## Tuesday, August 31, 2010

### More on Deflation Traps

This is a reply to a comment on the previous post, but I thought I would just post another entry. There are two equations here determining a steady state nominal interest rate R and an inflation rate, p. They are, first, a Taylor rule:

R = a(p-p*) + r + p,

where a > 0 is a parameter, p* is the target inflation rate, and r is the long-run real interest rate, assumed constant. The other equation is the long-run Fisher relation,

R = r + p.

Now, all this tells us is that there is one steady state, where p = p*. However, we really want to account for the zero lower bound on the nominal interest rate, so write the Taylor rule like this:

R = max[0,a(p-p*) + r + p].

Now, just as in Bullard's picture (though he has a nonlinear Taylor rule instead of this piecewise linear one), there are two steady states. In one, we have p = p* and R > 0, and in the other we have p = -r and R = 0. The second steady state is the Friedman rule steady state. Benhabib et. al. supply the dynamics, and the examples with optimizing models. Krugman is making up some dynamics, but maybe he can supply us with the details.

Of course, baseline monetary theory, from Friedman's optimum quantity of money essay on tells us the Friedman rule steady state is optimal, and the Taylor-rule central bank should set p* = -r, and you'll get one steady state. An important point is that something has to be going on in the background to support the Friedman rule steady state. For a serious look at this problem see this. One condition you require is that the money stock go to zero in the limit as time runs off to infinity. From a practical policy point of view, I think we can agree that the Fed is committed to not having that happen.

An important policy question is what p* should be. New Keynesians say it should be closer to zero, if not zero, to eliminate sticky price frictions. There may be other good reasons (taxing currency transactions) for having a positive inflation rate, maybe even 2%, as the Fed seems to think is a good idea.

### Deflation Traps

Here's a Krugman post about deflation. Early on he says this:
Now, at this point any Taylor rule fitted to past Fed behavior says that the Fed funds rate should be something like minus 5 or 6 right now, but you can’t do that, so we’re stuck with an interest rate that’s too high given low inflation and very high unemployment.
I wish people would stop making the argument this way. If your model is a New Keynesian one, as seems to be the case here, and you are thinking about policy in terms of a Taylor rule, you better take account of the fact that there is a zero lower bound on the nominal interest rate. If the rule is telling you that the fed funds rate should be minus 5 or 6, you have the wrong rule.

Roughly, the rest of Krugman's argument hangs on this:
The crucial thing to understand about this position is that it’s not self-correcting. On the contrary, as inflation falls over time and possibly goes to actual deflation, we sink deeper into the trap.
Now he's just making it up. "As inflation falls over time..." Why? How? Then he qualifies it ("...possibly goes to actual deflation"). Is that high probability or low probability? Can you put a point estimate on that, with a confidence interval? Why do you get trapped? If Krugman knows, he should lay this out for the rest of us so we can evaluate it.

A crucial element in this is what happens to the quantities, in particular the ones on the Fed's balance sheet, as this process unfolds. New Keynesians wanted to ditch monetary quantities from their models, in part because this made things simple, and so they could focus on what they thought was important, principally the welfare losses from sticky price frictions. Contributing to that was the failure of Old Monetarism, principally due to instabilities (over virtually any horizon) in "money demand" functions.

However, the financial crisis caught many people with their pants down, unfortunately. The New Keynesians are trying to rectify that by getting monetary quantities and financial factors back in their models. Of course the Real Business Cycle people had their pants down too - it's as dangerous to put all your eggs in the TFP basket as it is to put them all in the sticky price basket.

Here, I construct what I think is a plausible future scenario for future Fed policy, and I can't convince myself that sustained deflation can happen. If you think it is likely, you need to explain (carefully) why financial institutions, and everyday Joes and Marthas, will continue to hold \$2.3 trillion in outside money which is appreciating in real terms, and not somehow use the stuff in transactions, thus causing inflation. And the answer can't be "Japan."

## Monday, August 30, 2010

### Speechmaking

Narayana Kocherlakota, 9th Federal Reserve District President, gave a speech, posted here, which I originally commented on here. He's speaking to an audience of Upper Peninsula business people, and he treats them with respect. Narayana uses the opportunity to explain Fed policy to his audience, to teach them some economics, and to say something to the wider community (us) by posting the speech on the Minneapolis Fed website. The speech is quite comprehensive, touching on all the current monetary policy issues and, as it should, it brings to bear all the relevant macroeconomics we know to address the issues. Some of this theory is sophisticated, but Narayana does a good job of bringing this down to a level where a lay audience should be able to get most of it. We have Irving Fisher, search and matching theory of unemployment, New Public Finance, etc., all rolled into a coherent whole. We have come a long way. William McChesney Martin could not have pulled this off, and neither could Alan Greenspan.

Now I think the Invisible Hand got things right when she/he/it made Narayana Kocherlakota, Jim Bullard, and Jeff Lacker (for example) Fed Presidents, and sent Paul Krugman, Brad DeLong, and Mark Thoma off to the blogosphere. Brad wouldn't get far with Cargo Cults at the FOMC meeting (The Chairman: Thanks for sharing, President DeLong. Now on to more important matters. Who used up all the paper towels in the 3rd Floor wc, causing me to wipe my hands on my pants?). I'm done with the Kocherlakota speech. If you have more questions about it, please ask Narayana for help.

## Sunday, August 29, 2010

Yes, I can picture you out there drumming your fingers on the desk. I thought I had said my piece and was ready to move on. However, I'll take a stab at this if you promise to be nice.

(i) Kocherlakota says this:
Monetary policy does affect the real return on safe investments over short periods of time.
This seems uncontroversial. He is recognizing that there are short-run nonneutralities of money - tight monetary policy can make the real rate of interest go up. Then he says:
But over the long run, money is, as we economists like to say, neutral. This means that no matter what the inflation rate is and no matter what the FOMC does, the real return on safe short-term investments averages about 1-2 percent over the long run.
Again, uncontroversial. You can quibble about super-nonneutralities here, but I think the consensus is that, for the types of changes in rates of long-run inflation we are talking about here, those effects are small. Then he says:
Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative.
This seems to be what set everyone off. This is a statement about the long run. My interpretation of this is that this is just Irving Fisher. What does it mean to "maintain the fed funds rate at its current level?" Some people seem to think the Fed can't do this. Krugman and a number of other people cite Wicksell, and argue that it's impossible. My reading of the implications of Wicksell (and remember that Wicksell expressed himself in words, not math, so he's hard to interpret) is that the Fed cannot peg the real rate forever. Friedman said something like this too, but I don't have the quote. I know that there are issues about nominal interest rate policy rules and determinacy. However, Woodford thinks he solved those problems. I replied to most of the comments I had time for, or could understand. Some people had what I thought were confused notions of equilibrium. In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe - I looked up Benassy and he is still hard at work. However, most of the mainstream - and here I'm including New Keynesians - sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don't have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it's not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with "disequilibrium." In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.

Anything else I can do for you?

### More-Than-Ever Worked Up About Nothing

I missed some of this stuff, as I try not to read DeLong's blog, for fear of depreciating my human capital. Here's a Krugman post, and a DeLong post relating to this. Having a rational discussion with these guys is something like having afternoon tea with a couple of hyperactive ferrets.

Here's what I said in response to a commenter:
This is a long-run proposition. I know it's confusing. Tighter monetary policy, in the short run, raises nominal interest rates. Ultimately, the lower monetary growth as the result of tightening leads to lower inflation and lower nominal interest rates over a longer horizon. Look at what happened after the Volcker tightening. Nominal interest rates went up, then they came back down again as the inflation rate fell. In the short run, there is a "liquidity effect" whereby tight monetary policy tends to increase the nominal interest rate. In the long run, what dominates is the "Fisher effect" whereby an inflation premium gets built into the nominal interest rate.
That's pretty much what Krugman and DeLong seem to be trying to say. What's all the heat about?

(typo corrected)

## Saturday, August 28, 2010

### More Thoughts on Bernanke's Speech

I was in the Whole Foods store buying eggplant and thinking about Ben Bernanke. That has to be weird on some dimension. Bernanke, in his speech was talking about the recent announced change in Fed policy, which was to replace MBS (mortgage backed securities) that are running off the Fed's balance sheet with long-term Treasuries. Here's his explanation:
However, more recently, as the pace of economic growth has slowed somewhat, longer-term interest rates have fallen and mortgage refinancing activity has picked up. Increased refinancing has in turn led the Fed's holding of agency MBS to run off more quickly than previously anticipated. Although mortgage prepayment rates are difficult to predict, under the assumption that mortgage rates remain near current levels, we estimated that an additional \$400 billion or so of MBS and agency debt currently in the Fed's portfolio could be repaid by the end of 2011.

At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome.
Now, as an example, suppose that \$100 billion in MBS run off because people are refinancing their mortgages. Then, suppose that the new mortgages these people take out are sold to Fannie Mae, which holds them, and finances the purchases by issuing \$100 billion in agency securities. What has changed? The private sector is now holding \$100 billion less in reserves, and \$100 billion more in agency securities. Both of these types of securities are effectively obligations of the (consolidated) federal government. Furthermore, the reserves (under current conditions) are the same as T-bills. Bernanke says that this involves an "implicit tightening." Why? This is of course the key to the whole "quantitative easing" program. The Fed thinks that shortening the average maturity of federal debt obligations in the hands of the private sector is somehow expansionary. Thus the policy action the Fed just announced: we undo the "implicit tightening" by having the Fed buy \$100 billion in long-term Treasuries. Now, reserves are unchanged, and this is just a swap of \$100 billion in agency securities for \$100 billion in Treasuries, and those assets are essentially identical.

On my last post, Jordan sent me a link to a finance paper by Vayanos and Vila, which is a start in thinking about segmented markets, preferred habitat, and the term structure of interest rates. What I am wondering about is the following. By issuing reserves and holding long-term Treasuries, the Fed is intermediating across maturities. Of course there is an array of private intermediaries who do the same thing, including banks and bond mutual funds. If the Fed can change market asset prices by issuing short maturity liabilities and buying long maturity assets, it must be that the Fed has some cost advantage over the private sector in this type of intermediation. Outside of the circumstances of the financial crisis, what would that advantage be?

Now, go one step further. Suppose the Fed has such an advantage. What this says is that the Treasury somehow got things wrong. It issued debt of too long a maturity. But why not have the Treasury fix their own problem then. The Treasury could issue T-bills and buy up existing long-maturity debt. Now go one step further. If this is such a great idea, why doesn't the Treasury issue only T-bills on a regular basis?

### Bernanke at Jackson Hole

Bernanke's Jackson hole speech is quite interesting, though the poor guy doesn't seem to be relaxing in the mountains. There is a photo of him in the New York Times with Kohn, who looks a little dressed-down, but Bernanke is in the regular suit-and-tie mode.

Here are the interesting parts of the speech (at least for me). On why Fed purchases of long-term debt matter:
The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
"Porfolio balance channel" is reminiscent of Tobin's "A General Equilibrium Approach to Monetary Theory," (JMCB 1969), and the rest is basically a market segmentation story. This is not much to go on, but of course serious modern dynamic financial economics has not delivered much that is usable here for a central banker. I think any effects we might get from changes in the maturity structure of the Fed's Treasury holdings have more to do with the effects on liquidity premia at different maturities, due to the fact that Treasuries of different maturities play different roles in financial market exchange and as collateral. Actually, later in his speech, Bernanke says something consistent with that, which is
...such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high.
Now I think we are getting somewhere.

A second issue has to do with what happens if the Fed reduces the interest rate on reserves, say to zero. Bernanke says:
A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System. Inside the Fed this rate is known as the IOER rate, the "interest on excess reserves" rate. The IOER rate, currently set at 25 basis points, could be reduced to, say, 10 basis points or even to zero. On the margin, a reduction in the IOER rate would provide banks with an incentive to increase their lending to nonfinancial borrowers or to participants in short-term money markets, reducing short-term interest rates further and possibly leading to some expansion in money and credit aggregates. However, under current circumstances, the effect of reducing the IOER rate on financial conditions in isolation would likely be relatively small. The federal funds rate is currently averaging between 15 and 20 basis points and would almost certainly remain positive after the reduction in the IOER rate. Cutting the IOER rate even to zero would be unlikely therefore to reduce the federal funds rate by more than 10 to 15 basis points. The effect on longer-term rates would probably be even less, although that effect would depend in part on the signal that market participants took from the action about the likely future course of policy. Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed's purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.
What is weird here is the focus on the fed funds rate, as if that is what matters. Suppose the Fed reduces the IOER rate to zero. I think what he is saying is that the fed funds rate will still be positive, since there is some risk premium associated with lending on the fed funds market (all unsecured). But so what? The important thing is that a lower IOER reduces the incentive of banks to hold reserves (not by much of course by going from 0.25 to 0). We don't really care what the fed funds rate is when there is a positive quantity of excess reserves in the system. The Fed also should not care whether or not the fed funds market is active. Presumably most of the current activity in the fed funds market is just Fannie Mae and Freddie Mac lending overnight (because they do not receive interest on their reserve accounts) to other market participants (who do). Maintaining that activity is somehow important to monetary policy? Baloney.

## Friday, August 27, 2010

### What Happened to Coordination Failure Models?

In the 1980s, there was a Keynesian research program using coordination failure models. Early on there was John Bryant's model, and Peter Diamond has a neat search model with multiple equilibria. Russ Cooper worked on this too. People took those ideas, and what was known about sunspot equilibria, and developed dynamic models with intrinsic aggregate uncertainty, that in some forms (I'm thinking of work by Farmer and Guo, for example) could replicate features of the data. Woodford did some work in this literature, as did Benhabib, and others. Those were coherent market-clearing competitive general equilibrium models that, one could argue, captured ideas in Keynes's General Theory. One could not only fit the models to data, but extract features that could in principle be used to argue for or against their empirical plausibility. Why did that stuff get shoved aside in favor of the New Keynesian sticky-price model?

### New Keynesian Models

Mark Thoma tells us here why he thinks "economists rejected flexible price models." Of course, the models were never "rejected," but New Keynsians have been very successful with central bankers, and in shaping the research program in macroeconomics for the last 10 years or more. This really has nothing to do with empirical evidence. Smets-Wouters and Christiano-Eichenbaum-Evans medium-scale models fit the data, but there are so many bells and whistles and shocks in these models that this seems no more than data description. New Keynesian economics is succesful, because Mike Woodford has been a brilliant salesman. The approach is sold as a synthesis, meant to be inoffensive to the hard-core Prescott RBC people and to old-school Keynesians alike. Nobody's human capital depreciates with the adoption of the New Keynesian synthesis, and policymakers can keep doing what they have been doing, with Mike's seal of approval.

An expansion of these ideas, and a description of the alternative can be found here, in a piece I wrote with Randy Wright for the St. Louis Fed Review, and here, in our forthcoming Handbook of Monetary Economics chapter. Both are a little on the long side, but you can pick and choose.

Let's go through this morning's Krugman NYT column.

First point:
The important question is whether growth is fast enough to bring down sky-high unemployment.
It's not that simple. Clearly, particularly given the downward revision of second-quarter real GDP growth from 2.4% to 1.6%, it will take a very long time (see here) for the US economy to return to its long-run growth path, if it ever does. If we think that, at the point where we're back on the long-run growth path, the US economy looks like it did before the recession, this tells us we have high unemployment for a very long time. However, one interpretation of recent evidence on the unemployment/vacancies relationship (see here) is that there is an unusual degree of mismatch in the labor market - the unemployed don't live in the places where the vacancies are, and may not have skills that match well with what firms want. As further evidence, look at labor market behavior in Canada, where the real GDP path through the recession is fairly similar (though the recovery is somewhat stronger). In the US, our mismatch problem is not only making the unemployment rate high - it's making GDP low. How long this matching process takes to work itself out, or what policy might do about it are questions I hope people (who know more than I do about labor markets) are studying.

Next:
After its last monetary policy meeting, the Fed released a statement declaring that it “anticipates a gradual return to higher levels of resource utilization” — Fedspeak for falling unemployment. Nothing in the data supports that kind of optimism.
What's in the Fed statement is pretty bland. They're hardly sticking their necks out, and I wouldn't call it "optimistic." It's rather bold to say there is nothing in the data that could support what they are saying.

Now, we know where this is going.
Why are people who know better sugar-coating economic reality? The answer, I’m sorry to say, is that it’s all about evading responsibility.

Then,
So what should officials be doing, aside from telling the truth about the economy?
Note that, Ben Bernanke. Krugman just called you a liar.

We'll stick to the monetary policy part. Krugman's recommendation is:
The Fed has a number of options. It can buy more long-term and private debt; it can push down long-term interest rates by announcing its intention to keep short-term rates low; it can raise its medium-term target for inflation, making it less attractive for businesses to simply sit on their cash.
(i) The Fed's portfolio of Treasuries already consists mainly of long-maturity debt. If the Fed bought more, it would simply be swapping reserves for long-maturity Treasuries. As the system is already swamped with reserves, this would do essentially nothing. (ii) The Fed is currently holding in excess of \$1 trillion of mortgage-backed securities. This purchase of private assets was controversial, as it threatens the Fed's independence, and the public perception of its role. While one might make a case for such an intervention on emergency grounds, this should not be considered a standard instrument in the Fed's toolbox. Further, at best this type of intervention simply replaces private intermediation with Fed intermediation, and at worst it reallocates credit from productive investment to housing. (iii) The Fed has already announced (over and over) its intention to keep rates low "for an extended period." What more can they do? (iv) Raising the "medium term target for inflation" is redundant. The Fed has to take some action - buying or selling some class of assets, or changing the interest rate on reserves - or announce future actions, to effect a change in the inflation rate. We've already covered all of that stuff.

Here's a fiscal policy recommendation:
It [the administration] can use Fannie Mae and Freddie Mac, the government-sponsored lenders, to engineer mortgage refinancing that puts money in the hands of American families
Remember how we got into this mess? Fannie and Freddie are not the solution to anything. They are a big part of the problem.

Conclusion:
It’s time to admit that what we have now isn’t a recovery, and do whatever we can to change that situation.
Well, it certainly does stink, especially if you are unemployed. However, on the monetary policy front, the Fed has already pulled out all the stops, and done whatever it can do, in an unprecedented fashion. This is one of those cases where you just can't squeeze blood from a stone, and that's true in more ways than one.

## Wednesday, August 25, 2010

### How to Get Worked Up Over Nothing

Have at look at this:

1. Krugman.
2. Rowe
3.Harless
4. Thoma

Is there something in the water, or did these guys sit through some funny macro classes? What they are objecting to in Kocherlakota's speech is one of the most innocuous things he said. Here's the simplest example I know. Suppose a cash-in-advance model with a representative consumer, period utility u(c), discount factor b, constant aggregate endowment y. c is consumption. The consumer needs cash to buy c each period. Suppose y is a fixed quantity of output received by a firm, which is sold for cash within the period, and then the cash is paid as a dividend to the consumer at the end of the period. Have the money stock grow at a constant rate m. The real interest rate is constant at 1/b -1. The nominal interest rate is (1+m)/b - 1, and the inflation rate is m. Constant m implies a constant nominal interest rate and a constant inflation rate. If m < 0, there is deflation, and the nominal interest rate is sufficiently low to support the deflation. I can think of the instrument the central bank sets as either the money growth rate or the nominal interest rate - that part is irrelevant. This type of result holds in virtually all monetary models, though of course sometimes the real rate may depend on the inflation rate. That's not a big deal though. What's the problem?

### The Fed's Balance Sheet, Deflation, Etc.

I've been puzzling over two key current policy questions: (i) Does a change in the maturity structure of the assets held by the Fed matter? (ii) Is sustained deflation possible in the United States in the near future? In answer to the first question, I'm beginning to think that the answer is yes, and I'll explain why. For the second question, I've explained before (here and here) why I think the answer is no. I'll expand and modify that view here.

The Fed's Balance Sheet
Let's start with the current composition of the Fed's balance sheet, posted here. On the asset side, of a total of \$2.3 trillion, \$780 billion are US Treasuries, \$157 Billion are agency securities (Fannie Mae and Freddie Mac obligations), \$1.113 trillion are mortgage-backed securities (MBS, backed by conforming loans), and the remaining \$250 billion is what remains of the emergency credit programs instituted after the Lehman Brothers failure plus assets acquired from Bear Stearns and AIG.

These asset holdings are financed, on the liabilities side, by \$947 billion in currency outstanding, \$1.039 in reserve balances, with the largest component of the remainder (something more than \$300 billion) being primarily deposits of the US Treasury with the Fed.

If we compare the current Fed balance sheet to what it was on January 2, 2008, what's the difference? First, in this table, note that the total quantity of Treasury securities held relative to August 10 of this year is only about 5% smaller. The composition of Treasury securities is quite different though. At the beginning of January 2008, about 30% of Treasuries held were T-bills, but these holdings are now mainly long-maturity nominal T-bonds. On the liabilities side, in the following two charts I show total currency outstanding and reserve balances. As we all know, pre-crisis the Fed financed most of its portfolio with currency outstanding; currently more than half of the Fed's liabilities are reserves. Further, currency has recently been growing at a steady pace of about 4%, year-over-year. We shouldn't forget the Treasury's deposits with the Fed, which are signficantly larger than was the case pre-crisis. These deposits, about \$200 billion in a "supplemental financing account" we could think of as a convenient accounting gimic which allows the Treasury to intervene in the mortgage market without having this show up on the Treasury's books in an obvious way.

Now, part of the Fed's "quantitative easing" program has been the dramatic shift towards long-maturity assets. One can certainly question the wisdom of private asset purchases (MBS) by the central bank, but let's focus on the Treasury holdings. Clearly policymakers in the Fed (e.g. Jim Bullard) and some empirical work in the Fed system (e.g. Chris Neely's work) support the view that purchases of long-maturity assets by the Fed matter. Why would it make any difference if the Fed swapped T-bills for long-maturity Treasuries? Certainly, in a complete-markets world, this cannot matter - indeed in such a world we would not need the Fed, currency, or banks, so we obviously need to depart from that paradigm. However, one can still derive irrelevance results for monetary policy in models with frictions, for example see this paper by Neil Wallace. However, suppose that we think about the "liquidity yield" on assets, i.e. their value in transactions. Clearly, T-bills have a high liquidity yield - they are used as collateral in a wide array of financial transactions, for example, and are traded frequently. T-bonds have a low liquidity yield. Now, what happens if the Fed swaps T-bills for T-bonds? T-bills are now less scarce relative to the transactions in which they are useful, so we might expect their prices to fall. However, under current circumstances where, with a positive stock of excess reserves, short-term interest rates are essentially determined by the interest rate on reserves, we would not expect anything to happen at the short end of the yield curve. What about the long end? With a larger supply of liquid assets on hand, maybe long-maturity bondholders demand a lower premium to hold long Treasuries, and their yields fall.

This is actually fairly straightforward. It's no more sophisticated than the reasoning that tells us that a standard open market purchase matters - we are trading a highly-liquid asset for a less-liquid one. To the extent that any theory is brought to bear on why the Fed could currently reduce long bond rates through intervention, people have appealed to vague "preferred habitat" stories. I prefer my story, but of course I have no empirical evidence, and only a vague idea what the model would look like that would deliver this result.

Now, was what the Fed did a good idea? We could argue yes at least for the early stages of the crisis. The MBS that, pre-crisis, were used widely as liquidity in financial markets, essentially went away and had to be replaced by T-bills. It made sense for the Fed to, at least temporarily, restructure its portfolio toward long-maturity assets. One could argue that this replaced public liquidity with private liquidity, and was efficient. Would be a good idea to keep this maturity structure in place or for the Fed to buy more long-term Treasuries. That's more questionable. Maybe the need for this is long past.

Deflation
I argued here that we should not be worried about deflation. In part, this was a backward-looking argument, based on the behavior of the stock of currency, along with observations about the implied inflation premium on long-term Treasuries. Now, if you have been watching bond yields recently, you will have observed two things: (i) The yields on both nominal Treasuries, and inflation-indexed Treasuries (TIPS) have both fallen; (ii) The difference in those yields (a measure of the inflation premium on long Treasuries) has also fallen. This may reflect the view of the market that, given the last Fed statement, and public statements by Jim Bullard, among others, the Fed knows something the market cannot see directly, which is that inflation is going to be much lower for an extended period, if not negative.

In this case, I agree with Kocherlakota, that the market has it wrong. As Kocherlakota argued, most of our monetary models tell us that, if the Fed maintains a constant nominal interest rate target forever, that will essentially determine the inflation rate, by way of the Fisher relation. If the Fed keeps the short-term overnight rate at 0.25% forever, and if the long-run real interest rate is 2%, the inflation rate must be -1.75%, which would be supported (roughly) by long-run growth in some monetary quantity of -1.75% plus the long-run growth rate in real GDP.

This makes deflation seem like a real possibility if the Fed maintains a target nominal interest rate of 0.25% for an "extended period," as specified in the FOMC statements since all the trouble started. However, consider this. Suppose, as seems to be implied by the last FOMC statement, that the Fed intends to hold the size of the balance sheet constant, in nominal terms, for the immediate future. Suppose that what they mean by this is that the balance sheet will remain constant until the stock of excess reserves "runs off," at which time we will go back to a "normal" policy regime. By normal policy, I mean an implicit inflation target of 2% supported by a nominal fed funds target, recalibrated at each FOMC meeting.

Now, what happens between now and the time at which excess reserves go to zero? Suppose over that period that the interest rate on reserves (the relevant policy rate when excess reserves are positive) stays at 0.25%. Suppose that the inflation rate over that period is 2% and that real GDP grows at 3%. Also suppose that the quantity of currency relative to nominal GDP is constant, implying that the stock of currency outstanding is growing at 5% per year. At this rate, excess reserves will run off in about 18 years. By that time, the majority of the MBS on the Fed's balance sheet will have disappeared, and the Fed will be back to having mainly Treasuries in its portfolio. Could this be an equilibrium path for the economy? Well, given what I specified here, it seems unlikely that banks will wish to hold excess reserves for 18 years given a real return of -1.75%. Somewhere in that 18-year period, the Fed will have to raise the interest rate on reserves, otherwise the stock of currency will be growing in excess of 5% per year, and the inflation rate will rise above 2%. Thus, if anything, the inflation risk appears to be on the up side, given stated policy. I don't see the deflation risk.

## Sunday, August 22, 2010

### PK Froths

Here's PK's morning blog entry. The second paragraph is:
Yet from late 2009 until just the other day, all the Very Serious People were mainly concerned about the possibility of surging interest rates. Why?
Who are all these "Very Serious People?" It's not clear. There is a link to an article in Forbes, then he picks on Kocherlakota. Apparently PK doesn't like this part of Narayana's speech. :
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation. The good news is that it is certainly possible to eliminate this eventuality through smart policy choices. Right now, the real safe return on short-term investments is negative because of various headwinds in the real economy. Again, using our simple arithmetic, this negative real return combined with the near-zero fed funds rate means that inflation must be positive. Eventually, the real economy will improve sufficiently that the real return to safe short-term investments will normalize at its more typical positive level. The FOMC has to be ready to increase its target rate soon thereafter.

That sounds easy—but it’s not. When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation.

While this scenario is conceivable, I consider it to be a highly unlikely one. The FOMC and the Board of Governors have displayed exactly the required unconventionality in solving many seemingly intractable problems over the past three years. I am confident that the Federal Reserve will display that same attribute if this deflationary challenge should ever arise. I am sure too that households and financial markets will share my confidence—which would actually eliminate the need for the Fed to ever confront hardened deflationary expectations.
Now, this seems quite unobjectionable. The reasoning is good, and Narayana is doing the best he can to articulate this so that a lay audience can understand it - though they probably still had some trouble with it I'm sure.

Then Krugman finishes with this:
And though the story shifts, the moral is always the same: the little people have to suffer.
Of course this is just the standard Krugman narrative. (i) Set up a straw man. (ii) Beat him to death. (iii) Characterize the fight as the morally-upright PK battling the Very Serious People for the cause of the poor little people.

What we need here is something more constructive. Try to get beyond these vague calls for more Econ-101-type Keynesian intervention. Help us figure out what exactly (if anything) is ailing the economy. Show us how policy can solve the problem. Be specific. Address all the risks involved. Be more subtle.

## Friday, August 20, 2010

### Mr. K #2

Now that I've dealt with Mr. K #1 (i.e. NK), I can go to Mr. K #2 (i.e. PK). If you are into predicting Krugman behavior, you could probably guess what Krugman would be writing in response to the recent reduction in Treasury yields, and that is today's NYT column.

It's a colorful world that Krugman lives in, peopled by gods, human sacrifices, and vigilantes - something like an Indiana Jones movie. There's Krugman in the hat (former academic doing right for mankind) fighting off snakes and assorted bad guys. The bond vigilantes I have never quite understood. Somehow we're not supposed to care about the views of people who are lending to us (or potentially lending to us). Go figure.

Anyway, here's the opening paragraph:
As I look at what passes for responsible economic policy these days, there’s an analogy that keeps passing through my mind. I know it’s over the top, but here it is anyway: the policy elite — central bankers, finance ministers, politicians who pose as defenders of fiscal virtue — are acting like the priests of some ancient cult, demanding that we engage in human sacrifices to appease the anger of invisible gods.
What a lot of nonsense. Our policymakers are irresponsible, elite, callous bastards, because they won't engage in more intervention? Our central bank just engaged in a huge, risky intervention, which they are reluctant to unwind. There is little more that they can, or should, do. Our federal government is running a large deficit and accumulating debt at a rapid rate. There is risk that we may not return to the long-run growth path that we were on prior to 2000 (see this), and thus our capacity for repaying our debts may be compromised. Why shouldn't we be a little cautious?

PK finishes off with this:
So here’s the question I find myself asking: What will it take to break the hold of this cruel cult on the minds of the policy elite? When, if ever, will we get back to the job of rebuilding the economy?
As usual, anyone arguing against more "stimulus" is a heartless creep. Apparently "rebuilding the economy" involves only the guiding light of the federal government. Again, go figure.

### Kocherlakota Redemption

Narayana gave a nice speech, posted here, in Marquette, Michigan. I had to look this up on the map - it's in the UP (upper peninsula) of Michigan which, as everyone should know, falls within the 9th Federal Reserve District (Minneapolis).

From our point of view, there are two important issues raised in Kocherlakota's speech, relating to labor markets and the Fed's balance sheet.

Labor Markets
As many have noticed by now, there are important recent anomalies in the behavior of of the US labor market. One way to look at this is in terms of the Beveridge curve relationship, as displayed on Rob Shimer's web page. As Kocherlakota points out:
Beginning in June 2008, this stable [Beveridge curve] relationship began to break down, as the unemployment rate fell much faster than could be rationalized by the fall in the job openings rate. Over the past year, the relationship has completely shattered. The job openings rate has risen by about 20 percent between July 2009 and June 2010. Under this scenario, we would expect unemployment to fall because people find it easier to get jobs. However, the unemployment rate actually went up slightly over this period.
Another way to look at this is to take a standard Mortensen-Pissarides matching function and use that to interpret the data. Suppose that we assume a Cobb-Douglas matching function, with a "share" parameter for unemployment of 0.75, as in Shimer's 2005 AER paper. Following a quick-and-dirty approach, which ignores the not-in-the-labor-force state, various time-aggregation issues, and different units of measurement for the unemployment rate and vacancy rates (all dealt with in Shimer's AER paper, for example), I calculated a "productivity" residual from the assumed matching function and the vacancy/unemployment data for December 2000 to June 2010. Assuming a constant separation rate of 3% per month, I get this picture. What we get is a measure of matching efficiency in the labor market, analagous to calculating a Solow residual. The picture tells us that, given the same unemployment rate and vacancy rate, the US labor market currently produces about 45% fewer matches of unfilled vacancies with unemployed workers as it did in early 2007.

This is a phenomenal shift and, of course, it would be very useful to understand why this has happened. One possible explanation is that this is just a measurement problem. In terms of matching in the labor market, all we can measure are reports about the number of economic agents who are searching on either side of the market. We do not measure search intensity. One explanation for the current anomalies in the Beveridge curve relationship, and in the chart, could be that firms are posting vacancies but are not very serious about filling them, a view that I have heard attributed to John Haltiwanger (though I haven't verified this).

Alternatively, what we may be seeing in current behavior is an increase in mismatch in the labor market. A plausible story is that the post-2000 housing construction boom in the United States postponed some of the effects of a long-run sectoral shift in resources in the US from low-skill to high-skill occupations. The collapse in the construction industry, along with geographical shifts in production (for example in the auto industry) worked in the other direction to exacerbate the effects of these long-term sectoral shifts. Here is Kocherlakota's take on this:
What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.
This I agree with completely. But we could go further. Fiscal policy - at least the short-term stimulus that Krugman has in mind - can't transform construction workers into manufacturing workers either. The role for government here has more to do with long-run educational policy and social insurance.

Perhaps surprisingly, mismatch has not been studied extensively (to my knowledge) in macro/labor economics. Shimer has a somewhat stylized model of mismatch here, which doesn't quite get at the sectoral production issues I have in mind, but certainly is a good start. Conventional Mortensen-Pissarides search models, while seemingly motivated by heterogeneity in the labor market, avoid it altogether. Typical Mortensen-Pissarides workers are all identical, as are the firms, and the friction in matching them is all embedded in the matching function - a non-structural object if there ever was one. This can't be very helpful in addressing the current mismatch issue.

The Fed's Balance Sheet
Kocherlakota provides an explanation for the Fed's recent minor change in policy, which I discussed here. He says:
But the MBSs do have another kind of risk called prepayment risk. If long-term interest rates are low, then many people prepay the mortgages in the MBS. The owners of the MBS—in this case, the Fed—get a large coupon payment and the MBS’s principal falls. However, if long-term interest rates are high, then few people make these prepayments.

This kind of fluctuation in prepayments is at the heart of the FOMC’s new policy action in August. Long-term interest rates declined surprisingly fast in the past three months. But the fall in long-term rates meant that more people were prepaying their mortgages, and the Fed’s MBS principal balances were falling. In this sense, the Fed’s holdings of long-term assets were shrinking, leaving a larger share of the long-term risk in the economy in the hands of the private sector. This extra risk in private hands could force up the risk premia on long-term bonds and be a drag on the real economy. The FOMC decided to arrest the decline in its holdings of long-term assets by re-investing the principal payments from the MBSs into long-term Treasuries.
The Fed announced that, rather than letting the mortgage-backed securities (MBS) on its balance sheet run off as they mature (or are prepaid, or defualted on), it would replace them by US Treasuries, keeping the size of the balance sheet constant. Kocherlakota says (and I had not heard this before) that this was in response to prepayments of the underlying mortgages in the MBS. This is a little puzzling, as in the next picture, you can't see any reduction in the the Fed's MBS holdings. Maybe there is a lag in how this shows up in the published statistics, or maybe the Fed anticipates a reduction? Anybody know?

If the recent reductions in long-term Treasury yields is a response to a perceived change in policy, this is even more puzzling than Kocherlakota acknowledges here:
In my view, this reaction is unwarranted. The FOMC’s decisions were largely predicated on publicly available data about real GDP, its various components, unemployment, and inflation. I would say that there is no new information about the current state of the economy to be learned from the FOMC’s actions or its statement.
The Fed does not know more than the rest of us do. As well, the implications of the Fed's announcement are very small. The Fed has announced that they are going to keep something constant - the nominal size of their balance sheet - for the time being. Otherwise, this nominal quantity would have been falling very slowly. Even if the outstanding liabilities of the Fed are constant in nominal terms, they will be falling relative to total nominal GDP, and so the Fed's interventions will ultimately unwind (after a long time of course) even if the Fed does not change policy from what it just announced.

## Tuesday, August 10, 2010

### FOMC Statement, August 8

Today's FOMC statement has some news in it.

1. There is a recognition of the somewhat more gloomy news on the real side.
2. The difference in policy comes here:
To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
Thus, the Fed will for the time being keep the size of its balance sheet constant. They could have been more aggressive, and made moves to purchase more assets - MBS, Treasuries, or agency securities. They could have announced that they would sell off MBS and agency securities, or that they would reduce the average maturity of Treasuries on the Fed's balance sheet to something resembling what it was in the past. Relative to the other possibilities, what the Fed will actually do is a somewhat modest middle road.

The interpretation of this move is that the Fed wants to be active in responding to real events in the economy, but has some concerns about further intervention through private asset purchases. Is maintaining the size of the stock of long-maturity assets on the Fed balance sheet a good idea? There is risk, due to the mismatch in maturities on either side of the Fed's balance sheet, and I don't think anyone, including those on the FOMC, have any idea what the effects are of intervention in long-maturitity Treasuries. Now would be a great time for the Fed to sell long-maturity assets, while the prices are high, and I think this would have little or no effect on interest rates.

## Saturday, August 7, 2010

### More on Deflation

Jim Bullard's paper from last week was widely covered in the blogosphere and in the mainstream press. Jim attempts to use available economic theory to justify further monetary "easing" through the purchases of long-maturity Treasuries. As I argued in my previous piece on Bullard's work, Jim's argument failed to convince me either that inflation was an impending peril or, if it were an impending peril, that further purchases of long-maturity Treasuries (or mortgage-backed securities for that matter) would accomplish the intended goal of increasing inflation.

Bullard at least attempts to use received macroeconomic theory to make his arguments, which is more than I can say for Krugman (see this). Krugman, apparently under some pressure from his readers, comes up with some arguments for why deflation is bad. These are essentially: (i) at the zero lower bound on the nominal interest rate, deflation makes the real interest rate "too high," and people will not want to borrow and spend; (ii) unanticipated deflation redistributes income from borrowers to lenders; and (iii) nominal wage rigidity implies that, with deflation, the real wage rises, and unemployment grows.

On (i): I think what Krugman is trying to say is that, given the high anticipated rate of return on cash when there is an anticipated deflation, people would rather hold money as an asset than alternative assets - loans for example. The problem is that this cannot continue indefinitely. In real terms, the quantity of cash ultimately gets very large, and people will eventually want to spend it. A long-run deflation cannot be supported without the money stock declining on trend - and we know that is not happening.

On (ii): This is certainly true. But why is a reduction of the inflation rate from, say, 2% per annum to -0.5% per annum a big deal? The large disinflation we had in the 1980s certainly does not seem to have been a disaster.

On (iii): Anyone who thinks that wage rigidity (or price rigidity) is important to any current macroeconomic phenomena in the United States should provide some serious evidence. The serious evidence cannot be: "I see a large quantity of unemployed people, and in Econ 101 I was taught that people are only unemployed due to nominal wage rigidity."

Now, Krugman's bottom line seems to be this:
And when that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.
As I mentioned above, Bullard at least tries to use received theory to think about this. Some serious macroeconomic researchers have written down models with multiple equilibria, and there is the possibility that, in these models, we can converge to a deflationary steady state. These results were vetted by serious editors and serious referees, and published in serious economics journals. Bullard thinks the results have something to do with our current predicament, and draws some policy conclusions. I think he is blowing hot air.

Krugman is also blowing hot air, but in a different way. Whatever deflationary "trap" he is thinking about makes no economic sense to me - I can't see how to write down the model that produces this.

It is certainly clear that the inflation rate is low, by any measure. The most broad measure, the implicit GDP price deflator, grew 0.8% between 2009Q2 and 2010Q2. But of course what matters for economic policy, particularly for the FOMC meeting next week, is future inflation. What can we say about that? One measure of anticipated future inflation is the difference in yields between nominal Treasury bonds and TIPS (inflation-indexed Treasury bonds) of the same maturity. The first chart shows the difference in yields between nominal 10-year Treasuries and 10-year tips. This yield differential is not literally the anticipated inflation rate over a 10-year horizon. We have to worry about effects due to inflation risk premia, and the fact that the zero lower bound on inflation-contingent TIPS coupon payments biases the measure up. However, this is the best we can do in terms of a market measure of anticipated inflation, and we can at least attach some significance to movements in the measure. Note that the yield margin has dropped recently below 2%, though the drop has not been large. Further, the most recent observation (Friday, August 6) was 1.92, which is up from the last observation in the chart, which is the average for July. I don't see anything here that tells me financial markets are expecting a prolonged deflation - and these are people that have to put their money where their mouth is.

What does standard macroeconomics tell us about inflation forecasting? New Keynesians, and Krugmaniacs, typically think in Phillips-curve terms. There is a very large output gap, so we should expect inflation to be very low. There is strong empirical evidence, however, (here) that Phillips-curve constructs are useless for forecasting inflation, and the recent data is entirely consistent with that evidence.

How would a New Monetarist think about the causes of inflation? The price level is the inverse of the price of outside money in terms of goods and services. The component of outside money that is actually exchanged for goods and services is currency. Thus, what determines the price level is the demand and supply of currency. Of course this may not be very helpful if I want to forecast inflation. As is well-known, a large fraction of the stock of US currency (half?) is held outside of the United States. Also, inside and outside the US, currency is widely used as a medium of exchange in various illegal transactions. Thus, we know at the outset that some important factors that determine the demand for currency are going to be difficult or impossible to measure. However, let's take a stab at this anyway.

The first chart shows the stock of currency (the currency component of M1) relative to nominal GDP for the period 1947Q1 to 2010Q2. Now, if anyone thinks that currency is somehow going away (based on their own use of the stuff), this chart should disabuse them of that notion. Currency is still important, not only because it is financing essentially all of the central bank's portfolio in normal times, but because there is a lot of it in circulation. The quantity of currency bottomed out in about 1980 at 4% of GDP, but it currently sits at about 6%. That is, the quantity of US currency in circulation in the world at any point in time is 6% of annual US GDP.

Now, what if I conduct a standard Old Monetarist exercise, which is to plot the log of the ratio of currency to nominal GDP against the nominal interest rate (the 3-month T-bill rate)? This is in the next chart. Observations from 2000Q1 to 2010Q2 are shown in red, tracking from right to left (with a loop). This doesn't look bad, in terms of "money demand" observations, and the recent data does not look anomalous, i.e. there does not appear to have been a large increase in the demand for currency associated with the financial crisis, which would have tended to drive down the price level.

Next, what has been happening to the nominal stock of currency recently? For this, see the next chart. The currency stock has been growing at a reasonable pace - indeed a pace that is entirely consistent with the inflation we have been seeing, given the short-run fluctuations in currency demand that we are typically prone to. Further, since 2008Q1, the currency stock has been growing at an average annual rate of about 6.4%. There is nothing here that would make us anticipate deflation.