion) that kept the Fed timid. In our interview, Gauti made an interesting observation related to this point. The Fed seemed okay being aggressive with QE, but not with reflation. It is a bit of puzzle why it was so bold in the former but timid in the later. 

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 episodes are coming.

P.S.

Gauti and I also touched on how best to sell level targeting to policymakers and the public. Here is a recent Bloomberg article that looks at Gauti's innovative attempt to do so at the New York Fed in 2010 using 'Inflation Budget Accounting". Below is an excerpt:

We suggest that the FOMC keeps track of the extent to which it has "missed" its inflation target. Let us call these accumulated misses "inflation debt". Hence if the inflation target is 2 percent, and inflation is at 1 percent for two years in a row, then the accumulated "inflation debt" is 2 percent. 

The FOMC would then announce an "easing bias" until the inflation debt accumulated in the current recession has been extinguished. If this is credible, a deflationary reading of the data would signal a larger "easing bias" going forward.

P.P.S.

As I note in my working paper mentioned above, the Fed has been explicit about its plan to eventually shrink its balance sheet. It said so in its exit strategy plans reported in the June 2011 and September 2014 FOMC meetings. Janet Yellen recently reiterated those plans in her August 2016 Jackson Hole speech (see footnote 13). More recently, the Federal Reserve updated its basic guidebook to monetary policy in October 2016. Here too it stresses the balance sheet will be reduced:

As the policy normalization process proceeds, the Federal Reserve’s securities holdings—and the supply of reserve balances—will be reduced in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the portfolio...

The FOMC intends that the Federal Reserve will, over the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities (p.52)

And if there were any questions about what this means, the Fed later notes that "no more securities than necessary" means doing away with the overnight  reverse repurchase facility:

During normalization, the Committee is using an overnight reverse repurchase (ON RRP) facility as a supplementary tool as needed to help control the federal funds rate... The FOMC plans to use the ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate (p.51).

I would also add from a political economy perspective that the balance sheet will have to be reduced given IOR. The increasingly bad optics of the Fed paying banks larger interest payments as interest rates go up  will force the Fed's hands on reducing its balance sheet.

The Bank of Japan: Monetary Mastery or Quantitative Quagmire?

The New Abenomics Program

The Bank of Japan (BoJ) just launched a new phase in its monetary easing program popularly known as Abenomics. It is doing so in the hopes of shoring up economic growth. This monetary program until today had involved a targeted expansion of the monetary base at ¥80 trillion a year matched by ¥80 trillion in government bond acquisitions. There were also targeted purchases of ETFs and REITs on a smaller scale.¹

The new phase unveiled today consist of three key developments. First, the BoJ will target the 10-year government bond interest rate at zero percent. Second, it will aim to overshoot its 2% inflation target so that it is truly symmetric. Third, it will drop its quantity target for the monetary base and simply make its expansion conditional on the inflation overshoot. Everything else in Abenomics remains roughly the same. 

So has the Bank of Japan finally mastered its monetary conditions in a way that will spur economic growth? Or is this just another step into the quantitative quagmire of Abenomics? The short answer: do not get your hopes up. There are two reasons why this probably will not make much difference. 

First, the BoJ is pegging the 10-year yield on government bonds at a level it would be at anyways. Because of slow global economic growth and continued uncertainty, yields on safe assets around the world have been falling since 2008. This race to the bottom for safe asset yields can be seen in the figure below:

Over the past eight years, this downward march of yields has occurred before, during, and after various QE programs. So while it is true that the BoJ has been the marginal buyer of Japanese government bonds over the last year, its actions are only doing what the global bond market was already doing and would have continued to do in the absence of BoJ actions. Put differently, the market-clearing or 'natural' interest rate that is based on fundamentals has been falling for some time and is already very low. The BoJ's new long-term interest rate target simply is a recognition of this fact. So there really is nothing new here.

Second, there is a serious credibility issue when it comes to the expansion of the Japan's monetary base. As seen in the figure below, the monetary base has seen a three-fold increase in its size since the beginning of Abenomics. If this expansion were truly permanent, then the price level would also increase threefold over the long-run. There is no way that can happen. The population is aging and depends increasingly on fixed income. Inflation for them is a non-starter. There is no political economy support for such a radical change in the price level.

Here is why this matters: some  portion of the monetary base injection (above that needed for normal money demand growth) needs to be viewed as permanent in order for spending and inflation to rise. If monetary injections are expected to be temporary they would do little to spur spending. If they are viewed as permanent, however, they would raise the expected future price level and thus temporarily push up expected inflation. The higher expected inflation, in turn, would spur robust spending in the present. But this requires some portion of the monetary base growth to be seen as permanent.

The problem, though, is that the expansion of the monetary base has been so large there is no way this growth can be seen a permanent for fear of excessive inflation taking off. The BoJ wants 2% inflation with some overshoot. If the threefold increase of the monetary base were made permanent, the BoJ would get 300% inflation with overshoot! Put differently, the massive expansion of the BoJ's balance sheet undermines its very goal of raising nominal spending and inflation.

So making the growth of monetary base conditional on inflation hitting its target is not credible. The monetary base is simply too large for the BoJ to get any traction this way.

So Does Abenomics Matter?

With all that said, Abenomics has been able to spur some aggregate demand growth and some inflation. Just nowhere near where the government wants it to be.  Below is a figure that shows the level of nominal spending (as measured by nominal GDP) for Japan.  Nominal spending has grown under Abenomics, far more than under the origional QE program of 2001-2006:

I used to think this moderate success was because the monetary base expansion under Abenomics was permanent. But now that the monetary base has gotten so large, I am doubtful for the reasons laid out above. So Abenomics has been moderately successful, but it is not entirely clear to me why this is happening.

It is worth noting one of the goals of Prime Minister Shinzo Abe's government is to raise nominal GDP to ¥600 trillion by 2020. Yes, Japan has a NGDP level target. The Prime Minister first called for this goal in September 2015 and spoke to it again in December 2015.  Since then, it has been in the government's economic and fiscal projections For example, here is the July 2016 executive summary of the projections. The nominal GDP goal stated near the top of the document.  

When the goal was first introduced, it was an ambitious 20% growth  goal for Japan's nominal GDP. It is now closer to 17% given the growth of nominal GDP since then, but this still remains a very ambitious goal as seen in the figure below. This figure shows different paths towards the ¥600 trillion by 2020. 

All of these paths seem ambitious given the recent growth rate of nominal GDP in Japan. It is not clear how to get there without having a major overshoot of inflation.  Maybe the BoJ could reiterate the governments nominal GDP level target and try to communicate that some small portion of the monetary base will be permanent and that it will be injected via purchases of perpetual government bonds. Admittedly, this would be a tough message to communicate. But it is not clear what alternatives there are for Japan. 

So to answer the question in the title to this post, I suspect Japan may be heading further into a quantitative quagmire rather than mastering its monetary conditions. 

P.S. Yes, the markets seem happy about this development so far. But they also seemed happy about the ECB's added stimulus in March 2016. That euphoria did not last and neither will this reaction to the BoJ. 

¹ETFs were and continue be purchased at annual rate of ¥9 trillion while REITs are purchased at a targeted rate of ¥60 billion.