Monday, November 26, 2012

SED Newsletter: Lucas Interview

The November 2012 SED Newsletter has some useful information on upcoming meetings. There is also an interview with Robert Lucas, which is a gem. Some excerpts:

On the Lucas Critique:
But the term "Lucas critique" has survived, long after that original context has disappeared. It has a life of its own and means different things to different people. Sometimes it is used like a cross you are supposed to use to hold off vampires: Just waving it it an opponent defeats him. Too much of this, no matter what side you are on, becomes just name calling.

Business cycles are all alike?
As I have written elsewhere, I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!

ED: If the economy is currently in an unusual state, do micro-foundations still have a role to play?
RL: "Micro-foundations"? We know we can write down internally consistent equilibrium models where people have risk aversion parameters of 200 or where a 20% decrease in the monetary base results in a 20% decline in all prices and has no other effects. The "foundations" of these models don't guarantee empirical success or policy usefulness.
What is important---and this is straight out of Kydland and Prescott---is that if a model is formulated so that its parameters are economically-interpretable they will have implications for many different data sets. An aggregate theory of consumption and income movements over time should be consistent with cross-section and panel evidence (Friedman and Modigliani). An estimate of risk aversion should fit the wide variety of situations involving uncertainty that we can observe (Mehra and Prescott). Estimates of labor supply should be consistent aggregate employment movements over time as well as cross-section, panel, and lifecycle evidence (Rogerson). This kind of cross-validation (or invalidation!) is only possible with models that have clear underlying economics: micro-foundations, if you like.

This is bread-and-butter stuff in the hard sciences. You try to estimate a given parameter in as many ways as you can, consistent with the same theory. If you can reduce a 3 orders of magnitude discrepancy to 1 order of magnitude you are making progress. Real science is hard work and you take what you can get.

"Unusual state"? Is that what we call it when our favorite models don't deliver what we had hoped? I would call that our usual state.

Wednesday, November 21, 2012

What the Economics Profession Looks Like to Yglesias

It took three weeks for Matt Yglesias to figure out that I was having fun at his expense. As my mother would have said, better late than never.

Yglesias tries to get my goat by arguing that people who talk about economic science are full of it. But here is something interesting:
Here's what I think about ambition. I think that if I were an ambitious monetary economist who believed in good faith that the current course being pursued by the FOMC will be ineffective in boosting employment and is likely to produce a troubling level of inflation, I'd be shouting that from the rooftops.
Why? Because when we're mired in inflation, all the whores and politicians will look up and shout "save us!" and they'll be shouting at the people who called it right. When Milton Friedman warned that the naive Phillips Curve economics being pursued by the Federal Reserve in the late-60s and 70s would lead to ruinous inflation, nobody listened to him. Until suddenly they did listen to him and low and behold Milton Friedman was super-famous. Developing a correct analysis of the situation and then explain it is obviously no guarantee of success in your career. But all else being equal, it tends to help. That said, sometimes things aren't equal. But I wonder what it is Williamson thinks isn't equal here? What job is Kocherlakota angling for? And how will pretending to believe something he knows is wrong help him get it?
This, I think, is a strange view of the economics profession, but possibly not so far away from how the average non-economist thinks. If you're an economist, you might be anticipating that Uncle Billy is going to ask you for a forecast tomorrow over Thanksgiving dinner, and you probably won't know what to tell him. Probably his forecast is as good as yours. Some economists are indeed forecasters, but most of us hardly think about the forecasting problem.

Yglesias has a story in his head about how Milton Friedman became "super-famous." Actually, Friedman was super-famous long before he made his 1968 address as President of the American Economic Association, and long long before the importance of that address was widely understood. Further, in terms of research impact, Friedman's influence today has more to do with the Friedman rule, the permanent income hypothesis, and the Monetary History.

Yglesias thinks that the way to get ahead in the economics profession is to make an outlier forecast, make a big noise about it, and hope that you're right. There's certainly a cynical view out there that says this works - Nouriel Roubini comes to mind. I guess Yglesias and I are very different. He puts himself in the shoes of an "ambitious monetary economist" and asks what he'd do. Maybe I'm not ambitious, or too old for it, but I think of everything I do as learning and teaching. I want to learn, and I enjoy passing the knowledge on to other people. Fame is for Yglesias and Lady Gaga.

On the particular questions at hand: First, it is indeed accurate that I think what the Fed has done recently (QE, Twist, forward guidance) matters little for US labor markets. Second, it is not accurate to say that I think a "troubling level of inflation" is "likely." Given current and planned monetary policy actions, and how I think the Fed will behave in the future, I can see an equilibrium path on which the inflation rate is higher than it should be. I can't say anything sensible about "likely." Actually, my hope is not that this comes to pass and people think I am remarkably prescient, but that I have some influence and it doesn't happen. That would be better for everyone, don't you think?

Second, there are plenty of economists for whom Narayana Kocherlakota is a puzzle. He may yet redeem himself, but my current thinking is the following. Nerds are valuable members of society. I think we should give them resources and room to work. But we should think twice about letting a nerd run anything.

Shameless Advertising

The fourth Canadian edition of my intermediate macro book is now out, though the Pearson web page claims you can't actually buy it yet. I have a physical copy of the thing, so you should be able to get it soon.

One innovation in this edition is a version of the Mortensen-Pissarides search model of unemployment, for undergraduates. This model has been with us for a very long time, and has been responsible for some Nobel prizes, so I thought its introduction to undergads was long overdue.

Some people ask me what the difference is between my Canadian and US books. The straight answer is that some Canadian institutions are different, as is the data, and examples. I usually make a joke out of it, though, and tell people that I have to translate into Canadian.


US English: My friend and I were going to the hockey game. I hadn't put the snow tires on my car, and perhaps I had had too many beers, and I ran into a moose. Boy, am I a loser.

Canadian English: Well, me and my buddy were goin to da hockey game, eh. No snow tires on the car, so she was slidin around a bit, not to mention we had been at the hotel playing shuffleboard and had got plowed. A big moose in the road, eh, and we hit her. What a hoser.

Monday, November 19, 2012

The Future of Federal Reserve Policy

If the rumors are correct, Ben Bernanke is likely to leave his post when his term ends on January 31, 2014. Bernanke's likely successor is Janet Yellen, who is currently Vice-Chairman (official title - not sure why they haven't dropped the "man") of the Federal Reserve Board, and former President of the San Francisco Fed. How does Janet Yellen think? We can get some ideas about that from her most recent speech.

Yellen's speech is primarily a defense of mainstream views on the FOMC, and I find some of those views troubling. Yellen argues that, in contrast to the bad old days of central bank secrecy, we are now in an age of Fed transparency. What the Fed says matters, and she is on board with policies that use Fed statements about its future policy actions - forward guidance - to influence the behavior of private economic agents. With regard to policy goals, Yellen favors a "balanced approach," whereby unemployment matters as much as inflation to Fed decision-makers. But what would that mean for policy decisions? This gives you an idea:
Put differently, the purpose of providing greater clarity about the FOMC's longer-run inflation goal is to anchor inflation expectations more firmly. These more firmly anchored expectations in turn free the Committee's hand to more actively and effectively stabilize short-run fluctuations in economic activity. The Committee can act in this way because the FOMC can tolerate transitory deviations of inflation from its objective in order to more forcefully stabilize employment without needing to worry that the public will mistake these actions as the pursuit of a higher or lower long-run inflation objective.
So given that the Fed is now so transparent and able to speak directly and honestly to the public about its goals for long run inflation, it is free to do almost anything in the short run to influence real economic activity. This seems like an excuse for perpetual postponement of decisions to come to terms with inflation.

For Yellen, the Phillips curve is alive and well:
...the essence of the balanced approach, is that reducing the deviation of one variable from its objective must at times involve allowing the other variable to move away from its objective. In particular, reducing inflation may sometimes require a monetary tightening that will lead to a temporary rise in unemployment. And a policy that reduces unemployment may, at times, result in inflation that could temporarily rise above its target.
We know where those ideas led us.

What would Yellen's "balanced approach" imply for economic policy over the foreseeable future? She's quite specific, particularly in how she evaluates policies:
...I need to rely, as I noted, on a specific macroeconomic model, and, for this purpose, I will employ the FRB/US model, one of the economic models commonly used at the Board.
That the FRB/US model is "commonly used at the Board," and that Yellen takes its policy implications seriously, is shocking. We don't know exactly what is in the FRB/US model, but my best guess from this 1996 publication (and it's pretty poor that the latest documentation on this thing is 16 years old) is that the FRB/US model looks much like the large-scale macroeconometric models that existed in 1970. These are basically elaborate, pseudo-dynamic IS/LM models, which were debunked as policy tools by the mid-1970s.

What does the FRB/US model have to tell us?
The optimal policy to implement this "balanced approach" to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016...
I should note here that, in addition to being a poor policy tool at any time, FRB/US knows absolutely nothing about quantitative easing, interest on reserves, how the world works when the Fed holds a very large stock of long-maturity Treasury bonds and mortgage-backed securities, what happens when there is a very large stock of reserves outstanding, or how a financial crisis matters. But Janet Yellen wants us to take this model seriously.

With regard to forward guidance, Yellen is all for publishing more detailed Fed forecasts, and being more explicit about the "liftoff" date.
the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range. For example, Charles Evans, president of the Chicago Fed, suggests that the FOMC should commit to hold the federal funds rate in its current low range at least until unemployment has declined below 7 percent, provided that inflation over the medium term remains below 3 percent. Narayana Kocherlakota, president of the Minneapolis Fed, suggests thresholds of 5.5 percent for unemployment and 2.25 percent for the medium-term inflation outlook. Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.
This is a rather foolish idea. To be well understood, a liftoff rule has to be simple. It has to contain specific numerical goals, in terms of a few economic variables. But that is the liftoff rule's fatal flaw. Sensible central banking policy requires that policymakers look at everything. Unforeseen contingencies arise that would make it obvious that the liftoff rule should be abandoned, with an ensuing loss of credibility for the Fed. As well, the unemployment rate is a poor summary statistic for economic welfare, and the unemployment rate fluctuates for many reasons that the Fed should want to ignore.

To bring us down to earth, this speech by Charles Plosser, President of the Philadelphia Fed, is helpful. Janet Yellen thinks that monetary policy is a powerful tool for influencing real economic activity, but Plosser reminds us that modern economics tells us that it ain't so:
The ability of monetary policy to influence employment has long been recognized as tenuous at best. Indeed, the current workhorse models in macroeconomics rely on some form of wage or price stickiness to generate real effects of monetary policy. As wages and prices adjust, the effects of monetary policy on the real economy dissipate; in other words, the effects are transitory. In addition, the experience of the 1970s clearly demonstrated that attempts to use monetary policy to pursue an employment or unemployment target can lead to extremely poor economic outcomes, jeopardizing both employment and inflation.
People seem to forget this simple point. Outside of multiple-equilibrium models, which are not the "current workhorse models" taken seriously by central bankers, all models of short-run monetary non-neutrality involve transient real effects from monetary policy actions. Further, those real effects become smaller the more sophisticated economic agents become at seeing through central banking policy. Janet Yellen would like you to think that economic agents are so unsophisticated that they can't figure out how to adjust wages and prices in response to an announced future monetary policy, yet so sophisticated that they can predict the effects of the announced future monetary policy - for wages and prices. Further, she wants us to believe that the financial crisis - which happened in 2008 - will have lingering effects that need to be corrected by monetary policy, until 2016!

Plosser goes on in his speech to discuss the risks associated with current accommodative Fed policies. He sees those risks as associated with "moral hazard, future inflation, and loss of institutional credibility." On moral hazard, here's an interesting point:
By engaging in targeted purchases of housing-related securities, the Fed has affected expectations about what monetary policy will do in the future should the housing market take a sharp downturn. Will market participants price housing-related assets with the expectation that the Fed will protect the market from significant losses? Will investors in other markets expect similar treatment and therefore be encouraged to take excessive risk?
Those are useful points. Whether the Fed can move mortgage rates more - if at all - by purchasing mortgage-backed securities than long-maturity Treasuries, the perception is that it can. If firms and consumers take into account that the Fed will bail out their sector in the event of adverse events, this causes problems. Those firms and consumers will take on more risk than is socially desirable, and in the event that the Fed does not act as expected, the damage will be worse.

Here are Plosser's fundamental principles:
The first principle is to be clear and explicit about the goals and objectives of policy. And in so doing, policymakers must acknowledge what policy can and cannot achieve.

The second principle is for policymakers to make a credible commitment to their goals by describing how they will conduct policy in a way that is consistent with those goals. One way to do this is for the central bank to articulate a reaction function or rule that will guide policy decisions.

The third principle is to be clear and transparent in communicating to the public the policy actions that are taken.

The fourth principle is to strive to ensure central bank independence.
It's important to note that those principles aren't so different from Yellen's. That's important. A given statement of principles can lead you in entirely different directions.

In contrast to Yellen's "balanced approach," Plosser favors a "systematic approach," which again does not differ so much from what Yellen has in mind. Plosser likes "robust rules," which includes the class of Taylor rules. The Taylor rule of course takes account of both sides of the dual mandate. I'm not sure exactly what Plosser wants. He could mean a public announcement of a specific policy rule, or he could mean simply clear statements about the reasons for Fed policy decisions, which allow the private sector to deduce what the FOMC is up to. It matters which. The former type of systematic policy seems prone to the risks that Plosser is worried about.

Finally, Plosser appears to have no sympathy for liftoff targets.
In my view, this threshold approach could cause some long-lasting confusion, especially if the thresholds are misinterpreted as the FOMC’s longer-run policy goals. But how do you decide on the right numerical values? Moreover, if numerical thresholds were provided as a way to convey forward guidance for the fed funds rate, a numerical stopping rule would also be needed to convey when QE3 asset purchases could be expected to end. This means we may have multiple thresholds associated with multiple tools. It would be difficult to describe all the various conditions necessary for this multi-faceted strategy and communicate them to the public in a comprehensible and credible fashion. I am concerned that we would create more confusion than clarity.
This is an important point. In the Fed's attempt to be more transparent about the future, it may have only sown confusion. There are now multiple facets to the Fed's forward guidance. If even the most sophisticated financial market participants have figured this out, I would be very surprised.

Tuesday, November 6, 2012

Monday, November 5, 2012

Managing a Liqudity Trap: Monetary and Fiscal Policy

Ivan Werning's paper on liquidity traps is getting attention in the Federal Reserve System. For example, Narayana Kocherlakota cited the paper in a recent speech. Ivan presented a version of the paper at the 2011 St. Louis Fed Policy conference, which was where I saw it.

What's the paper about, and why would the FOMC be interested in it? The basic model Werning uses is a well-worked-over linearized New Keynesian sticky price model, much like what can be found, for example, in Clarida, Gali, and Gertler's survey paper. The key differences here are that Werning works in continuous time with no aggregate uncertainty, which is going to lend tractability to the problem. Further, he's going to solve an optimal policy problem. Perhaps surprisingly, New Keynesians do not often do that. The typical approach is to assume a Taylor rule for monetary policy, and go from there.

Here's the basic model(changing notation a bit):

(1) dx/dt = a[i(t)-r(t)-p(t)]
(2) dp/dt = bp(t)-kx(t)
(3) i(t) >= 0

x is the output gap, i is the nominal interest rate, r is the natural real rate of interest, and p is the inflation rate. a, b, and k are positive parameters. Equation (1) is an inverted Euler equation, equation (2) is a Phillips curve, and (3) imposes the zero lower bound on the nominal interest rate. Given an exogenous path r(t), the central bank determines i(t), and this determines a solution p(t) and x(t). Werning assumes a typical quadratic loss function, where bliss is taken to be a zero output gap and zero inflation.

What is an optimal monetary policy in this environment? If r(t)>=0 for all t, then the answer is easy. Bliss is attainable for all t. An optimal monetary policy is i(t)=r(t), which implies x(t)=p(t)=0.

The interesting question is what happens if r(t)<0 for some t. A simple example is r(t)=r1 for t<=T and r(t)=r2 for t>T, where r1<0 and r2>0. This will imply that bliss is not feasible for all t, and the zero lower bound (3) must bind at some dates. This is intended to look like the type of monetary policy problem that the Fed is currently faced with, as we'll see.

It will make a big difference whether or not the central bank is able to commit to a policy. With no commitment, we know that the central bank chooses i(t)=r(t) from date T on, with x(t)=p(t)=0 for t>T. Then we can work back to find the dynamic path up to time T. Before time T, we are in a liquidity trap, with i(t)=0, and things can be very bad. The output gap and the inflation rate are increasing, but until the time of liftoff there is a negative output gap and deflation. The problem gets worse the larger is T, i.e. the longer the liquidity trap scenario lasts.

Basically, the problem is that the real rate of interest is too high, and there is nothing the central bank can do about it, being constrained by the zero lower bound on the nominal interest rate. Further, the problem is compounded because of deflation during the liquidity trap period.

But, the central bank can do better if it can commit to a policy different from i(t)=r(t) after date T. After date T, the optimal policy with commitment is for the central bank to generate inflation above zero and an output boom (i.e. a positive output gap) after date T, which feeds back to the liquidity trap period, increasing inflation and output before period T.

You can see why people looking for a rationale for the FOMC's recent policy decisions like this paper. If you buy Werning's results, you might write something like the following in an FOMC statement:
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 Fed is under a lot of pressure to "do something" about the weak labor market, and that pressure has been fed (no wordplay intended) by the Fed's confident statements about the efficacy of its policies. Apparently they are looking for serious research that will support what they are doing.

But how seriously do we want to take Werning's paper? Is this a basis for sound monetary policy in the circumstances we find ourselves in? I don't think so.

What's the shock that is driving the policy? As in much recent Keynesian analysis, the reason for being in a prolonged state with a binding zero lower bound on the nominal interest interest rate is that the "natural real rate of interest" is low (negative, in the model). In the underlying model, the natural interest rate is the real rate of interest under flexible prices. What would cause the real rate to be low? The underlying model is a standard neoclassical growth model, in which the natural rate of interest depends (with a constant relative risk aversion utility function) on the discount factor (from preferences) and consumption growth. The natural real rate goes down if the discount factor rises (people care more about the future) or if efficient consumption growth falls. We're supposed to think that the financial crisis was about everyone simultaneously taking a greater interest in the future? At the optimum, this would make them want to save more. Or maybe the financial crisis shock - whatever it was - should have resulted in lower than average consumption growth coming out of the recession? These things are inconsistent with the Keynesian ideas about intervention that I have been hearing.

In terms of the logic of the model, and what we know about the recent recession, the negative natural real rate shock does not make any sense. More fundamentally, this is a model which does not incorporate any financial factors. There is no credit, no banks, and in fact no money. Monetary policy is about setting a market nominal interest rate, and that's it. The model has nothing to say about quantitative easing, why it may or may not work, and how that policy fits into the forward guidance policy that Werning's paper is about. It seems particularly bizarre to be attempting to address monetary policy in the wake of the financial crisis in a model that can exhibit nothing that looks like a financial crisis.

Approximations. There are at least a couple of papers in which it is argued that nonlinearities are important at the zero lower bound, one by Villaverde and coauthors, the other by Braun and coauthors. Sometimes accounting properly for the nonlinearities doesn't just change the results quantitatively, but gives you qualitatively different results. It's a big deal. Werning uses the standard approach of linearizing around zero inflation, and then using a quadratic loss function to approximate welfare loss. I think the latter is suspect as well. As evidence that approximation may be leading Werning astray, look at his results on the effects of allowing for more price flexibility. Monetary policy in this model is all about correcting the price distortions that arise from price stickiness. Thus, one would expect that any monetary policy problems become less foreboding as prices get less sticky. That's not true in Werning's linearized model. In fact, in the economy without commitment, the output gap goes to minus infinity as price stickiness goes away in the limit. Something wrong there, I'm afraid.

Basic New Keynesian problems. I've come to think of the standard New Keynesian framework as a model of fiscal policy. The basic sticky price (or sticky wage) inefficiency comes from relative price distortions. Particularly given the zero lower bound on the nominal interest rate, monetary policy is the wrong vehicle for addressing the problem. Indeed, in Werning's model we can always get an efficient allocation with appropriately-set consumption taxes (see Correia et al., for example). I don't think the New Keynesians have captured what monetary policy is about.

Commitment. The original idea about monetary policy and commitment came from an example in Kydland and Prescott's paper. In that model, in the absence of commitment the central bank is always tempted to use inflation to increase the output gap. The result is a bad equilibrium with high inflation. That model was used to justify commitment to policy rules that would lower long-run inflation with no cost in terms of output. The Werning paper, and related work, is being used to turn that argument on its head. Now, we are supposed to think that committing to high inflation in the future, when the central bank would otherwise choose low inflation, will be a good thing. Whether Kydland and Prescott's monetary policy model was any good (it has its problems), the idea certainly played out well in the policy realm, beginning with the Volcker disinflation.

The forward guidance idea in FOMC policy, backed up by Werning's work (and Woodford's), may prove to be harmless. But maybe not. Some FOMC members, particularly Evans and Kocherlakota, seem bent on writing down explicit numerical criteria for future policy tightening. I hope they run up against resistance.

Friday, November 2, 2012

Dave Altig: Has Fed Behavior Changed?

I never thought I would be reporting regression results in public, let alone having people comment on those results. Life is full of surprises. Dave Altig has written a response to this blog post.

1. Dave points out that, given my crappy model, the current fed funds rate is well within a standard error of a predicted value of 1.1%. I am of course no Taylor rule fanatic, and am willing to blame Taylor for any shortcomings of his rule. Dave could also have pointed out that the relevant policy rate is the interest rate on reserves, which is the overnight nominal rate of return faced by most of the financial institutions in the system. The current fed funds rate is only relevant to the GSEs, who now do most of the lending in the fed funds market. 0.25% is even closer to 1.1% than the current fed funds rate, which makes Altig's case stronger. But hold on. Given past behavior, the FOMC should at least be considering that they will be increasing the policy rate soon. But they are promising to keep it where it is until mid-2015. Seems like a break with previous behavior, don't you think?

2. Here's Dave's dual mandate analogy:
Consider a homeowner with the dual mandate of keeping both the roof of the house and the driveway in good repair. If the roof isn't leaking but there are cracks in the driveway, I think you would expect to see the owner out on the weekend patching the concrete. I don't think you would conclude as a result that he or she had ceased caring as much about the condition of the roof. I do think you would conclude that attention is being focused where the problem exists.
I see it more like this. Suppose the homeowner has a husband. The dual mandate is: Keep the roof in good repair, and make sure the husband behaves well. Keeping the roof in good repair is a task with a well-defined goal, and the homeowner knows how to do it. Getting the husband to behave well is ill-defined, and at best the homeowner knows that she can only move him temporarily toward what she might see as well-behaved. She would be foolish to think otherwise.

Fed Speculation

Mark Thoma wonders what will happen at the Fed after the election. Bernanke's job must be unpleasant. This one is more interesting, and the salary is much better.