The Fed, The Budget Deficit, and The Facts

My last post generated some heated push back from the hard-money types.  That post showed the Fed sill has about the same share of treasuries, 15%, as it did before the crisis.  Thus, the large run up in public debt over the past four years has been funded mostly by individuals, their financial intermediaries, and foreigners.  The Fed has not been the great enabler of the government deficits as claimed by the hard-money types.  This fact seems to have been very uncomfortable for them because they largely ignored it.  Instead, they quibbled with my definition of debt monetization and resorted to ad-hominen attacks. 

Given these responses, it is probably too much to hope for further meaningful engagement with them. But in the event some are still listening, here are some additional points I hope they consider.

First, safe asset yields across the globe have been falling for the past four years.  Even more remarkable, is that the yields have been falling in a similar pattern.  This can be seen in the figure below which shows the long-term government yields for Canada, Germany, Japan, the United States, and the United Kingdom.  U.S. monetary policy cannot explain this worldwide phenomenon. 

 

It was already hard to explain the decline in U.S. yields by looking to U.S. monetary policy.  The Fed only holds about 32% of long-term treasuries and the long decline began well before Operation Twist.  The similar decline among all these different long-term government interest rates only further undermines the view that Fed is enabling the low U.S. treasury yields.  A much simpler explanation for the low interest rates is the ongoing economic slump that keeps the demand for safe assets elevated.  

Second, the Fed and U.S. Treasury Department have been pursuing opposite objectives with regard to the maturity of the publicly-held debt.  The Fed has been trying to shorten the maturity with Operation Twist while the Treasury Department has been trying to extend it.  The figure below sums up this tension nicely. It shows the average maturity of marketable debt has been growing and is projected to grow more.  Thus, the Treasury is offsetting the Fed's Operation Twist efforts and will continue to do so.  Surely if the Fed was working to enable the budget deficits it would coordinate with the Treasury department.

Third, even if the Fed were responsible for the low yields it has failed to generate upward inflationary pressures.  For four years hard-money types have been warning about inflation exploding.  This has not happened and indicates that treasury yields are not being held below their natural rate level, the interest rate consistent with the economic fundamentals. This indicates that should the Fed preemptively raise interest rates, as some have suggested, it would not spark a recovery but choke the already weak economy.

Fourth, the hard-money types have overlooked the safe asset shortage problem that has emerged over the past few decades and its implication for U.S. treasuries.  Over this time the global economy has grown much faster than its ability to produce safe assets.  As a consequence, the world has been turning increasingly to the U.S. financial system to create safe assets, particularly U.S. treasuries.  This means the demand for U.S. debt is higher than would otherwise be the case.  It also means for the world financial system to operate smoothly it needs the U.S. government to run budget deficits.  A failure to do so will only drive safe asset yields lower and intensify the all the problems associated with low interest rates. The crisis has only intensified this development.  This means that the rest of the world may continue to enable our budget deficits for some time.

Finally, my view of debt monetization is that it occurs when monetary policy causes the stock of money assets to unexpectedly exceed the real demand for them.  When that happens, the resulting inflation will be higher than anticipated and erode the real burden of the public debt.  This increase in the money supply may also temporarily push interest rates lower and reduce the government's financing costs.  Note, though, for there to be debt monetization it is not enough to say the Fed is purchasing treasury assets.  Such purchases could simply be keeping the money supply in line with real money demand.  Asset purchases by the Fed, therefore, do not necessarily lead to debt monetization.  In fact, the evidence currently points to the opposite problem, an excess demand for money assets. 

For all these reasons, I find it hard to stomach the claims of folks who say the Fed is enabling the large budget deficits.  One such claim by former Fed officials is what motivated the previous post. Equally troubling is this one from the Shadow Open Market Comittee:

The Fed is facilitating the government’s massive deficit spending by lowering the government’s debt service costs and by neutering market discipline on fiscal policy... the Fed is effectively preventing the fixed income markets from sending out warnings about fiscal policy and disciplining policymakers. The “bond vigilantes” of the past that effectively disciplined Washington have been pushed to the sidelines. The old adage “don’t fight the Fed” certainly rings true when the Fed is the biggest holder and purchaser of US Treasury bonds, signals its intentions to keep bond yields low until labor markets improve significantly, and expresses its tolerance—and even advocacy—of a rise in inflation above its stated target.

These type of wild claims that point to debt monetization simply do not stand up to the data.  I agree we need a conversation on what the Fed should be doing, but before we can even do that we need to have our facts right.  Here is hoping this post is a push in that direction.

The Biggest Myth About the Fed

There many myths about Fed policy over the past few years, but the biggest one has to be that the Fed has been monetizing the national debt.  This simply is not true, but it does not stop some folks from making this claim.  For example, at last week's Cato Monetary Conference we find former Fed officials pounding the Fed-is-monetizing-the-debt drums:

Mr Warsh and Mr Poole (who was filling in for Allan Meltzer) made a sharp distinction between the “legitimate” efforts to fight the crisis and the subsequent easing actions that were, allegedly, unjustified by the economic fundamentals. According to them, the interventions of 2007-2009 were required to ensure that “the markets could clear”, as Mr Warsh put it, while the second round of easing was done to satisfy “political masters” by monetising the debt. In fact, Mr Warsh said that the Fed was being actively unhelpful by “crowding in” Congress’s supposedly poor policy choices.

My first response is how can they can say this with historically-low U.S. treasury yields and muted inflation expectations? Surely, if the Fed were truly monetizing the debt we would be seeing a 1970s-repeat in the bond market, but we are not.  And this is happening, in part, because the Fed is not that big of a treasury purchaser.  Consider the figure below.  It shows the Fed's stock of treasuries by remaining maturity compared to the total stock of marketable treasuries as of the end of October, 2012.  Though the Fed's share of treasuries increases by remaining maturity, at most it hits 32% of the total for 10-30 years category. That means that after many months of Operation Twist that roughly 68% of long-term treasuries are still held outside the Fed. Overall, the Fed holds about 15% of marketable treasuries as seen in the "All Years" category.  It is hard to square these numbers with the allegations that the Fed is monetizing the debt.

Some commentators like to focus on the change in treasury holdings in 2011 because it sounds so scary.  Here is Arnold Kling:

In 2011, the Federal Reserve bought 77 percent of new debt issued by our government. We are already resorting to inflationary finance.

While the Fed did purchase a large share of new treasuries in 2011, these purchases only returned the Fed's share of total marketable treasuries to its pre-crisis level as seen below.  Again, not exactly a picture of debt monetization.

So stop accusing the Fed of monetizing the debt and enabling the large budget deficits.  And stop blaming the Fed for the long decline in treasury yields.  If anything, blame the Fed for allowing treasury interest rates to fall, but that is a different story.

Update: JP Koning says we need to carefully define what debt monetization means.

There Is No Fiscal Slope

Households and firms make economic decisions based on how they expect the future to unfold.  If households expect higher future incomes they are more likely to increase consumption spending today. Likewise, if firms expect higher future sales they are more likely to increase investment spending today. Economic expectations are therefore key to understanding current decisions about aggregate nominal spending. They are also why I think it is is a mistake to talk about a "fiscal slope" like this:

But there is not really any kind of “cliff” in the sense that if you stepped over the edge, you would fall fast, land on something hard, and not get up for a long time. In the modern US economy, the scheduled changes constitute more of a fiscal “slope” – meaning that the full effect of the tax increases would not be felt immediately (income withholding takes time to adjust), while the spending cuts would also be phased in (the government has some discretion regarding implementation). 

If households and firms expect the economy to get much worse because of this fiscal tightening--and they have no reason not to given all of media coverage--it does not matter that it is will unfold slowly over next year. They will change their behavior today in anticipation of this fiscal cliff and make it a self-fulfilling outcome.  So unless the Fed offsets the fiscal tightening, there is no fiscal slope.  It is a pipe dream.

This understanding may shed some light on recent developments in expected inflation that have folks like Ryan Avent worried. Expected inflation, as measured by treasury breakeven rates, during this crisis has been a good indicator of the market's economic outlook. Higher expected inflation implies higher future nominal spending. Given the current slack and nominal rigidities, higher expected nominal spending in turn implies higher future real economic growth. That is why the stock market has closely tracked this indicator over the crisis as seen below:

 But lately expected inflation has been falling.  Here is Ryan Avent:

[S]ince mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.

Avent goes on to speculate why expected inflation would be falling now. He cites as possible explanations an expected economic slowdown elsewhere in the world or the breakdown of the relationship between expected inflation and demand growth.  There is a third alternative: markets in mid-October began to price in the increasing likelihood of the fiscal cliff materializing since they realized President Obama was probably going to win reelection.  This fits nicely with the fact that the decline in expected inflation is being matched by a sustained fall in the stock market, indicating the relationship is still strong.  This can be seen in the figure above or in the close up below:

If this interpretations is correct, then it supports the view that it is a mistake to hope for a fiscal slope.  Expectations matter.

There is Another Solution to the Fiscal Cliff

Have the Federal Reserve work to offset every dollar drop in federal spending with a dollar increase in private sector spending.  The Fed would incentivize the private sector to do this by raising expected future nominal income growth via aggressive open market operations or by helicopter drops.  Rapidly raising the public's expectations of future nominal income growth would cause household and firms to increase current spending and offset the decline in federal spending.  Aggressive open market operations could look like this and helicopters drops like this. The point is, the Fed is capable of keeping total current dollar spending stable if really wanted to do so.  In fact, this stabilizing of nominal spending by the Fed has a name: nominal GDP level targeting.  With a credible version of this target, the Fiscal Cliff should not be a big a deal.  The only question is whether the Fed will act.

Along these lines, Michael Darda of MKM Partners had this to say:

NGDP growth has been quite steady at about 4% per annum despite a 200-300bps swing in the fiscal deficit over the last several years and, over the last five quarters, the weakest real government spending growth since the Eisenhower era. The steadiness of NGDP since 2010 suggests that the Sumner critique is still operative, even at the zero lower bound on short rates. The Sumner critique states that fiscal multipliers converge toward zero if a central bank is NGDP or inflation. In other words, the central bank shifts policy in a way that offsets the effect of spending/tax changes on aggregate demand, or MV. Although the Fed does not currently target a path for NGDP, it is aiming for its dual-mandate contingency based on its forecast of how NGDP growth will evolve: While the Fed cannot currently cut rates to offset a shock, it can ramp up QE (or commit to making some portion of the monetary base permanent) to increase the money supply or to check a decline in velocity. Perhaps this also a reason to not worry too much about demand-side implications of the so-called “fiscal cliff” (assuming Bernanke will do enough QE to offset any potential drag on MV from the cliff).

Come on Fed, you can do this.  Save us from the Fiscal Cliff.

P.S. Yes, I know a helicopter drop is really fiscal policy, but it probably needs to be initiated by Fed operation to make it politically viable. 

A Great Vacation or a Great Recession?

[Update: Beveridge Curve analysis added below]

Casey Mulligan is back:

A high ratio of unemployed to job openings means that the unemployed are competing a lot for jobs, many news reports say, when in fact it could indicate the opposite.

It’s true that a reduction in labor demand — from, say, a new tax on employers — would motivate employers to get by with fewer employees. As they do, employers would reduce job openings and lay off workers. One result would be fewer job openings and more unemployed people, and thereby more unemployed people per job opening.

But a reduction in labor supply in the form of additional subsidies for unemployed people would have similar effects. Unemployed people would be choosier about the jobs they accept, especially the low-wage ones. With more help for people after layoffs, employers and employees in struggling industries would do less to avoid layoffs, especially layoffs from low-paying positions. Either way the result would be more unemployed people.

I agree that labor supply incentives matter, but fail to see this as an important explanation for the weak recovery. Most of the evidence I have seen suggests weak labor demand and demographics to be the more important story in labor markets over the past few years.  In regards to Mulligan's specific claims above, unemployment across all groups has been slow to come down, not just with the low-skill laborers looking for low-paying jobs. For example, college-educated individuals have seen similar changes in their unemployment rate as the nation overall.  

Weak labor demand is a powerful explanation for much of these developments and is borne out by the data from the NFIB's Small Business Economic Trend survey.  Among other things, this survey asks firms what is the single most important problem they face.  The answers to this question include government regulation, taxes, inflation, labor quality, labor costs, financing costs, etc. The number one answer over the past few years has been concerns over a lack of sales (though regulatory concerns have been growing).  Labor concerns are near the bottom of this list, not something one would expect if the labor market distortions were as important as Mulligan thinks they are.  What is even more remarkable about this finding is that how close concerns about the lack of sales fits to changes in the unemployment rate:

Note how sales concerns tend to lead the unemployment rate.  No other small business concern has this relationship with the unemployment rate.  The easiest way to interpret this finding is that owing to weak aggregate nominal expenditures growth during the Great Recession firms were reluctant to hire workers and, as a consequence, the unemployment rate rose.  Now, with sales concerns falling, these firms are hiring more and the unemployment rate is falling.

As noted above, weak labor demand is not the whole story.  Demographics are important too as shown by the Kansas City Fed, Chicago Fed, CBO, and the Center on Budget and Policy Priorities.  The point here is that changes in the labor force over the past few years can be explained in part by long-term trends in the baby-boom population.  Specifically, many of them are now retiring which is causing the labor participation rate to shrink.  This is why observers should be careful when looking at measures like the employment-population ratio which currently is flat lining at its new low even as the unemployment rate falls.  Some might conclude this is because of structural changes in the labor market.  But looking at the employment-population ratio for prime-age workers (which controls for retiring baby boomers) in the age bracket of 25-54 years shows that this ratio is recovering in a pattern similar to that of unemployment:

So between weak labor demand and demographics, most labor market developments over the past few years can be explained.  There is no need to resort to implausibly large labor supply effects arising from distortionary government policies.  There is no doubt in my mind that these effects are there--incentives matter--but it is hard to believe they are large. There are far easier ways to explain the Great Recession than claiming it was a Great Vacation.

Update: Below is a modified Beveridge Curve. It shows the relationship between employment and   job vacancies.  Presumably, employment would rise with increasing job vacancies. Following Soberlook, I have drawn the Beveridge Curve with job vacancies plotted against the employment to population ratio for prime age workers (to avoid the demographic changes noted above).  

The figure shows the expected positive relationship up through August 2009, after which it seems to break down for about 20 months.  Some have attributed this to structural shifts in the economy.  However, this figure also shows that the relationship picks back up in early 2011 as seen with the red triangles.  I am not sure how to interpret the black diamond period, but given the return of the relationship I would wary to attribute it to structural shifts.  Especially with studies like these.

Bond Vigilantes and the Risk Premium

Some folks seem to be having a hard time with my previous post, bond vigilantes to the rescue.  They assume that there could be an actual default by the U.S. Treasury Department that would be reflected in a rising risk premium. While this is certainly possible, I find it highly unlikely since the U.S. government could always  print dollars to buy up its debt.  It could gradually "monetize the debt" and allow slightly higher inflation to slowly erode the burden of the national debt as it did after World War II.  This is, in my view, the most likely worst-case scenario, not an outright default.  The real risk for treasury holders then is a higher inflation risk premium, not a higher risk premium. 

But even this outcome seems unlikely in the near term.  The most likely development treasury holders face over the next year or so is a temporary bout of higher-than-expected inflation associated with Fed easing or more rapid economic growth.  This was the premise of my post, not an outright default.  Given my view that a robust recovery has not taken hold because the demand for safe assets remains elevated (i.e. portfolios remain overly weighted to low yielding, liquid assets), a temporary rise in inflation would cause the much needed treasury sell off that would start a recovery.  That is, treasury holders would sell their treasuries and other safe assets and move into riskier, higher yielding assets. We already see this in the relationship between expected inflation (using 10-year treasury breakeven) and stock prices.  The treasury sell off, therefore, would catalyze the rebalancing needed for a strong recovery. 

Note in this story, the risk premium would actually fall with the recovery.  Currently, it is too high as indicated in this post and as suggested by the figure below from Ed Bradford.  The figure shows the S&P500 earnings yield less the 20-year treasury yield.  This equity risk premium spread has been hovering around 5% over the past two years which seems unreasonably high. 

These indicators of inordinately high risk premiums correspond to the ongoing high demand for safe assets. Once the demand for safe assets is normalized--via the portfolio rebalancing--these risk premiums should decline too.

Bond Vigilantes To the Rescue

Paul Krugman claims that should the much-dreaded bond vigilantes show up, they actually would be good for the economy.  He notes that unlike Greece, the United States has its debt denominated in its own floating currency.  Consequently, the appearance of bond vigilantes would lead to an expansionary decline in the value of the dollar, not a contractionary rise in interest rates.  Tyler Cowen is not buying this story, but Nick Rowe sees some merit in it.  I do too, but from a slightly different perspective.  

Currently, investors around the world have their portfolios inordinately weighted toward safe, liquid assets.  This is because of the ongoing economic uncertainty caused by the Eurozone crisis, fiscal cliff, China slowdown, etc.  They also have a seemingly insatiable demand for these safe assets as evidenced by the ongoing decline in their yields across the globe (see below).  These developments, however, mean that investors are avoiding higher yielding, riskier assets more so than normal. Consequently, these unbalanced portfolios are suppressing asset prices, keeping household balance sheets weak, and ultimately are holding back robust aggregate nominal spending.  Another way of saying this is that risk premiums are currently too high relative to fundamentals.  

 Source

The appearance of bond vigilantes would indicate their economic outlook has changed and are in the process are rebalancing their portfolios.  This rebalancing, whether it was driven by higher expected inflation or higher expected growth, would catalyze more aggregate nominal expenditures and given the significant economic slack, more real economic growth.  The problem, as noted by Nick Rowe, is that we want some portfolio rebalancing, but not too much  That is why an nominal GDP level target is important.  It would clearly set expectations on how much nominal income growth and, by implication, how much portfolio rebalancing would be allowed.  In other words, a nominal GDP target would guarantee we get the just the right dose of bond vigilantism needed to shore up the recovery.  And note that the recovery in nominal GDP would push up interest rates too. Using Paul Krugman's terms, this would be an expansionary rise in interest rates. So let's not fear bond vigilantes, but learn to manage their expectations in a way that will spark a real economic recovery.

Update: Just to be clear, the expansionary rise in interest rates does not mean the Fed would raise rates before the recovery.  Rather, recovery would naturally cause yields to rise (i.e. demand for credit increases, desired savings falls) and the Fed would respond by raising its target federal funds rate.  For more on this point see here.

Update II: Further thoughts on bond vigilantes here.