Thursday, March 5, 2020

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 NGDPGap is the percent difference between the forecasted level of NGDP and the NGDPLT for the period of t to t+hΔb 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. 

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.

Monday, October 14, 2019

Allan Meltzer's Life Work

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

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

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

Thursday, October 3, 2019

New Policy Brief on NGDPLT

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

Related Links

Monday, September 23, 2019

The Repo Man Cometh

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: FRED Data

Monday, September 9, 2019

Some Assorted Macro Musings

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

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

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

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

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

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

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

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

Wednesday, August 28, 2019

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

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

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

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

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

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

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

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

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

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

Friday, June 7, 2019

New Articles on NGDP Targeting

Just a quick note on a couple of my papers that recently got published. First,  Josh Hendrickson and I published in the Journal of Money, Credit, and Banking earlier this year with an article titled "Nominal GDP Targeting and the Taylor Rule on an Even Playing Field". Here is the abstract:
Some economists advocate nominal GDP targeting as an alternative to the Taylor Rule. These arguments are largely based on the idea that nominal GDP targeting would require less knowledge on the part of policymakers than a traditional Taylor Rule. In particular, a nominal GDP targeting rule would not require real‐time knowledge of the output gap. We examine the importance of this claim by amending a standard New Keynesian model to assume that the central bank has imperfect information about the output gap and therefore must forecast the output gap based on previous information. Forecast errors by the central bank can then potentially induce unanticipated changes in the short‐term nominal interest rate, distinct from a standard monetary policy shock. We show that forecast errors of the output gap by the Federal Reserve can account for up to 13% of the fluctuations in the output gap. In addition, our simulations imply that a nominal GDP targeting rule would produce lower volatility in both inflation and the output gap in comparison with the Taylor Rule under imperfect information.
Many of you may have  seen this article before since it has been a working paper for many years now. I am glad to finally get it published. 

More recently, I published an article in the Cato Journal titled "The Financial Stability Case for NGDP Targeting." I presented this paper at the 2018 Cato Monetary Policy Conference. Here is the abstract:
Ten years after the financial crisis there is a new appreciation for the role household debt and financial fragility play in the business cycle. As a result, policymakers are looking for tools to promote financial stability. A number of recent studies claim that nominal GDP (NGDP) targeting is just such a tool. For it can theoretically reproduce the distribution of risk that would exist if there were widespread use of state-contingent debt securities. This paper empirically test this view by exploiting an implication of the theory: those countries whose NGDP stayed closest to its expected pre-crisis growth path during the crisis should have experienced less financial instability. This paper constructs an NGDP gap measure for 21 advanced economies to test this implication and finds there is a meaningful role for NGDP in promoting financial stability.
There are a lot of other interesting papers in this Cato Journal that were presented at the conference. So take a look. For those interested, here is the video of my panel at the conference:

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