Trends, Doom, and Gloom

A few negative pieces of information seem to have put the usual people in a funk. DeLong is panicing, Krugman invokes the D-word, and David Leonhardt wants something done NOW. Mark Thoma is more restrained, but wants us to "fix" the deficient demand problem he perceives.

Thoma shows us some pictures from one of Lucas's talks, one of which shows the US real per-capita GDP time series going back to 1870. The key feature of the time series, as most people know, and as I point out to my undergraduate students, is that it hews very closely to a 2% growth trend, excluding the Great Depression and World War II. What we find compelling about this is that it conforms roughly to the behavior of a standard neoclassical growth model subject to a constant rate of growth in total factor productivity (TFP). Of course, while the neoclassical growth model tells us a nice simple story about trend growth, it does not have much to say about the Great Depression, what was going on in World War II, or what causes fluctuations about trend. As we know, those issues get us into various kinds of stochastic shocks, frictions, heterogeneity among economic agents, etc., that we add to the basic framework.

Fundamentally, though, most macroeconomists seem to agree on what the basic driving forces are behind economic growth and the models that are useful for understanding trend growth. This I think is the source of Mark Thoma's faith that we will ultimately return to the 2% per-capita real GDP trend growth path that we embarked on in 1870 (or earlier). Most of us cannot see any good reason why historically-observed TFP growth should not continue indefinitely in the US at a rate that produces historically-observed per-capita trend GDP growth.

But how have we been doing recently relative to trend? The first chart shows the natural log of post-1947 aggregate real GDP (not per-capita) with a fitted linear trend, which implies average growth of 3.3%. The next chart shows the percentage deviations of real GDP from the trend. The interesting thing about this chart is the recent history. Note that the largest recent positive devation from trend was 3.43% in 2000, and that the growth rate in real GDP has (roughly) been below the post-1947 average of 3.26% since. The current deviation from trend is an enormous -13.4%, which is unprecedented in the 64-year sample.

Thus, in this sense things definitely look bad. Given the slow recovery from the recent recession, we are continuing to lose ground relative to the post-1947 trend. Can we say that the post-1947 trend is "potential GDP," and that we currently have a 13.4% output gap? Of course not. Without understanding the mechanism driving the recession, we cannot say what economic inefficiencies might be at work here or what fiscal and monetary policy should be doing about this, if anything. David Leonhardt has the answers though. In fact, he read about it in a textbook:

Any temporary measures will eventually need to lapse, of course. But the current moment remains a textbook time to use them — when the economy is struggling to emerge from the aftermath of a terrible recession.

I'm not sure what textbook David has in mind. Presumably this book has a description of a quantitative model of the macreconomy that includes some financial frictions and allows us to think about how the incentive problems in the mortgate market and, more broadly, in the financial intermediation sector, acted to bring on the recent downturn. Such a model must also tell us how quantitative easing works to boost output, as Leonhardt seems convinced that Ben Bernanke is reading the same book:

The Fed could stop worrying so much about inflation, which remains historically low, and look at how else it might encourage spending. As Mr. Bernanke has said before, the Fed “retains considerable power” to lift growth.

Now, I'm not sure whether this is encouraging or not, but the next chart shows the path of real GDP from the most recent NBER-dated business cycle peak, relative to the previous two recessions. What is interesting here is that, given the depth of the recent recession, the negative deviation from a 3.26% growth trend (from the NBER-dated business cycle peak) appears no more persistent than in the recent two recessions. Thus, whatever phenomenon is driving the slow recovery may not be new, and may have nothing to do with the particulars of the financial crisis.

In any event, what I do not like in any of the blog/mainstream news posts I have linked to above is the notion that we know exactly what is going on, and exactly what we should be doing about it. There are good reasons to question Keynesian orthodoxy in the current context. Even if we thought that sticky wages and prices were important factors in the recent recession (which I do not), it is hard to believe that the effects of this stickiness would matter 14 quarters after the onset of the recession. Those pushing the Keynesian narrative need to provide us with some more explicit evidence about wage and price stickiness as it relates to recent events.

Further, though Keynesians may wish for more stimulus, they are not going to get it. It cannot come from the Fed, for reasons I have discussed before, and the federal government seems incapable of deciding how big it wants to be, let alone whether it wants to engage in Keynesian fine-tuning.

The Core is Rotten

This speech by Jim Bullard is excellent. It makes the case that the Fed should be focused on headline inflation.

Monetary Policy

The minutes for the FOMC meeting of April 26-27 were released today, and contain much more information than is usual. Typically, the minutes just give some background to the previously-released FOMC statement and, without names, or exact words spoken, they don't tell you a lot.

In this case, there is a detailed account of a discussion about "strategies for normalizing the stance and conduct of monetary policy." "Stance" refers to whether policy is tight or accommodative. By normalizing the stance, the committee seems to mean that, with an inflation target of 2%, a normal fed funds rate should be in the range of 3%-5%. Normalizing conduct seems to mean reducing the size of the Fed's balance sheet to the point where the quantity of excess reserves held overnight is zero.

It is clear that the Fed will have to tighten at some point, but how to do it?

The first key issue was the extent to which the Committee would want to tighten policy, at the appropriate time, by increasing short-term interest rates, by decreasing its holdings of longer-term securities, or both. Because the two policies would restrain economic activity by tightening financial conditions, they could be combined in various ways to achieve similar outcomes.

This comes from a presentation by the "staff," which I take to be the Board's staff. Apparently they think, in line with public statements by Bernanke and others, that there is some kind of equivalence between asset sales and increases in the Fed's policy rate, which is currently the interest rate on reserves (IROR). I guess they do not agree with this.

There are a set of principles here that the FOMC agreed to concerning policy normalization:

First, with regard to the normalization of the stance of monetary policy, the pace and sequencing of the policy steps would be driven by the Committee's monetary policy objectives for maximum employment and price stability. Participants noted that the Committee's decision to discuss the appropriate strategy for normalizing the stance of policy at the current meeting did not mean that the move toward such normalization would necessarily begin soon. Second, to normalize the conduct of monetary policy, it was agreed that the size of the SOMA's securities portfolio would be reduced over the intermediate term to a level consistent with the implementation of monetary policy through the management of the federal funds rate rather than through variation in the size or composition of the Federal Reserve's balance sheet. Third, over the intermediate term, the exit strategy would involve returning the SOMA to holding essentially only Treasury securities in order to minimize the extent to which the Federal Reserve portfolio might affect the allocation of credit across sectors of the economy. Such a shift was seen as requiring sales of agency securities at some point. And fourth, asset sales would be implemented within a framework that had been communicated to the public in advance, and at a pace that potentially could be adjusted in response to changes in economic or financial conditions.

There is of course some vagueness here. What do they mean by "intermediate term?" Is this a year or two, or five to ten? I like the idea that the FOMC thinks it is important to get back to Treasuries-only asset holdings. The plan for asset sales looks basically like QE1 in reverse.

In the discussion, again, members of the FOMC are convinced that asset purchases or sales matter when there is a positive quantity of excess reserves in the system:

Most participants indicated that once asset sales became appropriate, such sales should be put on a largely predetermined and preannounced path; however, many of those participants noted that the pace of sales could nonetheless be adjusted in response to material changes in the economic outlook. Several other participants preferred instead that the pace of sales be a key policy tool and be varied actively in response to changes in the outlook.

Dream on.

For me, this was the most puzzling part of the minutes:

Most participants saw changes in the target for the federal funds rate as the preferred active tool for tightening monetary policy when appropriate. A number of participants noted that it would be advisable to begin using the temporary reserves-draining tools in advance of an increase in the Committee's federal funds rate target, in part because doing so would put the Federal Reserve in a better position to assess the effectiveness of the draining tools and judge the size of draining operations that might be required to support changes in the interest on excess reserves (IOER) rate in implementing a desired increase in short-term rates. A number of participants also noted that they would be prepared to sell securities sooner if the temporary reserves-draining operations and the end of the reinvestment of principal payments were not sufficient to support a fairly tight link between increases in the IOER rate and increases in short-term market interest rates.

The "reserve-draining tools" are reverse repurchase agreements and term deposits. As I have argued elsewhere, these are not additional instruments in the Fed's box of tools, and with both the Fed has lower-cost means of accomplishing exactly the same thing. The Fed can sell assets outright rather than engaging in reverse repos, and the interest rate on a term deposit with the Fed cannot be smaller than the IROR that a financial institution requires to hold the same quantity of funds for the same period of time in its reserve account.

It is unclear why the FOMC seems doubtful that there will not be a tight link between the IROR and the fed funds rate. Granted, some of the recent behavior of the fed funds rate is hard to understand. With the IROR at 0.25%, one would think that arbitrage would dictate that fed funds also trade at 0.25%, but due to the fact that the GSEs do not receive interest on reserves, and because of some heretofore unexplained friction, the fed funds rate (see the chart) has typically been less than 0.25%. Further, during the QE2 period, the effective fed funds rate fell from around 0.2% to 0.1%. This is interesting, as it seems to indicate that the quantity of excess reserves in the system has something to do with the gap between the IROR and the fed funds rate. In any case, I don't see this as a big concern. It is unlikely that the gap will increase as the IROR goes up, and it should fall as assets are sold.

Finally, in the discussion concerning the policy decision, we get this:

In their discussion of monetary policy, some participants expressed the view that in the context of increased inflation risks and roughly balanced risks to economic growth, the Committee would need to be prepared to begin taking steps toward less-accommodative policy. A few of these participants thought that economic conditions might warrant action to raise the federal funds rate target or to sell assets in the SOMA portfolio later this year, but noted that even with such steps, monetary policy would remain accommodative for some time to come. However, some participants indicated that underlying inflation remained subdued; that longer-term inflation expectations were likely to remain anchored, partly because modest changes in labor costs would constrain inflation trends; and that given the downside risks to economic growth, an early exit could unnecessarily damp the ongoing economic recovery.

This does not make it look like tightening is coming any time before the end of the year. Most of the FOMC members seem to be hoping that the increases in headline inflation are temporary, they have strong faith in Phillips curves, or both.

Money and Inflation

Milton Friedman told us that "inflation is always and everywhere a monetary phenomenon," but that statement is so loose that it can only be suggestive. What is money anyway? If we know what money is, can observing its behavior help us predict inflation? If we have more or less inflation than we would like, do time series observations on the stock of money help us to get us where we want to go?

Among Old Monetarists (or quantity theorists), led by Friedman, the standard view was that money should include all media of exchange (more or less), and that the key factor guiding our choice of an appropriate monetary aggregate be the existence of a stable, parsimonius demand function for that monetary aggregate. Friedman argued in his 1968 AEA Presidential address, that central banks should target the growth rate in some monetary aggregate. Note that he also argued that targeting the price level would be a bad idea, as it would lead to instability. Current conventional wisdom appears to be just the opposite. Central banks that jumped on the money-targeting bandwagon in the 1970s and 1980s subsequently jumped off, and some of them adopted explicit inflation targets.

Modern central banking (under normal circumstances) typically amounts to setting some target for an overnight interest rate, with the central bank intervening over the very short run (a few weeks) to hit that target. Decisions about changes in the target are made based on recent inflation experience, recent real economic activity (particularly in the US, where there is an explicit "dual mandate"), and forecasts. This operating procedure appears to work well, in part due to substantial instability in the demand for means of payment at the retail level and among financial institutions.

How does a New Monetarist think about money and inflation? Certainly inflation is always and everywhere a monetary phenomenon. The prices of goods and services, and the full array of asset prices and interest rates, are the terms on which we collectively hold the existing stocks of assets. The quantities of assets used extensively in transactions involving goods and services must have primary influence on the prices of goods and services. However, attempting to add up some asset quantities, calling the total "money," and then attaching some significance to that total, seems like a pointless exercise. For example, an Old Monetarist might add currency and reserves together and call the total "outside money," but of course most of the $1.5 trillion in reserves now outstanding in the United States just sit overnight, and are not used in transactions of any sort. Indeed, US Treasury bills currently have a greater claim to membership in the "money" club, as they are much more useful in financial transactions than are reserves, at the margin.

For a New Monetarist, the most fruitful way to think about a central bank (as might be obvious) is as a financial intermediary. Central banking then must matter to the extent that the central bank has some specific advantages relative to private financial intermediaries. These advantages stem from the central bank's monopoly over currency issue, and its payment system monopoly, whereby reserve accounts are the primary vehicle for settling debts among financial institutions. Under current circumstances, it is the stock of currency that matters, and reserves matter to the extent that they are convertible one-for-one into currency. Currency can be withdrawn by a financial institution from its reserve account just as you withdraw cash from your checking account at the ATM.

As I argued here and here, open market operations by the Fed in US Treasury debt are currently essentially irrelevant. When the Fed is holding a positive stock of excess reserves, and paying interest on those reserves, it should be obvious that traditional swaps of reserves for T-bills have no effect. There is essentially a liquidity trap, no matter what the interest rate on reserves (IROR) is. What is not so obvious is that this also applies to swaps of reserves for long-maturity Treasury securities, since the Fed is no better at transforming long Treasuries into overnight liabilities than is the private sector.

Thus, the $1.5 trillion in reserves currently outstanding in the US do not represent any more of an inflation threat than if the Fed were holding $1.5 trillion less in assets and excess reserves were zero. However, if the Fed continues to hold the IROR at 0.25%, the stock of currency can grow in a purely passive fashion to produce more inflation. That is, suppose that financial institutions perceive that the nominal returns from assets other than reserves are higher. When reserves become relatively less attractive, holding constant the total quantity of Fed liabilities, the composition of those liabilities must change, i.e. ultimately there must be less reserves and more currency. Part of the adjustment can occur through an increase in the price level. If the quantity of excess reserves were zero, the perception of higher nominal asset returns on the part of financial institutions would imply that the Fed would have to engage in open market purchases in order to maintain its fed funds rate target, and these open market purchases would be reflected in a larger stock of currency. Thus, the only difference between what happens with positive excess reserves and zero excess reserves is that, with positive excess reserves the overnight interest rate is fixed and the quantity of currency adjusts passively, and with zero excess reserves the quantity of currency is fixed and the overnight interest rate adjusts passively.

Thus, the stock of currency seems important for the determination of the price level, but what do we know about the demand for US currency? The first chart shows the ratio of currency (the currency component of M1) to nominal GDP, since 1947. The chart shows that the currency/gdp ratio fell from above 11% in 1947 to a low of 3.8% in the early 1980s, then rose. There was a substantial decrease before the financial crisis, to about 5.3%, but the currency/GDP ratio is currently at 6.2%, a level last seen in 1960.

Now, in light of the popular view that the demise of currency is imminent, these numbers might be surprising. I wrote about this earlier here, in the days when looming deflation seemed to be the big worry. In the case of US currency, much is held overseas. How much? As a comparison, currency held in Canada is 3.4% of Canadian GDP, so possibly about half of the stock of US currency is held abroad. If that were the case, that still implies that the quantity of currency held within US borders is more than $1500 per US resident. That's a lot of cash, and a significant fraction (how much I have no idea) is being used in nefarious activities.

Thus, the stock of US currency outstanding is large, and it has become larger since the onset of the financial crisis. Yet due to the nature of currency, and the role of US currency as an international medium of exchange, we cannot quantify the demand for US currency, or forecast it. Further, under current circumstances the Fed does not directly control the quantity of currency in circulation, but can control it indirectly, through the IROR.

What has been happening to the stock of currency recently? The next chart shows year-over-year percentage growth rates in currency (blue), the headline CPI (red), and core CPI (green). Year-over-year growth in currency has been increasing for the last year and now exceeds 8%.

Now, it is hard to see how the demand for US currency in the world is likely to increase further, in real terms. Whatever was driving the increase in currency demand in the financial crisis will likely reverse itself, so if US real GDP grows at 2-4% this year, and currency growth is at 8% per year and increasing, it seems the lower bound on the inflation rate in the near term is about 4%. Here, Ben Bernanke tells us:

FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years.

Now, maybe FOMC participants know something about future tightening that they are not telling us, but this forecast seems well on the low side given the FOMC's stated goal of keeping the IROR at 0.25% for an "extended period."

Bernanke and company would like us to ignore the increase in headline inflation that we have seen, but money does not discriminate between goods and services that are in the "core" and those that are not. If money is growing at a rate that seems in excess of what is consistent with 2% inflation, and the demand for the stuff is not increasing in real terms, then headline inflation has to exceed 2%, and it's not going to be temporarily high if money growth is sustained at that level. It's not crazy to think that the Fed should be tightening in the fall, if not earlier.

More on Sticky Prices

This is an update on this previous post. There are a few papers in the literature that explore the consequences, in sticky-price Keynesian models, of having more price flexibility in some sectors of the economy relative to others. Here are a couple of early papers by Lee Ohanian and coauthors, in the JMCB and the Richmond Fed EQ. Also see a more recent paper by Barsky, House, and Kimball, "Sticky Price Models and Durable Goods." The upshot of this work is that it is important to think in general equilibrium terms. Sometimes prices that are actually flexible can behave like sticky prices, and sometimes there are counter-intuitive effects of monetary policy shocks, or effects which appear inconsistent with evidence. I'll leave it to others to sort out whether this literature has anything to say about current observations.

A recent paper that has some bearing on these issues is this one, by Head, Liu, Menzio,and Wright. Basically, this takes a Burdett/Judd search model of price dispersion, and uses it to think about the implications of monetary intervention for the distribution of prices across sellers. The idea is that, when the equilibrium object is a distribution of prices, then shocks that change this distribution do not require that all sellers change their prices. Indeed, we could observe prices changing very infrequently in a world where all prices are flexible and money is neutral in the short run. The first time I saw this paper, I thought of it as just a clever example, but now I think the idea is quite deep.

While it is useful to have the characterization of the price data that we get from work by Bils/Klenow, etc., as macroeconomists we should not be too focused on the behavior of individual prices. We observe price dispersion because of search and information frictions, and this can help explain observable price behavior, and yet have no implications for the short run effects of monetary policy. Further, most sellers are sellers of multiple goods, and the prices of those goods are interdependent. For example, the Target store prices particular items to bring shoppers into the store, and then uses physical placement of goods in the store and the prices of those goods to extract as much revenue from the buyer as possible. Online shopping is obviously different, as physical location and travel costs are irrelevant but, for example, Amazon uses a set of techniques to bring people to its site, and then uses information and prices to direct you to things they hope you will buy. None of this looks much like incurring a menu cost for each individual price posted, and then meeting whatever demand arises at that price.

Mankiw Piece

I like this piece by Mankiw in the Sunday NYT. Mankiw knows what he doesn't know. What we don't know is whether Krugman knows that he doesn't know, or doesn't know that he doesn't know.

Sticky prices and the Keynesian Narrative

In sticky price Old Keynesian or New Keynesian economics, there are two key ideas. First, it is taken as given that some prices are more sticky than others. There is now a large body of empirical work that characterizes the size and frequency of price changes across a wide variety of goods and services. For example, we now know that the price of gasoline changes about once every three weeks, while prices for restaurant items change once every 11 months. Second, in Keynesian models with sticky prices, the quantity of output produced by a firm is demand-determined when the firm's price is stuck.

Suppose then that we accept the standard Keynesian narrative about our current predicament as truth. Correct me if I'm wrong, but the standard narrative is that it is irrelevant how we got into our current state. The relevant feature of the current state is that there is deficient aggregate demand. Deficient demand spreads itself across sectors of the economy and, according to the narrative, can be remedied with stimulative fiscal and monetary policy.

The standard Keynesian narrative, coupled with the sticky price mechanism, is very useful, as it seems that it could generate restrictions on what we should see in the data, with regard to price and quantity variation and dynamics across sectors of the economy. As far as I know no one explores these things, but I could be wrong. It would be helpful if readers who know this literature could direct us to the relevant research.

What am I thinking about here? First, in a Keynesian world that experiences a fall in aggregate demand, relative prices become misaligned. The relative prices of sticky-price goods rise and the relative prices of flexible-price goods fall. Second, employment will fall in the sticky-price sector relative to the flexible-price sector.

Now, my empirical work here is going to be very crude. This is just a blog, after all. Suppose we look only at the 8 primary components of the consumer price index. These are:

1. Food and beverages (weight 14.8%) This includes two very different items, food at home and food away from home (about half-and-half). The purchase of food away from home, is primarily the purchase of a service.
2. Housing (41.5%) This includes not only the cost of shelter, but energy, furniture, and appliances as well.
3. Apparel (3.6%)
4. Transportation (17.3%) This includes gasoline, cars, and public transportation.
5. Medical care (6.6%)
6. Recreation (6.3%) Includes consumer electronics.
7. Education and Communication (6.4%) Computers are included in communication.
8. Other (3.5%) Includes tobacco and miscellaneous services.

Now, we'll take January 2005 as our base period, and look at the time series for the 8 components, displayed in the first chart. Now according to Mike Bryan and Brent Meyer (Mike took his sticky-price index ideas to the Atlanta Fed when he moved), of these 8 items the flexible ones are: food and beverages (food-away-from-home is sticky, but let's put it in this category anyway), transportation (dominated by energy prices), and apparel (they put infants and toddlers in the sticky category, but it just makes it). Bryan and Meyer use Bils and Klenow to categorize prices as flexible or sticky, but Bils and Klenow do not address housing. Since more than half of the housing component is somehow tied to the price of housing, we'll say that housing prices are flexible, since I don't think anyone wants to argue that house prices are sticky. Otherwise, the prices of medical care, education, recreation, and "other" are sticky.

Now, during the recent recession, we certainly see marked changes in the trajectories of the flexible prices. There is a decline of more than 25% in the transportation component, and food prices (which had been increasing) level out, as does the housing component. This all seems more or less consistent with the Keynesian narrative. However, the price of apparel seems to be behaving like a sticky price which is impervious to the recession. Indeed the prices that are supposed to be sticky - medical services, education, recreation - are also impervious. Surely, in the face of this persistent deficient aggregate demand, the sticky prices should ultimately be adjusting downward.

Now, even more puzzling is what happens from early 2009 to the end of the sample. The decline in transportation prices reverses itself (energy prices up again) and food prices pick up again. According to the Keynesian paradigm, this now looks like an increase in aggregate demand, reflected in flexible price increases, and decreases in the relative prices of the sticky-price goods. Of course, this is not the standard Keynesian narrative we hear at all.

Finally, look at where we are in March of 2011 relative to January 2005. If the dominant force over this period was the period of persistent insufficient aggregate demand that began in late 2007, what we should see at the end of 2011 is lower relative prices of flexible price goods and higher relative prices of sticky price goods. The relative price increases were for transportation (flexible), "other" (sticky), medical services (sticky), food (flexible), education (sticky), and housing (flexible). Relative prices declined for recreation (sticky) and apparel (flexible). Thus, the medium-term relative price movements seem to have nothing to do with stickiness/flexibility as it is spelled out in the Keynesian narrative.

The second chart shows some components of establishment employment, chosen to correspond (pretty rough, I know, but the best I could do) to the CPI components. These are medical and education services (sticky), leisure services (sticky), energy (petroleum and coal products - flexible), food (manufacturing - flexible), construction (flexible), durables (flexible), and apparel (flexible). In the chart, the big employment declines are in fact in the flexible price sector. Sectors that are doing relatively well - medical and education services, leisure, energy, and food - are a mix of flexible/sticky price goods and services.

Conclusion: I can't square what I'm seeing in the data with the standard narrative. Can anyone help me out?

Noah Smith Should Come to Wash U

I'm glad to hear that Noah Smith, a grad student at Michigan is interested in frictions and financial economics, with a little history thrown in. We would be glad to have him here at Washington University, provided he can pass our prelims.

I taught a course in the fall of last year in advanced monetary economics and macroeconomics. This is for students who have been through the first year of the PhD program, and the students who took it were mostly second-year PhD students. As you can see from the syllabus, this is pretty friction-heavy. It's full of non-neutralities of money, private information, financial contracts, financial intermediation, and financial crisis-related papers, including my own work. Where it's useful, I throw in some history to motivate the ideas. Most of the monetary history I know came my way informally. I pick it up when I need it, and I learned a lot from Bruce Smith, Warren Weber, Art Rolnick, and other people.

Now, some people, including Brad, Paul, and Larry, on the sorry state of macroeconomics and how no one is teaching what is relevant. It's unfortunate that some people who like to spout off are so ill-informed. When the financial crisis hit, there was plenty of off-the-shelf economic theory of financial contracts, financial intermedition, and monetary theory that could be, and was, brought to bear on understanding the important issues. Pay attention, you guys!