Macro and Other Market Musings

My Reply to Krugman

david.beckworth@gmail.com (David Beckworth) — Fri, 06 Nov 2009 17:57:00 +0000

Paul Krugman has chimed in on my figure showing the collapse in nominal spending. He, however, is less enthusiastic about its implications:

[The figure is] certainly suggestive. But I disagree with the interpretation that this shows that the current slump is mainly about insufficiently expansionary monetary policy...

[...]

Focusing on nominal spending makes you think that low nominal spending is the problem, a problem with a monetary solution; but actually it’s the symptom, and monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).

Note that the part about changing expectations of future inflation in parentheses is actually an admission that monetary policy can do something about the current slump. Krugman, however, does not explore this point anywhere else in his post. That is unfortunate because it is the very argument advocates like Scott Sumner have been making in their case that monetary policy could have done more to prevent the nominal spending crash of 2008-2009. One way to think about this is to imagine what would have happened had the Fed set an explicit inflation target of say 3% in mid-2008 and promised it would do whatever was needed to keep actual inflation there. If such a policy had been adopted it is unlikely inflation expectations would have collapsed liked they did in late 2008, early 2009 as seen in the figure below (click on figure to enlarge):

And if inflationary expectations had not collapse then current nominal spending would have been far more stable. This is because if folks think that inflation will be permanently higher going forward they are more likely to spend their money today. That is, money demand will fall and velocity will pick up.

This is a point I empirically tested in a recent post. There I took the monthly expected inflation series implied by the difference between the nominal 10-year Treasury yield and the 10-year TIPs yield and put it in a vector autoregression (VAR) along with the monthly GDP series from macroeconomic advisers. Nominal GDP was turned into an annualized monthly growth rate and the data used runs from 1999:1 through 2007:9. More data would have been helpful, but TIPs only start in the late 1990s.* The two figures below show what the typical responses of expected inflation and nominal GDP to the typical sudden change or shock to expected inflation over the sample. The solid line shows the point estimate while the dashed lines show two standard deviations around the point estimate. Upon impact, the shock causes expected inflation to jump 16 basis points and occurs as the level of nominal GDP increases by 1.16 percent. In other words, a sudden positive change in expected inflation is associated with an increase in current nominal spending. Both effects persist but eventually become insignificant about 14-15 months later. (Click on figures to enlarge.)

So contrary to Krugman's claim, there is reason to believe the Fed could have prevented the great nominal spending crash of 2008-2009. The real question for me is why did the Fed allow inflationary expectations to fall so dramatically in late 2008, early 2009. My guess is they simply dropped the ball or there was too much pressure from inflationary hawks.

Update I: The Economist blog Free Exchange responds to Krugman's post by arguing that monetary policy is not out of gas.

Update II: Scott Sumner also shoots down Krugman's nominal nonsense.

*(Technical note: both series were in rates so no unit root problems, 13 lags were used to eliminate serial correlation, and corporate bond spreads were included as a control variable for the financial crisis).

Why Care About Nominal Spending?

david.beckworth@gmail.com (David Beckworth) — Fri, 06 Nov 2009 14:24:00 +0000

Thanks to Alex Tabarrok, The Economist's Free Exchange blog, Ezra Klein, and Bruce Bartlett my last post on the history of U.S. nominal spending received a lot of attention. It also raised the important question of why we should care about nominal spending. Before I answer this question let me first define nominal spending: it is the current dollar value of total spending in an economy. More simply, it is total demand in an economy. Technically, what I showed in the last post was the growth rate of final sales to domestic purchasers or U.S. domestic demand. One could also look at final sales of domestic product--which includes foreign purchases of U.S. made goods and services--which is aggregate demand for the U.S. economy. Either way, both series show a large collapse in nominal spending late 2008, early 2009 as seen in this figure.

Now on to the importance of nominal spending. I have asserted that the best way for the Fed to reduce macroeconomic volatility is to stabilize nominal spending rather than inflation. Here is why. If an economy is running at full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that are not sustainable. This is because there are numerous rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending (i.e. create a nominal spending shock) and not have real economic activity move as well.

Note that the key here is not to aim for inflation stability, but to aim for nominal spending stability. This is because inflation is merely a symptom of nominal spending shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high (low) inflation due to positive (negative) aggregate demand (AD) shocks or negative (positive) aggregate supply shocks (AS)?--and as a result monetary policy that targets inflation rather than nominal spending may make the wrong call. To illustrate this point, consider the following two cases*:

(1) A central bank has a 2% inflation target and the economy's sustainable (i.e. natural) rate of growth is 3%. Here we have nominal spending growing at 5%. Now imagine that fiscal policy generates a positive AD shock that increases nominal spending and pushes inflation temporarily to 4%. Now nominal spending is growing at 7% and if there are any nominal rigidities (i.e. upward slopping SRAS curve) this increase in nominal spending (or AD) should also push real economic activity beyond its natural rate. Hence, a positive output gap is created and there is an uptick in inflation. In this scenario--where a positive AD shock is the issue--a policy aiming to stabilize nominal spending would have prevented the output gap from emerging. An inflation target regime would have also addressed the output gap, but since inflation is a symptom of the nominal spending shock it only would have done so after the horse was out of the barn, so to speak. Still, in this case inflation targeting would have made the right call.

(2) A central bank has a 2% inflation target and the economy's natural rate of growth is 3%. Once again, nominal spending is growing at 5%. Now assume a permanent productivity innovation pushes the natural rate of real economic growth to 5%. Assume also that the surge in productivity in the absence of any new accommodation or changes in monetary policy--that is, the central bank is still increasing money supply at rate that would have created a 2% inflation target under the old steady state of 3% real growth--would have pushed inflation down to 0%. If the central bank adopts this approach and does not accommodate the increase in productivity, nominal spending will still be at 5% (0% inflation + 5% real growth). Note, there has been no change in AD (still growing at 5%) and thus no movements against the SRAS by which to create an output gap.

Now assume the central doesn't sit idly by but accommodates the productivity shock so that its inflation target is maintained. It will have to stimulate nominal spending such that the potential 2% drop in inflation is avoided. Now nominal spending jumps to 7% from its previous value of 5%. Here, we have a sudden increase in nominal spending (or AD) that in the face of an upward-slopping SRAS will temporarily push output beyond its natural rate. In other words, an positive output gap will emerge. But here there is no observed change in inflation or the inflation target! Had the central bank targeted a 5% nominal spending growth rate this output gap would not have emerged. Instead, its rigid focus on inflation caused it to be too accommodative.

There are other scenarios one could consider, but any way you slice it what becomes apparent is that monetary policy that targets nominal spending can handle both AD and AS supply shocks, while monetary policy that targets inflation can only handle AD shocks. I believe one example of this was the 2003-2004 period when the U.S. economy was buffeted with rapid productivity gains (i.e. positive AS shocks) that led to low inflation. The Fed interpreted this low inflation as indicating weak AD and kept monetary policy extremely loose. They were wrong, nominal spending was soaring by 2003 and thus, monetary policy was too accommodative. I also believe that had the Fed been targeting nominal spending it would been easier for them to avoid the collapse in nominal spending that occurred in late 2008, early 2009. Of course, an explicit inflation target would have helped too but why not go for root of the problem rather than its symptom?

For more on the importance of stabilizing nominal spending I would recommend you take a look at Scott Sumner's blog. Also, here is an article from the St. Louis Fed that provides a more thorough but gentle introduction to the importance of nominal spending and how monetary policy might target it.

* These are variations of scenarios I first posted over at Worthwhile Canadian Initiative.

Global Nominal Spending History

david.beckworth@gmail.com (David Beckworth) — Tue, 03 Nov 2009 15:41:00 +0000

As someone who believes that stabilizing nominal spending rather than inflation is key to macroeconomic stability, I have taken the liberty in the past to reframe U.S. macroeconomic history according to this perspective. Thus, I renamed (1) the "Great Inflation" that started in the mid-1960s and ended in the early-1980s as the "Great Nominal Spending Spree" and (2) the "Great Moderation" of 25 years or so preceding the current crisis the "Great Moderation in Nominal Spending." I also labeled the late-2008, early 2009 period as the "Great Nominal Spending Crash". Below was the figure I used to summarize this reframing of U.S. macroeconomic history (Click on figure to enlarge):

Recently, I learned the OECD has a quarterly nominal GDP measure (PPP-adjusted basis) aggregated across 25 of its member countries going back to 1960:Q1. The countries are as follows: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States. The combined economies of these counties make up over half the world economy and thus, provide some sense of global nominal spending. So in the spirit of reframing global macroeconomic history according to a nominal spending perspective I created the following figure (click on figure to enlarge):

I suspect the similarities between these two figures speak to the size and influence of the U.S. economy. I think it also speaks to the influence of U.S. monetary policy on global liquidity conditions and, thus, it influence on global nominal spending.

Pick Your Poison

david.beckworth@gmail.com (David Beckworth) — Tue, 03 Nov 2009 04:39:00 +0000

After reading Nouriel Roubini's latest article in the FT I feel less certain about what the Fed should be doing going forward. On one hand I see figures like the one below from the IMF's World Economic Outlook (p. 32) that point to excess global capacity and the ongoing threat of global deflation (the bad kind) and come to same conclusion as Scott Sumner:

If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.

In short, the Fed should use its monetary superpower status to ensure there is ample global liquidity and in so doing stabilize global nominal spending.

On the other hand, Nouriel Roubini claims the current Fed policies in conjunction with a large dollar carry trade is creating a new set of asset bubbles:

Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals... So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fueling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time.Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.
People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.
So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

Roubini is not optimistic about what this means for the future:

[O]ne day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

So what is the bigger threat: global deflation or asset bubbles driven by Fed policy and "the mother of all carry trades"? Tim Lee via Buttonwood also sees potential problems to the unwinding of this dollar carry trade. I hope there is another way out for the Fed.

More Takes on the Fed's Monetary Superpower Status

david.beckworth@gmail.com (David Beckworth) — Fri, 30 Oct 2009 15:56:00 +0000

As a follow up to my previous post, here are some more articles that point to the Federal Reserve (Fed) as a monetary superpower. Before I get to them I want to be clear why this discussion is important: if the Fed is a monetary superpower then it was more than a passive player during the global liquidity glut of the early-to-mid 2000s--it was an enabler. Moreover, the monetary superpower status means the Fed will continue to shape global liquidity conditions for some time to come. Until the Fed takes this role and the responsibilities that come with it seriously, it is likely to create more distortions in the global economy.

Now on to the articles. First up is Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary policy and was more the cause rather than the consequence of the funding coming from Asia.

Along these same lines Sebastian Becker of Deutsche Banks makes the following case:

[I]t might well be the case that excess savings in emerging markets and the resulting re-investment pressure on developed economies’ asset markets contributed to the pronounced fall in US long-term interest rates between 2000 and 2004. Nevertheless, a simple graphical depiction of the US Fed funds rate and selected US long-term market interest rates (as e.g. 15-year and 30-year fixed mortgage rates) rather suggests that the Federal Reserve’s monetary policy stance was the major driver behind low US market interest rates. [See the figure below-DB] Correlation analysis confirms that US mortgage rates and US Treasury yields have both been strongly positively correlated with the official policy rate since the early 1990s. Although global imbalances and the corresponding rise in world FX reserves are likely to have contributed to very favourable liquidity conditions prior to the crisis, the savings-glut hypothesis does not seem to tell the full story. Instead, what really caused global excess liquidity might have been the combination of very accommodative monetary policies in advanced economies between 2002-2005 coupled with fixed or managed floating exchange rate regimes in major emerging market economies such as China or Russia. Consequently, emerging markets implicitly imported at that time the very accommodative MP stance of the advanced economies. (Click on Figure to Enlarge):

The entire Becker piece is worth reading and is a follow-up to another interesting article he did on global liquidity in 2007.

Finally, let's turn to Scott Sumner for how the Fed could use its monetary superpower status in a productive manner going forward:

If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.

The Fed abused its monetary superpower status in the past by creating a global liquidity glut that in turn fueled a global nominal spending spree. Now the Fed has a chance to redeem itself by stabilizing global nominal spending and preventing the emergence of global deflationary forces.

More Evidence the Fed is a Monetary Superpower

david.beckworth@gmail.com (David Beckworth) — Fri, 23 Oct 2009 14:01:00 +0000

I have the made the case many times that the Fed is a monetary superpower. Recent developments seem to confirm this view: the Fed's low interest rate policy is making it difficult for other countries to raise their interest rates lest their currencies strengthen and they lose external competitiveness to the United States. Here is Vincent Fernando:

There's a huge problem with the entire world trying to have weaker currencies relative to the dollar right now.

It's that they've all become slaves to U.S. interest rate policy, even more so than they already may have been.

Right now, raising interest rates in any country before the U.S. does so is likely to strengthen that country's currency against the dollar, all else being equal.

[...]

For countries with a strong desire to keep exports competitive, that's a big problem.

Thus the Eurozone, the U.K., and most international countries have to decide whether their own fear of currency strength is worth the collateral damage it causes at home.

And you thought the ECB was a truly independent central bank? The Economist also has an article that touches on this issue:

The ECB will eventually face a problem that some central banks are already encountering. As long as America keeps its interest rates low, attempts by others to tighten policy (even stealthy ones that leave benchmark rates unchanged) are likely to mean a stronger currency. That is a price that Australia’s central bank seems prepared to pay. The minutes of its policy meeting on October 6th, at which it raised its main interest rate, revealed the exchange rate was not a consideration. The bank’s rate-setters ascribed the Australian dollar’s rise to the economy’s resilience and strong commodity prices. In New Zealand, similarly, the central-bank governor, Alan Bollard, told politicians that the kiwi dollar’s strength would not stand in the way of higher rates.

Note that this means the Fed is setting global liquidity conditions, just as it did during the early-to-mid 2000s. The Fed's official mandate is the U.S. economy, but its reach is global.

More on the Dollar

david.beckworth@gmail.com (David Beckworth) — Fri, 23 Oct 2009 13:51:00 +0000

From Barry Eichengreen:

[T]he dollar isn’t going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial centre. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.

From David Lynch:

In the short run, the only currency that could challenge the dollar is the euro... But for all its attractions, the euro lacks some essential attributes. Although the European Union has a central bank, comparable to the Federal Reserve, there is no European treasury. Instead, there are 27 European treasuries. Investors can't easily track or influence fiscal policy on the continent.

The dollar is also buoyed by the existence of a massive government bond market. There's roughly $4 trillion worth of U.S. Treasuries floating around, and almost $100 billion changes hands each day, according to investment management firm Pimco. Trading that's carried on almost 24 hours a day, rolling east to west from Tokyo to London to New York, makes it easy to move into and out of dollar positions in a hurry.

Europe, by contrast, has no analogue to the U.S. Treasury market. Instead there is a fragmented scene with individual sovereign debt from Germany, Italy, France and other EU members. No individual market enjoys anything like Treasuries' liquidity and size.
[...]

There's another potential dollar rival on the horizon, though its day likely lies a decade or more in the future... But before it does, China will have to thoroughly overhaul its existing financial system. Today, the yuan isn't freely convertible into other currencies, and there are strict limits on the cross-border movement of the Chinese currency. Chinese officials publicly have committed themselves to freeing the yuan to float alongside the dollar, euro, yen and other major currencies. That change, however, won't happen overnight.

Much Ado About Nothing: the Dollar's Decline

david.beckworth@gmail.com (David Beckworth) — Thu, 22 Oct 2009 16:11:00 +0000

There has been much angst by observers over the dollar's decline from the conspiracy laden to the serious and somber. Other observers say this discussion is pointless; the weakened U.S. economy needs some dollar depreciation so get over it. A quick look at the dollar's value in the figure below shows the dollar's decline is (1) only returning it to where it was 2007 and (2) pales in comparison to its slide between 2002-2007. (Click on figure to enlarge.)

Daniel Drezner provides great perspective on this development:

OK, let's be as plain as possible about this - as a reserve currency, the dollar is not going anywhere. Really.
The dollar's slide in value has been predictable, as the need for a financial safe haven has abated. By and large, a depreciating dollar helps the U.S. trade balance (though it would help much more if the Chinese renminbi got in on the appreciation).
Even the Chinese, who have spoken like they want an alternative to the dollar as a reserve currency, are in point of fact not doing much to alter the status quo. Why? To paraphrase Winston Churchill, the dollar is a lousy, rotten reserve currency - until one contemplates the alternatives.
Because all of the alternatives have serious problems. The euro, the only truly viable substitute for the dollar, is not located in the region responsible for the largest surge of growth. It would be unlikely for the ASEAN +3 countries to agree to switch from the dollar to a new currency over which regional actors have no influence (the Europeans wouldn't be thrilled either, as it would lead to an even greater appreciation of the currency). Oh, and the European Union has no consolidated sovereign debt market. The euro is worth watching, but it's not going to replace the dollar anytime soon.
The other alternatives are even less attractive. Most other national currencies beyond the euro - the yen, pound, Swiss franc, Australian dollar - are based in markets too small to sustain the inflows that would come from reserve currency status. The renminbi remains inconvertible. A return to the gold standard in this day and age would be infeasible - the liquidity constraints and vagaries of supply would be too powerful. There's the using-the-Special-Drawing-Right-as-a-template-for-a-super-sovereign currency idea, but this is an implausible solution. As it currently stands, the SDR is not a currency so much as a unit of account. Even after the recent IMF authorizations, there are less than $400 billion SDR-denominated assets in the world, which is far too small for a proper reserve currency.
So, what's really going on here with the dollar obsession? I suspect that with the Dow Jones going back over 10,000, Republicans are looking for some other Very Simple Metric that shows Obama Stinks. The dollar looks like it's going to be declining for a while, so why not that? Never mind that the dollar was even weaker during the George W. Bush era -- they want people to focus on the here and now.
The thing is, I'm not sure this gambit is going to work. People who already think Obama is a socialist will go for it, sure, but that's only rallying the base. I'm not sure how much fence-sitters care about a strong dollar, however. If anything, populist movements tend to favor a debasing of the currency rather than a strengthening of it.

Read the rest of Drezner's article here.

Update: Martin Wolf has a great column on this issue titled "the rumours of the dollar's death are much exagerated."

Speaking of Taylor Rules...

david.beckworth@gmail.com (David Beckworth) — Thu, 22 Oct 2009 15:37:00 +0000

See this recent blog pos t on Taylor Rules by John Taylor himself and this discussion of Taylor Rules by Paul McCulley of PIMCO.

Interesting Interviews

david.beckworth@gmail.com (David Beckworth) — Wed, 21 Oct 2009 15:11:00 +0000

I found these two interviews interesting. First, Zanny Minton Beddoes, the economics editor at The Economist, joins Aaron Task of Tech Ticker for a conversation on the global economy.

Second, Niall Ferguson, an economic historian from Harvard University, talks with Aaron Task about the decline of the U.S. empire relative to the ascent of the Chinese empire.

Ben Bernanke vs. Edwin Truman on U.S. Domestic Demand

david.beckworth@gmail.com (David Beckworth) — Mon, 19 Oct 2009 00:59:00 +0000

Ben Bernanke is back at it. In a speech before the Federal Reserve Bank of San Francisco, he noted that Asia continues to save too much and the United States too little. As a result, global economic imbalances may once again grow. Here is what he had to say about Asia:

For their part, to achieve balanced and sustainable growth, the authorities in surplus countries, including most Asian economies, must act to narrow the gap between saving and investment and to raise domestic demand. In large part, such actions should focus on boosting consumption.

Bernanke is saying Asian economies must increase their domestic demand going forward to help reign in global economic imbalances. He also acknowledges that U.S. domestic demand will have to come down via less fiscal stimulus for this endeavor to work. So, in short, the key to a rebalanced world economy is better management of domestic demand. Fine, but where was the Federal Reserve with managing U.S. domestic demand back in 2003-2005? If better management of domestic demand is key to removing global imbalances now, surely it would have helped in the early-to-mid 2000s. The Federal Reserve could have done a lot on this front. Had it reigned in U.S. domestic demand back then it seems likely Asia would have been more likely to switch to its own domestic demand sooner. As Mark Thoma notes, though, Bernanke fails to mention this point in his talk.

The Federal Reserve cannot claim ignorance on this point. Edwin Truman, one of its long-time former employees, argued forcefully for the Federal Reserve to take seriously the growth in U.S. domestic demand and its implications for the build up of global economic imbalances back in 2005:

What the Federal Reserve has not acknowledged is that monetary policy has a role to play in slowing the growth of total domestic demand relative to the growth of total domestic supply or domestic output. The issue of concern is not just the effects of external adjustment on financial markets, but also on the real economy. It is one thing for politicians to be reluctant to acknowledge the real economic costs of external adjustment. The Federal Reserve does not have that excuse.

The majority of the members of the FOMC apparently do not embrace the view that they should pay more attention to total domestic demand. They are mistaken. Monetary policy is not just about managing domestic output and employment; it is also about managing total domestic demand, and most importantly managing the balance between demand and output. The view that net exports are a “drag” on GDP rests on knee-jerk arithmetic analysis. Exports and imports of goods and services are jointly determined with consumption, investment, and many other macroeconomic variables. Moreover, policy should focus significant attention on total domestic demand. In particular, the Federal Reserve should ponder whether it is not unnatural to continue to stoke the furnace of domestic demand three years after the dollar has begun to weaken, the US economy has moved into an expansion phase, and the US external deficit has widened. It was wrong for Mexico to ignore the message for monetary policy from the foreign exchange markets in 1994 and for Thailand to do so in 1996. Is it wise for the Federal Reserve to do so in 2005?

Too bad his views were not embraced by the FOMC. Let's hope he gets more of hearing going forward.

More Fed Cheerleading

david.beckworth@gmail.com (David Beckworth) — Thu, 15 Oct 2009 13:47:00 +0000

The battle for the narrative of the Fed actions in the early-to-mid 2000s continues. The latest salvo comes from a blog post by David Altig of the Atlanta Fed and a Cato Policy Analysis piece by Jagadeesh Gokhale and Peter Van Doren. In both cases the authors absolve the Fed of any wronging doing during the housing boom period. I am not surprised to see Fed cheerleading coming from a Fed insider, but from the CATO institute? These are strange times.

In the first article, Altig conveniently finds a modified form of the Taylor Rule that shows the Fed acted no differently than it had in past 20+ years when monetary policy seemingly worked fine. The first problem with this piece is the obvious problem of data-mining a modified Taylor Rule that justifies ex-post his employers actions. If Altig really wants to be convincing, he needs to explain why the original Taylor Rule, which does show the Fed being unusually accommodative during the housing boom, is suspect and why his modified Taylor Rule is better. As John Taylor has shown, the original Taylor rule goes a long way in explaining this crisis. For example, Taylor shows in the figure below that deviations from the Taylor rule in Europe were closely associated with changes in residential investments during the housing boom there (click on figure to enlarge):

Even if Altig could show that his modified Taylor rule makes more sense, there is still the question of whether monetary policy was truly optimal during the previous 20+ years to the housing boom. This was the period of the Great Moderation--a time of reduced macroeconomic volatility--whose appearance has been attributed, in part, to improved monetary policy. As many observers have noted, though, this also was a period of the Fed asymmetrically responding to swings in asset prices. Asset prices were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. This behavior by the Fed appears in retrospect to have caused observers to underestimate aggregate risk and become complacent. It also probably contributed to the increased appetite for the debt during this time. To the extent these developments were part of the reason for the decline in macroeconomic volatility, the Great Moderation and the monetary policy behind it becomes less of a success story.

In the second article Gokhale and Van Doren make the following arguments: (1) detecting asset bubbles is a difficult thing to do; (2) even if the Fed could have detected and popped the asset bubble in the housing market in the early-to-mid 2000s it would have done so at the expense of a painful deflation; and (3) the Fed's ability to reign in home prices was limited. On (1) I agree that responding to an asset bubble after it has formed is challenging. But that is not the the point of most observers who find fault with the Fed during this time. They would say the Fed could have prevented the housing boom from emerging in the first place had monetary policy started tightening before June 2004. On (2) the authors still think the deflationary pressures of that time were the result of a weakened economy. This is simply not the case. As I just recently noted on this blog (here and here), rapid productivity gains were the source of the deflationary pressures, not declining aggregate demand. In fact, by 2003 nominal spending was soaring at a rapid pace. In other words, the deflationary pressures of 2003 were vastly different than the deflationary pressures of 2009. On (3) the authors claim that there was simply no way for the Fed to reign in home prices since the influence of its target federal funds rate on other interest rates declined during the time of the housing boom. While it is true the link between monetary policy and long-term interest rates is more tenuous, the authors argue that even interest rates on ARMs and other subprime-type mortgages were beyond the Fed's influence. A CATO Policy Briefing by Lawrence H. White, however, provides evidence that the supbrime market was in fact very sensitive to the Fed's action during this time. Below is figure that corroborates White's work by showing the effective interest rates on ARM mortgages along with the federal funds rate. Is there any doubt? (Click on figure to enlarge):

Update: To support my claim that nominal spending was soaring by 2003 I have posted a figure below that shows the growth rate of domestic demand relative to the federal funds rate since 2002. The years 2003 to 2004 are marked off by the dashed lines. Note that the growth rate of nominal spending is increasing during the 2003-2004 period while interest rates are kept low for most of the period (click on figure to enlarge):

A Positive Global AS Shock + Loose U.S. Monetary Policy = Trouble

david.beckworth@gmail.com (David Beckworth) — Wed, 14 Oct 2009 13:28:00 +0000

Menzie Chinn is not pleased with the new paper by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg. In this paper the authors argue the underlying cause of the current crisis was a large positive labor supply shock to the global economy that originated in Asia:

Labor in developing countries – countries with vast pools of grossly underemployed people – can now augment labor in the developed world, without having to relocate, in ways not thought possible only a few decades ago. We argue that this large shock to the developed world’s labor supply, triggered by geo-political events and technological innovations is the major underlying cause of the global macro economic imbalances that led to the great recession. The inability of existing institutions in the US and the rest of the world to cope with this shock set the stage for the great recession[.]

Menzie notes there is (1) no discussion in the paper on the role U.S. economic policies played in contributing to the financial crisis and (2) it implies that forces outside the U.S. are the sole driver of U.S. macroeconomic activity. I too am skeptical of studies that suggest developments elsewhere alone are the source of our current problems. However, this study does make a good point in that there was a large positive labor supply shock to the global economy with the opening up of China and India over the past decade. This development created a large positive global aggregate supply shock (AS) that--in addition to positive AS shocks coming from ongoing IT gains--had implications for the global economic policy. The primary implication is that global interest rates should have gone up since the return to the global capital stock increased as a result of this shock (i.e. the marginal product of the global capital stock increased as the global labor supply increased). Instead, the global monetary superpower, the Federal Reserve, pushed global short-term interest rates down and created a global liquidity glut. Throw in some financial innovation, credit market distortions, complacency created by the Great Moderation and the stage is set the greatest financial crisis in the world since the 1930s Great Depression. This point was made by The Economist magazine back in July 2005 in an article titled "From T-Shirts to T-Bonds." Here is a key excerpt:

The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a is allocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.

So, contrary to the paper's assertions, the U.S. could have handled this global AS shock better had its monetary policy been more appropriate. Until we began to take seriously the role U.S. economic policy played in the buildup of global imbalances that ultimately led to this global crisis we are bound to repeat history.

How Well Known Was the Productivty Surge of the Early 2000s?

david.beckworth@gmail.com (David Beckworth) — Tue, 13 Oct 2009 01:32:00 +0000

In my previous post I noted that the rebound in productivity growth that started in the 1990s did not end with the tech bubble bursting in 2000. Rather, it took a temporary respite and then continued to accelerate for a few more years. The point of my sharing this information is that the robust productivity gains of the early-to-mid 2000s imply interest rates should have been higher. Instead they were dropping, a sign that monetary policy was too loose. This development also sheds light on the origins of the deflation scare of 2003: inflation was falling because of positive aggregate supply shocks (i.e. the rapid productivity gains) not negative aggregate demand shocks as was believed back then. Nominal spending, in fact, was soaring during this period. Consequently, the U.S. economy was getting juiced-up on easy money at same time it was being buffeted with positive productivity shocks. This policy response primed the U.S. economy for the emergence of economic imbalances.

A few commentators objected to this interpretation of events. They conceded that the actual productivity growth rate may have continued to surge, but questioned whether productivity expectations kept up with reality. Instead, they surmised that expectations of productivity growth declined after the tech bubble burst. If so, the expected marginal product of capital would have declined, investment demand would have decreased, and the neutral rate of interest also would have fallen. This is a great objection and one I had to check out. First, I went to the Survey of Economic Forecasters from the Philadelphia Fed and looked at the forecast of the average productivity growth rate over the next 10 years. This series begins in 1992 and is graphed below (click on figure to enlarge):

This figure show that the 10-year productivity forecast decline slightly in 2002 but resumed its climb in 2003. It peaks out in 2004, with mild declines in 2005 and 2006. By 2007 the writing was on the wall and the forecast begins to rapidly decline. This figure suggest, then, the actual productivity gains during this time were known and shaping the long-term forecast of productivity growth.

As a robustness check--and because I vaguely remembered there being a lot productivity stories in the media back in 2003-2004--I went to Lexus-Nexus and did a U.S. newspaper and news wire search with the following key words: productivity growth, accelerated or increased or pick up or faster or miracle or upward or improved or strong or robust or sustained. This search was intended to pick up articles, if any, discussing the productivity surge at the time. Here is what I found over 1992-2009 (click on figure to enlarge):

This figure shows a similar pattern: news stories on positive productivity growth articles temporarily declined in 2001 but then continued their upward momentum thereafter. The series peaks in 2005 and then begins a dramatic collapse. The positive productivity news stories bubble pops at that time.

The above figures may not convince everyone, but they are enough evidence for me to conclude that my earlier interpretation of events during the early-to-mid 2000s cannot be too far off the mark.

Obstfeld and Rogoff's New Paper

david.beckworth@gmail.com (David Beckworth) — Sun, 11 Oct 2009 03:35:00 +0000

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):

This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

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 is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are 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 monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

The Amazing Resilience of the Fed's Inflation-Fighting Credibility

david.beckworth@gmail.com (David Beckworth) — Thu, 08 Oct 2009 16:21:00 +0000

I was looking at the Philadelphia Federal Reserve Bank's Survey of Professional Forecasters and found the CPI inflation forecasts tell some interesting stories. Below is a plot of the 1-year forecast and the 10-year average inflation forecast (click on figure to enlarge):

Unfortunately, the 10-year forecast data only goes back to 1991, but based on the similarities in the two forecasted series we can infer the 10-year forecast was probably elevated in the early 1980s as well. Not a terribly surprising result given the upward-trending inflation experience of the 1960s and 1970s.

What is surprising to me is that relative to where it is today, the Fed's inflation-fighting credibility was still being earned as late as 1998. I was under the impression that Paul Volker came in and with one fell swoop earned the Fed the inflation-fighting credibility that it has today. The figure above suggests it was more of journey with inflation-fighting credibility being gradually earned over the next 17 years or so.

What is even more amazing to me is that the Fed's inflation-fighting credibility has not been harmed by recent developments. The forecasters continue to predict a stable long-term trend inflation rate of 2.5%, roughly the same value that it has been since 1998. Given all the talk about the Fed blowing up its balance sheet and the potential of monetizing the debt this result is nothing less than amazing. It should also give pause to those inflation hawks who only see trouble on the horizon.

Assorted Musings

david.beckworth@gmail.com (David Beckworth) — Tue, 06 Oct 2009 13:56:00 +0000

Here are some more assorted musings:

(1) Caroline Baum asks a probing question: if the Fed is not able to identity an asset bubble and prick it in a timely fashion, how then is it able to know what are appropriate spreads in the credit market as it expands it balance sheet to shore up the financial system? In the former case it claims ignorance and refuses to intervene while in the later case it claims prescience and readily intervenes. Baum notes this asymmetry is typical of Fed policy in recent times.

(2) Has the Fed's independence already been compromised? Nouriel Roubini and Ian Bremmer argue yes and its not because of congressional probbing. Rather, it is because of its bailout of large financial institutions last year. Roubini and Bremmer also explain that if the Fed is not careful it could set the stage once again for the next bubble, a point recently made by Peter Boon and Simon Johnson.

(3) Roberto M. Billi has a new article that examines whether monetary policy was optimal in past deflation scares. He looks at Japan in the period 1990 to 1995 and the United States from 2000 to 2005. Using a Taylor Rule he concludes that monetary policy was too accommodative in the case of the United States. While I concur with his conclusion and have said so before, I also would like to note several things. First, the article assumes that deflation is always economically harmful. Deflation, however, can arise for reasons other than a collapse in aggregate demand. As I have noted before, positive aggregate supply shocks can also generate benign deflationary pressures and this form has far different policy implications than deflation arising from a collapse in nominal spending. Second, when constructing the federal funds rate prescribed the Taylor Rule one needs a measure of the output gap. There are, however, different measures of the output gap and, as result, different implications for the Taylor Rule. A popular version for the United States is the CBO's output gap measure. John Williamson of the San Francisco Fed , however, argues that the CBO measure is flawed since it doesn't allow for short-run fluctuations in the growth rate of potential output. Here is his preferred measure (LW) graphed along with the CBO measure:

The CBO measures show a negative output gap during the housing boom while the LW measure shows a positive output gap. The LW makes more sense for this period. Now plug the LW measure into a Taylor Rule and there is even a stronger case that monetary policy was too loose during the housing boom period. Finally, there are other ways to learn the stance of monetary policy. Here is one measure I like.

Josh Hendrickson on Money, Monetary Disequilibrium, and Arnold Kling

david.beckworth@gmail.com (David Beckworth) — Sun, 04 Oct 2009 05:13:00 +0000

Josh Hendrickson has a series of interesting posts where he examines Arnold Kling's views on money.

Measurement Before Theory

Measurement Before Theory, Part 2: A Reply to Arnold Kling

Measurement Before Theory, Part 3: A Reply to Arnold Kling

After reading these posts by Josh as well as those by Nick Rowe and Bill Woolsey, one is almost compelled to take seriously money and monetary disequilibrium.

Was it Nominal or Real?

david.beckworth@gmail.com (David Beckworth) — Fri, 02 Oct 2009 20:30:00 +0000

Scott Sumner has been arguing for some time that the current recession mutated from a mild downturn in early 2008 to a sharp contraction in late 2008 and early 2009 because of a nominal shock, not a real one. Specifically, he has been making the case that monetary policy effectively tightened in late 2008 and, as a result, nominal spending collapsed and pulled down an already weakened economy. According to this view, real shocks like the one coming from the financial crisis or the spike in oil prices, which were important in starting the recession, cannot explain the severity of the downturn that began in late 2008. As readers of this blog know, I have been sympathetic to this view as can be seen here and here. Many observers, however, do not buy it or if they do find it plausible refuse to endorse it due to the lack of empirical evidence. This post is my attempt to shed some light on this debate by using some rigorous (albeit imperfect) empirical methods to tease out what shocks drove the collapse in nominal spending. This essay is in some ways an extension of what I did earlier this week, but it is motivated more by the need for empirical evidence. I won't claim it is conclusive, but it is a start.

In order to uncover the shocks that drove the collapse in nominal spending, I turned to a vector autoregression that as a base line model included expected future inflation, nominal spending, and spreads on corporates yields. The expected future inflation data comes from the Philadelphia Fed's survey of economic forecasters, nominal spending is final sales to domestic purchasers, and corporate spreads are the difference between the yield on BAA and AAA corporate bonds. The reasons for using these variables is as follows. First, Scott has been arguing that the collapse of expected future inflation in late 2008 reflected an effective tightening of monetary policy that translated into reduction of current nominal spending. In other words, the market saw deflationary pressures on the horizon and immediately cut back on spending. Second, the corporate spreads provide a convenient measure of the financial crisis and should control for any collapse in nominal spending coming from a negative financial shock. The data for these variables run from 1971:Q1 thru 2009:Q2.

The VAR was specified and estimated in a conventional manner.* With the VAR estimated I then did a historical decomposition which decomposes or attributes the forecast error for a particular series--in this case the nominal spending growth rate--into shocks or non-forecasted movements in other series. In the baseline model, the other series are expected future inflation and the financial crisis. In other words, this exercise shows how much of the non-forecasted movements in nominal spending can be explained by non-forecasted movements in expected future inflation. The figure below graphs the results of this exercise. In this figure, the other series contribution to the forecast error--the difference the actual and forecasted nominal spending growth rate--is shown by the dashed lines. The closer a dashed line is to the solid red line the more of the forecast error is explained by that shock: (Click on figure to enlarge)

In this figure we see that both the expected inflation shock and financial system shock were important in the collapse of nominal spending. At its peak, the expected inflation shock explains 50% of the decline in the nominal spending shock during the time in question. This baseline model, however, ignores the oil shock and its potential contribution to the collapse in nominal spending. The VAR was reestimated, therefore, with oil prices and generated the following results: (Click on figure to enlarge)

Here the expected inflation shock is still important, but now only explains at most 31% of the decline in nominal spending. The financial shock becomes more important and oil itself is non-trivial in explaining the decline in nominal spending.

One problem with the above analysis is that it assumes the change in expected inflation is a good measure of the stance of monetary policy. I have argued elsewhere on this blog that a better measure is the difference between the nominal spending growth rate and the federal funds rates. I redid the model with this measure of the stance of monetary policy and this is what I found: (Click on figure to enlarge)

With this measure, monetary policy explains 95% of the decline in nominal spending for 2008:Q3, 78% in 2008:Q4, and 31% in 2009:Q1. This last figure confirms Scott's story. Of course, it assumes the monetary policy measure outlined above is actually measuring the stance of monetary policy. Note everyone will agree, but I certainly believe it is. To summarize the findings from the above figures the table below list the % contribution to the decline in nominal spending growth rate coming from the different measures representing monetary policy:

*The VAR had 5 lags to remove serial correlations and the variables were all in rate form so no unit root problem.

Update: Scott Sumner responds here.

Great Survey Paper on the Predictive Ability of the Term Spread

david.beckworth@gmail.com (David Beckworth) — Fri, 02 Oct 2009 15:28:00 +0000

There is new paper by David Wheelock and Mark Wohar of the St. Louis Fed that surveys the literature on the relationship between the Treasury yield curve spread and future economic activity:

Can the Term Spread Predict Output Growth and Recessions? A Survey of the Literature
This article surveys recent research on the usefulness of the term spread (i.e., the difference between the yields on long-term and short-term Treasury securities) for predicting changes in economic activity. Most studies use linear regression techniques to forecast changes in output or dichotomous choice models to forecast recessions. Others use time-varying parameter models, such as Markov-switching models and smooth transition models, to account for structural changes or other nonlinearities. Many studies find that the term spread predicts output growth and recessions up to one year in advance, but several also find its usefulness varies across countries and over time. In particular, many studies find that the ability of the term spread to forecast output growth has diminished in recent years, although it remains a reliable predictor of recessions.

What Was the Stance of Monetary Policy Late Last Year?

david.beckworth@gmail.com (David Beckworth) — Fri, 02 Oct 2009 14:12:00 +0000

How does one best measure the stance of monetary policy? There are many ways to answer this question and, as a result, there are often many differing views on the stance of monetary policy. This issue came up at Cato Unbound's discussion on monetary lessons from the crisis when Scott Sumner argued that the reason the economy tanked in late 2008 and early 2009 was because tight monetary policy caused nominal spending to crash. Jeffrey Rogers Hummel disagreed; he contended that it was not tight monetary policy per se, but a collapse of velocity (i.e. increase in real money demand) that caused the fall in nominal spending. Here is Scott's reply:

[E]conomists are all over the map as to what the terms “easy money” and “tight money” really mean. In that case I am inclined to throw up my hands and ask this pragmatic question:
In a fiat money world where the central bank has almost limitless ability to pump money into the economy, and impact the expected growth of nominal aggregates, what is the most useful definition of the stance of monetary policy?
Since I believe that the Fed should target the expected growth rate of NGDP on a daily basis, I decided the most useful way to think of “easy money” was as a policy expected to lead to above-target nominal growth, and vice versa. Is this so unusual? I notice that those who favor targeting interest rates (Keynesians) define the stance of monetary policy in terms of interest rates. And I notice that many who favor targeting the money supply (monetarists) tend to define the stance of monetary policy in terms of the money supply. I prefer to target NGDP expectations. So that’s my policy indicator.

What I think Sumner is saying is that no matter what the source of volatility in nominal spending, its the Fed's job to counteract and stabilize it. In late 2008 the Fed should have been more aggressive in responding to the fall in velocity. By not doing so, Sumner is arguing monetary policy effectively was tight. I agree and have some evidence to support this view.

My evidence is based on what I consider to be a useful metric for the stance of monetary policy. This metric is difference between (1) the growth rate of nominal spending in the U.S. economy and (2) the federal funds rate. Using this metric, the federal funds rate should not deviate too far from the nominal spending growth rate otherwise monetary policy is either too loose (the federal funds rate is significantly below the nominal spending growth rate) or too tight (the federal funds rate is significantly above the nominal spending growth rate). So what does this metric look like? Using monthly nominal GDP as my measure of nominal spending I have constructed it as follows: the year-on-year percent change in nominal spending minus the federal funds rate. Here is what this series looks for the period 1993:1 - 2009:7 (Click on figure to enlarge):

Note that I have highlighted two periods in red where there was a marked spread between the nominal spending growth rate and the federal funds rate. They just so happen to be the housing boom period and the mini-great contraction period Scott Sumner has been discussing. In the former case monetary policy was too loose while in the later is was too tight.

Unfortunately the monthly GDP data only go back to 1992. However, I created the same series on a quarterly basis back to 1961. This time I used final sales to domestic purchasers as my measure of nominal spending. I took this series and plotted it against the output gap series lagged 5 quarters.*

There is surprisingly strong relationship here: almost 60% of the variation in the output gap 6 quarters ahead can be explained by current variation in this monetary stance measure. Monetary policy does matter--take note Arnold Kling--and its stance can be easily determined by this metric.

*I used the output gap measure from John Williams et al. of the San Francisco Fed. See here for why it appears to be a better measure than the CBO's output gap.

New Paper on the Greenspan and Bernanke Fed

david.beckworth@gmail.com (David Beckworth) — Tue, 29 Sep 2009 14:19:00 +0000

John Ryan and Ryan Koronowski have a nice survey paper on the Greenspan and Bernanke Fed (Hat tip to Mark Thoma). The paper explains in a straightforward manner how the Fed works and considers its policy actions during the tenure of Greenspan and Bernanke. The paper draws upon the work of William White, Claudio Borio, and the other folks at the BIS as well as Martin Wolf. It provides a nice complement to David Wessel's "In Fed We Trust" and, among other things, would work well in a money and banking course.

Here is one excerpt from the paper that sounds like something I would say:

White argues that price stabilization which tries to avoid periods of deflation (what is characteristic for definitions of price stability as a central bank’s target) sometimes may be too expansionary and it may lead to an asset price bubble. This may happen in a situation of “good deflation” when prices decrease as an effect of some positive supply shocks such as rapid growth of productivity or – as recently – globalization. However, it is interesting in this context to ask to what degree monetary policy should be more accommodative in case of “bad deflation” – one induced by a financial crisis and falling demand - without risking it may turn out to have been too easy.

Another way of saying this is that the Fed should stabilize nominal spending. Rapid productivity gains create deflationary pressures. If such productivity gains are accompanied by an easing of monetary policy to offset the downward price pressures there will be a surge in nominal spending. On the other hand, deflationary pressures could also arise from a collapse in nominal spending. Fed policy should avoid both types of swings in nominal spending because such swings in conjunction with nominal rigidities (e.g. sticky prices) would cause output to move outside its sustainable or natural rate level. As I have noted before, though, the Fed failed to do this in the 2003-2005 period and more recently in the late 2008-early 2009 period. Stabilize nominal spending or more macroeconomic bust!

Making the Case for Financial Innovation

david.beckworth@gmail.com (David Beckworth) — Mon, 28 Sep 2009 16:30:00 +0000

In a refreshing change, Robert Shiller makes the case for financial innovation. Along the way he lists some ideas about where financial innovation could go. I like this one in particular:

I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Financial innovation may one day actually serve to prevent financial crisis from ever emerging

Putting Klingonomics to the Test

david.beckworth@gmail.com (David Beckworth) — Mon, 28 Sep 2009 13:27:00 +0000

Arnold Kling has been promoting a macroeconomic theory he calls "Recalculation" which takes a controversial view on the efficacy of monetary policy. You can read his discussion of recalculation macro here, here, and here. Within these discussions he summarizes his view of monetary policy as follows:

In the short run, the economy is going its own way, regardless of monetary policy. Higher M leads to lower V, and vice-versa. In the long run, a significant change in the rate of money creation causes a similar change in the rate of inflation. However, the lag is long and the effect on the rate of Recalculation is small and of indeterminate sign[.]

As this and other passages from his postings show, Kling makes three controversial assertions about monetary policy in his recalculation macro theory. They are as follows:

(1) Monetary policy has no effect on expectations in the short-run.

(2) Monetary policy has no effect on nominal economic activity in the short run.

(3) Monetary policy has no effect on real economic activity in the short run.

Bill Woolsey has been all over Kling's case for making these assertions and the assumptions behind them. I will speak in a moment to Woolsey's critique but for now I want to see what the data says about the assertions (1) - (3).

Number (1) touches on an important question: can the Fed influence expectations about the future in such a way as to shape current economic behavior? Standard macro theory says yes--it is the reasoning behind the current arguments for why the Fed should be explicitly targeting some positive rate of inflation now. Kling, however, does not buy it. In order to test this question empirically, I took the monthly expected inflation series implied by the difference between the nominal 10-year Treasury yield and the 10-year TIPs yield and put it in a vector autoregression (VAR) along with the monthly GDP series from macroeconomic advisers. Nominal GDP was turned into an annualized monthly growth rate and the data used runs from 1999:1 through 2007:9. More data would have been helpful, but TIPs only start in the late 1990s. (Technical note: both series were in rates so no unit root problems, 13 lags were used to eliminate serial correlation, and corporate bond spreads were included as a control variable for the financial crisis). The two figures below show what the typical responses of expected inflation and nominal GDP to the typical sudden change or shock to expected inflation over the sample. The solid line shows the point estimate while the dashed lines show two standard deviations around the point estimate. Upon impact, the shock causes expected inflation to jump 16 basis points and occurs as the level of nominal GDP increases by 1.16 percent. In other words, a sudden positive change in expected inflation is associated with an increase in current nominal spending. Both effects persist but eventually become insignificant about 14-15 months later. (Click on figures to enlarge.)

Now presumably the change in 10-year expected inflation comes from a expected change in monetary policy, but just to be sure and to fully address (2) and (3) I have posted below some figures from another VAR I did that looks at the effect of unexpected changes or shocks to the monetary base for the period 1960:3 - 2008:2. This is a larger VAR that controls for more things. (This figure is actually an excerpt from a series of VARs I did in response to Nick Rowe's post on monetary policy and debt.) Here, the monetary base is shocked 1%. Note how all the real variables increase on impact. In other words, an unexpected positive increase in the monetary base historically has led to an increase in the short run of real economic variables. As predicted by theory, the effect of the monetary base shock eventually wears out--money becomes neutral. (Note that the price level is implicitly in these figures too: it is difference between real money and money. Here, there is a permanent effect)

So the assertions (1), (2), and (3) are empirically falsified. Of course we did not need my VARs to know this. There is already a lot of empirical evidence out there that reaches a similar conclusion. Moreover, Bryan Caplan notes numbers (1) and (2) fly in the face of everything we know from hyperinflation experiences. So why make such assertions? Bill Woolsely explains that Kling's assertions can work if prices are sticky in the short run, real income is determined by productive capacity, and real money demand is not affected by real income. As Bill Woolsely notes, this last assumptions is incredibly wrong, as many empirical studies have demonstrated over the past 50 years.

In light of the evidence I say it is time for Arnold Kling to join the ranks of the monetary disequilibrium bloggers.

Update 1:Here are some definitions to add clarity to the figures above. The real stock price series is the real S&P 500, the debt series is financial sector debt to GDP, the money supply is the monetary base, and the real money balance series is the monetary base divided by the CPI.

Update 2: Josh Hendrickson provides a nice follow up to the issues raised here while Arnold Kling assails my use of the "Dark Age Macroeconomic"-based VAR.

Should Monetary Policy "Lean or Clean"?

david.beckworth@gmail.com (David Beckworth) — Thu, 17 Sep 2009 18:01:00 +0000

That is the title of a new paper by William White, one of the few influential economists who saw the crisis coming and tried to warn others. Here is the abstract:

It has been contended by many in the central banking community that monetary policy would not be effective in "leaning" against the upswing of a credit cycle (the boom) but that lower interest rates would be effective in "cleaning" up (the bust) afterwards. In this paper, these two propositions (can't lean, but can clean) are examined and found seriously deficient. In particular, it is contended in this paper that monetary policies designed solely to deal with short term problems of insufficient demand could make medium term problems worse by encouraging a buildup of debt that cannot be sustained over time. The conclusion reached is that monetary policy should be more focused on "preemptive tightening" to moderate credit bubbles than on "preemptive easing" to deal with the after effects. There is a need for a new macrofinancial stability framework that would use both regulatory and monetary instruments to resist credit bubbles and thus promote sustainable economic growth over time.