Pushback on the FOMC Transcript Hysteria

Almost everyone seems to be reveling in the release of the 2006 FOMC minutes that show the Fed was not terribly concerned or aware of the looming dangers from the housing bust.  For example, the Atlantic Wire headlines that the "Federal Reserve officials look extra dumb in 2006 transcript" while the Wall Street Journal RTE blog similarly notes that the Fed was "riding housing roller coaster with eyes shut."  Even the USA Today leads with "Fed slow to see fallout from housing."  It is a full blown Fed-bashing party.

Normally, I am the first one to participate in such parties, but here I actually want to push back against this hysteria.  Yes, the Fed like most observers did not understand all the linkages between housing, the financial system, and the broader economy at the time, but this fact does not really matter. What matters--and is missed by these observers--is that the Fed was fairly successful in preventing the housing recession from spreading to the broader economy for almost two years!  From the peak of the housing market in the spring of 2006 to about mid-2008, the Fed was able to keep aggregate nominal spending growing with minimal slowdown from the housing recession.  It did so by keeping nominal spending (and by implication inflation) expectations stable over this time.  The figure below shows this remarkable performance for this period using the TIPs-generated 10-year expected inflation series:

More figures on the Fed's relatively successful performance over the 2006-2008 period can be found here.   Now, ultimately the Fed did make a historically large policy blunder in mid-2008 by allowing the largest peacetime collapse in nominal GDP since the late 1930s. The collapse is evident in the figure above.   But that was mid-2008, not 2006, and it is something the Fed could have been minimized, if not prevented, with something like a nominal GDP level target.  But that is an another story.  The main point here is that all the excitement over the 2006 FOMC transcripts completely ignores the success of the Fed in 2006 and 2007.

Update:  Matthew Yglesias and Karl Smith make similar points.

A Graph for Mario Draghi and the ECB to Ponder

ECB President Mario Draghi thinks he is doing a swell job.  Well, maybe, but if he and the rest of the ECB governing council really want to restore robust growth in Europe they should spend some time wrapping their minds around the following figure.

Now should President Draghi and the rest of the ECB governing council get stumped they can find the meaning of this figure here.   

Is There Really A German Bias at the ECB?

Following up on a post by Scott Sumner, Christian Odendahl at The Economist pushes back on my claim that there is a German bias to ECB monetary policy.  He argues that ECB monetary policy was not appropriate for Germany prior to the crisis and since then it is only been a coincidence that ECB policy seems more aligned to the needs of the German economy than the rest of the Eurozone. He therefore concludes there is no German bias at the ECB.

I think both Sumner and Odendahl are wrong for several reasons.  First, they reach their conclusion by pointing to specific episodes where ECB monetary policy may have been inappropriate for Germany rather than taking a systematic view of how the ECB responds to regional economic shocks.   If one looks at how the ECB on average conducts monetary policy, then it is hard not to conclude they do so in a manner that favors Germany and the core.  Such evidence can be shown with Taylor Rules and nominal GDP (NGDP) trend graphs, but let me provide some further evidence using the figure below.  It shows for the period 1999:Q1-2011:Q3 the percent of the forecast error for the ECB refi interest rate that can be explained by shocks to the NGDP growth rates in the core and non-core regions of the Eurozone, as well as from shocks to ECB monetary policy.  In other words, this figure shows how important unexpected economic developments in the two regions were on average to changes in ECB monetary policy over this period.  (These results come from a vector autoregression that also controls for the Fed's influence on the ECB policy rate. More details below.*):

This figure indicates that economic shocks to the non-core region were not very consequential in shaping ECB monetary policy, while shocks to the core were very important.  Empirical evidence like tihs is hard to ignore when trying to make sense of what the ECB has been doing.

The second problem is that Sumner and Odendahl both ignore important political eocnomy considerations, which in my view makes for an even stronger case that the ECB has a Germany bias. First, the Germans only agreed to cede monetary power to the ECB after they got it located in Frankfurt and made sure its first leader (Wim Duisenberg) and chief economist (Otmar Issing) were supporters of the hard money view.  These decisions guaranteed the ECB would inherit the conservative Bundesbank culture and its approach to monetary policy.  Second, since Germany is the largest economy in the Eurozone, its influence was bound to be disproportionate at the ECB.  Germany's inordinate influence was evidenced just last year by the market reaction to the resignation of Germany's Jurgen Stark from the ECB.  It is also evident in the implicit deal making the ECB seems to be doing with the German government on the crisis.  To claim there is no German bias at the ECB is to ignore the significant political influence Germany has over the ECB.  As Ryan Avent noted awhile back, if Germany really wanted to end the crisis via the ECB monetary spigot they could do so.  The fact that the ECB has not aggressively opened its spigot is another testament to the German bias at the ECB.

So yes, there is a German Bias at the ECB.  Fortunately, that bias is ebbing though not fast enough.

Update:  Below is a figure that shows the regional NGDP growth rates (% change from a year ago) and the ECB policy rate.  As explained here, the spread between the NGDP growth rate and policy interest rate can  provide an indication of the stance of monetary policy.

No surprise here to see the ECB kept its policy rate close to the core regions NGDP growth rate.  According to this metric, ECB monetary policy was much more in tune with the core countries prior to the crisis.  (One drawback to this metric is that it does not account for past misses.)

*The core is defined here as the combined NGDP of Germany, France, Netherlands, Austria, and Finland. The results come from a vector autorgession (VAR) using 6 lags, a constant, an the federal funds rate (ffr) as an exogenous variable.  The ffr enters the VAR exogenously for reasons discussed here.

Weekend Macro Musings

Here are some some macro musings for the weekend.  I hope to revisit them in more detail later.

(1)  More safe asset discussion.  Arpit Gupta replies to my reply on his critique of my post on the importance of safe assets.  My view (summarized well by Matthew Yglesias) is that safe assets matter to the extent they act as transaction assets (or money) in the modern banking system and that they are currently in short supply. Rebecca Wilder weighs in on how to properly define a safe asset and  Tyler Cowen says maybe the safe assets problem explains the large stock of excess reserves in the United States. 

(2) Caroline Baum does a take down of the Fed's new policy of providing long-term forecasts of its target federal funds rates. Meanwhile, Stephen Williamson says sometimes more information is not always better and that this new policy may simply add more confusion. 

(3) Marcus Nunes responds to Scott Sumner's claim that the there is no German bias to the ECB.  I agree with Marcus for reasons laid out here, here, and here.

(4)  Izabella Kaminska has lost all hope in central banking, claiming that the monetary policy transmission mechanism is frozen up in Europe and that central bankers are having an existential crisis. This article in The Economist lends support to her view.  I think these worries are all wrong.  Similar problems existed during the Great Depression and yet monetary policy was able to spark a robust recovery in 1933 that lasted until 1936 (it was unfortunately cut short by misguided policies). The monetary stimulus was not dependent on a bank lending channel, but instead relied  on the FDR signalling and then doing a quantitative easing program guided by an explicit price level target.  Today, both the Fed and the ECB could do the same by adopting a nominal GDP level target.  Here is how it would work and here are responses to objections to nominal GDP level targeting. 

(5)  John Chapman notes that despite the Fed claiming it intends to keep the stock of mortgage back securities (MBS) stable by reinvesting earnings, its stock of MBS is actually declining and causing a steady decline in the monetary base.  Is this the Fed doing a stealth tightening?  

FOMC Decides to Focus on the Rudder, Not the Destination

The FOMC minutes from the December meeting reveal that starting this month the Fed will start publishing conditional long-term forecasts for the federal funds rate in its Summary of Economic Projections (SEP):

At the conclusion of their discussion, participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions.

So what to make of this new policy?  One view is that it provides more certainty about the future path of the target policy interest rate.  Consequently, it would easier to make long-term investment decisions and that added certainty by itself might add some stimulus to the economy.  The long-term forecast could also be used as a back-door way to provide more monetary stimulus to the economy.  The Fed could do this by lowering its long-term forecast of the target federal funds rate which could be interpreted as indicating greater than expected monetary stimulus in the future.  This, in turn, would improve the economic outlook and thereby encourage households and firms to increase their spending today.  In short, a lower forecast of the future target federal funds rates could raise current aggregate demand. 

The FOMC lowering its expected path of the target federal funds rate, however, might also be interpreted as the Fed revising down its economic forecast and adjusting its target interest rate forecast accordingly to maintain the current stance of monetary policy.  In other words, a lower long-term interest rate forecast might simply be viewed as the Fed expecting the natural interest rate to remain depressed longer than previously expected and thus needing to hold down its target federal funds rate target longer than expected.  Here, the Fed would not be adding stimulus, but maintaining the status quo as the economic outlook worsened. Given the Fed's failure over the past three years to add sufficient stimulus to restore robust nominal spending and close the output gap, this less favorable interpretation in the current environment would amount to more passive tightening by the Fed. 

That there could be different interpretations of the Fed lowering its long-term forecast for the target federal funds rate speaks to a more fundamental problem with this new policy: the Fed has failed to set an explicit nominal target for monetary policy.  Not knowing where the Fed is ultimately heading makes it difficult to interpret changes in the FOMC's long-term interest rate forecast. It is like a captain of a ship who navigates by focusing on the rudder, but fails to set a destination point.  It would be far better for the captain to pick his target destination and then adjusts the rudder accordingly.   This is why it is so important for the Fed to set a nominal GDP level target.  It would provide a clearer road map of where the Fed wants the nominal economy to go and it would make interpreting changes in the expected path of interest rates easier, if not redundant.  It is time for the Fed to focus on the destination.

P.S. Cardiff Garcia notes another problem with this new policy:

One longstanding concern about doing this is that the public might misinterpret the projections as a promise of what the Fed will do rather than something contingent on how the economy performs over time, and the minutes noted that at least one committee member expressed this worry.

Market Monetarism in The Telegraph

Guess who wrote this paragraph:

Central banks have the means to prevent a 1930s outcome, even with rates at zero, if willing to deploy Fisher-Friedman monetary stimulus with conviction, buying assets from non-banks and targeting nominal GDP growth of 5pc. But policy defeatism is in the air... The European Central Bank has guaranteed trouble by letting M3 money contract... The ECB's Mario Draghi will cut interest rates to 0.5pc by February, just to keep pace with passive tightening. 

In this small excerpt we find the  ideas of nominal GDP targeting, purchasing assets from the non-bank public (i.e. using the portfolio channel), and the passive tightening of monetary policy. No, the author is not a Market Monetarist blogger.  Rather, this is Ambrose Evans-Pritchard, a columnist for The Telegraph and fan of Market Monetarist's views.  As Lars Christensen notes, this is not the first time Evans-Pritchard has advocated Market Monetarist views.

Scott Sumner and Russ Roberts Discuss Monetary Policy

Russ Roberts interviews Scott Sumner in the latest EconTalk podcast.  Roberts seems open to Sumner's ideas, which makes me wonder how he reconciles them with his earlier skepticism about there being insufficient aggregate demand. Should Roberts need any more evidence on the importance of nominal income (i.e. aggregate demand) shortages in explaining the ongoing slumps in the United States and the Europe, he should check out this post and this one. 

P.S. Russ Roberts' recent interview with Alex Tabarrok on innovation was really good too.