Wednesday, April 24, 2019

Is the Fed's Floor System Beginning to Fold?

Last December, I participated in an AEI event where I made the case that the Fed's current floor operating system could collapse into a corridor operating system fairly soon. My argument was that even without a significant reduction in the supply of reserves, a large shift in the demand for reserves could be sufficient to move the Fed off the perfectly elastic or 'flat' portion of the bank reserve demand curve. The Fed, in other words, could have a relatively large balance sheet and still end up in a corridor operating system. 

Graphically, such a development is depicted in the figures below. The figure on the left shows a floor operating system with a large supply of reserves on the flat portion of demand curve. In this system, the IOER is both the target and overnight interest rate. The second figure on the right shows what I imagined could be happening. The demand for reserves was shifting outward because of new regulatory requirements and the supply of reserves was shifting inward as the Fed began shrinking its balance sheet. As depicted, these actions together would push the Fed off the flat portion of the reserve demand curve. In turn, this would cause overnight rates to rise above the IOER and end the Fed's floor system. 

When I brought this up late last year it was pure speculation on my part, but it was informed by the Senior Financial Officer Survey and the Fed's balance sheet reduction plans. In my AEI talk, I told George Selgin, who dislikes the floor system, that if this comes to fruition Christmas will come early for him.  

Well, Christmas did not come early for poor George. He may, however, get a late gift from Santa Claus as there is some evidence my prediction may be coming true. Jeff Cox reports that interbank interest rates are rising above the IOER rate. The figure below shows the overnight bank financing rate (OBFR), the new and improved interbank interest rate measure, has started rising above the IOER. The old federal funds rate (FFR) has been above the IOER for almost a month. (The closely-related overnight Libor replacement, the Secured Overnight Funding Rate (SOFR) tells a similar story.)

To be clear, this move is small from a broader perspective as seen below. Nonetheless, this rise in both series is part of a longer-term change in their trend, where previously they were consistently below the IOER but now are bouncing above it. If they continue to rise above the IOER, the floor system's days are numbered. 

A similar story emerges if we look to the overnight treasury repo rates. The DTCC treasury repo rate has been tending up over the past month and so has the BNY Mellon treasury repo rate.

Now the DTCC repo rate has been above the IOER for awhile, but the BNY repo rate has not. This is relatively new. And like the interbank rates, the repo rates collectively have been gone from trending below the IOER to bouncing above it as seen below. Again, if this upward movement is sustained the floor system will fold.

Now, with all that said, there is something of a puzzle here: there has been no revival in interbank lending. One would expect, all else equal, that a rise in interbank interest rates above the IOER to spark some interbank lending. Instead, it appears interbank lending has been flat to declining:

One possible resolution to this puzzle is that banks are lending to the overnight treasury repo market rather than to each other. The overnight yield is slightly higher in this market and according to the Fed's H8 database there has been an explosion of reverse repo activity as seen below. 

Maybe part of the new normal is that the treasury repo market has permanently displaced interbank lending. In any event, these developments all point to some big changes taking place that could force the Fed back to a corridor system.

If that is the case, I would recommend the Fed get ahead of this transition and intentionally guide itself to a symmetric floor system like the one in Canada. In my next post, I will offer some practical suggestions for making this journey.

P.S. The technical definition for the "federal funds sold and reverse repos" in the H8 database is as follows: "Includes total federal funds sold to, and reverse RPs with, commercial banks, brokers and dealers, and others, including the Federal Home Loan Banks (FHLB)." So maybe part of the explanation for the lack of interbank lending is that bank are lending indirectly to each other via the repo market. 

Tuesday, April 16, 2019

Is Low Inflation Really a Mystery?

Over the past decade, inflation has persistently undershot the Fed's inflation target. The Fed's preferred measure of inflation, the core PCE deflator, has average 1.56 percent over this time compared to a target of 2 percent. The Fed officially begin inflation targeting in 2012, but was implicitly targeting 2 percent long before that time. So below-target inflation has been happening for close to a decade and for many observers it is a mystery.

There have been a spate of articles as to why the Fed has not been able to hit its inflation target. Some have wondered if the Fed really understands or even controls the inflation rate. Even Fed officials have been perplexed by the low inflation since it cannot be explained by their Phillips curve models. As a result, they sometimes attribute the persistently low inflation to developments such as falling oil prices, demographics, global competition, changes in labor’s share of income, safe asset shortage, and even the rise of Amazon.

These explanations, however, are not satisfactory since the Fed should be able to determine the inflation rate over the medium to long-run. That is, the Fed should be able to respond over time to developments that might cause inflation to drift off target. The Fed should be, in theory, the final arbiter of the trend inflation rate.

So why has inflation been so low? In my view, the answer is simple: the Fed is getting the inflation it wants. There is no mystery. One does not get a decade of trend inflation that is below target by accident. Instead, revealed preferences tell us inflation is where it is because the FOMC allowed it to be there.  Put differently, the Fed has chosen not to fully offset the shocks and secular forces listed above that have pushed inflation down. This is a policy choice.

Fed officials and others may disagree, but the revealed preference argument is hard to ignore. Moreover, there are other reason to believe that the low inflation is, in fact, the desired outcome of the FOMC. They are presented below.

SEP Core Inflation Forecasts
The first reason to believe the low inflation is a desired outcome comes from the FOMC itself. The FOMC's Summary of Economic Projections (SEP) provides a central tendency forecasts for core PCE inflation. The FOMC's definition of the SEP is as follows (my emphasis):
Each participant’s projections are based on his or her assessment of appropriate monetary policy.
The SEP, in other words, reveals FOMC members forecasts of economic variables conditional on the Fed doing monetary policy right. And up until recently, doing monetary policy right was not overshooting 2 percent inflation in the following year, as seen in the figure below. Even now, 2 is still seen largely as a ceiling. There is nothing symmetric about 2 percent in these SEP forecasts.

Most FOMC members, therefore, have treated 2 percent as a ceiling over the past decade. This is "appropriate" monetary policy for them. Keep in mind, that at this forecast horizon most of them also believe they have meaningful influence on inflation. Both of these observations point to the low inflation as a choice.

Textual Analysis
The second reason to believe that low inflation is a desired outcome comes from a recent study by the San Francisco Fed. It is titled "Taking the Fed at its Word: Direct Estimation of Central Bank Objectives using Text Analytics" and the abstract reads (my emphasis):
We directly estimate the Federal Open Market Committee’s (FOMC) loss function, including the implicit inflation target, from the tone of the language used in FOMC transcripts, minutes, and members’ speeches. Direct estimation is advantageous because it requires no knowledge of the underlying macroeconomic structure nor observation of central bank actions. We find that the FOMC had an implicit inflation target of approximately 1.5 percent on average over our baseline 2000 - 2013 sample period.
Fed officials, via their words, actually want 1.5 inflation on average. And shocker of all shockers, they are very close to getting that just that rate of inflation since 2009. 

The Neel Kashkari Counterfactual
The third reason to believe low inflation is a desired outcome comes from imagining a counterfactual FOMC. Imagine a FOMC that has twelve members that are all clones of Neel Kashkari, as seen below. In this FOMC, where interest rates were not raised over the past few years--and maybe even lowered--do we really think inflation would be the same? I find that hard to believe.

To be clear, I do think there are important secular forces pushing down trend inflation, like the demand for safe assets. But again, the Fed should be able to offset such pressures if it chose to do so. The real question, then, is why the Fed has settled for trend inflation near 1.5 percent. That is a question for a different post. This post is simply a retort to all those who think the low inflation is a mystery. Folks, it is not a mystery. It is a choice.

It is worth nothing that this choice is actually more than a choice for trend inflation. It is implicitly a choice for lower trend aggregate demand (AD) growth. As seen below, aggregate demand growth was averaging 5.6 percent in the decades before the crisis. Since the recovery started, it has averaged about 3.6 percent. That is a 2 percentage point decline in the trend. The red line in the figure shows what a naive autoregressive forecast would have predicted over the past decade conditional on past nominal expenditure history. There has been a sizable AD shortfall.

In my view, it is this dearth of aggregate demand growth rather than the low inflation that is a problem. The slowdown in AD growth has arguably contributed to problems like hysteresis and populism. If so, this policy choice has been costly.

P.S. Adam Ozimek gives us estimates of how costly this AD shortfall has been.