Friday, September 21, 2012

Kocherlakota: Some Iffy Ideas

Here is another post-QE3-announcement speech by a Fed President. This time it's Narayana Kocherlakota, Minneapolis Fed president, who is focused on how the Fed might provide clearer messages with forward guidance. While I liked what Jeff Lacker had to say - I thought he provided a good case for no change in policy - I'm not much excited about what Kocherlakota has to say.

Kocherlakota makes very clear what he's recommending. Indeed, it's written out twice in the speech, in bold:
As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.
As he points out at the end of the speech, this is in the spirit of policies that Charles Evans (Chicago Fed) has supported.

Elaborating on this, Kocherlakota's key points are:

1. This does not violate the Fed's commitment to 2% inflation. Some people - Woodford in particular - have recommended that the Fed tolerate higher inflation immediately after "liftoff" occurs (liftoff is the time at which the Fed commences tightening).

2. If liftoff occurs when the unemployment rate is too high, this will prolong the period of high unemployment.

3. Kocherlakota is confident that the Fed is not going to be faced with the prospect of tightening before the unemployment rate reaches 5.5%. He trusts the Fed's inflation forecasts and thinks the inflation rate will remain at 2% - plus or minus 1/4%.

At this point, I think people have started to take forward guidance far too seriously. You can see that in Woodford's Jackson Hole paper. These things may be fun to think about, but ultimately I think the effects are second-order. The Fed, in trying to make commitments, has probably created more confusion, with the result that tweaking the forward guidance carries no information at all.

Possibly Kocherlakota thinks that his proposed policy rule is simple enough that everyone can understand it, and the message will be crystal clear. Not to me. Why the unemployment rate? Why 5.5%? Why a tolerance band of plus or minus 1/4% around the inflation target? We're not given the answers to those questions, and I can only think of reasons why these might represent bad choices. Does the fraction of the labor force actively seeking work accurately capture the inefficiency in the economy that the Fed can correct? The "efficient" unemployment rate fluctuates for all kinds of reasons. By 2015, is Kocherlakota going to feel the same way about 5.5% he does now?

What's missing in Kocherlakota's talk? We're never really given a story about what determines the inflation rate. The closest we get is this:
I noted earlier that the FOMC’s current projections for the long-run unemployment rate are well below 8.1 percent. These projections suggest that there will be little upward pressure on inflation until the recovery is sufficiently robust that the unemployment rate has fallen back to a level that is more consistent with historical norms. I see an unemployment threshold of 5.5 percent as being readily rationalized under this perspective, although slightly higher or slightly lower thresholds should not materially affect the impact of this plan.
Thus, in Kocherlakota's mind, there seems to exist a Phillips curve theory of inflation, which is more than a little troubling. And why would anyone be thinking about "historical norms" at a time when nothing is normal? The financial system is holding a very large stock of reserves, those reserves are bearing interest, and the policy rate is close to zero. Nothing normal about that - it's totally different from what existed pre-financial crisis. Central bankers should be thinking about why that could mean something different about how we should think about future unemployment and inflation.

In an earlier post I talked about how Kocherlakota in particular has bent over backwards to speak the New Keynesian language of some of his other colleagues on the FOMC. Maybe Kocherlakota is a New Keynesian. Maybe he thinks that speaking the language is a necessary compromise that buys influence on the Committee. In any case, the approach comes with some dangers. Primarily, if New Keynesian theory is not useful for understanding our current predicament, which I don't think it is, then we are in for more trouble.

Wednesday, September 19, 2012

Lacker Speech

Here's a speech from yesterday by Jeff Lacker, President of the Richmond Fed. Lacker was the only dissenter at the last FOMC meeting.

The speech begins with a useful discussion of the Fed's dual mandate, in particular how we should think about "maximum employment" in the short run and the long run. Then he discusses the reasons for his dissent. Basically he doesn't like any of the components of the Fed's change in policy - the planned asset purchases, the change in forward guidance, and the type of assets to be purchased.

Lacker argues that more accommodation now is not warranted, for two reasons. First, employment growth may be sluggish and the unemployment rate high, but
... my assessment is that a reasonably strong case can be made that the natural rate of unemployment that corresponds to the Fed’s maximum employment mandate is now relatively elevated.
Second, the Fed is doing fine on the inflation front, particularly relative to where it was at the brink of previous policy interventions.
It’s worth noting that when previous asset purchase programs were adopted in 2009 and 2010, the inflation outlook was significantly different than today. Back then, deflation appeared to be a very real possibility, so further accommodation, whatever it did for unemployment, also helped keep inflation closer to the Committee’s goal of 2 percent.

Lacker thinks the change in forward guidance may raise doubts about the Fed's commitment to control inflation.
The Committee’s statement also altered the “forward guidance” regarding future monetary policy, stating for the first time that it expected a highly accommodative stance of monetary policy for “a considerable period after the economic recovery strengthens.” I disagreed with this statement because I believe a commitment to provide stimulus beyond the point at which the recovery strengthens and growth increases implies too great a willingness to tolerate higher inflation and would be inconsistent with a balanced approach to the FOMC’s price stability and maximum employment mandates.
Finally, Lacker has problems with purchases by the Fed of mortage-backed securities (MBS).
Such purchases, as compared to purchases of an equivalent amount of U.S. Treasury securities, distort investment allocations and raise interest rates for other borrowers. Channeling the flow of credit to particular economic sectors is an inappropriate role for the Federal Reserve. Central banks abuse their independence when they promote some borrowers at the expense of others.
This is an important concern. Even if MBS are close substitutes for Treasury debt, and the decision about whether the Fed purchases MBS or Treasuries matters little, there is a perception that the Fed intends to favor a particular sector of the economy with this type of intervention. If indeed the MBS are not close substitutes for Treasuries, then, as Lacker points out, the Fed's actions will serve to reallocate credit. For example, investment in capital equipment will suffer relative to residential construction.

Lacker should not be characterized as some kind of extreme hawk. His views, as reflected in this speech, are well-reasoned, and well within the mainstream of modern economic thought.

Tuesday, September 18, 2012

Alan Greenspan and the Gold Standard

Speaking of weird monetary economics. Maybe everyone knows this, but a commenter on the last post led me to some details about Alan Greenspan's past that I did not know about.

First, Greenspan puts Paul Ryan to shame in the Ayn Rand department. Greenspan was not just a casual reader of Rand, but was in her inner circle while she was writing Atlas Shrugged. Greenspan was, or is, a committed Objectivist and wrote an essay, "Gold and Economic Freedom," for Rand's book Capitalism, the Unknown Ideal. That essay is described in the link as being influenced by the ideas of Murray Rothbard, whose ideas also have a bearing on what Ron Paul thinks. Like Rothbard, Greenspan thinks that backing bank deposits with gold is a good idea, but he doesn't go so far as to recommend a 100% gold-reserve requirement. Somehow the reserve requirement is supposed to limit inefficient credit creation. Like Rothbard, Greenspan is confused as to why unfettered markets should work so well everywhere except in the banking system. He also thinks that the "golden" age of monetary arrangements existed prior to the existence of the Federal Reserve System. Most monetary historians think of the National Banking era (1863-1913) as a period when the financial system of the United States was fatally flawed, as it produced repeated banking panics. Not Greenspan apparently.

Here's an excerpt from "Gold and Economic Freedom":
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.
You could put those two paragraphs in Ron Paul's "End the Fed," and no one would notice. The use of "insidious" is interesting. That's the same word that Paul Ryan used to describe QE3.

The amazing part of this story is that Greenspan served as Chair of the Fed for a long time, and didn't seem to screw up (though some people lay some of the blame for the financial crisis at his doorstep, I'm inclined not to). If I had read "Gold and Economic Freedom" before his appointment I would have been in a panic. Maybe this means we could appoint Ron Paul to replace Bernanke, and everything would be fine. No, never mind.

For your entertainment, here's a 2007 interview with Greenspan on the gold standard. Apparently his views have not changed much.

Monday, September 17, 2012

Weird Monetary Economics and the Republican Party

Ron Paul's views on the role of the Federal Reserve System are well-known. Paul has found little support for actually ending the Fed, but he managed to get a bill through the House during the summer which would have established additional "auditing" of the Fed. Fortunately, the bill went nowhere in the Senate.

The Fed is of course audited by the General Accounting Office. What Ron Paul has in mind is not auditing in the conventional sense, but an opening-up of FOMC deliberations, along with other elements of Fed decision-making. While transparency might seem like a good thing, there are elements of Fed secrecy that actually work to our advantage. A strong and independent Fed may be able to work more effectively in the public interest than a Fed that is constantly being "audited" by Congress.

The view that the Fed is in need of reform has been written into the Republican Party's election platform. The key passage is this one:
...the Republican Party will work to advance substantive legislation that brings transparency and accountability to the Federal Reserve, the Federal Open Market Committee, and the Fed’s dealings with foreign central banks. The first step to increasing transparency and accountability is through an annual audit of the
Federal Reserve’s activities. Such an audit would need to be carefully implemented so that the Federal Reserve remains insulated from political pressures
and so its decisions are based on sound economic principles and sound money rather than on political pressures for easy money and loose credit.

Determined to crush the double-digit inflation that was part of the Carter Administration’s economic legacy, President Reagan, shortly after his inauguration,
established a commission to consider the feasibility of a metallic basis for U.S. currency. The commission advised against such a move. Now, three decades later, as we face the task of cleaning up the wreckage of the current Administration’s policies, we propose a similar commission to investigate possible ways to set a fixed value for the dollar.

There are two ideas in there. The first is Ron Paul's Fed audit, and the second sounds like sympathy for a return to the gold standard. Once we enter into discussions of how precious metals should be an integral part of modern monetary systems, we have slipped into the territory of the lunatic fringe.

But this is just the Republican party's platform. Maybe the candidates aren't actually serious about it. Romney was asked about Fed audits at a town hall meeting, and expressed what the Wall St. Journal characterized as "lukewarm support," coupling sympathy for an audit with comments on the importance of Fed independence (much like in the party platform).

Similarly, public comments by Romney on the Fed's recent policy announcement were somewhat muted. Romney's campaign issued this statement:
The Federal Reserve’s announcement of a third round of quantitative easing is further confirmation that President Obama’s policies have not worked. After four years of stagnant growth, falling incomes, rising costs, and persistently high unemployment, the American economy doesn’t need more artificial and ineffective measures. We should be creating wealth, not printing dollars. As president, Mitt Romney will enact bold, pro-growth policies that lead to robust job creation, higher take-home pay, and a true economic recovery.
Romney seems to understand that directly criticizing the Fed is a bad idea if you are running for President, so he uses this as an opportunity for Obama-bashing. There is some Fed-bashing in the statement though. "Artificial and ineffective measures?" That may be true, but Romney should not be saying that, or approving of other people saying it. "We should be creating wealth, not printing dollars?" Is this saying that financial and monetary factors never make a difference, or what?

Paul Ryan, in his attack-dog role, goes further. He says, commenting on the Fed's new policy:
One of the most insidious things a government can do to its people is to debase its currency.
Now we're venturing into Ron Paul territory. Start talking about "debasement," and you're not many steps down the road to Murray Rothbard, apparently a key influence on Ron Paul. Rothbard is a somewhat confused libertarian. Markets are good, except when it comes to the provision of "money." According to Rothbard, not only should we return to the gold standard, but anything that looks like a transactions medium should be backed 100% by gold. Most economists, including Paul Krugman, can understand why this is a bad idea.

Bad monetary ideas have always been with us. But, like other bad ideas, the financial crisis and the recent recession appear to have flushed those ideas into the open again. Ben Bernanke may think he has been doing the right thing, but he might do well to take a lesson from Alan Greenspan. While Bernanke knows far more economics, Greenspan was a master at staying out of sight. Good central banking proceeds in a way that nobody notices. The more unusual things you do, the more you get noticed.

Friday, September 14, 2012

How Will the Introduction of the iPhone 5 Affect GDP?

Apple is about to introduce a new iPhone. Michael Feroli at JP Morgan thinks that the introduction of the iPhone 5 will make GDP go up significantly. Why? Feroli estimates sales for the iPhone 5 and adds that to GDP. That can't be right. Even worse, Paul Krugman, thinking like a student in a bad intro-macro class with a homework problem, says GDP will indeed go up. Worse than that, he thinks this has implications for fiscal policy, which got David Andolfatto justifiably perturbed.

The simplest way to think about the introduction of the iPhone 5, is that it's an increase in total factor productivity (TFP). The iPhone 5 does not appear to do anything that its predecessor did not - it just does it better. It seems Apple is just producing more of the thing, quality-adjusted, with roughly the same capital and labor inputs. In a world with flexible prices, real GDP will go up as a result, but the increase has to be very small - certainly much smaller than the JP Morgan estimate. But what happens in a world with sticky prices - the world in which Krugman lives? GDP is demand-determined, and demand does not change as a result of the change in TFP, so the change in GDP is zero. Further, employment falls, as we can now produce the same quantity of output with less inputs. This is surely not something Krugman would like.

Eggertsson/Woodford and Forward Guidance

In this post I overlooked a crucial sentence in the FOMC statement. In the "forward guidance" paragraph, it says
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.
The FOMC is telling us that, in circumstances under which it would otherwise tighten, it doesn't expect to be doing that.

You can find the motivation for that element of the Fed policy in Woodford's work. It's in his Jackson Hole paper, but the key reference is this 2003 paper by Eggertsson and Woodford. The logic is fairly simple. In New Keynesian models, the central bank sets the nominal interest rate so as to achieve the "correct" real interest rate, but sometimes the zero lower bound gets in the way, and the real interest rate will be too high relative to the "Wicksellian natural rate," with the nominal interest rate at zero. But, according to Eggertsson and Woodford, all is not lost. The central bank can promise a period of high inflation when the nominal interest rate "lifts off" the zero lower bound and/or a longer period over which the nominal interest rate will be zero. Then, given higher expected future inflation, inflation is higher in the present, and the real interest rate falls, in spite of the fact that the nominal interest rate is zero and can't go lower.

Key to making the policy work is commitment. A Taylor-rule policymaker acting with complete discretion will not choose the high inflation policy in the future.

The FOMC appears to have bought the Eggertsson/Woodford argument. It's reflected both in the sentence quoted above, and in the extension of "expected liftoff" to mid-2015. What's wrong with that?

1. Do we think that Eggertsson/Woodford provides a good description of what is currently going on in the world? We have to buy the idea that the key problem we face is that the real rate of interest is too high. Real rates of interest - for all maturities - are historically very low. We need to think that the "Wicksellian rate" is even lower. Why should that be? In the Eggertsson/Woodford model, central bankers hit the zero lower bound because there are exogenous shocks to the optimal real interest rate. Just what drives those shocks is unclear, and it is also unclear what a low Wicksellian real rate has to do with the recent financial crisis. If anything, we can think of the financial crisis, and the European sovereign debt crisis, as having produced a shortage of safe assets, which makes real rates of return too low rather than too high.

2. Eggertsson Woodford does not tell us anything about quantitative easing (QE). How does the FOMC know that the model which has all the effects in it that they want - effects on inflation and real activity from various kinds of asset swaps and forward guidance - is actually going to have the Eggertsson/Woodford effect in it? Note that Eggertsson/Woodford work out a neutrality theorem - QE does not matter in their model. But of course Eggertsson/Woodford don't have a serious theory of the term structure of interest rates, and neither does anyone else, including the economists at the Fed. If we put together a monetary policy motivated by results from model x, model y, and model z, we might want to make sure that x, y, and z are mutually consistent.

3. The Eggerstsson/Woodford analysis relies on log-linearized solutions. This work by Toni Braun and coauthors shows how this can lead us astray.

Thursday, September 13, 2012

The Fed Plays With Its Tools

Well I got most of this right, except for the change in forward guidance. Today the FOMC announced that the Fed will be purchasing more mortgage-backed securities, and expects to maintain the policy rate where it is for a longer period than previously announced.

In its press release, the FOMC first tells us what it is worried about:
The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.
Here, both parts of the dual mandate are addressed. The Committee thinks they are missing on the low side on real economic activity. From their point of view, while things are improving, they are not improving quickly enough. What exactly would an appropriate rate of improvement be? The statement makes that clear - economic growth has to be proceeding at a sufficiently high rate so the there is "sustained improvement in labor market conditions." I think the right interpretation of that is that the Committee wants to see the unemployment rate decreasing and the employment/population ratio increasing.

The second element in the dual mandate is inflation, of course. Note that the FOMC does not speak to the current or past rate of inflation, but to what they anticipate it will be. In some economic models, the central bank should want to control the anticipated rate of inflation, and current and past inflation are bygones, but there are pitfalls in practice. The key problem is that the Fed gets to write its own performance review if it defines success in terms of what it forecasts. In this case, the Fed's forecasts are in this document, and the inflation component of those forecasts is very optimistic. The pce inflation rate is forecast to be lower than 2% out to the end of 2015. I'm not sure what generated that projection, other than wishful thinking. I can't see how it's consistent with the forward guidance in the current FOMC statement, but more on that later.

In the paragraph in the FOMC statement that details "QE3," the latest Fed asset-purchase program, the Committee first tells us what they think QE does:
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate,...
Thus, according to the FOMC, quantitative easing both increases inflation and real economic activity - the Committee thinks more QE will move us up the Phillips curve. The Phillips curve, if you hadn't noticed, seems to be at the core of current Fed religion.

The announced QE program is to be added on top of two previously-announced asset purchase policies. The first of these replaces maturing agency securities and mortgage-backed securities (MBS) that run off (because of prepayments and defaults) with more MBS. In the absence of other asset-purchase programs, that policy would hold constant the size of the Fed's balance sheet (in nominal terms) - i.e. the balance sheet would otherwise be shrinking, though at a fairly slow rate. The second policy is so-called "operation twist," which had been extended to the end of the year, involved swaps of short-maturity Treasury securities for long-maturity Treasuries, at the rate of about $45 billion per month. The newly announced program calls for purchases of MBS at the rate of $40 billion per month.

Given past Fed actions, this move is somewhat aggressive. An operation twist purchase of long-maturity Treasuries is roughly the same as purchasing the same dollar amount in MBS. The fact that the Fed is issuing reserves in the latter case rather than selling short-maturity Treasuries should not make much difference, and it should not matter much if the Fed purchases MBS, rather than Treasury bonds (though I know there are claims to the contrary - see this and this). So, roughly, what the Fed plans is $85 billion in asset purchases per month (as it points out in the statement), which is a little larger than QE2, which proceeded at the rate of about $75 billion per month.*

An interesting feature of QE3 is that it is open-ended. Assuming one thinks that QE is a good idea under the current circumstances (and I don't think it matters at all), this also seems like a good idea. In cases where Fed decisions concern only a target for the overnight rate, it is deemed useful for the FOMC to reconsider what it is doing at each FOMC meeting. Why not do that for asset purchases as well?

Of course, it's important that the Fed adopt a reasonable stopping rule for QE3. What is it?
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
Consistent with typical central-banker vagueness, that leaves the FOMC a lot of wiggle room, but I take it that they want to see the unemployment rate falling and the employment/population ratio rising in line with what we might see in a "normal" recovery.

The Fed also threw some forward guidance into the mix, for good measure:
the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
The previous wording said "late 2014." At this point, I think the forward guidance is essentially meaningless. This is not a promise - it's just a forecast - and no one should think the Fed is actually confident about that forecast.

We should also be asking why the change in forward guidance did not go the other way. If the Fed is so confident about the effectiveness of QE, it should be shortening the period until "liftoff," not lengthening it.

*Corrected from an earlier version.

Monday, September 10, 2012

FOMC Meeting This Week

The FOMC will meet Wednesday/Thursday this week, so now is a good time to review the current state of monetary policy in the United States. The dominant argument within the committee is likely to be that: (i) The Fed is falling well short of its dual-mandate goals; (ii) Therefore more accommodation is called for; (iii) The monetary accommodation should take the form of more quantitative easing (QE), and the most effective QE action would be the purchase of more mortgage-backed securities (MBS).

How is the Fed doing with respect to its dual mandate? The Fed thinks that a 2% annual rate of increase in the personal consumption (pce) deflator is optimal. The first chart shows the 12-month percentage increase in the pce deflator, and by this measure the Fed is missing its goal on the low side.
The year-over-year percentage increases in the pce deflator have been well below 2% for several months.

However, it's easy to make the case that inflation is neither too high nor too low, but about right. The next chart shows the pce level, and a 2% growth path from January 2007.
If we adopt a longer time horizon, the pce deflator is only slightly below the 2% growth trend, and it does not particularly matter if we treat the base period as January 2007, or January 2009, for example. If the Fed wants to make up for the period in the recent past of inflation above 2%, it should consider inflation to be currently on track.

Further, financial markets seem to be confident that the Fed will continue to be serious about inflation control into the indefinite future. The breakeven 10-year inflation rate, measured as the difference between the nominal 10-year Treasury yield and the 10-year TIPS yield, is shown in the next chart.
In the chart, the current breakeven rate is a little below the pre-financial crisis average, which seems roughly consistent with a 2% average inflation rate for the next 10 years. While there exists at least one measure of anticipated inflation, the Cleveland Fed's inflation expectations measure that is quite low and falling, I don't take it seriously, principally as it seems inconsistent with what is happening to the breakeven rate.

In conclusion, if the Fed were looking only at inflation and measures of anticipated inflation, it would not find good reasons to change policy.

But what about the "real" side of the Fed's mandate? By most measures, economic performance in the US appears poor. For example, the next chart shows the log of real GDP and a 3% growth trend from the first quarter of 2000. 3% growth is taken as a benchmark, as this is roughly the post-World War II average.
Real GDP was already below the 3% trend when the last recession began, and never made up the ground lost during the recession. Indeed, real GDP post-recession appears to be on a lower growth path with a smaller rate of growth. Labor market observations give an even more sluggish picture.

But if we think that there is something about real economic activity that the Fed can correct, we must think that real economic activity is too low relative to potential. To quote myself, from this post,
What is the economy's "underlying potential" anyway? It's the level of aggregate real GDP that we could achieve if, within the set of feasible economic policies, policymakers were to choose the policy that maximizes aggregate economic welfare.
This is pretty tricky as, even if we thought that the US economy's long run potential was the 3% growth path in the last chart, the optimal policy would generally involve some period over which we adjust to that growth path. New workers cannot be hired and more output produced overnight. Indeed, long run potential could be the 3% growth path, and current policy could nevertheless be optimal.

But that is not what the majority of FOMC participants seem to think. My guess is that the consensus view is that the current adjustment to a better future state of the world is taking place too slowly, and that the Fed needs to be more accommodative, whether inflation is low low or about right.

Is more accommodation called for? Before answering that question, we have to ask whether it is actually feasible for the Fed to take any action that is more accommodative. I don't think so, as discussed here and in other posts. But suppose we think that the Fed can intervene, either by way of forward guidance or QE, and move asset prices in the way it says it can. What will lower bond yields do for us? The next chart shows a measure of the real 10-year safe bond yield - the yield on 10-year TIPS.
This real yield was at about 2% at the end of the recession, and has fallen on trend to less than -0.5% since then. By any measure, real bond yields are historically extremely low. Suppose that the FOMC were to announce that the target for the policy rate will stay where it currently is until late 2015, or that it will buy a few hundred billion dollars more in long-maturity assets. How much lower could the Fed move real bond yields? How large an effect could this have on any aspect of real activity, for example what investment projects are going to be financed that would not otherwise have been?

Why MBS purchases? Some people in the Fed system and on the FOMC seem to be worried that, if the Fed purchases more Treasury bonds, that this would disrupt markets in these assets. These views, and support coming from this work, for example, are pushing the FOMC toward MBS purchases, in addition to (perhaps) a waning in enthusiasm for the use of forward guidance. The disruption argument seems wrongheaded. First, disruption would seem to be a good thing if one thinks that QE works and is looking for the asset market where the Fed can get the most bang for the buck. By purchasing Treasury bonds and disrupting the Treasury market, the Fed will drive asset market participants elsewhere, which seems to be the whole idea. Second, there are plenty of good reasons for the Fed to favor moving in the direction of a portfolio consisting almost entirely of Treasury debt.

What are the potential costs of further intervention in the form of QE? If QE matters little, what's the big deal? Perhaps the FOMC can vote for another round of QE, hope for GDP growth to pick up on its own, and Ben Bernanke will come out of this looking very good. The problem is that Fed people have bought into QE in a big way. They really think it works, to the point that they believe that reverse-QE will control inflation, which it won't. In the event that it becomes clear that inflation is too high and needs to be curbed, the FOMC will take some time to learn how to do it properly.

Wednesday, September 5, 2012

What the Nobel Prize in Economics Gets You

The per-word wage rate in this business must be very high. How many takes do you think it took to get that right?

Sunday, September 2, 2012

Jackson Hole Conference

Ben Bernanke's job is not easy, though that's partly his fault. By speaking extensively to the "maximum employment" part of the dual mandate, he has defined success in a way that dooms him to failure. By embarking on unprecedented and aggressive policy programs - quantitative easing (QE) and forward guidance of various sorts - he has taken on some big risks.

In his Jackson Hole speech, Bernanke's job was to do the best he could in defending past decisions, and in arguing that the Fed is prepared to face whatever the future holds.

Bernanke wants you to think of the people running the Fed as mechanics with a large box of tools. If the economy is to run the way we want it to, all we need to do is find the right tool, and fix it. The more tools, the better. In his speech, Bernanke wants to tell us about "balance sheet tools" and "communication" tools - QE and forward guidance, respectively.

QE and forward guidance are "unconventional" central banking tools. Why do we need these unconventional tools? According to Bernanke, the economy needs fixing, and we can't use conventional tools - open market purchases of short-term government debt - as the overnight nominal interest rate is as low as the Fed is willing to push it.

How do we know that the unconventional tools work? As economists, we feel more assured if we have sound theory and empirical evidence that we can argue are consistent with particular policy actions. What's the theory behind QE? According to Bernanke:
One mechanism through which such [long-maturity asset] purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors' portfolios.
For most modern macroeconomists, that won't be very assuring. "Porfolio balance theory" was the stock and trade of James Tobin more than forty years ago. In this class of models, one specifies a set of asset demand functions - one for each asset, where the demand for an asset depends on the rates of return on assets and on wealth. In general, open market operations in any asset will be non-neutral in such a model. If the central bank purchases a particular asset, then its price will go up, and the rates of return on other assets will change, depending on whether these assets are substitutes or complements for the asset the central bank purchased.

What's wrong with portfolio balance theory? Principally, it ignores how assets are used in retail and financial transactions, and how assets are intermediated by financial institutions. As well, complementarity and substitutability among assets are in practice functions of financial regulation and government policy rules, and should not be treated as "structure." Further, Tobin's models were static, and dynamic elements are critical for studying the effects of monetary policy.

But, Bernanke may be one step ahead of us, as in a footnote, he states:
For modern treatments of the portfolio balance channel in a macroeconomic context, see Andrés, López-Salido, and Nelson (2004). The portfolio balance channel would be inoperative under various strong assumptions that I view as empirically implausible, such as complete and frictionless financial markets and full internalization by private investors of the government's balance sheet (Ricardian equivalence).
Standard frictionless models have no role for quantitative easing. Indeed, the Arrow-Debreu framework has no role for a central bank or for central bank liabilities. To start thinking about monetary policy and what it does, we need a model with "frictions," i.e. we need a formal description of how different assets are used in exchange and an explanation for why conventional and unconventional central banking actions might matter.

The Nelson et al. paper builds a model based on conventional representative agent macroeconomic frameworks, and adds to this some frictions, of sorts. It's certainly not in the New Monetarist spirit. Central bank liabilities are in the utility function, there are costs to adjusting money balances, and the frictions that will give a role for QE are transactions costs associated with purchasing long-maturity bonds, and "self-imposed reserve requirements." This paper did not teach me much about why QE may or may not work.

Basically, Bernanke does not have much to go on in the way of theory to justify the use of QE. What about empirical work? Plenty of this has been done by now, and Bernanke cites some of it, but without a theory, where are we? We can find plenty of people - most of them in the Federal Reserve System - who are now willing to vouch for the fact that QE announcements move asset prices in the "right" direction. But what of it? What do the announcements mean? How do we separate the forward guidance aspect of a QE announcement from the basic QE effect?

On forward guidance, Bernanke makes clear what the "2014" language in the FOMC statement means, in case you were confused:
As the language indicates, this guidance is not an unconditional promise; rather, it is a statement about the FOMC's collective judgment regarding the path of policy that is likely to prove appropriate, given the Committee's objectives and its outlook for the economy.
Thus, there is no commitment implied by the language in the statement. Bernanke wants us to interpret the forward guidance in the FOMC statement as a forecast for when the Fed is likely to raise its policy rate. Maybe this is not such a bad idea. Under normal circumstances, every FOMC meeting gives us more information on the Fed's implicit policy rule, and theory tells us that the more we know about the policy rule, the better. But at the zero lower bound, we don't get much information about what the Fed is up to. Forward guidance might help in this respect, though I doubt that the FOMC will want to keep the interest rate on reserves at 0.25% for the next two years.

Woodford's paper from the Jackson Hole conference seems to be getting some attention. I wouldn't recommend reading all 96 pages of this tome unless the value of your time is close to zero. To get the general idea, read pages 82-87. Here's something I disagree with:
To the extent that central banks have been willing to make explicit commitments about the future conduct of policy, it has most often been to underline their commitment not to allow higher inflation than would correspond to their normal, long-run inflation target, even temporarily. Thus, in the case of the Federal Reserve, the introduction of more explicit forms of forward guidance and aggressive expansions of the Fed balance sheet have been accompanied by assurances that these policies should in no way suggest that there will be any relaxation of the FOMC’s vigilance when it comes to preventing any increase in inflation. Such assurances tend to contradict precisely the kind of signals that one would want such policies to send in order for them to be effective in providing people a reason to spend more.
A key problem for the Fed is that it needs to reassure people that it remains committed to controlling inflation, in spite of the unusual circumstances. The fact that inflation expectations - as reflected in TIPS yields, for example - remain subdued, reflects the Fed's efforts to maintain its hard-won credibility as being serious about inflation. I don't think Woodford, or anyone else, would like the results if the Fed were to abandon that commitment.

Woodford seems not to think much of QE, and goes off on an extensive discussion of forward guidance, most of which made me happy that Woodford is not in charge of forward guidance at the Fed. If he were, we would never understand what they are up to.