What If the Fed Had Tightened Monetary Policy in 2003?

Dean Baker provides a nice follow-up to my last post.  He argues the Fed could and should have done something to stem the housing boom back in 2003-2004. His post reminds me of the interview Alan Greenspan did on the House of Cards documentary.  In it, Greenspan claims that if the Fed had tried to stop the housing boom it would have (1) caused a recession and (2) faced political backlash for stalling the drive for increased home ownership. I am not convinced of (1), but even if it were true surely a recession in 2003 would have been far milder than the Great Recession we are working our way through now. Household balance sheets would not be the wreck they are today and, as a result, neither would government balance sheets be so damaged (i.e. public spending stepped in to replace private spending during the recession and thus created a mess in government's balance sheet). On (2), the whole point of central bank independence is to be able to make the tough, unpopular call sometimes. Anyways, here is Dean Baker: 

[The NYT] notes Bernanke's statement that in 2003-2004 it was not clear that the housing market was in a bubble and that by the time it was clear, it was too late for the Fed to do anything without seriously harming the economy. Of course it was clear as early as 2002 that the housing market was in a bubble, but more importantly, Bernanke's claim that the Fed could not act until it was clear is absurd.

The Fed always acts in an uncertain environment. For example, Alan Greenspan raised interest rates in anticipation of inflation on numerous occasions. The logic of this action was that it was worth slowing the economy and raising the unemployment rate rather than risk an increase in the rate of inflation. In effect, this action assumes that the certainty of higher unemployment from raising interest rates is better than the risk of higher inflation.

Had the Fed acted to burst the bubble in 2003-2004, the risk would have been that it temporarily depressed house prices by scaring people about excessive prices and limiting the exotic mortgages that were boosting demand. By contrast, if it had acted correctly in preventing the growth of a dangerous bubble, it would have prevented the worst downturn in 70 years.

Any serious weighing of the benefits and risks of bursting the bubble in 2003-2004 would have surely come down in favor of bursting the bubble. The Fed's decision not to burst the bubble was one of the most disastrous failures of monetary policy in history.

Nice smackdown Dean!

What Role Did the Fed Play In the Housing Bubble?

I really did not want to revisit this question since  I have already covered  it here many times before.  Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played  by the Fed's low interest rate policy.  I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it  does appear  to be one of the more important ones.  Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.  It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative.  Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential).  There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007).  Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa.  This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.

(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates.  The low interest rates  at the time encouraged investors to take on riskier investments than they otherwise would have.  Some of those riskier investments end up being tied to housing.  Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.  The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

Update: An good question was raised in the comments section: if the federal funds rate was below the neutral rate for so long, then why was there disinflation? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it should have been less concerned since it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point.  It shows the productivity surges at this time coincided with the two sustained drops in inflation while demand growth surged. (Click on figure to enlarge.)

What Can Be Done to Hasten the Recovery?

I believe the Fed can and should be doing more to create a more stable macroeconomic environment.  There is much they can yet do to stabilize aggregate spending and improve economic certainty.  However, even if we were to get this from the Fed it still would not solve all our economic problems. We are in the midst of a massive deleveraging cycle by households and unless something radical happens like swapping  the underwater portion of household mortgages for equity  this process will probably take years to unfold. Ken Rogoff reminds us of this point in a recent article:

What more, if anything, can be done? The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

The only palliative he sees is higher inflation:

Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.

I too don't want to comprise the Fed's long-run inflation credibility.  That's why I want a NGDP  level target (my first choice) or price level target (my second choice... I really don't like this one but I will settle for it). It would create some higher (catch-up) inflation until we hit some target level and stabilize thereafter. If this policy were made explicit it would do much to stabilize economic expectations, a big plus in our current mess.  Again, this will not fix our structural problems, but it would create a more stable macroeconomic environment in which to make the needed structural adjustments.  Now if we could get more discussion on  proposals to hasten the restoration of household balance sheets, such as the one to swap underwater mortgage debt for equity, maybe the structural adjustments could  be expedited too.

The Right Kind of Helicopter Drop

Some observers say the Fed is out of ammo, that any further attempts by it to stimulate nominal spending is like pushing on a string--it's futile.  This understanding ignores the fact that the Fed has yet to use all of its big guns and that these guns were found to be highly effective in ending the Great Contraction of 1929-1933.  Moreover, Fed officials including Bernanke believe the Fed could do more if it wanted to do so.  So the "Fed is pushing on a string" folks are simply wrong.  Still, it is always useful to consider exactly how the Fed could stimulate total current dollar spending. Ricardo Caballero does just that in his recent proposal to have the Fed do a helicopter drop via the U.S. Treasury Department. His proposal is very explicit in how it would work and with a few minor tweaks I believe it could be effective in stabilizing aggregate demand. Here is Cabellero:

[T]he Federal Reserve has the resources but not the instruments, while the US Treasury has the policy instruments but not the resources. It stands to reason that what we need is a transfer from the Fed to the Treasury...what we need is a fiscal expansion (e.g. a temporary and large cut of sales taxes) that does not raise public debt in equal amount. This can be done with a “helicopter drop” targeted at the Treasury. That is, a monetary gift from the Fed to the Treasury.

I would tweak this proposal in two ways.  First, I would do fiscal expansion via a payroll tax holiday.  Second, I would announce that this payroll tax holiday would be contingent on hitting an explicit nominal GDP or price level target.  Thus, as long as the target was not being met the payroll tax holiday would be in effect. I really like this proposal for the following reasons:

1. The money is sent directly to the public; it bypasses the credit-clogged banking system and puts into the hand of the spenders.
2. There is no increase in the public debt, thus there is no Ricardian Equivalence problems.  
3. It is politically feasible: the Republicans get a payroll tax cut and the Democrats get fiscal expansion.
4. It is radical enough to work.  To change expectations there has to be some shock-and-awe break from the current policy of allowing declines in inflation expectations, core prices, and nominal spending. This should do it.

The biggest drawback to this proposal is the issue of how the Fed could unwind the monetary expansion at a later date. This program would have the Fed increase its liabilities (i.e. the monetary base) without any offsetting increase in Fed assets (e.g. treasury securities).  Having these assets available would be important for the Fed down the road if, say after the economic recovery, it needed to pull back some of the money created through this program.  Caballero suggest the Fed could use some of its new tools (e.g. Fed term deposits ) or add contingency conditions that would require the Treasury to return money to the Fed. None of these solutions would be painless.  Felix Salmon suggests a way around this problem is simply to front-load the seigniorage (i.e. Fed profit)  returned to the Treasury.  It is unclear, though, how well this would work.   Seigniorage is limited and thus the Fed could not unconditionally commit to an explicit NGDP or price level target with it. It would therefore be difficult shake deflationary expectations. One soultion might be to have the Fed simply buy treasury securities directly from the U.S. Treasury instead of giving it a "monetary gift" via a helicopter drop. As long as the Fed held  securities there would be no increase in the amount of publicly held debt. Some of the debt may ultimately leak bank into the public domain if the Fed used it to reverse some of the monetary expansion.  As long as the leakage was not too much the same benefits outlined above would apply.

Are You Smarter Than A Professional Forecaster?

I have been making a lot of noise here about the Fed's passive tightening of monetary policy.  In particular, I have been pointing to declines in both inflation expectations and forecasts of nominal GDP (NGDP) to show that the Fed is allowing expectations of future aggregate demand (AD)  to fall.  Since future spending affects current spending, current Fed policy is also effectively slowing down current AD.  Given this running discussion of mine, I thought it would be interesting to see what my undergraduate students think about it.  Specifically, what is their outlook for AD?  On the first day of class I assign a personal profile sheet they have to fill out--helps me get to know them better--and this semester I added a question that asks them to forecast of the annualized NGDP growth for 2010:Q3 and 2010:Q4. I gave them a chart of the annualized NGDP figures of the previous 6 quarters and and told them to use it and their knowledge of what is happening to make their forecasts.

Since these are undergrad students mostly from Texas, a state that hasn't been hit as hard by the recession, and since many undergrads are not as engaged with the current events as they should be I expected rather optimistic forecasts.  Here is what I got from my three classes (click on figure to enlarge):

Much to my surprise my students overall see an ongoing downward trend in the growth rate of nominal spending.  All of their 2010:Q4 forecasts are lower than that coming from the Survey of Professional Forecasters.  I really expected more optimistic numbers.  Maybe they simply followed the trend from the previous quarters in making their forecasts or maybe they truly are worried about the future.  I look forward to class today to hear their justification for their forecasts.  I also look forward to seeing how their forecasts pan out compared to the professionals during the semester.  

Bernanke's Speech: A Big Tease

Ben Bernanke delivered a much anticipated speech today at the Jackson Hole Economic Symposium.  Many observers, myself included, were wondering if he would advocate a more aggressive role for monetary policy given the signs of weakening in the U.S. economy.  Instead, what he delivered was a big tease: he acknowledges three points made by advocates of more monetary easing, but then either ignores the implications of these points or argues against them.

Let's look at the three points he acknowledges in turn.  First, he concedes that the low interest rates can reflect a weak economy rather than being a sign of loose monetary policy.  Second, he grants that the Fed can be effectively tightening monetary policy simply by being passive.  He makes these two big concessions in his discussion of why the FOMC decided to stabilize the Fed's balance sheet (my bold):

[A]llowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.

Consider the implications of these points.  First, if lower interest rates reflect economic weakness--though he mentions long-term interest rates recall they are the expectation of a bunch of short-term interest rates plus some term premium--then one implication is that the low federal funds rate may not be so accommodative after all. Given the state of the economy, maybe the 0%-0.25% range for the federal funds rate is not low enough.  Now the federal funds rate cannot go negative (and this is one of the problems with using an interest rate target), but if it could the implication here is that it may need to go deep into negative territory in order to be at the appropriate level.  Folks like Andy Harless and Glenn Rudebusch have made this very point. So what does Bernanke think? Does he run with his own argument to its logical conclusion?   The answer is no. Elsewhere in the speech he claims that "monetary policy remains very accommodative" and that the "Fed has also taken extraordinary measures to ease monetary and financial conditions. Notably,... the FOMC has held its target for the federal funds rate in a range of 0 to 25 basis points..." In short, Bernanke thinks the low federal funds rate is sufficiently accommodative, even after acknowledging that low interest rates can reflect weak economic conditions rather than loose monetary policy.

Now consider his second concession: the Fed can effectively be tightening monetary policy just by being passive.  He acknowledges this point in the context of stabilizing the Fed's balance sheet.  This is an important insight, but what about the other ways the Fed can passively tighten monetary policy? Currently, the Fed is failing to stabilize the NGDP or aggregate demand forecast. By allowing this to happen the Fed is effectively tightening monetary policy.  Why is he not concerned here too about such passive tightening of monetary policy?

Bernanke's third concession is an important one too. In his discussion of what the Fed can do if more action is required, he alludes to the idea of price level targeting. Now this option is not as good as NGDP level targeting, but it would be vast improvement over what is going on. Here is what he said:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability... in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

He is absolutely right that a price level target would mean higher than normal inflation currently to get the economy back to its previous price level path.  If such a price level target were formally announced, it would go a long ways in (1) creating more economic certainty  and (2) helping household balance sheets repair themselves. So is Bernanke on board? Unfortunately, for two reasons the answer is no. First, he sees no support for such a policy in the FOMC .  And, apparently, this is one battle he does not want to fight at the Fed.  Second, and more troubling, he does not think it is needed and believes it could even be problematic:

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy

 This is perplexing on so many levels. First, an explicit price level target would not destroy long-run inflation expectations.  Yes, there may be an inflation catch up period, but over the long-run the inflation rate would be governed by the inflation rate implied by the price level target.  (Of course, an even better solution would be targeting a NGDP level, but I digress.) Second, for the 100¹⁰⁰ time, inflation expectations are not stable or well anchored.  The have been falling all year across all horizons as can be seen with the Clevend Fed data .  This sustained decline can also be seen below on a daily basis for the five-year horizon:

How can there be any question about falling inflation expectations?  (For those concerned that the liquidity premium is distorting the implied expected inflation rate from the Treasury market note the following.  First, the Cleveland Fed data corrects for this potential distortion.  Second, even in the case of the chart above a heightened liquidity premium only reinforces the likelihood of growing deflationary pressures. This is because a heightened liquidity premium implies a heightened demand for highly liquid assets like treasuries and money. In turn, this implies less spending and greater deflationary pressures.) Third, if there is anything driving increased uncertainty it is a weakening economy. And by failing to stabilize  inflation expectations, the Fed is allowing economic uncertainty to grow.  Bernanke seems hung up on a potential source of economic uncertainty instead of looking to an actual source of economic uncertainty. 

What a big tease.

Time's A Ticking

The always colorful Ambrose Evans-Pritchard:

Fiscal and interest rate ammo has been exhausted, though not QE. I have little doubt that central banks can lift the West out of debt-deflation if needed with genuine QE – not Ben Bernanke's Black Box "creditism", or Japan's fringe dabbling. Whether they have the nerve or the ideological willingness to do so is another matter.

Also see his earlier comments on Bernanke's "creditism" here.