Monday, February 5, 2018

Panic Over Inflation?

The S&P 500 has dropped about 6% since last Thursday, so people are looking for reasons why. Given the proximity to Friday's US jobs report, could there be something in there that looked like bad news to market participants? Some think this has something to do with news about inflation. For example This FT article, this one in the Guardian, and this one in Quartz piece together the following narrative:

1. Wage growth was up in the jobs report.
2. More wage growth causes higher inflation.
3. Higher inflation causes the Fed to increase its interest rate target.
4. Even with the same FOMC composition as we had last week, we might anticipate tighter monetary policy in the future on Friday's news.
5. With dovish Janet Yellen gone from the FOMC, and with a (possibly slightly) less dovish Powell as chair, hawkish regional Fed presidents voting in 2018, and the addition of hawkish Governors (Quarles, Goodfriend, and whoever else gets nominated and confirmed to the empty Governor slots) we could get four 25-basis-point interest rate target increases in 2018.
6. Higher interest rates reduce output.
7. If future output is expected to be lower, that lowers current stock prices.

Does that make any sense?

First, let's look at year-over-year increases in nominal wages, from the Friday jobs report:
So, there was a big increase in wage growth relative to last month. But wage growth is not much higher than it was two years ago. Further, if we look at the real wage (measured as the average hourly wage divided by the personal consumption deflator) and productivity (real GDP divided by total hours worked), here's what we see:
In the chart, I've normalized by setting each variable to 100 at the start of the last recession. Productivity, by this measure, has been close to flat since the end of the recession, but the real wage is still catching up to it. Economic theory tells us that productivity growth should determine growth in the real wage, and that seems roughly consistent with the chart.

And inflation (year over year PCE inflation) looks like this:
So, the Fed's preferred measure of inflation has been increasing toward the 2% target, though still falling somewhat short. Further, if we look at the PCE levels, relative to a 2% trend, from the beginning of 2007, we get the following chart:
If the Fed had been following a price level target rather than an inflation target, there would be a lot of ground to make up - relative to base period of January 2007, the PCE deflator would now be 4.5% below the 2% trend path. This reflects the sense in which the FOMC is not achieving symmetry in its inflation targeting procedure. Inflation targeting with symmetry, i.e. caring as much about positive as about negative deviations from the 2% inflation target, should achieve roughly the same outcomes as price level targeting.

The financial media seems also to be making a big deal of recent increases in nominal bond yields. For good measure, let's look at the 10-year nominal bond yield and the 10-year TIPS (inflation-indexed) yield:
So, there is a small increase in the 10-year real bond yield, and a larger increase in the 10-year nominal bond yield. Thus, we can infer that the primary driver of the increase in nominal bond yields is anticipated inflation. Qualitatively, we can see something similar at a five-year horizon, but the the increase in the five-year nominal Treasury yield is larger than for the 10-year. To summarize, the key movement is in the breakeven rate (nominal bond yield minus TIPS yield), so I'll show that for both the five-year and the ten-year Treasury yields:
So, the 10-year breakeven is above 2%, and the 5-year is under 2%, but close to it. For the Fed, this is good news, as it says that market participants expect the Fed to hit its inflation target (roughly) on average for the next five years, and for the next 10 years. TIPS are indexed to the consumer price index, which is upward-biased measure of inflation, so we might be a little more comfortable if these measures were 10 or 20 basis points higher, but this is pretty good.

There has also been some concern recently with the slope of the Treasury yield curve. Usually people look at the 10 year yield minus the 2-year yield as a summary measure, but I'll go even shorter, and look at the 10-year bond yield minus the 3-month T-bill rate:
As is well-known, the yield curve tends to be flat or negatively sloped leading a recession. One reason for this could be that monetary policy moves slowly, and the markets see a recession coming before the Fed cuts rates significantly. But the markets anticipate that the Fed will cut interest rates during the recession, and this then is reflected in long bond yields. So the yield curve flattens, or short-term interest rates might even exceed long-term rates. The slope of the yield curve right now is just short of its average in the sample shown in the chart. The average is 1.55%, while the current value is 1.38%. So the yield curve is definitely not flat currently, and if we relied on yield curves to predict recessions, we wouldn't be predicting one anytime soon.

What's the conclusion? There's not really any sign of excessive inflation in the data. There are indeed signs that inflation, and anticipated inflation, are very close to what is consistent with a 2% inflation target, for the indefinite future. So, I'm having trouble drawing any connection between the behavior of inflation, the behavior of the Fed, and the drop in stock prices.

There is potential risk in terms of monetary policy decisions, though. As I discussed in my last post, the Fed is as close as it typically gets to achieving its goals. But the FOMC has been getting up a head of steam for interest rate increases. As I've mentioned before, I think they have the sign wrong. That is, consider the following chart:
Inflation has been coming up recently, as nominal interest rates have gone up (that's the 3-month T-bill rate in the chart). That's consistent with Neo-Fisherian logic - increase the nominal interest rate if you want more inflation. Of course, inflation was low in 2014-2015 in part because of a fall in the price of crude oil. Nevertheless, some people were arguing that inflation would go down as a result of the Fed's interest rate hikes, and that certainly hasn't happened. The problem is that the Fed could continue to increase interest rates when this is not warranted, overshoot inflation, and continue to hike, thus overshooting even more. Fortunately, that's a politically difficult route to take, so I doubt it happens.


Wednesday, January 31, 2018

Janet Yellen: Performance Review

Janet Yellen has now attended her last FOMC meeting as Chair of the Committee. What has she accomplished, since she took the job in February 2014?

To start, we need to review what Ben Bernanke passed on to Yellen four years ago. As I wrote in the St. Louis Fed Review in mid-2014, the key elements of Bernanke's eight-year stint were:

1. Inflation Targeting: In January 2012, the FOMC wrote a "Statement on Longer-Run Goals and Monetary Policy Strategy" intended to make explicit the FOMC's intentions for addressing the dual mandate specified by Congress. Bernanke was well-known for his enthusiasm for inflation targeting, and the Statement includes an explicit 2% inflation target, measured as headline PCE inflation. In an addendum the FOMC clarified that this was a symmetric goal - the FOMC says it cares as much about misses on the high side as it does about misses on the low side of 2%.

2. Forward Guidance: Under Bernanke, FOMC statements became much more wordy and, post-financial-crisis, these statements contained more messages about the FOMC's future intentions. For example, after the financial crisis, forward guidance took the form of evolving statements about the length of time that the Fed's nominal interest rate target would stay low - extended period of low rates, low until at least some future date, low until some thresholds were met in terms of unemployment and inflation, etc. Bernanke also started doing press conferences after FOMC meetings - but only at alternate meetings: March, June, September, and December.

3. Quantitative Easing: After the financial crisis, the Fed engaged in large-scale asset purchases - three rounds of purchases of long-maturity Treasury debt and mortgage-backed securities, with an intervening swap of short-maturity government debt for long-maturity government debt. In February 2014, QE3 had not yet concluded - the Fed was still expanding its balance sheet.

4. Normalization: The FOMC began making normalization plans as early as 2011. FOMC members seemed to agree that the Fed's nominal interest rate target should ultimately rise to more "normal" levels from a fed funds target range of 0-0.25%, and that the size of the Fed's balance sheet should be reduced. Eventually, the Committee agreed that the policy interest rate target would rise first, followed by a balance sheet reduction. At a minimum, the Committee would eventually stop its reinvestment program, which replaced assets on the Fed's balance sheet as they matured, and the Committee reserved the right to sell assets outright.

First, under Yellen, normalization started to happen. Asset purchases ended in October 2014, though reinvestment stayed in place. And the FOMC began increasing its policy target rate in December 2015. Here is the course of the fed funds rate for the last four years:
Rate increases were slow at first - a year elapsed from the first 25 basis point increase to the second, but 2017 saw three 25 basis point increases, with the target range for fed funds now 1.25%-1.5%.

The FOMC was even more skittish about reducing the Fed's balance sheet, with the Committee agreeing as late as June 2017 - eight years after the end of the last recession - to a fairly timid plan for gradually eliminating reinvestment, with no plans for outright asset sales. You can see what is going on here:
So far, any reduction in the Fed's securities holdings is hardly perceptible. To see what the Fed is up against here, it's more useful to measure securities held outright as a fraction of GDP:
So, securities held by the Fed have fallen significantly, to 21.5% of GDP, as real GDP and prices have risen. But to see how far the Fed has to go, we need to look at currency as a fraction of GDP:
If the Fed wants to return to implementing policy as it did prior to the financial crisis, it will have to reduce the balance sheet to the point where there is a very small quantity of interest-bearing liabilities. Roughly, currency would be financing the whole asset portfolio. So, the further reduction needed is, roughly, the difference between 21.5% of GDP and 8% of GDP, or about $2.6 trillion worth of assets that need to mature. This could take perhaps 5 years, depending on how the demand for currency grows and on inflation. Of course, the FOMC might decide that "normal" is a large balance sheet. More about that later.

But, in terms of its ultimate goals, how is the FOMC doing? Here's the path for headline PCE inflation since February 2014:
There's a period of low inflation in 2015 and 2016 that we can blame on a fall in the price of crude oil, but otherwise that's not bad, as inflation targeting goes. With inflation at 1.7%, the Fed is very close to its target, though consistently missing on the low side of 2% is not consistent with the FOMC's commitment to symmetry. To be doing a perfect job, inflation should be 2% on average, but this is quibbling. 0.3 percentage points in inflation at an annual rate matters very little.

What about the real economy? Though the FOMC makes no specific commitments to goals for unemployment or real GDP growth, for example, the dual mandate matters, and Fed economists firmly believe that monetary policy is important for real economic activity. For them, policy is definitely not just about controlling inflation. Real GDP growth in the whole post-WWII time series looks like this:
Here, we're looking at year-over-year real GDP growth. Growth since the last recession ended has been lower than the post-WWII average of about 3% - closer to 2%. But the current growth rate is up to 2.5%, which isn't bad, especially given performance in other parts of the world. Europe, for example, took a long time recovering from the financial crisis.

What about the labor market?
So, in terms of the unemployment rate and vacancy rate, the labor market is as tight as it's been since the BLS began collecting vacancy data. With the labor force growing at between 0.5% and 1.0% per year, it's not possible for employment to grow at more than about 1% per year, rather than close to 2%, as has been the case recently. Unemployment cannot fall much further, so unless productivity growth picks up dramatically, real GDP growth will continue to be lower than the historical average, and perhaps lower.

Thus, in spite of relatively low (but OK) GDP growth, to the extent that monetary policy can do anything about the real side of the economy, it's already done it. This economy is growing at potential. Conclusion: Inflation looks pretty good, and there's no good reason to think there's some inefficiency in the US economy left for monetary policy to correct. So Janet Yellen should declare victory, and sail off into the sunset.

But, we shouldn't let her off the hook that easily. Why?

1. Yellen's last FOMC statement, from today, doesn't reflect the actual state of the economy. First, it says:
The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12‑month basis is expected to move up this year and to stabilize around the Committee's 2 percent objective over the medium term.
Why are further adjustments needed? The Fed is currently meeting its goals. We're already "around" the 2 percent objective. Then, further on in the statement, there's some more detail:
The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.
What's expected to change from here on in that would warrant further interest rate increases? Why should higher nominal interest rates prevail in the longer run? Again, we're there. Why should the FOMC be expecting that they have to do anything next meeting, or this year?

2. What about that large balance sheet? The Committee has been dragging its feet on this one. One would have expected that, since the Fed first dropped interest rates in the financial crisis, then expanded its balance sheet, that it would unwind the policy in reverse - reduce the balance sheet and then raise interest rates. Indeed, this would have been the most politically astute approach to normalization. Raising short rates with a large balance sheet of low-yield long-maturity assets risks reaching a state where the Fed stops sending transfers to the Treasury, because it is paying out more on its liabilities than it is earning on its assets. While not economically important, some people in Congress would jump all over this. It can still happen. Further, it seems likely that large-scale asset purchases will be used again in the future - though at least one newcomer to the FOMC, Marvin Goodfriend, isn't a big fan of QE. But it's not clear the Fed understands the effects of QE - why it may or may not work - any better than it ever did. QE is basically a move by the central bank to engage in debt management, the usual province of the fiscal authority. Without some agreement that this is a job assignment for the central bank, and effort to coordinate with the fiscal authority, it's not going to work properly, if it works at all. And, there's good reason to believe it doesn't work, or that it could be detrimental. For example, the Bank of Japan has tried in vain with massive QE to raise inflation, without success. QE may accomplish nothing more than reducing the efficiency of financial markets by swapping mediocre collateral (reserves) for good collateral (government debt).

3. Under Yellen, communication with the public has not been so great. It's well known that she doesn't like public appearances, and tends to avoid them. There wasn't a lot of Yellen speech-making. Further, she continued Bernanke's practice of giving press conferences only at the March, June, September, and December FOMC meetings. What this meant was that nothing every happened at the other meetings. Go back and look. Yet, Yellen always insisted that every meeting was a live one. That was a lie, and everyone knew it. I've been told by experienced central bankers that the FOMC should tighten on good news. The reason is that raising the interest rate target is never going to get a round of applause. Good economic data will give the Fed cover to hike rates, and it's sometimes necessary to do that. After all, how can you lower rates if you never raise them? But there's a lot of noise in economic data, so the central bank needs to take advantage of good news when it gets it. And, if 4 of 8 meetings in a year are off the table, that's a lot of potential missed opportunities. But maybe that was part of Yellen's strategy? Maybe she wanted a gradual normalization come hell or high water, and going to 8 press conferences a year would have allowed the rest of the Committee to thwart that goal. Yellen's usually given credit for being collegial, but maybe she's more devious than she looks.

4. It seems nothing has been resolved in terms of the long-term operating strategy for Fed policy. The FOMC already missed one opportunity for useful change when "liftoff" occurred in late 2015. At the time, the FOMC decided to stick with targeting the fed funds rate in a range. Due to quirks in US financial markets, that does not make a lot of sense, particularly with a large Fed balance sheet. It would be easier, and more effective, if the Fed targeted an overnight repo rate - in some sense it does that already, as it pegs the rate on overnight reverse repurchase agreements. But, the reverse repo facility should be larger, for various reasons. The FOMC never really got a handle on this issue, and it's stuck with an outdated fed-funds-rate targeting procedure. Further, it's unresolved whether the Fed stays with its large-balance-sheet system (or floor system) for pegging interest rates, or goes back to pre-financial crisis implementation, where it kept excess reserves essentially at zero (a channel system).

All that said, the one time I saw Janet Yellen in action - at the one FOMC meeting I attended - she was doing a first-rate job of running what could have been a very unwieldy decision-making process. There are 19 people on the FOMC (at full strength), and they all want to have their say. Greenspan was well-known for being somewhat dictatorial, but in the meeting I saw, Yellen stayed in the background, didn't dominate the discussion, but had a firm hold on the flow of ideas and decisions. She's a skilled leader, and it's hard to say that there was anyone else out there four years ago who could have done it better.

Monday, January 22, 2018

Is Bitcoin a Waste of Resources?

If nothing else, Bitcoin gives us something to talk about. My non-monetary-theorist colleagues want to talk about it; my students want to talk about it; it's a surefire conversation-starter with strangers; it's a distraction from Donald Trump. But, should a sensible person buy the stuff? Should society tolerate it?

First, let's review what Bitcoin is. The open-source software for Bitcoin was introduced in 2009, and it represents a decentralized means for transferring ownership of digital objects, along with a decentralized system for augmenting the supply of such objects. Central to how Bitcoin works is the blockchain, which consists of a record of the entire history of ownership of the digitial objects - the "coins." The ingenious part of the system (and the hardest part to understand) is how the blockchain is updated. David Andolfatto gives a nice explanation of how the thing works. Also see this paper by Berentsen and Schar. No one owns the blockchain, but it is distributed among the community of users - it's a "distributed ledger." "Miners" (which is really not an apt description of what these people do) compete to form the next block in the chain - basically their job is the counterpart of what happens in the clearing and settlement process in a centralized monetary system, such as interbank payments. For the system to work, it has to be more costly to cheat than for the correct information to be added in the new block. Thus, the system adjusts the costs of mining over time to keep up with technology. If the costs are too low, then cheating might occur - it's important to slow the clearing and settlement process down sufficiently, and the designers of the system shoot for a time lag of 10 minutes from when a transaction is posted to when it goes into the blockchain. The mining process is costly. Being a miner requires a lot of computing capacity, and one needs to burn much electricity in order to have a chance of winning the payment you receive for successfully verifying a transaction. Harnessing more computing power, finding cheap sources of electricity, and inventing faster chips (tailor-made for this purpose) implies a higher probability of a payoff, if you want to mine.

What role could Bitcoin - and other competitors such as Ethereum - play in the economy? What good could these systems do for society as a whole? The idea seems to be that such systems could provide us with an efficient means for carrying out transactions. In principle, centralized transactions - routed through the banking system and central banks - seem costly. There are large numbers of people working in these financial institutions, they occupy a lot of real estate, they require a lot of equipment and software, and they burn electricity. But, these systems work. They handle huge volumes of transactions every day, provide protection against fraud, and provide recourse when things go bad - like when the object you bought with your Visa card turns out to be something you weren't expecting. Further, we already have a decentralized means for executing transactions - paper currency. While currency doesn't permit some of the kinds of transactions we might like to make in modern societies - you can't buy stuff from Amazon with it - it is remarkably cost-effective. Proof of ownership is just a matter of physical possession, and transfer of ownership is essentially costless. I show the Starbucks cashier my cash, and hand it over. Of course, there's a centralized system in place that maintains the currency stock, assures that counterfeiting is a high-cost activity, and stabilizes the value of currency in terms of goods and services. That's called a central bank.

The monetary system we have, consisting of central banks which issue currency and run interbank payments systems, coupled with a private banking system that clears and settles transactions using debit cards, credit cards, and old-fashioned checks, evolved from earlier commodity money systems and commodity-backed paper currency systems. As a result of that transition, substantial resources were saved. Actual commodities - gold, for example - are costly to move around in large quantities, and making both small and large commodity money transactions can be awkward. Commodity-backed paper currency systems save on those costs, but the problem then - as for example under the gold standard - is that price stability can go out the window. That is, under a gold standard, the price of goods and services in term of money will be determined in part by the costs of digging gold out of the ground, the discovery of low-cost sources of gold, and the consumption value of gold. As a reminder of what that's about, consider the following chart:
The chart shows two prices. The blue line is the price of gold in dollars, while the red line is the price of US currency in terms of goods and services, measured by the inverse of the PCE deflator. The smoothness in the red line is no accident of course. That's the outcome of many person-hours of research, analysis, and meeting time in the Fed, all aimed at managing money and payments in such a way that the value of money in terms of goods and services is predictable. Clearly the price of gold in terms of money, and by implication the price of gold in terms of goods and services, is not very predictable. That's why no one wants to use gold to make payments - the alternatives are so much better.

It has been well-understood for a long time that, in order for money to have a predictable value in terms of goods and services, its supply has to be "elastic." The demand for means of payment fluctuates from day to day, week to week, and month to month. Why? (i) Aggregate economic activity fluctuates (even within the week - there are more people in the shopping mall on Saturday than on Monday); (ii) Wholesale payment activity can fluctuate considerably due to variation in financial market activity, and large one-time interbank transactions, for example. So, if demand is fluctuating, and we want price stability, supply needs to fluctuate in tandem with demand. Elasticity also makes the whole financial system work more efficiently. For example, the framers of the Federal Reserve Act understood that inelastic money in the post-civil war era in the US helped to create banking panics and financial instability.

Here's what's been happening to the price of Bitcoin, in dollars, lately:
That is, Bitcoin is worth about five times what it was in the middle of last year, but about half of what it was last month. This makes gold look stable. There's been a lot of talk about whether or not this represents a "bubble." Whenever someone talks to me about bubbles, I ask them to define it. The answer they give typically puts them into three camps: (i) irrational bubble people; (ii) rational bubble people; (iii) people who haven't the foggiest idea which end is up. Robert Shiller is probably the best-known irrational bubble person. He's written books like this one, coauthored with George Akerlof. An irrational bubble is supported by irrational behavior on the part of at least some market participants. For example, suppose there is an asset that will, with certainty, be valueless at some future date. But, people bid up the price of the asset, in the belief that there are some stupid people in the market who they can sell to before the price crashes. Sure enough, some stupid people enter the market, and they end up holding the bag when the price goes to zero, according to the irrational bubble folks. Shiller doesn't quite know what to make of Bitcoin. As far as he's concerned it could be gone tomorrow, or in a hundred years. But he seems to think it's a bubble, which isn't saying much, as Shiller sees irrational bubbles in essentially all asset markets.

Rational bubbles are all too familiar to any monetary theorist. A rational bubble occurs when an asset's value exceeds the present value of the expected future payoffs on the asset, appropriately discounted. To evaluate whether a rational bubble exists requires a model - in part to tell us what "appropriately discounted" means. Fiat money is a bubble, as it has no explicit future payoffs, yet people value it in exchange. There are other types of rational bubbles, for example the currently-observed low real interest rate on government debt can be considered a bubble phenomenon. Government debt is used in exchange, and as collateral in financial markets, so that its price exceeds the present value of its future payoffs - high prices imply low interest rates.

Is Bitcoin an irrational bubble? How would we tell? In some sense, going the irrational bubble route is a copout - we're abandoning any attempt to put structure on what is going on so we can understand it. Clearly the irrational bubble approach isn't helping Shiller - he can't tell us when the collapse will come. Could be tomorrow. Could be in 100 years.

Is Bitcoin a rational bubble phenomenon? One explanation for the appreciation in the Bitcoin price is that people are betting on Bitcoin's future as a means of payment. In the event that Bitcoin becomes widely acceptable as a means of payment, its value will be enormous - there is an upper limit on the supply of Bitcoin after all. Even if I think the probability of that happening is small, the expected value can be high, and if I buy a small quantity I'm bearing a small amount of risk for a huge expected payoff. But, the probability that Bitcoin becomes a serious means of payment looks like zero to me, as the system is fundamentally flawed. Transactions costs are too high, the price is far too volatile, and the system does not permit a large enough volume of transactions.

But, in spite of Bitcoin's price volatility, maybe people will ultimately treat it as a safe asset, like gold. Gold is an asset that people can flee to when the returns on financial assets are highly uncertain, and maybe it bears a premium above its "fundamental" value, because people coordinate on it for that purpose. I'm not sure if anyone has studied that. So, maybe Bitcoin can serve the same function? But precious metals have the virtue of having no competitors - there is only so much of the stuff. Though Bitcoin is ultimately limited in supply, the supply of potential competitors is unlimited, and we're currently seeing a flood of close substitutes for it.

So, I've run out of options for Bitcoin's future. It represents a poor payments system, and the ability to replicate it means that it can't survive as a safe store of value like gold. Advice: Don't buy that stuff, its value is going to zero - far short of a hundred years from now, I think. But does that mean this is an irrational bubble? Let's think harder. Not everyone is as certain about Bitcoin's demise as I am, and people are working with incomplete information and limited knowledge of how the world works. As with the Dot-Com "bubble" it takes a while for people to understand the market and to sort out which ventures are going to pay off. That doesn't look like the simple asset valuation models we have, but there it is.

But, we should give Bitcoin advocates a chance to defend themselves. What do they have to say? Well, Marc Bevand, who is apparently a miner, wrote a piece a couple of years ago, arguing that "Bitcoin Mining is Not Wasteful." He has five arguements, which I'll go through one-by-one:

Argument 1: Miners currently use approximately only 0.0012% of the energy consumed by the world. Most are forced to use hydroelectric power (zero carbon footprint!) because using cheap renewable energy is a necessity to win in the ultra-competitive mining industry.
It's true that .0012% seems like a small number. But this is for a would-be monetary system that hasn't even got off the ground yet. Some people claim that a Bitcoin transaction currently requires 80,000 times more electricity than a Visa transaction. If that high cost is a "necessity" in this system, maybe we can do without it.

Argument 2: Even in the future, economic modeling predicts that if Bitcoin's market capitalization reaches $1 trillion, then miners will still not account for more than 0.74% of the energy consumed by the world. If Bitcoin becomes this successful, it would have probably directly or indirectly increased the world's GDP by at least 0.74%, therefore it will be worthwhile to spend 0.74% of the energy on it.
Bitcoin's current market capitalization is about $180 billion. My estimate of its current contribution to world GDP: negative. There are plenty of economic activities that burn resources and contribute negatively to GDP - theft, for example.

Argument 3: Mining would be a waste if there was another more efficient way to implement a Bitcoin-like currency without proof-of-work. But current research has so far been unable to demonstrate a viable alternative.
But we don't have to implement a "Bitcoin-like currency." The relevant alternative is the monetary system we have.

Argument 4: Bitcoin is already a net benefit to the economy. Venture capitalists invested more than $1 billion into at least 729 Bitcoin companies which created thousands of jobs. You may disregard the first three arguments, but the bottom line is that spending an estimated 150 megawatt in a system that so far created thousands of jobs is a valuable economic move, not a waste.
Bevand either hasn't had economics, or he went to the class where they talked about Keynes, and missed the class on opportunity cost. The fact that people are spending time in activities associated with Bitcoin - designing it, trading it, mining, designing new chips, maintaining dedicated hardware, etc., is in fact a waste of resources. All those people could be doing something more productive with their time, assuming the opportunity cost of their time is not zero. To the extent we can learn something, the time spent is useful. But I think we are done with that. Time to stop.

Argument 5: The energy cost per transaction is currently declining thanks to the transaction rate increasing faster than the network's energy consumption.
I'm not sure this is true, but even if it were, this isn't the right metric. If the transactions aren't accomplishing anything socially useful, all we're worried about is the total economic cost of this project - electricity, time, hardware, software, buildings - which looks to be a significant waste.

Digital currencies could indeed be useful, but current technological constraints do not seem to permit a decentralized currency system using blockchain. It's certainly likely that central banks will get into the business of offering digital means of payment, but my best guess is that those systems will be centralized.

Wednesday, January 17, 2018

Bank of Canada meeting

As expected (see my post from yesterday), the Bank of Canada increased its target interest rate to 1.25% today. The risk they see on the horizon is a potential collapse in NAFTA.

In the first paragraph of the press release, the Committee summarizes its reasons:
Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity.
This might seem like a justification for doing nothing. The Bank has achieved its goals, so no action is warranted. This only makes sense if Bank people are forecasting that an economy operating "roughly at capacity" will wake up the Phillips curve and cause more inflation, which they think they should tamp down with higher interest rates - now, not when the inflation happens.

But, further on in the press release is this:
Recent data show that labour market slack is being absorbed more quickly than anticipated.
That seems inconsistent with the quote above. How can the economy be operating "roughly at capacity," with labor market slack? I'm running roughly as fast as I can, but I continue to run faster!

Finally, the forward guidance hasn't changed:
While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target.
Still no clarification as to why these higher interest rates should be warranted, and under what conditions rates will or will not rise in the future. And why is the current policy seen as "accommodative?" Short-term nominal interest rates may be unusually low, but it's generally accepted that the real effects of monetary policy actions dissipate over time. So, the real effects of monetary policy we should be seeing now are the effects of interest rate hikes last year. Certainly that's not accommodative. In terms of the effects on inflation of interest rate increases, again I think the Bank of Canada has the sign wrong - though they have good company in that belief. Inflation control is about moving the central bank's nominal interest rate target in the direction you want inflation to go. That's what the weight of theory and empirical evidence tells us.

Tuesday, January 16, 2018

Canadian Monetary Policy

The Bank of Canada's Governing Council will be meeting on Wednesday to decide on a setting for the Bank of Canada's policy rate target, so now is as good a time as any to get you (and me) up to speed on Canadian monetary policy. We'll start with basics. In Canada, the Bank of Canada operates under the Bank of Canada Act, passed in 1935, and amended since then. Policy decisions are made 8 times per year, at pre-specified dates, roughly 2 to 3 weeks before each FOMC meeting in the US. US monetary policy is important for what the Bank of Canada does, thus the synchronization of policy meetings, but presumably the Bank of Canada does not want to look like it is always following the Fed.

The decision making body at the Bank of Canada is the Governing Council, which consists of the Governor, the Senior Deputy Governor, and four Deputy Governors. All of those people are appointed by the Bank's Board of Directors. The Board of Directors, in turn, consists of the Governor, the Senior Deputy Governor, and a group of people appointed by the cabinet of the federal government. The mandate of the Bank as specified in the Bank of Canada Act, is to "promote the economic and financial welfare of Canada." That's of course pretty vague, but since 1991 the Bank has had an explicit inflation target, worked out as an agreement with the Government of Canada. This agreement is reviewed and renewed every five years. Currently, the inflation target is specified as a 2% target for CPI headline inflation, with a range of 1-3%.

Some critical differences between the Bank of Canada and the Fed:

1. The public doesn't know what happens in a Governing Council meeting. There are no minutes or transcripts, and no reported vote. After the meeting, a statement is issued, and at every other meeting there is a press conference.

2. The top Bank of Canada officials are somewhat shy. They don't speak in public as much as, for example, Jim Bullard, the President of the St. Louis Fed. As well, Bank of Canada officials generally speak with one voice. Public dissent is not a thing.

3. To properly deal with the public in Canada, Bank of Canada officials have to be bilingual. So, when they stand up in public, they'll talk to you in both English and French.

4. The actual mechanics of monetary policy implementation are considerably different. There is an overnight market in which the Bank of Canada intervenes, but there is a small number of participants in this market. As well, the Bank operates in an environment in which overnight reserves are essentially zero. The Bank of Canada never went in for a large balance sheet and large-scale asset purchases after the financial crisis, in contrast to the US, the Euro area, Japan, the UK, etc.

Let's review the state of the Canadian economy. Here's the recent time series for real GDP in Canada, normalized to 100 in first quarter 2007, so that we can compare this to the US:
As you may have expected, the behavior of real GDP is not so different in Canada and the US. North America is a highly interconnected economy, given the high volume of trade in goods, services, and assets. However Canada has a somewhat different sectoral composition of output from the US, for example Canada depends more on natural resource industries. That's what the slowdown from 2014-16 is about, which follows the drop in the price of crude oil. But recently, real GDP growth has been strong. Here's what year-over-year growth rates of real GDP look like, since 2010:
Growth rates are roughly synchronized in Canada and the US, over this period, but you can see somewhat more volatility in Canadian growth rates. As well, the average growth rate over this period is somewhat higher in Canada. Recently, growth has been quite strong in Canada, particularly in the second and third quarters of 2017 (in the 3-3.5% ballpark).

What about the labor market? The unemployment rate looks like this:
So, the unemployment rate is the lowest it's been for the last 18 years - indicating a tight labor market. We could go deeper into some other labor market variables, for example the participation rate:
As you can see, labor force participation has dropped somewhat in Canada since 2008, but not to the same degree as in the United States. Indeed, the Canadian population has a similar age structure to the US population - for example the post-WWII baby boom phenomenon is similar in the two countries. Yet, the Canadian participation rate is currently three percentage points higher than in the US. It's not clear what explains this or if, for example, one can explain all of the decline in the Canadian participation rate with demographic factors.

The employment/population ratio looks like this:
Again, Canada experienced a one-time drop in the employment/population ratio during the last recession, but the drop was not as large as in the US, and Canadians currently work harder than Americans, to the tune of about two percentage points in the employment/population ratio. In terms of employment growth rates, here is how it looks in Canada, year-over-year, along with growth in the labor force:
So, recent employment growth rates, year-over-year, have been in the vicinity of 2%, but with labor force growth hovering around 1%, that sort of rapid employment growth cannot be sustained.

Finally here is how the Bank of Canada is doing with respect to its inflation target:
With respect to headline CPI inflation, the Bank of Canada has tended to miss on the low side for the last five years, though inflation is current right at target. I've included a core measure inflation (excluding food and energy prices), but I'm not a big fan of stripping prices out of the index - better to have an idea how persistent the effects of particular shocks are on inflation.

The Bank of Canada increased its policy target twice during 2017. The target for the overnight interest rate went from 0.5% to 0.75% in July and then to 1.00% in August. So what will the Bank do on Wednesday? Given the data I showed you, it looks like the Canadian economy is performing well - somewhat better than the US economy, with relatively strong real GDP growth and employment growth, and a labor market that looks fairly tight. And the Bank is hitting its inflation target. So why should the Bank do anything?

Well, how do Bank of Canada officials look at the world? To figure this out, the press release after the December meeting might help. The two last paragraphs are important, I think:
Inflation has been slightly higher than anticipated and will continue to be boosted in the short term by temporary factors, particularly gasoline prices. Measures of core inflation have edged up in recent months, reflecting the continued absorption of economic slack. Revisions to past quarterly national accounts have resulted in a higher level of GDP. However, this is unlikely to have significant implications for the output gap because the revisions also imply a higher level of potential output. Meanwhile, despite rising employment and participation rates, other indicators point to ongoing­ – albeit diminishing – slack in the labour market.

Based on the outlook for inflation and the evolution of the risks and uncertainties identified in October’s MPR, Governing Council judges that the current stance of monetary policy remains appropriate. While higher interest rates will likely be required over time, Governing Council will continue to be cautious, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.
That's certainly Phillips curve language, so the Bank thinks that measures of excess capacity or slack tell us something about where inflation should be going. Here are some such measures that the Bank likes to look at, apparently. Like all Phillips curve believers, Bank officials have to be puzzled by their recent tendency to undershoot their inflation target in the face low unemployment. That's why they think there's still slack in the economy. Like the Fed, people at the Bank of Canada have gone on a slack hunt, looking for labor market variables that might justify a view that the economy is still underperforming. But, the statement above also says that "higher interest rates will be required over time." That is a form of forward guidance, but what's it telling us? The statement doesn't tell us why these higher interest rates might be required, or under what conditions increases might happen.

But, to fill in the gaps, my best guess is that Steve Poloz thinks like Janet Yellen, who believes that interest rate hikes are justified so as to head off higher future inflation. That's a convenient fiction that allows interest rates to go up - otherwise true Phillips-curve-believer central bankers would just get stuck in a policy trap with low nominal interest rates and low inflation forever - everyone turns into Japan, basically. In this instance, a Neo-Fisherian approach might justify another increase. On average, inflation has been below the target somewhat, so another 25 basis points north won't hurt - it'll make inflation go up. The Governing Council, using a get-ahead-of-the-curve approach - basically Phillips curve wakes up and asserts itself - will likely go for the 25 basis point increase in the policy rate, which of course will be self-fulfilling. News since the last meeting has been good in terms of labor market performance for example - the unemployment rate dropped two points - and inflation has gone up. Best guess is that the policy rate goes up tomorrow.