Monday, March 26, 2018

Assorted Macro Musings

Some assorted macro musings:

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

JEC Report on the Slow Recovery
The Joint Economic Committee of Congress has a new report where, among other things, it lays out a monetary explanation for the slow recovery.  A key excerpt on why QE did not create a robust recovery (page 61):
The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program: 
"Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are        intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future.
Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues. .
Obviously, I liked this part, but the entire report is good so take a look.

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

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

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

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

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

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

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

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