Macro Musings Blog

Storytelling: Friday Chart Edition

noreply@blogger.com (David Beckworth) — Fri, 20 Nov 2020 20:09:00 +0000

I have not posted here in awhile, so I thought it would be good to share a few recent charts that tell interesting stories.

Central Bank Balance Sheets

First up, are two charts that show the relationship between the size of the central bank balance sheets and inflation rates. The first one shows for the 2010-2019 period the average size of central bank balance sheets as a percent of NGDP plotted against the average core inflation rate. Since larger balance sheets are typically seen as adding more stimulus to the economy, one might expect to see a positive relationship between their size and the inflation rate over this long of an horizon. Instead, we see a negative relationship:

One objection to the above chart is it may be misleading since it is the rate of change in central bank liabilities, not the level, that should drive the inflation rate. To that end, the next chart shows the change in the size of the central bank balance sheets over the same period. The same relationship holds:

Another objection is that these charts simply show central banks responding to the low inflation environments: the lower the inflation rate the bigger the central bank balance sheets. I think that is fair, but again the horizon is an entire decade. Consequently, if the standard theories for QE such as the portfolio balance channel and the signalling channels hold, then we should expect to eventually see something different than a negative relationship. And 10 years seems long enough for 'eventually' to come to fruition.

My explanation for these charts, forthcoming in a working paper, is that something else is driving both the low inflation and the expanding central bank balance sheets.

NGDP Gap

Our 2020 Q3 report for the NGDP Gap came out recently. Here is the key takeaway:

[the] NGDP gap of −4.77 percent indicates that the dollar size of the economy is still significantly smaller than prepandemic expectations. Specifically, the neutral level of NGDP was $22.22 trillion in the third quarter of 2020, whereas actual NGDP came in at $21.16 trillion. That is a shortfall of $1.06 trillion, which is a vast improvement over the previous quarter’s shortfall of $2.57 trillion, but still a sizable hole to fill in the economy. This trillion-dollar hole means that both aggregate spending and income are still falling short of their prepandemic trend levels.

Below are the relevant charts. Note, you can now get the neutral NGDP and NGDP gap measures in both Haver and Macrobond data!

Real Interest Rates Determination

I was recently embroiled in a debate over what determines the path of real interest rates. The debate was whether the standard desired saving - desired investment (S-I) theory of interest rates or the liquidity preference theory best explains the path of real interest rates. The former looks to the fundamentals of time preferences, population growth, and expected economic growth as the explanation for real interest rates. The latter view looks to money markets and the expected interest rate path of the central bank as the explanation. My take has been the fundamentals view is more important over the longrun while the money view is more important in the shortrun.

Here are some charts I made that look at the longrun and show that fundamentals are, indeed, tied to real interest rate formation in advanced economies. Specifically, population growth rates and fertility rates are associated with the 10-year real yield. I created these charts after chatting with Matt Yglesias about his book "One Billion Americans" for the podcast. He verbally sketched out these scatterplots and I was curious to see if they held up in the data. They did!

FOMC Humor

Finally, here is my attempt at the two choice meme as it relates to Treasury Secretary Mnuchin's decision to pull back the Treasury backstop funds for the Fed's 13(3) facilities. I joked that maybe the Secretary was attempting to force Congress to be more active on relief and rely less on the Fed. Looks like I was not too far off. Anyways, the tension between asking the Fed to do more with 13(3) facilities and asking Congress to do more is real.

The Fed's New Framework

noreply@blogger.com (David Beckworth) — Wed, 02 Sep 2020 13:29:00 +0000

I have a new article presenting my take on the Fed's new average inflation target (AIT). It includes an explanation of how it works compared to the Fed's previous inflation target and what it could mean for the recovery. I note that although AIT it is not quite a NGDP level target, it is a step in that direction. Moreover, it could lead other central banks to follow suit. Check it out.

Also, here is an earlier piece I wrote on make-up policy and how it could be best implemented via a NGDP level target. It was published before the big announcement last week.

Finally, here is St. Louis Fed President Jim Bullard's take on AIT. He explains how this new framework gets us fairly close to NGDP level targeting.

A Twitter Thread on Interest Rate Determination

noreply@blogger.com (David Beckworth) — Mon, 10 Aug 2020 22:23:00 +0000

Over in the twitterverse, this discussion on interest rate determination happened.

Make-Up Policy: Where Art Thou?

noreply@blogger.com (David Beckworth) — Mon, 06 Jul 2020 21:22:00 +0000

As we head into the second half of the year, the swift recovery many were hoping for is facing an uncertain future. The resurgence of the COVID-19 virus and concerns about dwindling fiscal support have many worried. I submit that even in the absence of these worries, the recovery would still be on shaky grounds without the Fed explicitly committing to 'make-up' policy.

Make-up policy is an explicit framework that allows the Fed to correct for past misses in its target. In the case of a recession, this feature allows the FOMC to be fine with inflation temporarily overshooting its target while the economy bounces back. Tolerating this overshoot implies a similar surge in nominal income that would restore it to the levels expected by household and business prior to the crisis. This restoration is important since many fixed-price nominal financial obligations like mortgages, loans, and leases were made based on these forecasts of nominal income.

Without make-up policy, the Fed may feel uncomfortable with inflation temporarily overshooting and prematurely tighten monetary policy. This would prevent nominal income from returning to its pre-crisis trend levels and trigger secondary spillover effects like mass insolvencies and other financial stress.

Chris Condon notes that the Fed is aware of this issue and has been discussing it at the FOMC meetings this year. For all this talk, though, members of the FOMC have given no indication in the Summary of Economic Projections (SEP) that they are taking make-up policy seriously. The SEP indicates persistent undershooting of its inflation target and consequently, a lack of make-up policy in its implicit nominal income forecasts.

Nominal income or NGDP can be constructed from Table 1 in the SEP by combining the real GDP growth forecasts with the PCE inflation forecast plus 20 basis points (to make it GDP Deflator equivalent). This is done in a revised version of Table 1 below:

The second-to-the-last row of the table is titled "NGDP Change - 4.0" and is the forecasted NGDP growth rate minus the pre-crisis trend of 4 percent growth. The final row accumulates up these misses and reveals NGDP is still 5.3 percent below its per-crisis path even after 2022. Put differently, there is a permanent loss in nominal income according to the SEP.

These forecasts are applied to the current NGDP levels to create a forecast in dollar level form and are presented in the figure below. The sustained drop in nominal income can be seen as the difference between the pre-crisis trend and the forecasted level of NGDP:

Note, that this forecasted loss is based on FOMC members assessing what is "appropriate monetary policy" for the SEP. The FOMC, in short, currently does not see make-up policy in the cards nor does it see it as appropriate monetary policy. Similar implications fall out of other Federal Reserve forecasts, including this one from the New York Fed.

But it not just the Fed who thinks there will be no make-up policy and therefore a sustained loss in nominal income. First, the CBO's July update shows a persistent gap between nominal income and its pre-crisis trend over the next decade. This forecast is conditioned on, among other things, what the CBO sees as likely monetary policy going forward.

Second, the Blue Chip consensus forecasts of NGDP also shows a sustained drop in nominal income. The graph below shows this drop and compares it to the neutral level of NGDP, the level of nominal income needed to meet the expectations of households and businesses plans in years leading up to the crisis. The forecasted gap between these two measures is called the NGDP Gap.

So wherever one looks, make-up policy is not being forecasted. Its absence does not bode well for the recovery and underscores the urgency of the FOMC review of its framework. I really dread repeating the slow recovery of the last decade. So please FOMC, bring this review to a vote and give make-up policy a chance during this crisis.

Update: A reader informed me that adding 20 bps to the PCE inflation to make it equivalent to GDP deflator inflation may overstate the difference. If so, the analysis above actually understates the permanent loss in nominal income projected by the FOMC's SEP.

NGDP Targeting in the United Kingdom

noreply@blogger.com (David Beckworth) — Thu, 25 Jun 2020 02:32:00 +0000

Something interesting is happening in the United Kingdom. Some government officials there are pushing for the Bank of England to adopt an NGDP target. From the Independent:

Officials in the UK Treasury are “probably” considering whether to change the Bank of England’s inflation-targeting mandate due to the massive economic shock imparted by the coronavirus crisis, according to a former minister.

Lord Jim O’Neill, who was commercial secretary to the Treasury in 2015, wants the central bank to shift from its current target of keeping inflation at 2 per cent to targeting a steadily rising trend of nominal UK GDP growth instead.

Since the U.K. Treasury determines the monetary policy target for the Bank of England, these rumblings are more than noise. The U.K. Treasury's increased interest in an NGDP target is driven, in part, by the efforts of Jim O'Neil. He has written articles, done interviews, and made a forceful case for this approach to monetary policy. Another prominent voice is Sajid Javid who was recently the Chancellor of the Exchequer. He also has called for NGDP targeting in a new study. They are not alone, as other members of Parliament also talking about an NGDP target and several UK think tanks are promoting it as well. There seems to be, in short, some real momentum for NGDP targeting in the Boris Johnson government.

If the Bank of England were to get an NGDP target, it would be the first central bank to explicitly do so. The Bank of England was an early adopter of inflation targeting, so it would be fitting for it also to be an early adopter of NGDP targeting. Moreover, moving to this monetary policy framework should not be too hard for the British central bank since it already does something that looks a lot like an NGDP target.

Still, this would be seen as a big change for the central bank and many observers are unsettled by its prospects. Again, from the Independent:

Lord O’Neill conceded that the idea of moving to nominal GDP targeting would “scare” many people in the Treasury and the Bank who regard the current inflation-targeting regime as a proven success.

To those observers who are worried, I would encourage you to check out my paper from late last year that summarizes the facts and fears of NGDP targeting. It was written with the Fed in mind, but its lessons are applicable to any central bank. Here, I want to make three points that are specifically directed toward the Bank of England adopting an NGDP target.

Changes in Potential Real GDP: Much Ado About Nothing

My first point is that changes in potential real GDP should not be a practical concern if the Bank of England were to adopt an NGDP target. Changes to potential real GDP is a common objection to NGDP targeting and in principle a legitimate concern. In practice, however, the magnitudes involved make this a moot concern.

To illustrate this point, imagine that the Bank of England had been credibly targeting NGDP at 4% a year since the mid-1960s. Also assume that the potential real GDP (y*) evolved as it actually did over this period. The difference between this imagined NGDP target and the actual growth rate of y*, would be the counterfactual trend inflation experienced during this time. The figure below shows the outcome. It reveals that trend inflation in the UK would have ranged from about 1% to 3%. The average inflation rate over the whole period would have been just under 2%. Not a lot to see here. Even if we tweaked the NGDP target up a bit, there would still no runaway inflation. Instead, we end up in a world with longrun inflation well-anchored and a stable growth path for nominal income.

Now to the extent that changes in potential real GDP do matter, it actually favors NGDP targeting over flexible inflation targeting (FIT). Josh Hendrickson and I show this outcome in a JMCB paper (ungated version) last year. The punchline is that a central bank doing FIT needs to know both potential real GDP (y*) and real GDP (y) in realtime to avoid making mistakes. A central bank doing NGDP targeting does not need to know y* or y in realtime. In fact, it intentionally remains agnostic about them over the shortrun and simply aims to stabilize nominal income. As a result, it is less likely to accidentally make matters worse. This is not just a theoretical argument. Athanasios Orphanides, for example, shows that one reason for the Fed's tepid response to rising inflation in the in the 1970s was bad realtime data on the output gap. In more recent times, one see the Fed's talking up of rate hikes in the fist half of 2008 or the ECB's outright tightening of policy in 2008 and 2011 as manifestations of this problem.

Concerns about changes in potential real GDP, then, are much ado about nothing under an NGDP target and only meaningfully matter for a FIT.

NGDP Targeting Would Not Be a Radical Change

My second point is that the Bank of England adopting an NGDP target would not be a radical change. For it is already producing outcomes that closely mimic an NGDP target. This can be seen in the figure below.

This chart shows that prior to the COVID-19 crisis, the Bank of England had grown NGDP about 4% a year along a stable path. This is exactly what an NGDP level target would look like. Interestingly, former Governor Mark Carney actually wanted the Bank of England to follow an NGDP target when he first arrived. The idea was quickly shot down, but nonetheless he got the outcome he was calling for back in 2012. It is almost as if the Bank of England had a stealth NGDP target under his stewardship.

Prior to the Great Recession, NGDP was also on a relatively stable path, though during this time it was growing closer to 5%. This too looks similar to an NGDP level target. Both of these NGDP targeting-like experiences, however, end in a sustained trend path drop that is not made up. In other words, the Bank of England's implicit NGDP target is actually a version of a growth rate target rather than a level target. And that is where the recent calls for an NGDP level target are different from what the central bank has been doing.

The Real Change Would Be an Explicit Make-Up Policy

My final point is that the real change being called for is the adoption of a level target. That is, the goal is to move the Bank of England from an implicit NGDP growth rate target to an explicit NGDP level target. This would require the central bank to make up for past misses from its target. Put differently, an NGDP level target would empower the central bank to temporarily run the economy hot until NGDP got back up to its trend growth path. In the case of the United Kingdom, that means growing NGDP faster than the trend 4% growth rate. This faster-than-normal catch-up growth is sometimes called 'make-up' policy and is illustrated below:

What an NGDP Level Target Might Look Like in the United Kingdom

If the UK Treasury were to announce an NGDP level target for the Bank of England, it could be as simple as restoring NGDP to its trend growth path that existed under Mark Carney. That is, temporarily run NGDP hot to make up for shortfalls below its trend path that occurred during the COVID-19 crisis. After that, simply grow NGDP at 4%. As seen in the first figure, a 4% level target would probably be fine given likely changes in potential real GDP in the United Kingdom. More complicated versions of an NGDP level target are possible, but I would start simple.

In closing, it is worth noting that NGDP targeting is not a new idea. It was highly talked about in the 1980s, but gave way to inflation targeting in the 1990s. The United Kingdom's adoption of an NGDP level target would simply put monetary policy in advanced economies back on its original journey. Bon voyage to the Bank of England!

NGDP Targeting in the United Kingdom - Scott Sumner

The Public Finance Implications of COVID-19

noreply@blogger.com (David Beckworth) — Thu, 11 Jun 2020 17:04:00 +0000

Peter Stella joined me on the podcast this week. He was back by popular demand and we touched on two important and related questions: how should the government finance its relief efforts and who should ultimately manage the public debt? The U.S. Treasury may seem like the obvious answer to both questions, but it is not the whole story. The Federal Reserve can also finance the relief efforts and, in so doing, affect the structure of public debt. But is this a good thing?

Peter Stella says no, at least in the longrun. He makes the case that it is economically and politically cheaper to return the financing and management of the public debt back to the U.S. Treasury once the COVID-19 recession is over. In other words, the Fed's expansion of its balance sheet, an understandable response to the crisis, needs to be unwound as the economy improves. Otherwise, we might end up with two government agencies with very different objectives trying to manage the public debt.

This is an interesting argument and one I want to flesh out in this post by taking a closer look at the two questions of financing the budget deficits and managing the public debt.

Financing the Budget Deficits

The first issue is financing the budget deficit. The question here is whether the government should fund the deficit through (1) overnight debt with a variable interest rate or (2) long-term debt with a fixed interest rate. The former option is what happens when Federal Reserve liabilities--the monetary base--finance the deficit, while the latter option arises when it is funded by treasury securities.

The Fed financing of deficits, in other words, is not risk free. It could lead to higher financing costs as the economy recovers. In such a scenario, financing with long-term treasury securities with fixed interest rates would be ultimately cheaper. But is this even possible in the current crisis with the Fed buying up so much public debt? That is, even if Treasury Secretary Steve Mnuchin issued more long-term treasury bonds, the Fed's asset purchases have been so large they would effectively convert most of the long-term bonds into overnight reserves.

That, in fact, is what has happened over the past three months. The chart above shows that for March, April, and May, the Fed purchased about $1.67 trillion of treasury securities compared to $2.31 in new issuance. The Fed, in other words, bought up about 72 percent of the treasury securities supplied during this time.

Not only was the Fed buying up most of the new issuance, but it was buying up treasury securities with a maturity far longer than overnight reserves. This can be seen in the chart below. The Fed, then, has been acting as the final financier for most of the deficit during the COVID-19 crisis and, in so doing, has transformed the structure of $1.67 trillion of U.S. public debt into overnight government liabilities.

Managing the Public Debt

So are we stuck with these short-term government liabilities forever? As Peter Stella explained in the show, the answer is no. The U.S. government could convert those overnight reserves back into longer-term treasury securities once the crisis is over.

To illustrate how, imagine that by the end of 2020 the Fed has bought up $2 trillion in treasury securities. The purchase of these treasuries were used to indirectly fund the cash transfers to households, the PPP program, extended unemployment benefits, and other economic relief efforts. The figure below shows this development in terms of the respective balance sheets of the Treasury and Fed. The treasury securities are liabilities for the U.S. Treasury and assets for the Fed and vice-versa for Fed-issued reserves. The Treasury takes the reserves on its balance sheet and sends them to the private sector as part of the economic relief efforts.

If we now combine the Treasury and Fed balance sheets into a consolidated government account and also look at the private sector balance sheet, we see the following two t-accounts:

The net government liabilities are now $2 trillion in overnight reserves which are assets on the private sector's balance sheet. Again, during a crisis this is not a surprising outcome as the Fed rapidly expands its balance sheet. But left unchanged, it would imply rising interest rate costs once the economy starts recovering and the Fed is forced to raised the IOER to keep inflation in check.

To avoid this problem, Peter Stella recommends that after the crisis the Treasury issues additional long-term treasury bonds that lock in low interest rates. Selling these treasuries to the private sector means taking reserves off their balance sheets. The Treasury, in other words, is swapping long-term treasury securities for the overnight Fed liabilities. This is what the consolidated balance sheet would like after this activity:

Peter Stella outlines this process more thoroughly in his paper titled "Exiting Well". Again, this would not happen right away, but after the crisis has ended.

Historically, the Fed has financed about 20 percent of the consolidated public debt (CPD) based on data back through 1945. I define CPD as the sum of marketable treasury securities not held by the Fed and the monetary base. Using data from the Financial Accounts of the United States, I constructed the chart below that shows the share of CPD attributable to the Fed and the U.S. Treasury.

Unsurprisingly, the Fed's share of CPD during the Great Inflation rose to an average of almost 30 percent and hit almost 40 percent in 1974. During the Great Moderation it fell to about 14 percent. As of May, the Fed's share of CPD is approximately 24 percent, just above the historical average. The reason it is not higher is because of large budget deficits coming into the crisis.

If 'exiting well' means returning to the historical average, it might occur naturally with regular budget deficits after the crisis. If 'exiting well' means returning to something closer to the Great Moderation levels, then this will be a more ambitious project and require a vast reduction in the stock of reserves.

Other Considerations

The argument so far for reducing the Fed's management of the public debt is that it is likely to be economically cheaper. As noted by folks like George Selgin, Charles Plosser, Paul Tucker, and others, a second argument is that it is also politically cheaper for the Fed to avoid playing the role of public debt manager. The management of U.S. public debt is normally under the purview of the U.S. Treasury because this process is inherently politically and therefore overseen by representatives of the taxpayers. The Fed can avoid these political entanglements by minimizing its influence on public debt management. This, of course, requires a smaller Fed balance sheet.

A post-crisis journey to a smaller balance sheet, however, faces two big roadblocks. First, the Fed has chosen an 'ample reserve' or floor operating system. This keeps the stock of excess reserves large in normal times and therefore keeps elevated the Fed's influence over public debt management. A number of post-2008 bank regulations also has increased the demand for bank reserves. Some of these regulations have been tweaked in the crisis, but both they and the Fed's floor system would have to be reconsidered if we wanted to return to a world of scarce reserves and less political entanglement for the Fed.

Finally, it is worth noting that maintaining large central bank balance sheets do not guarantee robust growth. The charts below show the 2009-2019 averages of central bank balance sheets sizes against several measures of nominal economic activity. They, ironically, show bigger balance sheets are tied to slower nominal growth. Now, it could be the case that the countries with the weakest nominal growth responded with the most aggressive use of the LSAP programs. This is probably true, but the data span an entire decade so one would expect to see inflation, domestic demand, and credit growth respond to the use of LSAPs over this long of a period if QE worked as advertised. If nothing else, these figures should give us pause in considering the benefits of maintaining large central bank balance sheets over long periods. Further analysis of this data supports this interpretation.

So between the higher financing cost for the public debt, the greater political entanglement for the Fed, and the unclear benefits from maintaining a large central bank balance sheet over a long period, we should take seriously Peter Stella's suggestions for 'exiting well' once the crisis is over. Here's hoping we do.

Extensions to the NGDP Gap

noreply@blogger.com (David Beckworth) — Tue, 26 May 2020 20:19:00 +0000

The monetary policy program at the Mercatus Center recently released a new measure called the NGDP gap. We created it as an alternative way to gauge the stance of monetary policy and have provided a website that will update the measure as new data become available. In this post, I will briefly summarize the NGDP Gap and then highlight a few extensions that some readers may find useful.

Summary of the NGDP Gap

As mentioned above, the NGDP Gap provides a cross check on the stance of monetary policy. Its use does not require the Fed to adopt a NGDP target, but it does draw upon the fact that NGDP is comprised of both real GDP and the price level and therefore captures both elements of the Fed’s dual mandate. Moreover, since NGDP is a nominal variable it can be shaped by the Fed over the medium to long run.

The basic idea behind this measure is to construct a benchmark growth path for nominal GDP (NGDP) where monetary policy is neither expansionary nor contractionary. Deviations of actual NGDP from this neutral level of NGDP provide a way to assess the stance of monetary policy. These deviations, in percent form, are called the NGDP gap.

The NGDP gap can also be called the nominal income gap since NGDP equals NGDI. In fact, the construction of the neutral level of NGDP can be most easily understood from a nominal income perspective. To see this, consider that people make many economic decisions based on forecasts of their nominal incomes. Examples include households’ decisions to take out mortgages and car loans or firms’ decisions to finance with debt and commit to multiyear contracts on plants, raw materials, and labor. Sometimes, however, actual nominal incomes may turn out very different from what people expected and, as a result, may be disruptive for households and firms that are not able to quickly adjust their economic plans. These disruptions can be minimized by maintaining nominal income on the growth path expected by the public.

The neutral level of NGDP, then, is the public’s expected growth path of nominal income. Both this measure and the NGP Gap are shown below up through 2020:Q1 and come from a NGDP Fact Sheet we will be publishing each quarter.

To be clear, non-zero NGDP gap outcomes need not be the result of Fed policy but of monetary conditions more generally. For example, the current NGDP gap exists because of the severe nominal income shortfall that has emerged from the COVID-19 shock. Consequently, the job of the Fed and U.S. Treasury during this crisis is to close this gap and avoid the secondary spillover effects (e.g. mass insolvency) this shortfall could create. Failure to close it would indicate a failure of countercyclical policy. This measure, then, provides a useful guide for the economic relief efforts during the pandemic.

Extension I: Blue Chip Forecast Version

A key goal of this project was to provide a measure that is relatively simple to calculate and uses publicly available data. To that end, the neutral level of NGDP is based off of forecasts from the Philadelphia Fed's Survey of Professional Forecasters (SPF) and BEA data on NGDP. There is no use of r-star or u-star and therefore no "navigating by the stars" in this measure. The neutral level of NGDP is just an averaging of NGDP level forecasts from accessible data sources. Below is the formula for the neutral level of NGDP:

where NGDP_t^* is the neutral level and NGDP_t-i^{SPF forecast(t)}are NGDP level forecasts for period t coming from the past 20 quarters. NGDP_t^*, in short, is just a rolling average of NGDP level forecasts for a particular period. The difference between it and actual NGDP is the NGDP gap.

Given the five-year (20 quarter) window in creating NGDP_t^*, there is a need for long-term NGDP forecasts. They are available in the SPF, but begin only in 1992 and therefore limit our series to a start date of 1997.

The Blue Chip forecast database provides a long-term NGDP forecast that goes back further than the SPF. Alexander Schibuola and Andrew Martinez (2020) use it to construct an even longer time series of the NGDP gap. It is shown in the figure below along with the SPF version we use at Mercatus. The two NGDP gaps are very similar.

Interestingly, Schibuola and Martinez use the data to construct a forecasted NGDP gap and it is disturbingly large. Even the recovery looks nasty.

The use of Blue Chip data is a nice extension of the NGDP gap. However, we still plan to use the SPF version as our baseline version since the data is free and we can show the underlying calculations to the public. Eventually, we plan to provide the Blue Chip version as a complement to our baseline SPF version, but since it uses proprietary data only the final measure will be available.

Extension II: Precision Version

Schibuola and Martinez also provide another useful extension of the NGDP gap that looks at its precision. They motivate this by noting two potential issues: (1) the forecasters in the SPF sample change over time and (2) individual forecasts in the SPF may be very different. Accounting for these two issues they produce the following chart that shows the range of individual forecasts for a semi-fixed sample of forecasters in the SPF.

The median of the semi-fixed sample provides a very similar result to the overall median of all the forecasters. Also, the range of forecasts provides a way to better think about the stance of monetary policy. For example, one could make the case that monetary policy was neutral in 2019 since the range of estimates span both sides of 0 percent.

Extension III: NGDP Targeting Application

As noted above, the use of the NGDP gap does not require the adoption of a NGDP target by the Fed. Nonetheless, a closer look at the forecasts used in constructing the neutral level of NGDP reveal that it could be used by the Fed as the target growth path for a NGDP target. For it would amount to a NGDP level target that slowly changes the target NGDP growth path based on changes to forecasts of potential real GDP.

To see why this is the case, note that we use a combination of short-run and long-run forecasts of NGDP to construct the neutral level estimate of NGDP. The SPF provides distinct quarterly NGDP forecasts for five quarters out: t+1 to t+5. After that, we use the average annual NGDP forecast over the next 10 years adjusted to a quarterly basis for quarters t+6 to t+20. This is seen in the table below.

What this means is that three-fourths of each NGDP neutral level estimate is being shaped by a long-term forecast of NGDP. This long-term forecast, in turn, is the sum of a 10-year average GDP deflator inflation forecast and a 10-year average real GDP growth rate forecast. The long-term inflation forecast is determined by the Fed's inflation target while the long-term real GDP growth rate forecast is shaped by expected changes in the potential real GDP growth rate.

Consequently, as the neutral level of NGDP series moves through time, it can be seen as a rolling average of expected changes to potential real GDP growth plus the Fed's inflation target. This is the kind of NGDP level target some advocates, like Jeff Frankel, would like to see implemented.

The figure below shows the neutral level of NGDP constructed with the Blue Chip data, complements of Schibuola and Martinez. This version allows us to see a hypothetical NGDP level target from late 1987 to present based on the neutral level measure of NGDP.

Again, the original intent of the neutral level of NGDP and the NGDP gap is simply to provide a crosscheck against other measures of the stance of monetary policy. The discussion of a NGDP level target is simply an extension of this work.

Here's hoping, though, that the Fed and Treasury keep this measure front and central in their efforts to provide economic relief during the COVID-19 crisis.

Assorted Macro Musings

noreply@blogger.com (David Beckworth) — Thu, 02 Apr 2020 03:05:00 +0000

1. USA Today published my Op-Ed titled "Fighting the Coronavirus Pandemic: The Economic Front." In it, I make the case that the large relief package from the White House and Congress and the Fed's interventions are best seen as mobilizing for war:

The proposed government outlays can be best thought of as part of a mass mobilization for war, just like the country did for World War II. Back then, the war was against foreign powers, and we mobilized factories, machines and troops to fight a physical foe. Today, the war is against a virus or an “invisible enemy,” as President Donald Trump has described. We’re mobilizing our health care industry and the ability for people to stay home in order to fight.

This fight against the novel coronavirus, like World War II, is also a two-front war. The first front is the public health battle against the virus. The second front is saving the economy from a debilitating wave of bankruptcies and liquidations as businesses are shut down and workers are sent home. This lockdown amounts to an economically induced coma, and most of new government funding is a form of life support to make it through this ordeal.

Mobilizing for war is very different than responding to a garden-variety recession. Consequently, this government relief should not be viewed as 'stimulus' but as life support for an economy temporarily put into an induced coma.

2. The Mercatus Center published a new policy brief of mine where I call for Congress to grant the Federal Reserve the ability to do helicopter drops in very special circumstances. Specifically, the Fed should be allowed to do helicopter drops when interest rates hit their effective lower bound and the cash disbursements should be tied to a NGDP level target.

3. We have increased the number of podcasts to two a week as the COVID-19 pandemic has taken off in the United States. The shows have focused on what policymakers can do and there have been a number of excellent guests. Below is a screenshot of some recent shows. Check out these episodes here.

The Decline of the 10-Year Treasury: Implications for Fed Policy

noreply@blogger.com (David Beckworth) — Thu, 05 Mar 2020 17:53:00 +0000

The 10-year treasury yield reached an historic low this week, crossing the 1% barrier. For many observers, this was a troubling development that confirms the U.S. economy is being sucked into the mire of secular stagnation. For others, it was an unsurprising outcome given the long-run trajectory of interest rates and the ongoing safe asset shortage problem.

Both views have some merit. The decline of the 10-year treasury yield does create problems for the U.S. economy, but it has been happening for some time. There is nothing magical about crossing the 1% barrier, though it does brings closer the day of reckoning for the Fed's operating framework.

The decline of the 10-year treasury yield, if sustained, means the entire yield curve may soon run into its effective lower bound. This will render useless much of the Fed's toolbox. Fortunately, there is a fix for the Fed's operating framework that makes it robust to any interest rate environment. This fix, ironically, ties the Fed more closely to fiscal policy while making it more Monetarist in practice.

This post outlines the proposed fix, but first motivates it by explaining how the decline in the 10-year treasury yield creates problems for the U.S. economy.

Why The 10-Year Treasury Yield Decline Matters

The are three reasons why the fall in the 10-year treasury yield matters. First, it implies there is an excess demand for safe assets. These are securities that are expected to maintain their value in a financial crisis and, as a result, are highly liquid. The biggest sources of safe assets are government bonds from advanced economies, especially U.S. Treasuries. The global demand for them has far outstripped their supply and this has led to the global safe asset shortage problem. The 10-year treasury yield falling below 1% is the latest manifestation of this phenomenon.

The safe asset shortage is problematic because it amounts to a broad money demand shock that slows down aggregate demand growth. One solution is for safe asset prices (interest rates) to adjust up (down) to the point that safe asset demand is satiated. The effective lower bound (ELB) on interest rates prevents this adjustment from happening and causes investors to search for safe assets elsewhere in the world. Other economies, as a result, are also affected by the safe asset shortage problem and experience lower aggregate demand growth.¹

The demand for safe assets, as noted above, is closely tied to the demand for liquidity. This can be seen in the figure below which shows that the use of money assets (i.e. money velocity) closely tracks the 10-year treasury yield. Over the past decade, this has meant the public's desired money holdings have increased as the 10-year treasury yield has fallen. All else equal, this implies slower growth in aggregate spending.

Below is a chart from an upcoming policy brief of mine that illustrates this point from a global perspective. It shows the average 10-year government bond yield between 2009 and 2019 plotted against the average growth rate of domestic demand over the same period. The government bond yield can be viewed as the safe asset interest rate in these advanced economies. The figure reveals a strong positive relationship between the safe asset yield and the domestic demand growth rate.

One has to be careful interpreting the causality here, but I do further analysis in the policy brief and find shocks to the bond yields do influence domestic demand growth. The safe asset shortage, therefore, appears to be a drag on global aggregate demand growth. The first reason, then, why the decline in the 10-year treasury yield matters is that it portends weaker aggregate demand growth.

The second reason the decline matters is that it leads to a flattening of the yield curve. Financial firms that fund short term and invest long term rely heavily on a positive slopping yield curve to make this business model work. A flattening yield curve undermines it and may lead to less financial intermediation. This is one reason an inverted yield helps predict recessions. In this case, however, the effect may be longer lasting than the business cycle as the decline in treasury yields appears to be on a sustained path.

The third reason the decline matters is that it impairs the Fed's current tool box. The Fed's target interest rate is now down to a 1-1.25% range, a small margin for a central bank that normally cuts around 5% during a recession. The Fed could turn to large scale asset purchases once it hits the ELB, but with the 10-year treasury now near 1%, there is not much space here either. Consequently, the Fed's toolbox is shrinking and soon could be rendered useless.

Now the Fed can add to its toolbox and indeed the Fed is exploring new tools--such as negative interest rates and yield curve control--under its big review of monetary policy. Even these tools, however, are limited since the declining 10-year treasury yield is compressing the yield curve.

The Fed's current toolbox, in short, is premised on a positive interest rate world that is slowing fading. The Fed, therefore, may soon face a day of reckoning for its current operating framework. That possibility and what the Fed could do in response is considered next.

Revamping the Fed's Operating Framework

The Fed’s operating framework--defined here as the instruments, tools, and targets the Fed uses in its conduct of monetary policy--has been geared toward a positive interest rate environment. This framework has been increasingly strained by the downward march of interest rates. The 10-year treasury yield dropping below 1% underscores this challenge.

The Fed needs, consequently, an operating framework that is robust to any interest rate environment and one that is capable of stabilizing aggregate demand growth. I have proposed a fix to the Fed's operating system that addresses these challenges in a forthcoming journal article. Here I want to briefly outline that proposal. It has three parts: (1) the Fed adopts a dual reaction function, (2) the Fed adopts a NGDP level target, and (3) the Fed is empowered with a standing fiscal facility for use at the ZLB. The three parts are explained below.

Part I: A Dual Reaction Function. To make the Fed’s operating framework robust to both positive and negative interest rate environments, I call for a two-rule approach to monetary policy. Specifically, the Fed would follow a version of the Taylor rule when interest rate are above zero percent and follow the McCallum rule when interest rate are at zero percent or below. The former rule uses an interest rate as the instrument of monetary policy while the latter rule uses the monetary base as the instrument. Consequently, the Fed would have effective instruments to use no matter what happens to interest rates.

Part II: A NGDP Level Target. A level target provides powerful forward guidance since it forces the central bank to make up for past misses in its target. For reasons laid out here, I prefer a nominal NGDP level target (NGDPLT) and specifically, one that targets the forecast. This combined with the first feature implies the following dual reaction function system for the Fed:

Here, iⁿ is the neutral interest rate, the NGDP^Gap is the percent difference between the forecasted level of NGDP and the NGDPLT for the period of t to t+h, Δb is the growth rate of the monetary base, Δx* is the target NGDP growth rate, and Δv is the expected growth rate in the velocity of the monetary base for the period of t to t+h.

Part III: A Standing Fiscal Facility. The final part of the proposal establishes a standing fiscal facility for the Federal Reserve to use when implementing the McCallum rule. That is, when the Fed starts adjusting the the growth of the monetary base according to the McCallum rule, it will do so by sending money directly to the public. My proposal, then, incorporates 'helicopter drops' into the Fed's toolkit in rule-like manner.

I provide more details in the paper, but here are the advantages of this proposed operating framework. First, it keeps countercyclical macroeconomic policy at the Federal Reserve. This provides continuity with the existing division of labor between the U.S. Treasury Department and the Federal Reserve. Second, it enables the Fed to provide meaningful countercyclical monetary policy no matter what happens to interest rates. Third, it provides credible forward guidance since it combines a NGDPLT with helicopter drops. Finally, since this operating framework would require the Fed to be much more intentional about the rules it follows, it would make the Fed more rules-based and predictable.

This proposal would require approval from Congress. Given the Fed's shrinking toolbox and the ongoing expectation that it deliver countercyclical policy, this may not be as big an ask as some imagine. Moreover, it could easily be seen as return to a more Monetarist Federal Reserve since it would be relying more explicitly on the monetary base to implement monetary policy.

Conclusion
Some commentators have speculated that the corona virus might be a shock that forces us out of our complacency and spawns many unintended innovations. To the extent this shock leads to ongoing declines in the treasury yields and exhausts the Fed current toolbox, it might also lead to innovations in U.S. monetary policy. Here's hoping it does along the lines suggested above.

¹ The safe asset shortge can also become self-perpetuating and lead to what Caballero et al (2017) call a ‘safety trap’. This problem emerges when the excess demand for safe assets pushes down safe asset yields to the effective lower bound (ELB) on interest rates. If the excess demand for safe assets is not satiated at that point (i.e. the equilibrium real safe asset interest rate is below the ELB), then aggregate demand will contract and push down inflation. Via the Fisher relationship, the lower inflation will drive up the real safe asset interest rate and increase the spread between it and the equilibrium real safe asset interest rate. As a result, aggregated demand will further contract and the cycle will repeat. This is the safety trap.

Allan Meltzer's Life Work

noreply@blogger.com (David Beckworth) — Mon, 14 Oct 2019 16:00:00 +0000

The Hoover Press and the Mercatus Center have just released a new book on Allan Meltzer's contributions to economics. The book is comprised of papers that were presented at a 2018 conference commemorating his work on the monetary transmission mechanism, the history of the Fed, and his more general work on public policy. Below is the table of contents for the book:

I happen to be the editor of the book and, as seen above, have two chapters in it: the introductory chapter and a chapter based on my podcast interview with Allan Meltzer. So please check it out.

P.S. We had an event last week at the AEI highlighting the release of the book. It was hosted by Desmond Lachman and featured a panel discussion including John Taylor, George Selgin, Ed Nelson, and myself. I got to speculate on what Allan Meltzer would think of (1) the below-target inflation of the past decade and (2) the Fed's plans to incorporate 'make-up' policy in their monetary policy framework. You can see my comments in the video below:

New Policy Brief on NGDPLT

noreply@blogger.com (David Beckworth) — Thu, 03 Oct 2019 11:41:00 +0000

I have a new policy brief out on NGDP level targeting. The article summarizes in an accessible manner the key arguments for NGDP level targeting while also addressing the main concerns of this approach. The policy brief also shows how one could implement a NGDP level target in practice. The article comes out now as part of the conversation the Fed is having this year in its review of monetary policy. Please check it out.

NGDP Targeting and the Taylor Rule on An Even Playing Field

The Repo Man Cometh

noreply@blogger.com (David Beckworth) — Mon, 23 Sep 2019 10:29:00 +0000

Source

The repo market hit some road bumps last week. Trading pressures in this key funding market pushed repo interest rates well above the Fed's target interest rate range. This development caused some observers to worry that it was a 2008-type run on the repo market all over again. Bill Dudley and others, however, noted this was a technical blip, not the beginning of a financial crisis. Moreover it was something the Fed could easily fix with an old fashion tool, temporary open market operations, even if the Fed got off to a slow start doing so last week.

There have been great Twitter discussions and explanations of this repo market stress, including ones from Nathan Tankus, Bauhinia Capital, Guy LeBas, and George Selgin. There are also have been many good pieces from journalists and think tanks. Here, I want to echo a few of their points and speak to where I hope this experience takes the Fed's operating system in the long run. Let's begin with what happened.

Stumbling Back into a Corridor System

The standard explanation for what happened has two parts. First, the Fed's quantitative tightening (QT) put the U.S. banking system close to the point of reserve scarcity given the new post-crisis regulations. Second, the Treasury recently auctioned off new securities and at the same time collected corporate tax receipts. These two developments further reduced bank reserves and pushed the banking system back into a reserve-scarce environment. Put differently, the Fed unintentionally stumbled from its floor operating system of the past decade back into a corridor operating system, the framework it intentionally left in late 2008.

This story can be illustrated using a simple supply and demand model of bank reserves. Using this framework, the figure below on the left shows what the Fed's operating system looked like before the fall of 2008. This was a simpler time when the Fed kept minimal reserves and banks traded for them on the interbank market. The Fed would conduct open market operations (OMOs) to adjust the supply of bank reserves so that a particular interest rate target was hit. Graphically, this meant moving the red line (reserve supply) along the downward slopping part of the blue line (reserve demand). Changes in the supply of reserves directly influenced the interest rate target. Monetary policy and money were directly linked.

This changed in late 2008 when the Fed expanded the supply of reserve such that the reserves were now on the flat (perfectly elastic) portion of the demand curve. The Fed's floor operating system had emerged. This can be seen below in the figure on the right. Here, the quantity of reserves could change with no effect on the interest rate target. Monetary policy was now divorced from money. The Fed, in other words, could adjust its balance sheet independent of the stance of monetary policy. This was the appeal of the floor system.

The Fed's floor system got further refined after the crisis with changes in reserve demand brought about by Dodd-Frank and Basel III. New regulations likes the leverage coverage ratio (LCR), supplemental liquidity ratio (SLR), and resolution planning for global systematically important banks (G-SIBs) increased demand for reserves. This can be seen below with the shifting out of the reserve demand curve (blue line) in the figure on the left.

Finally, the Fed reduced bank reserves via the shrinking of its balance sheet or QT from 2017 to 2019. The goal was to keep the banking system on the flat part of the reserve demand curve, but with the lowest level of reserves possible. No one knew for sure where that would be, but if it were passed it would be made evident by overnight interest rates rising up. That is exactly what happened this past week with the Treasury sales and collection of corporate tax receipts and can be seen below in the figure to the right. The Fed's temporary OMO's is an attempt by the Fed to offset these recent Treasury actions and push the banking system back onto the flat portion of the demand curve.

What is the Fed Doing Now?

The Fed is now engaging in temporary open market operations (OMOs) via overnight and term repos to bring the repo rate in line with its interest rate target. Some are calling this a bailout of the banking system, but these responses are what normally happens in a corridor system. It is what the Bank of Canada currently does with its corridor system and it is what the Fed did from the 1920s up until 2008. This is not a bailout, but a temporary provision of liquidity to the banking system.

The figure below shows that $75 billion of overnight repos this past week are relatively small as a percent of the Fed's total assets. At 1.95% of total assets, they are small compared to the temporary OMOs in the decades leading up to the crisis. If we add in the additional $90 billion in term repo to be disbursed this week, it still is about where the temporary OMOs typically were as a percent of total assets prior to 2008.

The most striking part of the figure, if anything, is the absence of temporary OMOs over the past decade under the floor system. This absence of repo activity by the Fed apparently has led many observers to forget the Fed engaged in this type of activity for most of its history. Maybe it also led to some repo atrophy at the New York Fed as discussed below.

Why Did the Fed Stumble?

So, why did the Fed not see this Treasury-related reduction in bank reserves coming? It should not have been a surprise and the fact that it was has some questioning the competence of the New York Fed. Some are even wondering if the absence of Simon Potter, the former head of the New York Fed's Market Group, was a reason for the misstep.

This criticism seems off to me. Yes, Simon Potter's presence would have been nice this past week, but the Market Group is more than one person. There are other talented people in this group who are also well informed. I also find it a reach to blame the market inexperience of New York Fed President John Williams. This too puts too much weight on one person and ignores the collective wisdom of the New York Fed staff.

I think a simpler explanation is that a floor system is just hard to run in the United States. First, no one knew for sure when the reserve scarcity point would hit because no one knew exactly how the regulations would manifest themselves in each bank. Even if they did know this regulatory part, they still would not know for certain if they had hit reserve scarcity until overnight rates shot up.

Second, the New York Fed's slow response to the repo market stress might itself also be the fault of the floor system. The floor system has meant no need for temporary OMOs for almost a decade. Maybe the New York Fed was simply out of practice--no repo muscle memory--and caught off guard.

Third, as noted by George Selgin, the floor system encourages the Treasury to use its TGA balance at the Fed. For a fixed Fed balance sheet, this growth in the TGA requires a reduction in bank reserves. If the Treasury had instead used the TT&L accounts this could have been avoided. But the floor system discourages their use. Maybe the Fed's choice of a floor system needs a rethink.

Longterm Solution for the Fed

This repo market bump in the road should encourage the Fed to rethink the longterm future of its operating system. The floor system was supposed to bring greater interest rate control to the Fed, but this experience suggest that this is not the case. Moreover, as I noted in a previous post, the Bank of Canada appears to have better interest rate control with its symmetric corridor system. This, in my view, should be the longrun destination for the Fed's operating system.

As George Selgin notes, the Fed's adoption of a standing repo facility could be a step in that direction. There will also need to be tweaks to the regulatory front as well. The sooner we start this journey the better.

The Repo Man Cometh

Some commentators worry these funding problems will continue to plague the Fed's floor system in the future given the Fed's desire to keep its balance sheet as small as possible while still being on the flat portion of the reserve demand curve. Since it is hard to know exactly where that sweet spot is on the curve, I agree that we may see strains again in the repo market. Eventually, this discomfort should move us toward adopting the standing repo facility, but until that time get used to seeing more temporary OMOs and Bill Dudley explainers. The Fed's repo man will come again.

P.S. There was some discussion as to who was holding the remaining reserves. This chart partly answers that question.

Source: FRED Data

Some Assorted Macro Musings

noreply@blogger.com (David Beckworth) — Tue, 10 Sep 2019 01:50:00 +0000

Dollar Dominance

I have been part of a dollar dominance conversation for the past few weeks. It started with my NRO article, discussions on the topic at the Jackson Hole conference, and a follow-up blog post. Later, there were twitter conversations, an interview on Bloomberg TV, and several podcast recordings. This all culminated in an article I wrote for The Bridge that summarizes what I see as the main issues of dollar dominance and what realistically can be done about it. Check it out and also see the follow-up twitter thread I provided that documents some of the claims made in the piece.

Paul Volcker is What the Public Wanted

Back in May, I interviewed Robert Samuelson about his book on the Great Inflation of the early 1970s to early 1980s. One of the claims he makes is that inflation was a bigger deal than Watergate or Vietnam for most Americans during that time. Samuelson notes most histories of this period overlook this fact even though it is supported by poll data. I finally decided to track down this poll data for myself to verify this claim. Here is the Gallup Poll data I found:

Yes, inflation was the "most important problem" for a majority of people during most of the period between early 1970s and early 1980s. This implies that Paul Volcker's war on inflation was exactly what the body politic desired at that time. It would also explain why President Reagan supported him in his efforts to fight inflation.

Loss Functions and NGDP Targeting

I was pleasantly surprised to see Lars Svensson's updated paper from the Chicago Fed conference that took place this past June. Due to some pushback he got at the conference, he included a section in his revised paper on NGDP targeting. Here is an excerpt:

Obviously, I was thrilled to see Svensson cite my paper and recognize the financial stability argument for NGDP targeting. Ultimately, though, he rejects this monetary framework based on a loss function that assumes it is optimal to minimize the variance of output and inflation. A good central bank, in other words, is one that tries to reduce volatility in both inflation and the real economy as much as possible.

NGDP targeting, however, makes the opposite case. It explicitly aims for increased inflation flexibility in the shortrun--while still anchoring the dollar size of the economy--so that a central bank will not respond to swings in inflation caused by supply shocks. Doing so serves to minimize the variability of output and, ironically, inflation itself.

This point is vividly illustrated by the ECB in 2011. It succumbed to the siren call of temporarily higher inflation caused by negative supply shocks and, as a result, raised its target interest rate twice. This tightening helped create a second recession in the Eurozone and caused inflation to subsequently undershoot its target. In short, the ECB in its efforts to offset supply-shock induced inflation in 2011, actually increased the variability of output and inflation.

Ideally, central bankers should be able to see through such temporary changes in inflation, but in real time this is extremely hard to do. Especially, if central bankers have in the back of their mind the kind of loss function Svensson applies above. This is the very problem that NGDP targeting helps central bankers overcome as shown by Garin et al (2016) and Beckworth and Hendrickson (2019).

More on the U.S. as a Banker to the World

noreply@blogger.com (David Beckworth) — Wed, 28 Aug 2019 13:54:00 +0000

I have a new article where I make the case that the U.S. financial system acts as a banker to the world: it tends to issue safer assets to foreigners while acquiring claims to riskier assets abroad. As a result, the United States’ balance sheet with the rest of the world looks like a bank’s balance sheet. This banker-to-the-world role has becoming even more important over the past few decades as the financial integration of the world economy has not been matched by a proportional deepening of financial markets.

This is not a novel idea. Charles Kindleberger first made this point in 1965. Subsequent work by Gorinchas and Rey (2007), Caballero et al. (2008), Caballero and Krishnamurthy (2009), Mendoza et al. (2009), Forbes (2010), He et al. (2016), Gourinchas et al. (2017), Matteo (2017), Krishnamurthy and Lustig (2019), and others all build on this point. Here is my own contribution to this debate. So while some may find this view surprising, it is actually a well established idea in the literature.

In my article I provided figures that show the asset and liability side of the U.S. balance sheet with the rest of the world. In these graphs, I highlighted in blue the more liquid and safe assets while I put in shades of pink the riskier assets.

The figure below takes these groupings and divides them as a share of total assets on their respective sides of the balance sheet. This figure reveals the safe asset share of assets on the liability side (blue line) has come down some since the financial crisis, but still remains at about 60 percent of the financial assets we export to foreigners. The riskier share of assets the U.S. owns abroad has stayed relatively stable at about 70 percent. Again, this looks like a bank's balance sheet.

To be clear, one can quibble with what I define as a safe assets. Here I take a broad view that there is a continuum of safe assets. Specifically, I include currency, bank deposits, treasuries, GSEs, repos, commercial paper, money market mutual funds, trade receivables. corporate bonds, and derivatives. Some of these assets are clearly safer and more liquid than others, but the demand for them remains elevated indicating they are perceived as relatively safe by the rest of the world.

One may also wonder if the demand for U.S. safe assets is declining since foreign holding of treasuries has flatlined since about 2015. The chart below, however, shows that the export of safe and liquid assets to the rest of the world continues to grow in absolute dollar terms even if treasury holdings by the rest of the world has stalled.

I noted in the article that this banker-to-world role comes at a cost: a tendency for the dollar to be overvalued and, as a result, cause the United States to run trade deficits. It also leads to U.S. budget deficits since that is only way to create more treasury securities. Finally, this role means that the U.S. economy will tend to be more leveraged than otherwise would be the case. It is not clear to me how to eliminate these costs without causing more harm to the global economy. Until there is another viable mass producer of safe assets, we are stuck with these costs.

P.S. See Frances Coppola and Karl Smith who make similar arguments.

Update: It is worth noting that the BIS reports just over $11 trillion in dollar-denominated debt is issued outside the United States. Between this $11 trillion and the just over $16 trillion noted above, there is almost $28 trillion of relatively liquid dollar assets abroad. This large amount of dollar assets abroad makes it unlikely Facebook's Libra or Mark Carney's SHC proposal will ever replace the dollar as the reserve currency.

New Articles on NGDP Targeting

noreply@blogger.com (David Beckworth) — Fri, 07 Jun 2019 23:01:00 +0000

Just a quick note on a couple of my papers that recently got published. First, Josh Hendrickson and I published in the Journal of Money, Credit, and Banking earlier this year with an article titled "Nominal GDP Targeting and the Taylor Rule on an Even Playing Field". Here is the abstract:

Some economists advocate nominal GDP targeting as an alternative to the Taylor Rule. These arguments are largely based on the idea that nominal GDP targeting would require less knowledge on the part of policymakers than a traditional Taylor Rule. In particular, a nominal GDP targeting rule would not require real‐time knowledge of the output gap. We examine the importance of this claim by amending a standard New Keynesian model to assume that the central bank has imperfect information about the output gap and therefore must forecast the output gap based on previous information. Forecast errors by the central bank can then potentially induce unanticipated changes in the short‐term nominal interest rate, distinct from a standard monetary policy shock. We show that forecast errors of the output gap by the Federal Reserve can account for up to 13% of the fluctuations in the output gap. In addition, our simulations imply that a nominal GDP targeting rule would produce lower volatility in both inflation and the output gap in comparison with the Taylor Rule under imperfect information.

Many of you may have seen this article before since it has been a working paper for many years now. I am glad to finally get it published.

More recently, I published an article in the Cato Journal titled "The Financial Stability Case for NGDP Targeting." I presented this paper at the 2018 Cato Monetary Policy Conference. Here is the abstract:

Ten years after the financial crisis there is a new appreciation for the role household debt and financial fragility play in the business cycle. As a result, policymakers are looking for tools to promote financial stability. A number of recent studies claim that nominal GDP (NGDP) targeting is just such a tool. For it can theoretically reproduce the distribution of risk that would exist if there were widespread use of state-contingent debt securities. This paper empirically test this view by exploiting an implication of the theory: those countries whose NGDP stayed closest to its expected pre-crisis growth path during the crisis should have experienced less financial instability. This paper constructs an NGDP gap measure for 21 advanced economies to test this implication and finds there is a meaningful role for NGDP in promoting financial stability.

There are a lot of other interesting papers in this Cato Journal that were presented at the conference. So take a look. For those interested, here is the video of my panel at the conference:

P.S. In my last post I asked if the Fed's floor system was about to fold. Well, the answer is no, for now. My concerns about overnight interest rates rising above the IOER have faded as they have for the most part converged back to the Fed's target interest rate range. I also said I would outline in the next post how the Fed could transition to a symmetric corridor symmetric corridor if this collapse was imminent. That promise is still good, but on hold for now. I am doing some more reading and thinking on this topic and will return to it.

Is the Fed's Floor System Beginning to Fold?

noreply@blogger.com (David Beckworth) — Wed, 24 Apr 2019 19:10:00 +0000

Last December, I participated in an AEI event where I made the case that the Fed's current floor operating system could collapse into a corridor operating system fairly soon. My argument was that even without a significant reduction in the supply of reserves, a large shift in the demand for reserves could be sufficient to move the Fed off the perfectly elastic or 'flat' portion of the bank reserve demand curve. The Fed, in other words, could have a relatively large balance sheet and still end up in a corridor operating system.

Graphically, such a development is depicted in the figures below. The figure on the left shows a floor operating system with a large supply of reserves on the flat portion of demand curve. In this system, the IOER is both the target and overnight interest rate. The second figure on the right shows what I imagined could be happening. The demand for reserves was shifting outward because of new regulatory requirements and the supply of reserves was shifting inward as the Fed began shrinking its balance sheet. As depicted, these actions together would push the Fed off the flat portion of the reserve demand curve. In turn, this would cause overnight rates to rise above the IOER and end the Fed's floor system.

When I brought this up late last year it was pure speculation on my part, but it was informed by the Senior Financial Officer Survey and the Fed's balance sheet reduction plans. In my AEI talk, I told George Selgin, who dislikes the floor system, that if this comes to fruition Christmas will come early for him.

Well, Christmas did not come early for poor George. He may, however, get a late gift from Santa Claus as there is some evidence my prediction may be coming true. Jeff Cox reports that interbank interest rates are rising above the IOER rate. The figure below shows the overnight bank financing rate (OBFR), the new and improved interbank interest rate measure, has started rising above the IOER. The old federal funds rate (FFR) has been above the IOER for almost a month. (The closely-related overnight Libor replacement, the Secured Overnight Funding Rate (SOFR) tells a similar story.)

To be clear, this move is small from a broader perspective as seen below. Nonetheless, this rise in both series is part of a longer-term change in their trend, where previously they were consistently below the IOER but now are bouncing above it. If they continue to rise above the IOER, the floor system's days are numbered.

A similar story emerges if we look to the overnight treasury repo rates. The DTCC treasury repo rate has been tending up over the past month and so has the BNY Mellon treasury repo rate.

Now the DTCC repo rate has been above the IOER for awhile, but the BNY repo rate has not. This is relatively new. And like the interbank rates, the repo rates collectively have been gone from trending below the IOER to bouncing above it as seen below. Again, if this upward movement is sustained the floor system will fold.

Now, with all that said, there is something of a puzzle here: there has been no revival in interbank lending. One would expect, all else equal, that a rise in interbank interest rates above the IOER to spark some interbank lending. Instead, it appears interbank lending has been flat to declining:

One possible resolution to this puzzle is that banks are lending to the overnight treasury repo market rather than to each other. The overnight yield is slightly higher in this market and according to the Fed's H8 database there has been an explosion of reverse repo activity as seen below.

Maybe part of the new normal is that the treasury repo market has permanently displaced interbank lending. In any event, these developments all point to some big changes taking place that could force the Fed back to a corridor system.

If that is the case, I would recommend the Fed get ahead of this transition and intentionally guide itself to a symmetric floor system like the one in Canada. In my next post, I will offer some practical suggestions for making this journey.

P.S. The technical definition for the "federal funds sold and reverse repos" in the H8 database is as follows: "Includes total federal funds sold to, and reverse RPs with, commercial banks, brokers and dealers, and others, including the Federal Home Loan Banks (FHLB)." So maybe part of the explanation for the lack of interbank lending is that bank are lending indirectly to each other via the repo market.

Is Low Inflation Really a Mystery?

noreply@blogger.com (David Beckworth) — Tue, 16 Apr 2019 13:23:00 +0000

Over the past decade, inflation has persistently undershot the Fed's inflation target. The Fed's preferred measure of inflation, the core PCE deflator, has average 1.56 percent over this time compared to a target of 2 percent. The Fed officially begin inflation targeting in 2012, but was implicitly targeting 2 percent long before that time. So below-target inflation has been happening for close to a decade and for many observers it is a mystery.

There have been a spate of articles as to why the Fed has not been able to hit its inflation target. Some have wondered if the Fed really understands or even controls the inflation rate. Even Fed officials have been perplexed by the low inflation since it cannot be explained by their Phillips curve models. As a result, they sometimes attribute the persistently low inflation to developments such as falling oil prices, demographics, global competition, changes in labor’s share of income, safe asset shortage, and even the rise of Amazon.

These explanations, however, are not satisfactory since the Fed should be able to determine the inflation rate over the medium to long-run. That is, the Fed should be able to respond over time to developments that might cause inflation to drift off target. The Fed should be, in theory, the final arbiter of the trend inflation rate.

So why has inflation been so low? In my view, the answer is simple: the Fed is getting the inflation it wants. There is no mystery. One does not get a decade of trend inflation that is below target by accident. Instead, revealed preferences tell us inflation is where it is because the FOMC allowed it to be there. Put differently, the Fed has chosen not to fully offset the shocks and secular forces listed above that have pushed inflation down. This is a policy choice.

Fed officials and others may disagree, but the revealed preference argument is hard to ignore. Moreover, there are other reason to believe that the low inflation is, in fact, the desired outcome of the FOMC. They are presented below.

SEP Core Inflation Forecasts

The first reason to believe the low inflation is a desired outcome comes from the FOMC itself. The FOMC's Summary of Economic Projections (SEP) provides a central tendency forecasts for core PCE inflation. The FOMC's definition of the SEP is as follows (my emphasis):

Each participant’s projections are based on his or her assessment of appropriate monetary policy.

The SEP, in other words, reveals FOMC members forecasts of economic variables conditional on the Fed doing monetary policy right. And up until recently, doing monetary policy right was not overshooting 2 percent inflation in the following year, as seen in the figure below. Even now, 2 is still seen largely as a ceiling. There is nothing symmetric about 2 percent in these SEP forecasts.

Most FOMC members, therefore, have treated 2 percent as a ceiling over the past decade. This is "appropriate" monetary policy for them. Keep in mind, that at this forecast horizon most of them also believe they have meaningful influence on inflation. Both of these observations point to the low inflation as a choice.

Textual Analysis

The second reason to believe that low inflation is a desired outcome comes from a recent study by the San Francisco Fed. It is titled "Taking the Fed at its Word: Direct Estimation of Central Bank Objectives using Text Analytics" and the abstract reads (my emphasis):

We directly estimate the Federal Open Market Committee’s (FOMC) loss function, including the implicit inflation target, from the tone of the language used in FOMC transcripts, minutes, and members’ speeches. Direct estimation is advantageous because it requires no knowledge of the underlying macroeconomic structure nor observation of central bank actions. We find that the FOMC had an implicit inflation target of approximately 1.5 percent on average over our baseline 2000 - 2013 sample period.

Fed officials, via their words, actually want 1.5 inflation on average. And shocker of all shockers, they are very close to getting that just that rate of inflation since 2009.

The Neel Kashkari Counterfactual

The third reason to believe low inflation is a desired outcome comes from imagining a counterfactual FOMC. Imagine a FOMC that has twelve members that are all clones of Neel Kashkari, as seen below. In this FOMC, where interest rates were not raised over the past few years--and maybe even lowered--do we really think inflation would be the same? I find that hard to believe.

To be clear, I do think there are important secular forces pushing down trend inflation, like the demand for safe assets. But again, the Fed should be able to offset such pressures if it chose to do so. The real question, then, is why the Fed has settled for trend inflation near 1.5 percent. That is a question for a different post. This post is simply a retort to all those who think the low inflation is a mystery. Folks, it is not a mystery. It is a choice.

It is worth nothing that this choice is actually more than a choice for trend inflation. It is implicitly a choice for lower trend aggregate demand (AD) growth. As seen below, aggregate demand growth was averaging 5.6 percent in the decades before the crisis. Since the recovery started, it has averaged about 3.6 percent. That is a 2 percentage point decline in the trend. The red line in the figure shows what a naive autoregressive forecast would have predicted over the past decade conditional on past nominal expenditure history. There has been a sizable AD shortfall.

In my view, it is this dearth of aggregate demand growth rather than the low inflation that is a problem. The slowdown in AD growth has arguably contributed to problems like hysteresis and populism. If so, this policy choice has been costly.

P.S. Adam Ozimek gives us estimates of how costly this AD shortfall has been.

The FOMC Decision: A NGDP Perspective

noreply@blogger.com (David Beckworth) — Fri, 22 Mar 2019 19:51:00 +0000

The FOMC voted this week not to raise its target interest rate and signaled no additional hikes are planned for this year conditional on the outlook. This is a big change from last fall when the FOMC was talking up multiple rate hikes and dismissing concerns about the flattening yield curve. This 11th-hour conversion to a more dovish stance is a remarkable turnaround, one that some observers like Tim Duy are calling a "major break".

The change is being attributed to growth concerns and a weakening of financial markets. I do not want to go through all the indicators supporting the Fed's worries, but I do want to see whether Nominal GDP (NGDP) lends support to this decision. As many readers of this blog know, I believe that properly evaluated NGDP growth is probably the best indicator of the stance of monetary policy. Okay, so what does it say?

To answer that question, I like to look at a measure called the 'sticky forecast' growth path for NGDP and compare it to the actual level of NGDP. In this note, I show the spread between these two measures--the NGDP gap--provides a good measure of the stance of short-run macroeconomic policy. Here is the intuition for the metric:

The idea behind the sticky forecast path for NGDP is twofold. First, the public makes many economic decisions based on a forecast of their nominal incomes. For example, households may take out a 30-year mortgage based on an implicit forecast of their nominal income over this horizon. The actual realization of nominal income may turn out to be very different than expected, but the households may not be able to quickly adjust their plans given sticky debt contracts and other commitments that constrain them. Therefore, the consequences of previous forecasts are often binding on them and slow to change even if their nominal income forecasts have been updated. Second, in addition to these old forecasts and decisions whose influence lingers, new forecasts and new decisions are being made each quarter for subsequent periods that will also have lingering effects. Together, this means future periods have many overlapping and different forecast applied to them that only gradually adjust.

Given the public's expectations of nominal income, the sticky-forecast path of NGDP can be viewed as the neutral level of NGDP. Unlike the unobservable u*, r*, and y*, this neutral measure is simply a weighted quarterly forecast of nominal income found in the Survey of Professional Forecasters. There is no need for guesswork. The details of its construction are in the note, but it is worth mentioning that the NGDP gap created by this measure is remarkably similar to many measures of slack. I should also note that I constructed this measure using the IMF NGDP forecasts for 21 countries in a forthcoming paper (working paper version) and find it works well cross country too.

Here are what the sticky forecast and actual NGDP paths looks like:

And here is the NGDP gap--the percent difference between the two series:

This NGDP gap shows a standard story: aggregate demand growth overheated some in the late 1990s and to a lesser extent in the early-to-mid 2000s followed by a sharp collapse in 2008. A slow recovery followed that stalled around 2015-2016 and then started rising again. Currently, the NGDP gap is slightly below the neutral level of zero percent. This graph suggest it was appropriate for the Fed to pause on rate hikes this week. It also indicates, however, that the Fed arguably should not have started raising rates in 2015.

While the NGDP gap provides a nice cross check on the stance of monetary policy, it can also be used in an explicit monetary policy reaction function. Here is one I created:

Here it is a market interest rate, the first term measures the gap between the forecasted and targeted NGDP growth rates over the next year, and the second term is the NGDP gap as noted above. The 1-year treasury yield is used for it and the 1-year NGDP growth forecast comes from the Survey of Professional Forecasters. The NGDP target is set to 5.5 percent for 1985-2008 and 4 percent for 2009-2018 to reflect the actual trend NGDP growth rates experience during those times. The figure below plots the rule for different values of the coefficients:

Again, we see that if anything, the prescribed target interest rate is a little below the actual one suggesting the Fed's pause is appropriate. So overall, a smart move by the Fed and arguably one that is overdue.

Finally, I want to share one more application of the NGDP Gap that I have made before. The NGDP Gap does a decent job explaining nominal wage growth as seen in the figure below. The red dots show the portion of the scatterplot attributed to past few years. While the R² is 65 percent for the overall sample, the sample since 2016 has an R² of 85 percent. Here is hoping the Fed starts paying more attention to NGDP as a cross check for assessing the stance of monetary policy.

Oh, the Horror of a Corridor!

noreply@blogger.com (David Beckworth) — Thu, 10 Jan 2019 17:22:00 +0000

The December 2018 FOMC minutes are out and reveal members continue to discuss the potential long-run frameworks for monetary policy implementation. Their discussion as to whether they should keep their current floor operating system or move to a corridor operating system can be illustrated using the figure below:

The FOMC likes the floor system since it separates the size of the Fed's balance sheet from the setting of its target interest rate. This added flexibility is possible because the reserve supply schedule is on the horizontal part of the reserve demand curve as seen above. Here, banks will take all the reserves sent their way--killing off interbank lending--as their demand for reserves is perfectly elastic. The corridor system puts the reserve schedule back on the downward slopping part of the reserve demand curve. That creates an opportunity costs for reserves and resurrects interbank lending.

Recall that the floor system is a byproduct of the crisis. It was part of the unconventional monetary policy actions taken during that time. Consequently, the Fed is now discussing how to normalize its operating system. As I have argued in a recent paper and in various blog posts, I prefer the Fed leave the floor system and move to a symmetric corridor system. In my view, the political and economic costs exceed any benefits of a floor system.

I do not want to rehash these arguments, but I do want to respond to a claim made by the FOMC members as reported in the December 2018 minutes. Specifically, the FOMC claims there will be much greater interest rate volatility under a corridor system. Here is the relevant part (my stress):

Reducing reserves close to the lowest level that still corresponded to the flat portion of the reserve demand curve would be one approach consistent with the Committee's previously stated intention, in the Policy Normalization Principles and Plans that it issued in 2014, to "hold no more securities than necessary to implement monetary policy efficiently and effectively." However, reducing reserves to a point very close to the level at which the reserve demand curve begins to slope upward could lead to a significant increase in the volatility in short-term interest rates and require frequent sizable open market operations or new ceiling facilities to maintain effective interest rate control. These considerations suggested that it might be appropriate to instead provide a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve.

Well, if there were any doubts as to where the FOMC is leaning in this debate over operating systems this paragraph should put the doubts to rest. FOMC members apparently love their flat reserve demand curves. So much so, they cannot handle the imagined horrors of interest rate volatility under a corridor system.

Yes, the horrors of interest rate volatility in a corridor system. I mean, how can central banks like the Bank of Canada (BoC) impose such a cruel system on their financial system? How dare the BoC leave the peaceful sanctuary of a floor system and move to the interest rate jungle of a corridor system! Just look at the all the interest rate volatility they are imposing on the Canadian financial system.

Oh wait, the BoC corridor system actually looks okay. Yes, there is some interest rate volatility for the overnight repo rate relative to the BoC's interest rate target, but the repo rate stays well within the corridor bounds.

Maybe the FOMC means interest rate volatility in a corridor system compared to a floor system, like the one it runs. After all, the FOMC is a true believer in its own operating system. The FOMC did say in the minutes that the "efficient and effective implementation of monetary policy" most likely requires providing "a buffer of reserves sufficient to ensure that the Federal Reserve operates consistently on the flat portion of the reserve demand curve."

With such confidence in their own floor system, it must be that the FOMC members are indeed thinking of the interest rate stability in their system. Right?

Oops, maybe not. Overnight U.S. repo rates do not look so stable compared to Canada. Maybe the scales of the above figure overstate the volatility of repo rates in the United States? How about comparing the actual spread between the overnight repo rate and target rate for the two countries and their different operating systems?

Okay, maybe the corridor system is not so bad. Maybe the FOMC is thinking of a return to an asymmetric corridor system like the one that existed pre-2008. There might be more interest rate volatility in returning to that system, but most advocates of a move to corridor system--like George Selgin, Stephen Williamson, Bill Nelson, Peter Ireland, and myself--are not advocating such a move. Instead, we want a move to symmetric corridor system where the IOER pins down the lower bound and the discount rate anchors the upper bound.

Such a system can easily collapse into a floor system during a crisis, so the Fed could still have its desired flexibility if needed in a bind. Moreover, many other countries use some form of a symmetric corridor system. George Kahn of the Kansas City Fed has a great review of these experiences and the workings of these operating systems.

I am glad the FOMC is debating the future of its operating system. My hope is that Fed does not get blinded by its own experience with an asymmetric corridor system and instead looks elsewhere in the world for understanding how a symmetric corridor system can work.

A Risk Sharing View of Monetary Policy

noreply@blogger.com (David Beckworth) — Thu, 13 Dec 2018 03:41:00 +0000

I have a new working paper titled "Better Risk Sharing Through Monetary Policy? The Financial Stability Case for a Nominal GDP Target". I presented this paper at the recent Cato Monetary Policy Conference. Here is the abstract:

A series of papers have shown that a monetary regime targeting nominal GDP (NGDP)

can reproduce the distribution of risk that would exist if there were widespread use of state contingentdebt securities (Koenig, 2013; Sheedy, 2014; Azariadis et al., 2016, Bullard and DiCecia, 2018). This paper empirically evaluates this view by exploiting an implication of the theory: those countries whose NGDP stayed closest to its expected pre-crisis growth path during the crisis should have experienced the least financial instability. This paper constructs an NGDP gap measure for 21 advanced economies that is used to test this implication. The results strongly suggest that there is a meaningful role for NGDP in promoting financial and economic stability.

And an excerpt:

The key insight of Koenig (2013), Sheedy (2014), Azariadis et al. (2016), and Bullard and DiCecia (2018) is that in a world of incomplete markets where there is non-state contingent nominal contracting, an NGDP target can reproduce the risk distribution that would occur if there were complete markets and state contingent nominal debt contracting. An NGDP target, in other words, can make up for the lack of insurance against future risks that could affect debtors’ ability to repay their debt. Conversely, an NGDP target can also make up for the lack of insurance against potential returns a creditor might miss out on because their funds are locked up in a fixed-price nominal loan. Bullard and Dicecia (2018) show that this result holds even when the heterogeneity among debtors and creditors modeled approximates that of the actual income, financial wealth, and consumption inequality in the United States. They note this makes NGDP targeting “monetary policy for the masses.”

This paper uses what I call a 'sticky-forecast' of NGDP as a benchmark path. Here is the intuition for the measure:

The idea behind the sticky forecast path for NGDP is twofold. First, the public makes many economic decisions based on a forecast of their nominal incomes. For example, households may take out a 30-year mortgage based on an implicit forecast of their nominal income over this horizon. The actual realization of nominal income may turn out to be very different than expected, but the households may not be able to quickly adjust their plans given sticky debt contracts and other commitments that constrain them. Therefore, the consequences of previous forecasts are often binding on them and slow to change even if their nominal income forecasts have been updated. Second, in addition to these old forecasts and decisions whose influence lingers, new forecasts and new decisions are being made each quarter for subsequent periods that will also have lingering effects. Together, this means future periods have many overlapping and different forecast applied to them that only gradually adjust.

The sticky-forecast path of NGDP can be viewed, in other words, as the neutral level of NGDP given the public's expectations of nominal income leading up to each period. The gap between it and actual NGDP is the "NGDP gap" and provides a measure of the stance of monetary policy.

Here is a note that further explains its construction for the United States using quarterly data from the Survey of Professional Forecasters. The note also shows how the sticky-forecast measure can be used as cross-check on the stance of U.S. monetary policy. The figures below illustrate its use. The first figure shows the sticky-forecast path of NGDP along with the actual NGDP series.

This next figure show the NGDP Gap, the percent deviation between these two series. As noted above, this can seen as the stance of monetary policy. Interestingly, it provides results very similar to Taylor rules. The NGDP Gap indicates that currently the monetary conditions are still a bit tight, but close to neutral.

How Close is the Fed to a Corridor System?

noreply@blogger.com (David Beckworth) — Thu, 13 Dec 2018 03:20:00 +0000

I recently participated in an AEI event that showcased George Selgin's new book on the Fed's floor system. My role at the event was to comment, along with Bill Nelson, on George's book.

Readers of this blog will know I share many of George's concerns about the floor system that are outlined in his book and I would like to see the Fed move to a symmetric corridor system. The FOMC spent a good portion of its November meeting discussing this issue. My comments at the AEI event, however, were not on the tradeoffs between a corridor and floor system but rather on how close the Fed currently is to a corridor system. There are some indicators that the Fed may not be too far away.

To illustrate my point, consider the figures below. The question I considered is how far the Fed is from transitioning from the figure on the left below to the one on the right. Note, that there are two ways to make this move. First, the supply of reserves (red line) can shift back until it hits the slopping part of the reserve demand curve. Second, the demand for reserves (blue line) can shift out until the slopping part of the demand hits the reserve supply schedule. Or, there can be some combination of both developments. In either case, reserves become relatively scarce, unsecured interbank lending revives, and reserves once again will bear an opportunity costs.

In my remarks I noted that there have been both supply and demand shifts that have moved the Fed closer to a corridor system. (For more details on this simple supply-demand model see my recent paper.)

On the supply side, there has been a reduction in reserves going on since August 2014. Initially, the decline was largely due to the the growth of the Treasury General Account (TGA) and overnight reverse repos displacing reserves. Since October 2017 it also been the result of the Fed decreasing reinvestment of principal payments on its asset holdings. Collectively, these actions have led to a decline of about $1 trillion dollars in reserves over the past four years. Reserves are now just over $1.7 trillion. This can be seen in the figure below:

On the demand side, there have been new regulations and apparently a general rise in risk aversion that has led to a higher demand for reserves than existed before 2008. The main regulatory development is the liquidity coverage ratio (LCR) which requires banks to hold enough liquid assets to cover 30 days of withdrawals. The LCR treats bank reserves and treasuries as the top "high quality liquid assets" (HQLA) in meeting this requirement.

For most of the past decade, the IOER rate has been higher than that yield on overnight treasury repo rates creating an elevated demand for reserves to meet the HQLA. As seen below, however, this relationship has changed with measures of treasury repo rates bouncing around--and increasingly above--the IOER rate. As I have explained elsewhere, this is largely due to President Trump's budget deficits sharply increasing the supply of treasury bills.

This reversal in relationship should mean, all else equal, that that banks will be indifferent between holding bank reserves and treasury bills. However, the most recent Senior Financial Officer Survey indicates that even in this "constellation" of interest rates banks still want to hold a lot of reserves relative to the pre-crisis levels. Specifically, the banks indicate they would want to hold $617 billion in reserve balances. Now the survey only covers banks that currently hold two-thirds of bank reserves. Consequently, extrapolating this number out another third puts the total desired reserve balances at $927 billion. This implies a large rightward shift of the reserve demand curve compared to pre-crisis demand for reserves.

Given these developments, if the Fed continues to reduce its balance sheet by $50 billion a month then it should reach a point of reserve scarcity (i.e. $927 billion) by early-to-mid 2020. This can be seen in the figure below.

Put differently, the Fed could be back in a corridor system as early as 2020 if it were to put its balance sheet reduction on autopilot. Note that balance sheet would be permanently larger--even after accounting for currency or NGDP growth--at a size near $3 trillion.

Interestingly, the Senior Financial Officer Survey also indicates that if the Fed really wanted to shrink the supply of reserves to levels comparable to the pre-crisis system there is a way. All that is needed is for the price to be right.

Specifically, the survey asked the banks whether they would decrease their reserve holdings further if comparable short-term interest rates were to rise above IOER by 5, 25, and 50 basis points (bps). The percent of banks that answered yes were 8, 46, and 49 percent, respectively. So somewhere between 5 and 25 bps, there is a threshold were a large number of banks would find it worthwhile to depart with reserves and hold treasury bills. Everyone has a price.¹ Obviously, in this case the time to a corridor system would take longer as the reserve demand curve will have shifted inward.

The big takeaway, for me, is that the Fed may not be that too far away from a corridor system that maintains a moderately-sized balance sheet (owing to the residual demand for bank reserves). For reasons outlined in my previous post, however, I would prefer a return to a corridor system with fewer reserves and the Senior Financial Officer Survey suggests this outcome is possible.

P.S. Bill Nelson of the Bank Policy Institute had some really interesting comments at the event.

¹ What is really interesting about this finding is that Dutkowsky and VanHoose (2018) find in a theoretical model that banks would stop holding large amounts of excess reserves once the spread crossed 6 bps. This theoretical results fits nicely with the survey showing their is a threshold between 5 and 25 bps.

A New Paper on the Fed's Floor System

noreply@blogger.com (David Beckworth) — Tue, 27 Nov 2018 16:53:00 +0000

As readers of this blog know, I have an interest in the Fed's operating system. This interest has culminated in a new paper where I look at the consequences of the Fed moving from a corridor system to a floor system in 2008. In particular, the paper looks at what this change has meant for bank portfolios and, as a result, financial intermediation provided by banks. The paper concludes with some policy recommendations. I would also note that George Selgin has just released a new book on this topic. My hope is that these projects will help inform the conversation over what operating system the Fed wants as it continues to normalize monetary policy.

Paper Outline
So what does my paper have to say? It starts by laying out the standard arguments for a floor system:

The central idea behind this move was to remove the opportunity cost to banks of holding excess reserves by offering the banks a deposit rate at the Fed—the IOER rate—that was equal to or above short-term market interest rates. This favorable return was to sever banks’ incentive to rebalance their portfolios away from excess reserves toward other assets. The IOER rate was also to put a floor under short-term interest rates so as to align them with the Fed’s desired interest rate target. Together, these two facets of the floor system would allow the Fed to use its balance sheet as a tool of monetary policy while still maintaining interest rate control.

In this new operating system, the stance of monetary policy was no longer set by a market interest rate but by an administrative interest rate: the IOER rate. The stance of monetary policy also was no longer tied to the supply of reserves. Instead, it was linked to the quantity of reserves demanded by banks, which the Fed influenced through changes to IOER. Specifically, the Fed set the IOER rate high enough that banks’ demand for reserves became perfectly elastic with respect to the federal funds rate. As a result, changes in the quantity of reserves supplied led to identical changes in the quantity demanded, other things being equal.

The Federal Reserve, in short, went from an operating system in which monetary policy was transmitted through open market operations to one in which it is transmitted through the IOER rate. The Fed’s operating system changed from one in which money, in the form of reserves, mattered for monetary policy to one in which money has been “divorced” from monetary policy.

Okay, so why does this "divorce" matter? For advocates of a floor system the answer is simple:

This divorce from money is seen by many observers as the key advantage... because it gives the Fed the freedom to use its balance sheet independently of its desired interest rate target. The Fed, for example, can now sharply increase the supply of reserves in response to a liquidity crisis without causing a decline in its targeted interest rate.

Skeptics of the floor system, on the other hand, see this divorce as more problematic:

Others, however, see this divorce as creating an operating system that impairs the transmission mechanism of monetary policy... These observers’ understanding starts with the standard assumptions of a floor system. First, a floor system requires the IOER rate to be set at least equal to short-term interest rates. This removes the opportunity costs to banks of holding reserves and thereby keeps their demand perfectly elastic with respect to other short-term interest rates...

[This] can lead to a rebalancing of bank portfolios that causes the supply of loans to be lower than it would have been otherwise. Banks lend as long as the marginal cost of funding is less than the risk-free marginal return on bank lending. In the Fed’s floor system, the IOER rate sets the marginal funding cost. Consequently, by setting the IOER rate higher than other short-term interest rates, the Fed has raised the marginal costs of funding and narrowed the gap between these costs and the risk-free marginal return on bank lending. All else being equal, the narrowing of this gap implies a relative reduction in the supply of loans and therefore a relative decline in the money supply.

Are these worries merited? My paper provides an empirical look at bank portfolios before and after the advent of the floor system to see if (1) there have been big structural shifts in bank balance sheets consistent with the critics claims and (2) whether such shifts can be attributed to the Fed's floor system.

Empirical Evidence
On (1) I start with the following figure. It shows the share of bank assets allocated to loans and to safe assets (defined as the sum of cash, treasury, and agency asset holdings). Unsurprisingly, these series are almost mirror images of each other over both cyclical and structural time horizons. They tend to move in opposite directions during recessions--the grey bars--and over longer periods. At the advent of the floor system in late 2008, the loan share began declining as the safe asset share started rising. This change has been sustained and only recently has started reversing:

If we break the safe assets apart into its subcategories, we see that that this tight link has been historically driven by movements in treasury and agency investments corresponding with changes in the loan share. Since 2008, the driving force behind the tight link became cash not treasury and agency investments:

If we zoom in and use two scales, this apparent structural change is even clearer. Cash shares and loan shares become mirror images of each other:

Something big happened in 2008 that continues to the present that caused banks to allocate more of their portfolios to cash assets and less to loans. While the financial crisis surely was a part of the initial rebalancing, it is hard to attribute what appears to be 10-year structural change to the crisis alone. Instead, it seems more consistent with the critics view that the floor system itself has fundamentally changed bank portfolios allocation.

That takes us to question (2). The following figure shows the loan share of bank assets plotted against the spread between the IOER rate and the overnight dollar Libor rate. This IOER-Libor spread is negatively and strongly correlated with the loan share. This suggests banks invested less in loans when the relative return on bank reserves rose and vice versa.

Conversely, banks appear to have allocated more to cash assets with the IOER-Libor spread rose and vice versa:

The paper goes on to more carefully test these relationships using two-stage least squares regressions that control for endogeneity issues and other confounding influences. Moreover, the paper also provides a further breakdown of this relationship among foreign banks, large domestic banks, and small domestic banks. Collectively, the regressions point to a strong causal effect running from the IOER-Libor spread to the allocation of bank assets.

The Fed's move to a floor system, then, does seem to have influenced the amount of financial intermediation provided by banks to the private sector. The end of the paper provides some counterfactual exercises, including the following figure

This counterfactual shows the supply of bank loans would have been, at its peak, as much as $2 trillion higher in 2014. By mid-2018, with the IOER-Libor spread shrinking, it was closer to a $1 trillion shortfall. Now to be fair, other factors such as increased risk aversion, fintech, and new regulations also contributed to below trend growth in bank lending since the crisis. Still the evidence strongly suggest that financial intermediation to the private sector through banks declined because of the floor system.

Policy Implications

The Fed's floor system, in short, has caused banks to increase their investment in the Fed at the expense of investing in the private sector. The question, then, becomes whether the Fed is any better than banks in allocating this credit. Put differently, is the Fed as a financial intermediary--funding short and lending long--really providing a better financial service than would have been provided by the private sector financial firms? It is not obvious to me that the answer is yes.

What is obvious to me is that the Fed's floor system creates a whole set of other problems. First, as a profitable financial intermediary, the Fed is setting itself up for political shenanigans. Recall Congress taping into the Fed's capital surplus in 2018 and 2015. Though these transfers were relatively small and to some extent accounting gimmicks, they show how tempting a large, profitable Fed balance sheet can be to Congress. Second, the floor system effectively destroyed unsecured interbank lending. This market provided useful interbank monitoring and price discovery that no longer exists. Bringing this market-based monitoring back would be a nice addition to the bank regulator's existing toolbox. Third, the floor system forces the Fed to take safe asset collateral off the market which impairs other parts of the financial system. Only recently has President Trump's budget deficits begun to fill this hole. Fourth, the floor system can create bad optics for the Fed via the appearance of large 'subsidies' to large and foreign banks. In this era of populist politics, the Fed should be worried about the dangers to its independence this image could create. Finally, as noted above, I worry the Fed is a less effective financial intermediary than the private sector.

In short, I see the costs exceeding any benefits from the floor system. That is why I advocate a return to a corridor system, but this time with the IOER explicitly setting the lower boundary. That is, the IOER would still be around, but it would be set lower than overnight market interest rates. For the past decade it has been for the most part above them. More details are in the paper.

Update: I have had several commentators ask me about the difficulty of returning to a corridor system given the relatively new LCR. Let me quote Governor Randy Quarles from a recent speech:

How banks respond to the Fed's reduction in reserve balances could, in theory, take a few different forms. One could envision that as the Fed reduces its securities holdings, a large share of which consists of Treasury securities, banks would easily replace any reduction in reserve balances with Treasury holdings, thereby keeping their LCRs roughly unchanged. According to this line of thought, because central bank reserve balances and Treasury securities are treated identically by the LCR, banks should be largely indifferent to holding either asset to meet the regulation. In that case, the reduction in reserves and corresponding increase in Treasury holdings might occur with relatively little adjustment in their relative rates of return.

In other words, since reserves and treasuries are viewed as equal HQLA there could be a substitution between the two as the Fed shrinks its balance sheet down. Quarles notes that currently some banks favor reserves, but that tells us nothing about what is ideal or what would transpire in a new symmetric corridor system. Finally, it is also worth noting that banks can use Treasuries, but not reserves, as collateral for repos. Manhoman Singh is very good on that point. So Treasuries can actually make banks more liquid that non-hypothecatable reserves.

P.S. Here is a panel from the recent Cato Monetary Policy Conference on this issue. Great comments from Stephen Williamson, George Selgin, and Peter Ireland. Josh Zumbrum was the moderator.

Janet Yellen on NGDPLT

noreply@blogger.com (David Beckworth) — Mon, 26 Nov 2018 23:15:00 +0000

Andrew Metrick of Yale University interviewed former Fed Chair Janet Yellen today. It was an interesting discussion and one where they talked about, among other things, what changes the Fed could bring about in light of the recently announced strategies, tools, and communication review to be held in 2019. Janet Yellen said her idea for reform "has much in common with NGDP targeting". Her response can be seen in the video below:

Glad to see her endorse a NGDPLT-like monetary regime.

"Et tu, John Williams?"

noreply@blogger.com (David Beckworth) — Tue, 02 Oct 2018 20:44:00 +0000

Tim Duy reports that r-star, which rose to prominence over the past few years, is experiencing a Caesar-like betrayal at the Fed:

The Federal Reserve’s “r-star” has gone full supernova. New York Federal Reserve President John Williams, its key proponent, made clear in a speech late Friday that the neutral interest rate is no longer a guiding star for monetary policy. This means a federal funds rate in the range of what is considered neutral has no special significance as far as policy is concerned...

Williams’s attachment to r-star cannot be overstated. At a professional level, it has been a key element of his research agenda. As recently as May he said that for “the moment, r-star continues to shine brightly, guiding monetary policy, but hold steady, low on the horizon.” The moment quickly passed. Last week, he tossed aside the metric, saying that it has “gotten too much attention in commentary about Fed policy.” A remarkable shift after just two 25-basis-point rate increases since his May comments...

Williams’ speech marks the end of a transition in policy away from explicit forward guidance. It began this past August with Fed Chairman Jerome Powell’s Jackson Hole speech in which he noted the uncertainty surrounding estimates of key variables like the neutral interest rate. Fed Governor Lael Brainard pushed this point further in a subsequent speech, adding further uncertainty by differentiating between short- and long-run neutral. It continued in the September Federal Open Market Committee statement with the removal the description of policy as “accommodative.” And it ends with the primary proponent of the r-star concept — Williams — throwing it into the trash bin of crisis-era policy artifacts.

One is tempted to say "It was good knowing you r-star". However, r-star will still be around in all the models used by the FOMC and Fed staff. Just look at, for example, the policy rules on the Board of Governor's website or in its annual report. The reported change, as I see it, is more a move toward less explicit reliance on it. Implicitly, r-star will still be important to an FOMC that relies on the Phillips curve thinking in making its decisions.

Still, these developments do indicate there is some movement towards looking at other indicators as I noted in recent post. There I suggested one useful metric the FOMC could add to its lists of monetary policy indicators is the gap between a stable benchmark growth path for nominal GDP and its actual value. I outlined in this note several ways to create this metric and note that it is in the spirit of a NGDP level target without actually adopting one.

There are many reasons for the Fed to start following the NGDP gap. The most practical one is its ability to help the FOMC avoid falling for the inflation head fakes created by supply shocks. Here is hoping that out of the ashes of r-star's apparent demise arises an increased desire by the FOMC to pay attention to the NGDP gap.

FOMC Preview: "We Have the Nerve to Invert the Curve"

noreply@blogger.com (David Beckworth) — Fri, 21 Sep 2018 17:22:00 +0000

The quote in the title should be the motto for the 2018-2019 FOMC. For the FOMC is set to raise its interest rate target next week and expected to raise it several times more in 2019 despite a flattening treasury yield curve.

As seen in the above chart, the outright inversion of the treasury yield typically leads to a recession. Despite this robust pattern, a growing number of Fed officials have become emboldened in their dismissal of it "since this time is different." As Caroline Baum notes,

In April, John Williams acknowledged that an inverted yield curve is “a powerful signal of recessions,” based on a significant body of research, including that by staff economists at his former bank.

By September, Williams was already disavowing that signal. “I don’t see the flat yield curve or inverted yield curve as being the deciding factor in terms of where we should go with policy,” Williams said following a speech in Buffalo on Sept. 6.

Next up was Fed Gov. Lael Brainard. She broke new ground in a speech last week when she... invoked the four most dangerous words in finance — “this time is different” — and applied them to the prospect of an inverted yield curve.

To be fair, President John Williams and Governor Lael Brainard are simply expressing the natural implications of the FOMC projected path for interest rates. As I noted before, the FOMC's own summary of economic projections implies a yield curve inversion over the next year or so. The FOMC, in short, is becoming increasingly dismissive of fears about inverting the yield curve. That is why the title of this post should be their motto for 2018-2019. Here is a t-shirt you can buy to commemorate this surge in FOMC boldness:

Some observers side with Fed officials arguing that "this time is indeed different" because the term premium is so low. To that I would first remind them that former Fed chair Ben Bernanke made a similar argument in 2006. As it turned out, the term premium had declined but so had the expected path of short-term interest rates. This can be seen in the figure below, which is constructed using the New York Fed's estimates of term premiums. It shows the 10-year minus 1-year treasury spread decomposed into (1) an expected rate path spread and (2) a term premium spread. These two component add up to the overall spread. The lesson here for the FOMC is to avoid falling for the siren call of the term premium excuse.

I would also remind naysayers that even if it were the case that the flattening of the yield curve is all due to a lowering of the term premium, the inverting of the yield curve still matters for financial intermediation. An inverted yield curve means smaller net interest margins for financial firms and thus less financial intermediation. That is, once the yield curve inverts, it goes from being a predictive tool to a causal agent. So even in the best-case scenario, one should not be cavalier about inverting the yield curve. Be careful FOMC.

P.S. Here is the backside of the t-shirt: