Wednesday, February 24, 2016

The Chuck Norris and Jean-Claude Van Damme Approach to Central Banking

Over at FT Alphaville, I argue the Fed is not ready for the next recession:
Whether or not a recession actually occurs, one thing is certain. The Fed in its current form is not well equipped to handle another downturn. The Fed’s inability over the past seven years to create a strong recovery from the last recession speaks to this weakness. The Fed tried everything from pushing interest rates to zero percent to buying up trillions of dollars of government bonds and yet it was still not able to generate the spending needed to get the economy back to full health.
The real reason for this failure 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. 
I go on to argue that a nominal GDP level target (NGDPLT) is the answer, but with a twist: make it more credible by having a treasury backstop. The beauty of this arrangement is that since it throws the entire weight of the consolidated government balance sheet behind the NGDPLT, it increases the target's credibility and means the treasury backstop will rarely, if ever, have to be used. 

Nick Rowe likes to say that central banking is like Chuck Norris walking into a room and telling everyone to get out. They fear Chuck Norris and so will leave the room without him ever having to throw a punch. Chuck Norris is using expectation management just like a central bank does to shape behavior. Recall the market reaction to Mario Draghi saying "whatever it takes" in 2012 or Ben Bernanke doing his "taper talk" in 2013. These are examples of Chuck Norris the central banker at work.

Now imagine Chuck Norris the central banker comes to the room with his friend Jean-Claude Van Damme the treasury secretary. Chuck Norris still walks into the room alone and tells everyone to get out. This time, though, he mentions that his buddy Jean-Claude is waiting outside and has his back. Now the folks inside the room go from being fearful to truly terrified and flee out of the room. Jean Claude never has to go into the room. Just knowing he is outside is enough for the people in the room. That is the idea of an explicit treasury backstop to the Fed's NGDPLT. It will add credibility, but probably never have to be used.

P.S. Scott Sumner was on Reddit yesterday answering questions. One question that was asked is where are the models for Market Monetarism. There are no models for Market Monetarism. There is, however, serious model-based work being done on NGDP targeting. I thought I would list some of the recent ones below, including my work with Josh Hendrickson:  

Monday, February 22, 2016

Connecting the Dots: the Demand Side of Oil's Decline

Why have oil prices declined so sharply since mid-2014? For many observers the answer is obvious: there has been a surge in global oil production and it has pushed down oil prices. It is hard to argue oil supply has not been important, but the slowdown in emerging economies and in the United States also suggests that global demand is playing an important role too. If so, this understanding raises several questions: First, how much of the decline in oil prices since mid-2014 can be attributed to weakened global demand? Second, why did global demand begin falling in mid-2014? 

On the first question, Stephen King of HSBC believes that weakened global demand is a key reason for the recent decline in oil prices. Here is what he said to CNBC:
"You have a situation where emerging markets in general are extremely weak, that in turn is causing commodity prices to decline rapidly, including oil prices, so rather than saying lower oil prices are a stimulus for the commodity consuming parts of the world, I think you should see lower oil prices as a symptom of weakness in global demand," 
Jens Pedersen, an economist with Danske Bank, shares this view and provides following figure as evidence:

This figure is certainly suggestive of a link between global demand and oil prices, but exactly how much does this link explain?

Ben Bernanke had a recent post that attempted to answer this question. In it, he presented evidence from an estimated model for the demand of oil. The model builds upon the work of James Hamilton who estimated a regression where the demand for oil is determined by changes in copper prices, the 10-year treasury yield, and the dollar. Here is Bernanke's explanation for why this model approximates the demand for oil:
The premise is that commodity prices, long-term interest rates, and the dollar are likely to respond to investors’ perceptions of global and US demand, and not so much to changes in oil supply. For example, when a change in the price of oil is accompanied by a similar change in the price of copper, this method concludes that both are responding primarily to a common global demand factor. While this decomposition is not perfect, it seems reasonable to a first approximation.
Using this approach, both Bernanke and Hamilton find that 40%-45% of the decline in oil prices since mid-2014 can be attributed to weakening global demand. I reestimated their model, but added the BAA minus the 10-year treasury spread as another indicator of demand conditions. The idea behind its use is that weakening demand increases the credit risk of firms and therefore causes this spread to rise. Using this specification of the model, I was able to attribute 51% of decline in oil prices to weakening global demand. This can be seen in the figure below:

My estimates, which are similar to Bernanke's and Hamilton's, suggest that about half of the decline in oil prices since mid-2014 is due to weakening global demand. So yes, global demand does seem to be an important part of story behind the descent of oil prices.

As an aside, these results help shed some light on a puzzle with "breakevens"-- the spread between nominal treasury yields and real treasury yields from TIPs. Breakevens are supposed to capture the bond market's view of inflation (though it is sullied a bit by a liquidity premium for TIPS). Many observers have often noticed that these breakevens track oil prices and therefore conclude that either oil prices are driving inflation or that the breakevens really do not tell us much about expected inflation.  

I have always had a problem with this understanding. It ignores the possibility that something else might be driving both breakevens and oil prices. Moreover, breakevens also tracks the BAA-treasury spread mentioned above.

It always seemed to me that breakevens, oil prices, and the credit spreads may be responding in part to something else. The results above suggest that the something else is global demand. 

Anyways, this still leaves us with the second question: why did global demand and therefore oil prices began to tank starting around mid-2014? Readers of this blog should already know my answer. Beginning in mid-2014 the Fed started talking up interest rate hikes and continued to do so through 2015. This signalling that future monetary policy would be tightened got priced into the market and affected decisions well before the December 2015 rate hike. 

The talking up of interest rate hikes, therefore, amounted to an effective tightening of monetary policy for the United States and all the countries that peg their currency to the dollar.It explains the sharp rise of the dollar as shown below:

This tightening of monetary policy got ahead of the U.S. recovery and precipitated a slowdown in U.S. economic activity as I document here. It also put the noose around China's neck--who pegs to the dollar--as I show here. It is no surprise then that the oil prices began their dramatic fall after mid-2014. 

There is a rich irony to all of this. One of the reasons Fed officials talked up interest rate hikes is because they believed inflation was about to take off. They believed the only thing preventing it from happening sooner was the low oil prices which they saw as transitory. What they missed is that their own actions were a key reason for the decline in oil prices in the first place. Fed officials failed to connect the dots between talking up interest rate hikes, weakening global demand, and low oil prices. More and more, it seems Fed made a huge mistake in 2014-2015

P.S. Andres Ariza Meneses makes the same argument here.

Thursday, February 11, 2016

China's Coming Devaluation: Another Consequence of the Fed's Mistake of 2015

recently argued that the Fed did not make a mistake in December 2015 by raising interest rates. Rather, it made a mistake by talking up interest rate hikes the year and a half leading up to December 2015. This signalling that future monetary policy would be tightened got priced into the market and affected decisions well before the December rate hike. In so doing, the Fed got ahead of the recovery and helped precipitate a slowdown in U.S. economic activity in the second half of 2015.

That is the domestic side of this story. There is also an international side that I want to revisit here. Specifically, the Fed's tightening leading up to December 2015 catalyzed two important developments in the global economy: the reversal of capital flows to emerging markets and the turning of the Chinese economy into an explosive tinder box. 

Consider first the reversal of capital flows from emerging markets. According to the International Institute of Finance, emerging markets in 2015 experienced net capital outflows for the first time in almost three decades. They saw approximately $735 billion in net capital outflows in 2015, of which about $637 billion came from China. So to explain the sudden reversal of capital flows from emerging markets, one really has to explain what happened in China. 

One striking manifestation of China's capital outflow is the decline in China's foreign reserves. They peaked in June 2014 near $4 trillion and since then has declined almost $663 billion. Currently, Chinese monetary authorities are burning through about $100 billion of reserves a month. This dramatic turn can be seen below:

So what is driving this capital outflow from China? My contention is that the tightening of monetary policy caused by the Fed talking up of interest rates hikes was behind this outflow. This next figure supports this understanding. It shows how the growth of Chinese foreign reserves appear to be tied to changes in the stance of U.S. monetary policy. 

If we  zoom in on the period since 2012 and look at China's foreign reserve growth and the expected path of the federal funds rate we see a similar relationship. Using the 12-month ahead federal funds rate futures contract, the figure below shows that the Fed's talking up of interest rates closely tracks the decline in China's foreign reserves during this time:

So the timing of the Fed's tightening does suggest it was tied to sudden reversal of capital out of China. So what is the mechanism linking the two developments?

The answer is twofold. First, China's currency has been tied to the dollar and through this link Fed policy gets transmitted to China. Fed policy via the dollar, therefore, is an important determinant of Chinese nominal demand and economic activity. To be clear, the Yuan-Dollar link has not always been constant, but it has been steady enough to make Fed policy felt in China. This link can be seen below:

Given this connection, when the Fed started talking up interest rates in the second half of 2014 and continued doing so through 2015, not only did the dollar rise but so did the Yuan. Here is the rise of the dollar:

This appreciation of the dollar pulled up the trade weighted value of the Yuan by approximately 15% between mid-2014 and mid-2015, implying a sharp tightening of monetary conditions in China during this time. 

This imported monetary tightening could not have come at a worse time for China. Its economic growth was already slowing down as it naturally transitions from a high-growth economy based on heavy industry and a large tradeable sector to low-growth one based more on consumption and a large service sector. In addition, there has been a debt boom in China that started with the large fiscal stimulus of 2008 and continues to this day. This debt boom in conjunction with a lack of reforms to state owned enterprises and other parts of the economy has made the Chinese economy more vulnerable to economic shocks. So between a natural slowdown and an increased susceptibility to shocks, the Chinese economy was not ready for the Fed's tightening of monetary policy as it talked up interest rate hikes.

Chinese officials, however, were not going to go down without a fight. They tried to offset the effect of the Fed's tightening on the economy by easing domestic monetary conditions. This can be seen in the two charts below. They lowered the benchmark lending rate and the required reserve ratios for banks about the time the Fed started talking up interest rates. 

This response by Chinese officials is the second part of the answer for it created a tension. The easing of domestic monetary conditions puts downward pressure on the value of the Yuan, while the link to the dollar keeps it propped up. The fundamentals, in other words, are saying the Yuan needs to devalue while the exchange rate peg keeps it overvalued. Investors, anticipating this tension cannot last forever, have been rapidly pulling their money out of China in anticipation of a devaluation. The only way to defend the elevated value on the Yuan, then, is to burn through foreign reserves. So while there are many moving parts here, the catalyst to the sudden reversal of capital flows seems to be the Fed's tightening of late 2014 - 2015.

Consider now the turning of the Chinese economy into an explosive tinder box. To be clear, China's economy was already going to be a tinder box given the natural slowdown in economic growth and the rapid accumulation of debt. But the Fed's tightening turned it into an explosive one. The tightening of U.S. monetary policy has pushed China into corner where there are no good policy options.

The tightening has significantly overvalued the Yuan, some say by 15% or more. And it does not appear likely the Fed will be easing (relative to other central banks) anytime soon. So China appears stuck with an overvalued currency at a time of economic stress in China. What can Chinese officials do?

One option is that they could do a major devaluation of the Yuan. China, however, has a lot of external debt, including some $1 trillion in foreign debt owed by Chinese firms. So a devaluation would significantly raise its real debt burden. It could also create a huge deflationary drag on the global economy. We got a glimpse of the uncertainty a devaluation might create last August when China devalued a mere 2%. Imagine what happens when it falls 10% or more.

A second option is simply to defend the peg by burning through the foreign reserves. If this path is chosen, however, it is likely to cause China to start burning through reserves at an accelerating rate. Investors, worried that at some point reserves will run out and force a devaluation, would intensify their run out of China. We are already seeing signs of this acceleration. China still has a large stash of foreign reserves, but it could wind down relatively fast.

A final option is to tighten capital controls to prevent funds from fleeing China. There has been a growing chorus of supporters for this option. This option cannot end well either. As Eswar Prasad notes, tightening capital controls would only undermine confidence in China and hasten the capital flight. It is also hard to believe Chinese officials could put up capital controls that could meaningfully stem the outflow of capital for one of the largest economies in the world. China is too big and its institutions too weak to make this work. Finally, even if they could impose capital controls do we really think China would use this reprieve to do deep structural reforms to get it pass the crisis? I suspect it would only be kicking the can down the road and allowing more economic imbalances to grow. 

Put differently, the Fed's tightening has forced Chinese officials into trying the impossible trinity as there are no good alternative options. As the name implies, however, the impossible trinity is an unsustainable policy mix. Eventually something will give. Since capital controls are unlikely to work and since the stash of foreign reserves is finite, I believe China will be forced to do a major devaluation. It will not be pretty. And when it happens we can thank the Fed, in part, for bringing this about. 

P.S. This post was motivated in part by an conversation Cardiff Garcia and Matthew Klein of FT Alphaville had with Michael Pettis. 

Monday, February 8, 2016

Responding to Our Critics

Ramesh Ponnuru and I respond to the critics of our New York Times op-ed over at Bloomberg View:
Bold theses should receive skeptical reactions, and ours did. We argued in the New York Times that, contrary to what just about everyone believes, the financial crisis and the Great Recession that blew up the American economy in 2008 were not the necessary consequences of a housing bust...
Since some criticisms were directed at arguments we didn’t actually make, we should clarify a few things.

First, we are not saying that the right Fed policy would have kept any recession from happening. As we noted, the recession began in December 2007...Our argument, rather, is that [the Fed's] mistakes turned what could have been a mild recession into a “great" one.

Second, we aren't saying that better Fed policy could have prevented serious financial turmoil. Again, we explicitly note that financial stress began before the Fed’s worst errors. Our argument is the errors made that stress much worse.  
Please read the whole article. I would encourage interested readers to also see my follow-up post to the New York Times op-ed where I provide some empirical support for our claims. 

A key point we make in our Bloomberg View piece is that is one has to be careful in assessing the stance of monetary policy. Just because the Fed cut rates seven times from a high of 5.25% in September 2007 to 2.00% in April 2008 does not mean monetary policy was accommodative or even neutral. If that were that simple then the Fed would have been easy during the Great Depression when it cut its then policy rate, the discount rate, from 6.00% in October 1929 to a low 1.50% in July 1931. But almost no one believes that now. The Fed is seen as keeping monetary policy tight through the depths of the Great Depression. 

To really know the stance of monetary policy, one needs to know the market-clearing or 'natural' interest rate. If the Fed is not cutting rates as fast as the natural interest rate is falling, then, monetary policy is actually tight. This is not a controversial point. It is standard macroeconomics.

Even Atif Mian and Amir Sufi in their book “House of Debt” acknowledge this point in their discussion of the zero lower bound (ZLB). They acknowledge that if the Fed had been able to continue cutting rates pass 0% then it could have prevented the Great Recession. But don’t take my word for it, go read chapter four of their book or see this twitter conversation. Paul Krugman has similarly pointed to the ZLB as the true culprit for crisis and past seven years of sluggish growth. The point is that the Great Recession was not  inevitable had interest rates being allowed to reach their market-clearing level.

The only difference between Mian-Sufi-Krugman and us is that we believe the Fed had a chance to reach the market-clearing level of interest rates before it crossed the ZLB. We believe they had that chance through part of 2008. Had the Fed been less anxious about inflation and more aggressive in signalling it would do whatever is takes to keep economy stable the natural interest rate would have fallen far less--maybe even stabilized--making the ZLB less of a problem in the first place.

Instead, the Fed signaled during the first half of 2008 it was actually going to raise interest rates. The fear of a rate hike grew during this period, with fed fund futures rate for the 12-months ahead contract going from about 2.0 % in March  to almost 3.5% in June of 2008. Given that the natural interest rate had sharply fallen by this point, this means there was sizable gap between where interest rates needed to be and where they were expected to go. That means the Fed was strangling the already weakened economy. This only further depressed the natural interest rate. It is no surprise, then, that by mid-2008 expected inflation from breakevens started falling fast. And yet the Fed continued to fret over inflation through its September FOMC meeting of 2008. By the time it finally did cut rates and begin QE1 it was too late. The horse was already out of the barn, the ZLB had been breached.

So coming into 2008 was the economy already weak and vulnerable? Yes. Was it necessarily destined for a 'Great' recession? No. It took another shock to push it over the edge. That shock was the tightening of monetary policy in 2008. 

P.S. It appears Janet Yellen's Fed made the same mistake in its talking up of interest rates all last year.

Wednesday, February 3, 2016

More on the Fed's Mistake of 2015

Here is an interesting take on the Fed's December mistake by Jed Graham:
Janet Yellen’s Federal Reserve has done something that no other Fed has done since Paul Volcker aimed to quash runaway inflation in the early 1980s, even if it meant a recession — and it did.

New Commerce Department data out Friday show that nominal GDP grew at a 1.5% annualized rate in the fourth quarter, casting further doubt on the Fed’s decision to begin hiking its key interest rate in December. (Inflation-adjusted GDP rose just 0.7% in Q4.)With the exception of Volcker’s interest-rate hike in early 1982 amid a recession, no other Fed has raised rates during a quarter in which nominal GDP grew less than 3%, dating back to the early 1970s.
Remember, nominal GDP is simply total dollar spending--the money supply times how often it is used--on final goods sold. It is therefore a broad gauge of monetary conditions. Jed's point, then, is that the Fed chose to raise interest rates even though monetary conditions were weakening. Here is the figure from Jed's article documenting this 'historic misfire':

I like what Jed is doing here, but as noted in my previous post I think the Fed's mistakes began long before December. Nonetheless, there does seem to be a growing consensus that the Fed's tightening got ahead of the recovery as noted by Martin Sanbu. And this is not just a pundit thing. The fed fund futures market now seems to be signalling the same message.  

P.S. I was interviewed on Bloomberg TV yesterday about the Fed's policy mistake.

Monday, February 1, 2016

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.