Macro and Other Market Musings

Some Thoughts for St. Louis Fed's James Bullard

noreply@blogger.com (David Beckworth) — Fri, 10 Feb 2012 17:22:00 +0000

David Andolfatto recently discussed an interesting speech by St. Louis Fed president James Bullard:

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

To some extent the CBO agrees with Bullard. They have adjusted their potential real GDP estimates below pre-crisis trend path values. Still, there remains a large output gap, one that Bullard finds questionable given the negative wealth shock. So how much is the output gap is overstated? And how do we know which measure of the output gap to trust? These are hard questions and I am not sure they are even the right ones to be asking. I believe a more constructive approach is to consider whether there still remains monetary problems that could be addressed by monetary policy.

To begin thinking about whether monetary problems remain, and doing so in light of Bullard's concens about a negative wealth shock, consider the figure below. It shows for the years 1952:Q1 - 2011:Q4 the percent change from a year ago of households net worth plotted against the change from a year a ago of households liquid asset share (i.e. currency, checking accounts, saving and time deposits, retail money market funds, and treasuries as a percent of total household assets). This liquid asset share can be interpreted as a measure of household money demand.

Source

There is a strong negative relationship here that suggests positive household money demand shocks tend to pull down household net worth. And currently households are maintaining unusually high shares of liquid assets in their portfolios, indicating there has been series of positive money demand shocks:

Source

In other words, some of the negative wealth shock mentioned by Bullard is probably tied to the elevated money demand by households. Another way of viewing this issue is that household have adjusted their portfolios toward highly liquid, safe assets. Is this a problem could the Fed could fix? Yes. Through proper expectations management the Fed could cause households to start rebalancing their portfolios toward more normal levels. Josh Hendrickson and I have a paper that provides systematic evidence on the link between household portfolio rebalancing and aggregate nominal spending. The Fed has influence here and armed with something like a nominal GDP level target it could do wonders in catalyzing massive portfolio rebalancing by households. (And no, bank lending is not necessary for the rebalancing of household portfolios and no, long-term inflation expectations would not become unmoored since this is a level target.)

Household's elevated demand for retail money assets, however, is only part of the current monetary problem. There is also an elevated demand by large institutional investors for transaction assets that facilitate exchange (commercial paper, treasuries, repos, large-time deposits, institutional money market funds, etc.). Unlike retail money assets, though, which have grown in response to the spike in retail money demand, the problem here is that the elevated demand for institutional money assets has occurred as their supply has fallen. This can be seen in the following figure that shows monetary divisia aggregates through M4. These measures include the retail money assets but also institutional money assests (i.e. M4 divisia = M2 assets plus commercial paper, treasuries, repos, large-time deposits, institutional money market funds weighted appropriately).

Center for Financial Stability

Since M2 has risen, the reason for the M4 divisia decline in the reduction of institutional money assets. As I have argued before, the failure of the Fed to restore nominal incomes to their pre-crisis expected path (even after accounting for the slightly higher levels during the housing boom) both reduced institutional money assets while increasing the demand for them. The Fed could breach this gap by adopting a nominal GDP level target that restored aggregate nominal income to a reasonable pre-crisis path. This should be the focus of James Bullard's efforts. Forget the output gap, start worrying about the aggregate nominal income gap.

P.S. Josh Hendrickson has a forthcoming paper where he shows that the Great Moderation can be traced to the Fed effectively targeting nominal income. The failure of the of the Fed to keep doing so in late 2008, early 2009 explains many of our economic problems today.

Can Raising Interest Rates Spark a Robust Recovery?

noreply@blogger.com (David Beckworth) — Wed, 08 Feb 2012 00:20:00 +0000

Could the Fed spark a robust recovery by raising its federal funds rate target? For Bill Gross the answer is yes. He believes a key reason holding back the recovery is that the Fed is engaged in a type of financial repression where financial intermediaries' net interest margins--the difference between their funding costs and lending interest rates--are being squeezed by the Fed's low interest rate policies. He sees the Fed driving down interest rates across the yield curve and thus removing the incentive for lending. If only it were that easy.

Gross is correct that higher interest rates are typically associated with strong economic growth, but has the causality backwards. The economy is not sluggish because interest rates are low. Rather, interest rates are low because the economy is sluggish. The demand for credit by households and firms simply is depressed. They see uncertainty, lower-than-expected future income paths, on-going deleveraging, and consequently have pulled back on their borrowing. There also has been an increase in domestic private savings for the same reasons. And to pile it on, there is this global shortage of safe assets problem which causes foreigners to channel their savings here too. All of these developments mean lower interest rates.

It is true that the Fed's large scale asset purchases (LSAPs) over the past few years probably have lowered the risk premium on long-term yields. A spate of empirical studies, however, find that the effect of the LSAPs on long-term yields is modest at best. The LSAPs, for example, cannot account for much of the 300 basis points plus drop in the 10-year treasury interest rate since 2007. What can explain it is the ongoing slump in the economy and the global demand for safe assets. Another way of saying this is that even if there were no Fed, interest rates would probably still be very low.

There is a name for the underlying interest rate that reflects these fundamentals of the economy. It is the equilibrium or natural interest rate (also called the neutral interest rate). And it is this natural interest rate and its term structure that is depressed and squeezing net interest margins, not Fed policy. If anything, Fed policy since mid-2008 has been playing catch-up with the natural interest rate, a point made by none other than two prominent PIMCO employees back in 2008:

If the central bank does not act quickly enough – and financial conditions deteriorate further – the central bank may end up just chasing the neutral rate down without ever reaching the level needed to provide monetary stimulus to the economy.

This is an excellent point, one that I want to illustrate using the IS-LM model. Now the IS-LM is far from perfect, but it provides a simple and systematic way to think about interest rates. Paul Krugman agrees and I want to follow up on his reply to Bill Gross with my own use of the model.

First the setup. The standard IS-LM model has two curves: the IS curve and the LM curve. The IS curve shows the combinations of interest rates and real output where desired savings equals desired investment (or, alternatively, where spending equals output). This curve is downward slopping. The LM curve shows the combinations of interest rates and real GDP (Y) where the money market is in equilibrium. With the Fed targeting an interest rate, this curve is horizontal. This is depicted below along with a full-employment or natural rate output (red) line, Y^Natural. The natural interest rate, i^Natural , in this figure occurs where the IS curve intersects the natural output line. (Click on figure to enlarge.)

Note that in this figure there is no business cycle. Actual output is being produced its at natural rate level and consequently the interest rate is at is natural rate level too. Now imagine some negative shock increases desired saving and lowers desired investment. That will cause aggregate demand to fall and push the IS curve from IS₁ back to IS₂ as seen below.

This causes the natural interest rate to fall from 4.00% to - 2.00%. The Fed, seeing the collapse in aggregate demand, lowers its policy rate to almost 0%, say 0.25%. That shifts the LM curve from LM₁ to LM₂. What is interesting here is that the Fed cannot lower its policy rate below 0%, yet it needs to in order to close the output gap and restore full employment. But it cannot because of the 0% bound on nominal interest rates. The economy stays in a slump and the Bill Grosses of the world conclude it is the low policy interest rates causing the problem. They, therefore, think the Fed should raise interest rates (or shift up the LM curve). What they fail to see is that doing so would only further increase the gap between the actual and natural interest rate. This would tighten policy and further sink the economy.

Now one of the reasons I am not a big fan of monetary policy targeting interest rates is that it creates this very kind of confusion. Even if the Bill Grosses of the world did understand the above figure, it still creates the impression that once the 0% bound is hit monetary policy runs out of ammunition or at least has to switch to unconventional methods which itself can be confusing (e.g. what will the Fed do next?). Instead of creating this confusion, it would be far better for the Fed to ignore interest rates and target aggregate demand itself via a nominal GDP level target. If the Fed did, the Bill Grosses of the world would not be worked up about Fed policies depressing bank spreads via its low interest rate policy. Rather, they would be currently worked up about the failure of the Fed to restore trend nominal GDP, the true cure for restoring net interest margins. (Doing so in the model would shift back the IS and LM curves, and cause the latter to become upward slopping.) My hope is that the Bill Grosses of the world come to appreciate this point and start actively calling for a nominal GDP level target.

P.S. Nick Rowe presents an alternative way to draw the IS-LM model for the current slump that is worth a look.

The Cyclical Dimension of the Safe Asset Problem

noreply@blogger.com (David Beckworth) — Fri, 03 Feb 2012 01:49:00 +0000

An important problem facing the global economy is the shortage of safe assets, assets that facilitate transactions at both the retail and institutional level. There is both a long-term, structural dimension to this problem as well as a short-term, cyclical one. The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero. The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton. I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths. In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them.

I still hold this view, but after reading some papers on safe assets and talking with Josh Hendrickson I have come up with a more general view to the cyclical dimension of the safe asset problem. It goes as follows.

Gorton, Lewellen, and Metrick (2012) show that safe assets have constituted a relative stable share of all assets since the 1950s. They also show, as does Bansal, Coleman, and Lundblad (2011), that public and private safe assets tend to act as substitutes in providing liquidity services. Given these findings, it stands to reason that when the central bank is doing its job and nominal GDP (NGDP) is growing at its appropriate trend, then there will be enough safe assets being privately provided. If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions. All this requires is running a budget deficit which may or may not imply higher government spending (i.e. it could also come from tax cuts). Debates about Ricardian equivalence, crowding out, and other fiscal policy concerns become moot. What matters is if there are enough safe assets, and if not, whether fiscal policy can provide them in the absence of a NGDP-stabilizing monetary policy.

This understanding may serve as the basis for a paper, so I look forward to any feedback you can provide.

If Only Bloggers Ran the Fed...

noreply@blogger.com (David Beckworth) — Wed, 01 Feb 2012 01:47:00 +0000

From the latest Kauffman Economic Outlook, a quarterly survey of economic bloggers, we find this figure:

Too bad bloggers cannot run the Fed. At least we have changed the conversation so that the Fed is talking about NGDP targeting.

P.S. A note to those bloggers who want the central bank to target repo rates. If a central bank successfully adopts a NGDP level target, then many of the problems surrounding repos and interbank lending would disappear.

Yes, the Fed Still Has a Communication Problem

noreply@blogger.com (David Beckworth) — Wed, 01 Feb 2012 01:18:00 +0000

Ryan Avent's initial enthusiasm for the Fed's new communication strategy is beginning to wane. Avent began to lose his new-found Fed religion after reading Lorenzo Bini Smaghi's critique of the Fed's new policies. Here is Smaghi:

[I]f the objective of price stability is defined over the longer term, communication becomes more complex. In particular, the link between the inflation forecasts and the policy decision is unclear. What should market participants derive from a published inflation forecast above the two per cent target in the long run (but not necessarily over the next two years)? Should they expect a tightening to take place? And when? The long run is not a “policy-relevant” time horizon and thus has little value for those attempting to understand the central bank’s next moves.

Welcome to the club. As I have been arguing the past few weeks, the Fed's new communication strategy is at at best white noise to the market and at worst worst a quagmire of confusion. For example, how should one interpret the fact that FOMC's forecast did not just push out the horizon for increasing the federal funds rate but also lowered the expected growth rate for real GDP in 2012 and 2013? Is the FOMC signalling additional monetary stimulus or a weaker economy to come over the next two years? Some observers noticed long-term nominal interest rates dropped after the official launch of the policy last week and concluded the Fed was signalling more monetary stimulus. The fact that long-term real interest rates also declined suggests that the market interpreted the policy as signalling lower expected growth. So much for a policy that is supposed to add clarity and stimulus through expectation management. There is a better way to this.

The FOMC Confuses Me

noreply@blogger.com (David Beckworth) — Fri, 27 Jan 2012 00:02:00 +0000

The FOMC has spoken and here is what it said (my bold):

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Now what does this all mean? The first bold claims the Fed has been running a highly accommodative monetary policy and will continue to do so. Really, the Fed has been running a highly accommodative monetary policy? I did not realize that an ongoing nominal spending slump, high cyclical unemployment, elevated money demand, a shortage of safe assets, and a persistent output gap were signs of a highly accommodative Fed policy. Nor did I realize that the Fed Chairman acknowledging that the Fed may need to do further large scale asset purchases in the near future was also considered a sign that the Fed was being highly accommodative. Silly me, I must be confused.

But no worries, I can take comfort in knowing the Fed going forward will be providing aggressive monetary stimulus based on the second bold above, right? Ryan Avent seems to think so:

[T]he decision to push out the horizon for a rate increase isn't simply an admission that the economy will be weak in 2014. With the target rate at zero, the Fed can only bring down the real interest rate by raising inflation expectations. To generate higher inflation expectations, the Fed may have to promise to be imprudent at some future date—like 2014. Essentially, the Fed is hinting that it won't stomp on a boom in 2014 even if it's generating increases in prices and wages that might normally make the central bank a little uncomfortable.

That makes sense and others like Gavin Davies and Paul Krugman agree. But wait, I just looked at the FOMC's economic projections and now I am confused again. The FOMC did not just push out the horizon for increasing the federal funds rate, it also lowered its forecast for real GDP for 2012 and 2013. So is the FOMC pushing out the horizon because it now expects a weaker economy or is it really trying to be imprudent? And what is the Fed's definition of imprudence? In 2014 when the FOMC projects it will finally raise interest rates the unemployment rate is expected to be near 7% and inflation should be hovering under the Fed's new inflation target of 2%. That sounds more like prudence than imprudence to me.

But silly me, what do I know. Let's turn to the real arbiter of such issues, the bond market. How do they interpret this policy innovation? Has expected inflation taken off indicating the bond market expects higher aggregate demand because of this new policy? Uhm, no:

Expected inflation on the 10-treasury remains about where it has been over the last few months. Not exactly the what one expects from an aggressive stance of monetary policy. Nothing to see here, move along.

Okay, enough snark from me. The real problem with the Fed's new communication strategy is that it looks only at the expected path of the federal funds rate. But that really does not tell us much because a low federal funds rate is only stimulative if it is low relative to the neutral interest rate. And since the Fed is not providing an estimate of the neutral federal funds rate at the various horizons its really hard to know the implications of these forecasts. This lack of clarity is why I am confused and why this new policy probably will not pack much of a punch.

If the Fed really wants to manage expectations, then the FOMC should (1) add an expected path of the neutral interest rate to its forecast or (2) drop the forecast altogether and set up an explicit objective for monetary policy. I favor the latter and would have the Fed target a nominal GDP level target. It would be a whole lot easier to understand and implement. Maybe someday.

Update: I should have said for (2) that the Fed needs to set an explicit level target. Yes, it now has an explicit inflation target, but unless it is a really flexible one that corrects for for past misses and ignores supply shocks it is bound to create problems.

The Shining Star of Europe?

noreply@blogger.com (David Beckworth) — Wed, 25 Jan 2012 01:47:00 +0000

Fareed Zakaria points us to what may be the shinning star of Europe:

[P]erhaps the biggest reason for poverty-stricken nations like Egypt to pay close attention to Poland is that it is a very rare breed in today's world, especially in Europe. Poland has a strong economy - the sixth biggest in the European Union now and the only European Union country to avoid a recession altogether. None of its banks needed to be rescued. Its economy grew 4% last year, and is on track to grow 3% in 2012. Why, you'll ask. How did it survive the turmoil in the Euro Zone? One answer is that it has strong domestic demand and has been pouring money into infrastructure projects. But the real - and fortuitous - reason is that Poland has yet to be allowed in to the Euro Zone - it continues to use zlotys instead of the euro. So unlike Greece or Italy, it was able to devalue its currency to stay competitive.

I know that last part will leave some of my hard money readers in angst, so think of it this way. Poland has been able to stabilize domestic demand by adjusting its monetary policy accordingly. The Eurozone periphery has not been able to do this and paid dearly as seen below:

Now Poland has done other things right as noted by Zakaria, but what this contrast highlights is that the Eurozone crisis is as much a monetary crisis as anything else. Yes, there are deeper structural problems with the Eurozone, but if Eurozone officials want to address these deeper problems they need to first address the immediate monetary problems behind the crisis. Maybe the shining star of Europe will help them appreciate the monetary nature of the crisis.

The Fed's Long-Term Interest Rate Forecast May Backfire

noreply@blogger.com (David Beckworth) — Mon, 23 Jan 2012 23:57:00 +0000

The Fed is about to release it first long-term interest rate forecast. Gavyn Davies explains how this could enable U.S. monetary policy to add more stimulus without actually expanding its balance sheet. It would do so by managing nominal expectations. Here is Davies:

What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see...

[T]he new mechanism will provide the Fed with a potentially important tool to influence expectations, and therefore the course of the economy. Paul Krugman was the first to argue in the 1990s that, in the modern version of the liquidity trap, an economy could get stuck permanently with high unemployment because of undesirable expectations of deflation. With short rates not able to drop below zero, the real rate of interest could be too high to equilibrate savings and investment in the economy, so the normal monetary route back to lower unemployment might be blocked. The answer, said Krugman, was for the central bank deliberately to increase the expected rate of inflation, and therefore to cut the real rate of interest while nominal short rates were fixed at zero.

That is how the Fed hopes it will turn out. I think it will backfire because what observers really need is to know where the expected path of the federal funds will be relative to the expected path of the natural (or equilibrium) federal federal funds. Here is what I said about this previously:

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.

Gavyn Davies also recognizes another problem with using this policy innovation to steer monetary policy via expectations management: it may not be credible. Credibility, however, would not be a problem if the Fed would set an explicit nominal destination. Doing so would avoid the time inconsistency problem that concerns Davies. From my same post:

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.

Okay, so the Fed is not likely to announce a NGDP level target tomorrow. I do wish, though, that it would also provide the expected path of the natural federal funds rate on its long-term interest rate forecasts. If so, it would help the public better understand the implications of the FOMC's expected path of the federal funds rate.

How to Fix the ECB's Communication Problem

noreply@blogger.com (David Beckworth) — Thu, 19 Jan 2012 16:09:00 +0000

The ECB has a serious communication problem. It has undertaken a number of unconventional measures lately--the three year LTROs, the acceptance of questionable assets for collateral, and the large expansion of its balance sheet--that amount to a QE program by stealth. And therein lies the problem. The ECB's actions have not been communicated to the public ex-ante nor have they been linked to a targeted outcome. In short, the ECB is failing to manage expectations, the most important monetary policy transmission channel at its disposal.

Now Goldman Sachs would say that the above is a charitable interpretation of the ECB's recent actions. They note in a research paper (via Cardiff Garcia) that the ECB is not just failing to manage expectations, but is actually destabilizing expectations.

The ECB offers little ex ante information about its outright asset purchases via the securities markets programme (SMP). The stock of outstanding purchases is only revealed ex post, and no information ispublished on the composition of that stock, either by maturity or by country of issuer. There is no preannounced schedule of purchases. Market participants thus face substantial uncertainty about when and where the ECB will intervene: this probably serves to reduce the liquidity of the underlying market and precludes the possibility that the market will anticipate the ECB’s actions, helping policy makers to achieve their policy objectives.

This approach extends to other aspects of the ECB’s nonstandard policy measures. For example, the ECB has yet to announce whether further 3-year LTROs will be conducted beyond February this year. Such an announcement would serve to help stabilise market conditions further, by providing further reassurance about the availability of funding over longer horizons. Should we not see such an announcement at the February Governing Council meeting, the potential for a regression in market developments is obvious. The kink in peripheral yield curves at around 3-year maturities is evidence of this concern.

More generally, the wider ECB communication surrounding its enhanced credit support has always been grudging: the ECB has, at times, appeared reluctant to offer such support, despite the fact that, in practice, it has done so in vast amounts. By implication, the reassurance offered to households and firms about the ECB’s commitment to macro stabilisation has been weakened, to the prejudice of the effectiveness of the policy as a stabilisation tool.

There is an easy solution to the ECB's communication problem that directly and aggressively addresses the insufficient aggregate demand problem while still maintaining a long-run nominal anchor. And to boot, it does not depend on bank lending (though financial intermediation would probably increase as a result). The solution is setting a nominal GDP level target. The level part is important because it signals clearly to the public that the ECB would commit to buying up (or selling) as many assets as needed until nominal GDP hit some pre-crisis trend path. Not only would this fix many of the Euro debt problems, it would create more certainty and cause the public to much of the heavy lifting in restoring aggregate demand (i.e. the public would adjust their portfolios in anticipation of the ECB buying up more assets and in the process cause nominal spending to adjust largely on its own. See here for more details.) This is what makes the ECB's floundering so frustrating for me to watch.

Update: Be sure to read Cardiff Garcia's post on the ECB's communication problem. It was the motivation for this one.

Hey Newt, We Need Sound Money Not Hard Money

noreply@blogger.com (David Beckworth) — Wed, 18 Jan 2012 19:56:00 +0000

This is disappointing:

Speaking at a foreign policy forum in South Carolina on Tuesday, Gingrich advocated a "commission on gold to look at the whole concept of how do we get back to hard money."

I guess Newt Gingrich has not been reading fellow conservative Ramesh Ponnuru, the mostly right-of-center Market Monetarists, or even libertarian Tyler Cowen. If he had he would know what we need is sound money, not hard money.

P.S. There is no need for a new commission on the gold standard. It has been extensively studied and there is a huge literature on it. I would start with Barry Eichengreen.

James Pethokoukis on NGDP Targeting

noreply@blogger.com (David Beckworth) — Mon, 16 Jan 2012 18:52:00 +0000

James Pethokoukis has a new article in Commentary that examines nominal GDP (NGDP) targeting and its potential to spark a recovery. The piece starts out fine, but then gets gets confused because it fails to distinguish between a NGDP growth rate target and a NGDP level target. A NGDP growth rate target, like an inflation target, lets bygones be bygones. A NGDP level target, on the other hand, corrects for past mistakes. Under a NGDP level target a central bank would commit to reigning in aggregate nominal spending if it overshot and vice versa. Such a rule would therefore actually anchor long-run inflation expectations while allowing for aggressive catch-up growth (or contraction) in aggregate nominal spending so that NGDP returned to its trend path. The following figure illustrates these important differences:

Note that with a NGDP growth rate target (the blue line) NGDP can be growing on target and yet the big collapse in aggregate demand that precedes it is never corrected. With those points made, let's turn to Pethokoukis' piece:

And there’s the rub. The idea of nominal GDP-targeting would threaten the Fed’s hard-fought credibility as an inflation-killer and raise expectations of future inflation simply to jimmy the unemployment rate a point or so lower than it would be five years from now.

No. There might be higher inflation in the short-run, but over the long-run a NGDP level target would anchor (see the red line) nominal expectations. But even then, some higher inflation over the short run is actually justified. For it would restore nominal incomes to where they were expected to be when debtors and creditors agreed to nominal contracts and similarly it would return debt burdens to the path expected when the contracts were signed.

And then there is the Glenn Hubbard adding to the confusion:

[M]arkets [may] begin to worry that the Fed won’t be able to unwind its positions in a timely manner to prevent an uncontrolled inflation surge...That concern is well justified, according to R. Glenn Hubbard, dean of Columbia’s business school and potential Fed chairman if a Republican wins the White House in 2012. As he told me recently: “In the near term, it’s hard for me to imagine that [NGDP-targeting] would work much differently than what the Fed is currently doing, which isn’t exactly a booming success. And then in the longer term, I would worry about inflationary expectations becoming unhinged….

No. Hubbard is thinking of a NGDP growth rate target (the blue line.) Advocates of NGDP targeting are thinking of a level target (the red line) which implies more aggressive but systematic monetary stimulus. And no, the inflation expectations would not get unhinged because this is a level target. As we learned from FDR's experience with level targeting in 1933-1936, such an approach can do wonders for the real economy and still maintain a nominal anchor. Ben Bernanke knows all this and advocated something like it for Japan. Consequently, I do not think he is worried about unmooring inflation expectations, but is concerned about the politics of adopting such a new rule. If Republican leadership would give NGDP level targeting a fair hearing they might actually like it.

Did Fed Policy Matter to Housing Prices?

noreply@blogger.com (David Beckworth) — Mon, 16 Jan 2012 17:11:00 +0000

Kenneth Kuttner has a new paper that reexamines the relationship between the Fed's interest rates and house prices during the housing boom. The paper is receiving some attention because it claims that the existing literature on this topic collectively shows only a small role for interest rates on the housing prices. Here is Kuttner:

All available evidence — existing studies, plus the new findings presented above — points to a rather small effect of interest rates on housing prices. VAR-based estimates of the effect of a 25 basis point expansionary monetary policy shock range from 0.3% to 0.9%, both in the U.S. and in other industrialized countries....they are too small to explain the previous decade’s tremendous real estate boom in the U.S. and elsewhere.

Looking back it is clear that there were other developments that contributed to the housing boom like financial innovation, global demand for safe assets, poor governance, industry structure, housing policy, and misaligned creditor incentives. Contrary to the Kuttner's claim, however, this does not mean that the contribution of the Fed's low interest rates were trivial. Here are the reasons why.

First, to really learn the full impact of the low interest rates one needs to also consider their indirect effect on housing. One indirect effect of the Fed's low interest rate policy is that it influenced financial innovation and the demand for safe assets which further lowered yields. When the Fed pushed interest rates low, held them there, and promised to keep them there for a "considerable period" in 2003 it created new incentives for the financial system. First, via the expectations hypothesis (which says long-term interest rates are simply an average of short-term interest rates over the same period plus a term premium) these developments pushed down medium to longer yields as well, as seen in the figure below:

As Barry Ritholtz notes, this drop in yields caused big problems for fixed income fund managers who were expected to deliver a certain return. Consequently, there was a "search for yield" or as Ritholtz says these managers of pension funds, large trusts, and foundations had to "scramble for yield." They needed a higher but relatively safe yield in order to meet their expected return. The U.S. financial system meet this rise in demand by transforming risky assets into safe, AAA-rated assets. The Fed's low interest rate policies also increased the demand for safe assets for hedge fund managers. For them the promise of low short-term interest rates for a "considerable period" screamed opportunity. As Diego Espinosa shows in a forthcoming paper, these investors saw a predictable spread between low funding costs created by the Fed and the return on higher yielding but safe assets. They too wanted more AAA-rated assets to invest in so that they could take advantage of this spread that would be around for a "considerable period." Here too, the U.S. financial system responds by transforming risky assets into safe assets.

There is another way the Fed's low interest rate policy increased the demand for safe assets during the housing boom. The Fed controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across much of the globe--it is a monetary superpower. This means that the other two monetary powers, the ECB and the Bank of 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. In the early-to-mid 2000s, those dollar-pegged emerging economies pegged were forced to buy more dollars when the Fed loosened monetary policy with its low interest rate policies. These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets. To the extent the ECB and the Bank of Japan were also responding to U.S. monetary policy, they too were acquiring foreign reserves and channeling credit back to the U.S. economy. Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy. This is an important but overlooked point in most discussion about how the Fed's low interest rates contributed to the housing boom.

Second, the claim that "all available evidence" point to a small effect ignores some studies that actually reach the opposite conclusion. For example, there are two studies by Rudiger Ahrend et. al that show low interest rates, specifically ones lower than those prescribed by the Taylor Rule, in conjunction with rapid financial innovation were very important to the housing boom for most of the OECD countries. Here is one graph from the papers that makes this point:

Another study that finds contrary evidence is Eickmeier and Hofmann (2010) who use a factor-augmented VAR to show that monetary policy not only affected house prices, but also credit spreads and debt levels.

Third, one problem with using VARs for this analysis, as is done in the Kuttner paper, is that they show the effect of a monetary policy shock. Such shocks, however, have become notoriously hard to identify over the past few decades in VARS because Fed actions have become so much more transparent and predictable, and also because monetary policy has become better at responding to output shocks (at least prior to the Great Recession). As a result, shocks to the federal funds rate show much milder effects on other variables (See Boivin and Giannoni, 2006). Also, even if one is capable of properly identifying shocks, it seems the real problem was more the sustained shift in monetary policy--the 2002-2004 easing cycle--that cannot really be called a shock per se. Maybe one can call it a series of shocks or change in systematic monetary policy, but the point is not to look at one impulse response function and draw conclusions, but look at the cumulative effect of this easing cycle and its contribution to the housing boom. The Eickmeier and Hofmann (2010) study does just that. Among other things, it runs a counterfactual experiment that allows the authors to see what part of the housing price boom can be attributed to the Fed's actions, both shocks and systematic policy. Here is what they find:

The blue line is the combined effect of shocks and systematic policy on housing prices. The OFHEO house price index shows a large amount of the surge in home prices is because of monetary policy, while the Case-Shiller index shows somewhat smaller but still meaningfully large role for the Fed. In both cases, monetary policy only matters for the early-to-mid 2000 period. And that is what most critics have been arguing: the Fed's policies in early-to-mid 200s contributed to housing boom of that period.

Now Kuttner's view may one day be vindicated, but before that it happens the above points need to be addressed.

Pushback on the FOMC Transcript Hysteria

noreply@blogger.com (David Beckworth) — Fri, 13 Jan 2012 16:49:00 +0000

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

noreply@blogger.com (David Beckworth) — Fri, 13 Jan 2012 03:43:00 +0000

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?

noreply@blogger.com (David Beckworth) — Fri, 13 Jan 2012 03:21:00 +0000

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

noreply@blogger.com (David Beckworth) — Fri, 06 Jan 2012 23:11:00 +0000

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

noreply@blogger.com (David Beckworth) — Wed, 04 Jan 2012 17:13:00 +0000

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

noreply@blogger.com (David Beckworth) — Tue, 03 Jan 2012 15:30:00 +0000

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

noreply@blogger.com (David Beckworth) — Mon, 02 Jan 2012 21:26:00 +0000

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.

The Weak Recovery is a Policy Failure

noreply@blogger.com (David Beckworth) — Fri, 30 Dec 2011 19:05:00 +0000

In my last post I argued that nominal GDP targeting does not depend on bank lending to work. Instead, its success depends on the Fed using the nominal GDP target to manage expectations such that the portfolios of the non-bank sector rebalance in a manner that shores up aggregate demand. Bank lending may respond to this process, but is not essential to it. I mention this again because I just came across an interesting paper by Edward Nelson and David Lopez-Salido that lends support to this view. The authors show that, contrary to the claims of Reinhart and Rogoff (2009), recoveries following financial crises are not inherently weaker. Rather, they depend on policy. From their abstract [emphasis mine]:

We find that the regularity that recoveries are systematically slower in the aftermath of financial crises does not hold for the postwar United States. The pace of the expansion after recessions seems to reflect deliberate aggregate demand policy. A weak lending outlook does not appear to pose an insurmountable obstacle to the functioning of stimulative aggregate demand policies.

The implication of this paper and my previous post is that the weak economic recovery is a failure of policy to fully restore aggregate demand, nothing more. All the talk about how recoveries following financial crises are typically weaker and that we are now in a balance sheet recession distracts from this fact. There was nothing inevitable about the Great Recession and subsequent lack of robust recovery. A nominal GDP level target is the best way to fix this policy failure.

P.S. Edward Nelson also has a recent paper on Milton Friedman that provides a nice discussion of the portfolio channel.

The Market Monetarist, MMT, and Austrian Lovefest

noreply@blogger.com (David Beckworth) — Thu, 29 Dec 2011 06:02:00 +0000

The Economist magazine has a new article on the rising popularity of Market Monetarism, MMT, and Austrian economics. The article notes that all of these schools of thought have benefited immensely from the blogosphere and have each provided a critique of how macroeconomic policy has been conducted over the past few years. It was an interesting article, though as Scott Sumner notes the piece is wrong in its implication that nominal GDP targeting requires significant activism by the Fed. If implemented properly, nominal GDP targeting would require less activism since it focuses the Fed on a single, explicit mandate. In the case of Scott Sumner's nominal GDP futures targeting, this approach would actually put the Fed on automatic pilot. (It would also put many Fed economists out of work and make the Fed far less important, so do not bet on it happening!)

One point I want to stress here is that contrary to claims of some MMT advocates, the success of nominal GDP targeting does not depend on increased bank lending or on a naive belief in a simple money multiplier story where increased bank reserves lead to increased bank lending. In fact, the MMT emphasis on bank lending being influenced by capital considerations, credit worthiness of borrowers, and the demand for credit is entirely consistent with the Fed using a nominal GDP target to manage expectations such that portfolios are rebalanced in a manner that sparks a recovery. Here, bank lending responds to the improvement in current and expected economic activity brought about by nominal GDP targeting. This is how I explained the process before:

The ability of the Fed to influence total current dollar spending does not depend on banks creating more loans. Rather, it depends on the Fed's ability to change expectations so that the non-bank public rebalances their portfolios appropriately. Recall that a nominal GDP level target means the Fed makes an unwavering commitment to buy up assets until some pre-crisis nominal GDP trend is hit. As Nick Rowe notes, just the threat of the Fed doing this would cause the public to expect higher nominal spending growth and higher inflation. This change in expectations, in turn, would cause investors to rebalance their portfolios away from liquid, lower-yielding assets (e.g. deposits, money market funds, and treasuries) toward higher-yielding assets (e.g. corprate bonds, stocks, and capital). The shift into higher-yielding assets would directly affect nominal spending through purchases of capital assets and indirectly through the wealth effect and balance sheet channels. The resulting increase in nominal spending would increase real economic activity, improve the economic outlook, and thus further reinforce the change in expectations.

Bank lending would probably respond to these developments, but it would not be driving them. It is interesting to note that FDR did something similar to nominal GDP level targeting in 1933 and it sparked a sharp recovery that lasted through 1936. Bank lending, however, did not recover until 1935. Bank lending, therefore, was not essential to that recovery. That may be less true today, but in any event the key point here is that if bank lending does increase it would do so as a consequence of the improved economic conditions brought about by the change in economic expectations.

There is more here on how this transmission mechanism works. The real critique, then, is whether a change in nominal expectations can really affect current spending decisions by firms and households. I have an earlier post that shows inflation and nominal GDP expectations (as proxied by a survey of forecasters) do in fact influence spending decisions. Josh Hendrickson and I also show in this recent working paper that shocks to inflation expectations cause households to adjust their portfolios in the manner outlined above. Finally, as shown by Gautti Eggertson, a sudden change in nominal expectations was also key to FDR's 1933-1936 recovery. If the MMTers (and Austrians) could come to accept this evidence, then we could truly have a deficient aggregate demand lovefest.

Beckworth Smackdown

noreply@blogger.com (David Beckworth) — Wed, 28 Dec 2011 22:43:00 +0000

Arpit Gupta pushes back on my post about why safe assets matter. He invokes Jeffrey Friedman and Vladimar Kraus' argument that implies regulatory arbitrage created by the Basel reforms can explain the demand for safe assets. Here is Gupta:

If a bank decided to hold a AAA-rated sovereign bond, for instance, they typically had to hold zero excess capital to meet regulatory standards. However, if they held an equivalent amount of an unsecured private loan, they were required to hold substantially more capital in response. The net effect of these capital regulatory standards is that safe assets came to be valued not just for their economic riskless value — but also for how alter bank capital requirements. Banks that face fewer capital requirements can be more levered, risky, and potentially profitable than banks whose assets force them to raise substantial amounts of additional capital. This motive, arguably, is why banks around the world are eager to purchase safe assets — not because they are useful in conducting repo.

Gupta also makes some other points, but this is his main one. His point sounds reasonable, but I wonder how important this effect is explaining the overall trend. As I mentioned in my previous post, this shortage of safe assets can arguably be traced all the way back to the bursting of Japan's asset bubble. It is also influenced by the gap between the rapid economic growth in the emerging world and their own inability to produce safe assets. And then there is the demographic challenge: all the baby boomers in the rich world are shifting out of riskier assets into safer ones as they retire. Is Basel really more important than all these other factors?

P.S. Gupta also has an interesting post on whether deleveraging matters, which is timely once again given Richard Koo has a new paper pushing his balance sheet recession view. My view is that deleveraging can have dire consequences as described by Koo, but only if monetary policy is failing to do its job. Look no further than Sweden which has a lot of household debt, but managed to restore nominal incomes following the financial crisis and thus keep debt burdens manageable. Monetary policy was also not limited in the United States when it was tried during the Great Depression, a time of high debts too. If only balance sheet recession advocates would spend as much time gazing at the asset side of the household balance sheets as they do the liability side they might see the potential for monetary policy. Oh, and don't forget this Scott Sumner smackdown of the balance sheet recession view.

P.P.S. Matthew Yglesias does a better job than me summarizing why safe assets matter.

What Really Caused the Crisis?

noreply@blogger.com (David Beckworth) — Wed, 28 Dec 2011 21:54:00 +0000

I was looking at some employment data and was reminded of this figure:

This figure shows that construction employment reached a peak in April, 2006 and started descending thereafter. The housing recession was on, but remarkably employment in the rest of the economy continued to grow through early 2008. In fact, layoffs and discharges did not dramatically change during this almost 2-year period as seen below:

In other words, the Great Recession did not emerge because of the collapse of the housing market in early 2006. Something else had to happen about 2 years later to turn a sectoral recession turn into the Great Recession. As the figure above suggests, I see the evidence pointing toward a failure by the Federal Reserve to stabilize nominal spending and by implication nominal income. This failure meant that nominal income growth expectations of about 5% a year assumed by household and firms when they signed nominal debt contracts would not be realized. A debt crisis was therefore inevitable.

This understanding is corroborated by the data on personal income. The figure below shows that despite the fall in the growth rate of personal income from construction and real estate services that began in early 2006, personal income in the rest of the economy continued to grow at about 5% a year up through mid-2008. The Fed was able to stabilize nominal incomes overall for almost two years while structural changes were taken place in those sectors closely tied to the housing boom.

This stabilization between early 2006 and mid-2008 was no small feat given the problems in the financial system. The figure below shows that the rise in financial distress in mid-2007, as indicated by the Ted Spread, did not stop the nominal GDP from growing for about another year. Again, a remarkable performance. However, what this figure also shows is that once the Fed allowed nominal GDP to fall and made no effort to reverse it the financial crisis intensified. Thus, the Fed's failure to act and prevent the fall in nominal income meant, just as it did during the Great Depression, a systematic financial crisis was going to happen.

This is an argument I and others have made many times before, but it is worth repeating. It is also a story that can be told for the Eurozone crisis. Another way of saying this is that central banks are just as responsible for passive tightening as they are for active tightening. They should be held accountable for both.

The Real Negative Real Shock

noreply@blogger.com (David Beckworth) — Fri, 23 Dec 2011 21:36:00 +0000

Are all the problems in the U.S. economy nominal? Robert Gordon implicitly says no in a new paper on the long-run outlook for U.S. productivity (hat tip Reihan Salam). He makes the case that rapid productivity gains from 1995-2005 will not persist going forward:

The 20‐year period 1987‐2007 combines the inexplicably slow productivity growth of 1987‐95, the temporarily ebullient period 1995‐2000, and the interesting 2000‐07 period that in some dimensions looks like more normal behavior. The seven years between 2000:Q4 and 2007:Q4 were neatly divided in half, with extremely rapid productivity growth between 2000:Q4 and 2004:Q2 (2.68 percent), and much slower growth from 2004:Q2 to 2007:Q4 (1.36 percent), averaging out to 2.02 percent for the seven‐year interval. As argued above the productivity growth “explosion” of 2001‐04 rested on a combination of savage corporate cost cutting and delayed learning from the internet revolution. Once profits had recovered the pressure for cost cutting disappeared, and eventually the delayed learning subsided as well.

[...]

The paper approaches the task of forecasting 20 years into the future by extracting relevant precedents from the growth in labor productivity and in MFP over the last seven years, the last 20 years, and the last 116 years. Its conclusion is that over the next 20 years (2007-2027) growth in real GDP will be 2.4 percent (the same as in 2000‐07), growth in total economy labor productivity will be 1.7 percent...

So over the next two decades Robert Gordon sees labor productivity growing at annual average rate of 1.7% compared to about 2.5% for 1995-2004. If his view is widely held then that means firms will expect lower returns to investment and household will expect lower incomes. Such lower expectations, in turn, would translate into lower investment and consumer demand today. This, then, may account for some of the prolonged slump.

So is Gordon's view widely held? Is the forecast for productivity falling? The Quarterly Survey of Professional Forecasters can answer these questions. It asks forecasters what they expect the average annual productivity growth rate to be over the next 10 years. The data starts in 1992 and is at an annual frequency. Here is a figure of the data:

So yes, the consensus forecast is that productivity growth is expected to decline over the next 10 years. It is hard not to look at this figure and conclude at least some of the ongoing slump can be attributed to it. However, this does not necessarily mean it is the most important factor. And I do not think it can be because we do not see a sustained uptick in the inflation rate, something that should be present if the permanently lower productivity growth rate were the main culprit. Rather we see muted inflation since 2007 with the core inflation rate actually falling, something far more consistent with a large amount of insufficient aggregate demand. And there is the negative output gap. I still believe that the failure by the Fed to return nominal spending to its pre-crisis trend is the most important reason for shortage of aggregate demand.

Update: Bill Woolsey notes that the lower expected productivity growth should only affect real variables but have no bearing on nominal expenditures if properly stabilized.

More on the Shortage of Safe Assets

noreply@blogger.com (David Beckworth) — Fri, 23 Dec 2011 20:49:00 +0000

As a follow up to my earlier piece on the shortage of safe assets, I direct you to Rebecca Wilder's post where she documents the broad decline of investment grade sovereign debt. As I mentioned before, this increasing shortage of safe assets matters because many of these assets serve not just as a store of value but as transaction assets that either back or act as a medium of exchange. In other words, this problem matters because it adversely affects the demand for money and therefore nominal spending.

One solution is for producers of truly safe assets, primarily the U.S. Treasury, to create more safe assets. Brad DeLong takes this view. This approach, however, worsens the Triffin dilemma for the world's go-to safe asset, U.S. Treasury debt. Another solution is for the Fed and the ECB to restore nominal incomes to pre-crisis trends. Doing so would spur a sharp recovery that would lower the demand for safe assets and increase the stock of safe assets. Both of these developments would reduce the excess money demand problem and avoid worsening the Triffin dilemma for U.S. treasury debt. See my previous post for more.