Sunday, June 30, 2013

The Fed's Communication Problem

Since early May, real and nominal long-term bond yields have risen in the United States. The most stark depiction of this is in the following chart, which shows the 10-year TIPS yield - which has risen by roughly 100 basis points since early May - and the breakeven rate (nominal 10-year yield minus the TIPS yield) - which has fallen by about 50 basis points over the same period.
I think it's fair to say that this was not the Fed's intent. The Fed thinks that "accommodation" is what is appropriate, and the way it sees that working is through low real bond yields and high anticipated inflation. But apparently real bond yields have risen, and anticipated inflation has fallen. Further, I think it's also fair to say that the bond price movements since early May have been driven primarily by the interpretation by financial market participants of public statements by Fed officials - principally Ben Bernanke.

On Thursday, Narayana Kocheralakota was interviewed on CNBC, and tried to make sense of this. Narayana thinks that the key problem was that the markets were (are) misinterpreting statements about QE (quantitative easing) as statements about the future path of the policy rate. That's in the right ballpark, but doesn't quite get at the essence of the problem. While the Fed took some pains to to make public statements about how QE was just normal policy (ease by moving long rates down rather than short rates), they have consistently segmented QE from forward guidance (statements about the future path of the fed funds rate), particularly in the FOMC statement. QE and forward guidance are typically described by the Fed as two different tools - like a hammer and a saw. But it should be clear to anyone - and I think it is - that these two elements of policy are somehow related.

But how are QE and forward guidance related? The Fed tells us that purchases of long-maturity government bonds and mortgage-backed securities by the Fed work to reduce long bond yields, and that this will increase some components of aggregate expenditure. Sounds just like standard Fed talk, right? When things are too hot - in the sense of inflation being "too high," and real economic activity being "too high," then the Fed cools things down by "tightening," i.e. the Fed intervenes in an attempt to increase nominal market interest rates. And the reverse if things are "too cold."

So what could the problem be? As economists, we know that things are actually more complicated than that. We disagree about what "too hot" and "too cold" mean, whether the Fed can actually heat and cool in particular circumstances, and whether the heating/cooling/thermostat analogy makes any sense. Sometimes it makes me cringe, and medical analogies are even worse ("the patient is bleeding," "the appendix needs to come out," etc.) But, in terms of what can be understood by the average person on the street, or even by the average bond trader, this may be the best the Fed can do in terms of communication. There are two directions: up and down. And the Fed can communicate whether they are going up or down, and the likelihood of going up and down in the future.

So, the Fed seems to have communicated QE in its usual up/down hot/cold language, but the message isn't getting across. Why?

1. QE is an experiment. As with all experiments, ideas about how to run the experiment have changed as the experiment proceeds. Sometimes the Fed swaps reserves for long Treasuries (QE2 and QE3), sometimes it swaps short Treasuries for long Treasuries (operation twist), and sometimes it swaps reserves for mortgage-backed securities. Why has the Fed done this in different ways? Does it now think that one type of intervention is preferable to another, or that there were different circumstances along the path we have followed since the financial crisis that warrant different approaches? None of that is clear from Fed communications. The only explanation we have is that these are different tools, and that when you have a lot of tools and you're in a predicament, you should use them all. Maybe there's little difference among the effects (if any) of these different tools. If so, the Fed is needlessly confusing us.

2. QE2 and operation twist were announced as asset purchases of specific assets at a specific rate, for a specific period of time (with some provision to change the plans in unusual circumstances). QE3 started that way, but then changed to a contingent plan (move the rate of purchases up or down depending on new information). What's confusing about this is that we have no idea where some of the numbers are coming from. Why does the Fed think that $85 billion per month in asset purchases is the appropriate number to move long bond yields by the amount the Fed wants to move them? If the Fed can't tell us, we have to be suspicious that they don't know. Why doesn't the Fed just announce a target for, say, the 10-year nominal Treasury yield? The fact that they do not makes us suspicious that the Fed thinks it may not be able to move Treasury yields in the way it confidently tells us it can. So, if the Fed is confident on the surface, but we're suspicious that it is actually mired in ignorance and doubt, how are we to think about what the FOMC will be doing at the next meeting, or next year?

3. The Fed has taken pains to be more specific over time about when the date of "liftoff" will occur - the date at which the policy rate (the interest rate on reserves under current conditions) increases above 0.25%. Liftoff will occur after the unemployment rate passes the 6.5% threshold. But, until recently, the Fed was not specific about "tapering" in asset purchases. Whenever the forward guidance language changed, it was clear that this was intended as a change in policy (up/down; heating/cooling) toward more accommodation. So, when Ben Bernanke gives more information about how the tapering will occur, how else should anyone interpret that but as "tightening," even though that was clearly not the Fed's intention?

One last point. Most Fed officials who speak in public argue that, even if we don't understand how QE works, that the empirical evidence demonstrates that it does. That empirical evidence is based on announcement effects - the Fed says something, and asset prices move. For example, the Fed announces some upcoming asset purchases, and bond yields move down. I hope that recent movements in asset prices will call that logic into question. In this case bond yields have moved up in response to something the Fed said when, in terms of how the Fed thinks about policy, either nothing has happened on the policy front, or the news should be interpreted as more accommodation rather than less.

Wednesday, June 26, 2013

In Defense of Greg Mankiw

I don't think anyone is surprised at the reaction to Mankiw's forthcoming JEP article. Discussions about the distribution of income get people excited. I read Mankiw's piece, and thought it was a decent summary of what economists have to say about the distribution of income and wealth. Mankiw's own views certainly enter into it, but he makes it clear when he's relying on serious research, and when his argument is based only on casual empiricism.

There are two main points. First, Mankiw argues that the increase in dispersion in the income distribution in the United States is due mainly to two factors: technological change driving an increase in the relative demand for highly-skilled labor, and a scarcity of high-skilled laborers. He could add international trade as a third factor - the idea that wages of low-skilled are lower than they would otherwise be because of lower barriers to trade and a plentiful supply of low-skilled labor abroad. But the point is that most of the change in dispersion is due to factors that have little to do with government activity (except perhaps trade policy), i.e. with tax policy and regulation. I think those conclusions are not particularly controversial among economists who have worked in this area.

Second, Mankiw argues that, to the extent that there is something "wrong" with the income distribution, there are better ways to do the fixing than by changing the way we tax income. If government regulations serve to protect inefficient monopolies, or allow financial institutions to practice what is essentially theft, then we should change those regulations. If patents promote inefficiency, we should change our patent laws. If opportunities are poor for people living in inner cities, we need to be thinking about how we can promote education in those neighborhoods.

Tax policy is something we have to be careful about. Micro evidence seems to tell us that the incentive effects of income taxation are small. But, for example, work by Manuelli, Seshadri, and Shin tells us that, if we look at the full array of tax and retirement policies, and take account of lifetime decisions about capital accumulation in general equilibrium, then the incentive effects are big-time.

So, for the most part, I agree with Mankiw. I think we also a agree about "enrichment" programs for kids. This actually goes much beyond summer camps. At Washington University in St. Louis, where I work, undergraduate tuition fees for the 2013-14 academic year will be $44,100. What do students (or their parents) get for their money? As Mankiw says, a lot of it looks like consumption rather than investment. Indeed, a walk through campus can remind you of a summer camp. Rich parents certainly want to send their kids here, but there's no guarantee that sending them here will perpetuate family wealth. Apparently, taking economics helps, though.

Friday, June 21, 2013

Bullard Dissent

Jim Bullard has elaborated on his dissent at this week's FOMC meeting. Bullard has three objections:

1. The Fed has interpreted its price-stability mandate as a 2% inflation target. Given that the current 12-month pce inflation rate is well below the target, the FOMC should be addressing that. In Bullard's words:
...the Committee should have more strongly signaled its willingness to defend its inflation target of 2 percent in light of recent low inflation readings. Inflation in the U.S. has surprised on the downside during 2013.

2. Bernanke's elaboration at his press conference yesterday on how asset purchases would be wound down was inappropriately-timed. Apparently parts of Bernanke's statement at the press conference were approved by the FOMC and seem to have been intended as an extension to the formal FOMC statement. Here's the relevant passage from the press conference:
Although the Committee left the pace of purchases unchanged at today’s meeting, it has stated that it may vary the pace of purchases as economic conditions evolve. Any such change would reflect the incoming data and their implications for the outlook, as well as the cumulative progress made toward the Committee’s objectives since the program began in September. Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes. We also see inflation moving back toward our 2 percent objective over time. If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent...
Bullard's point is that Bernanke was emphasizing the wrong thing at the wrong time (or the right thing at the wrong time?).

3. Bullard did not like the language in Bernanke's statement at the press conference (authorized by the FOMC) that referred to calendar dates rather than state contingencies for reductions in asset purchases. The objection seems to be to the parts of Bernanke's statement quoted above where he says "...appropriate to moderate the monthly pace of purchases later this year..." and "...through the first half of next year, ending purchases around midyear."

Bullard is right. The official FOMC statement says:
The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.
But the committee is saying other things inconsistent with that statement. Bad communication is a central banker's worst enemy.

Thursday, June 20, 2013

Monetary Policy Confusion

Here's a quote from today's Wall Street Journal, which I think summarizes public perception of what the Fed is up to.
Fresh signs that the Fed is considering pulling back on efforts to support the U.S. economy rattled markets. The dollar rose, while stocks, emerging-markets currencies and bonds all fell.
So what are these "fresh signs?" The Fed's approach to monetary policy at the zero lower bound is two-pronged:

1. Forward guidance The Fed has effectively tied its hands with respect to the target for its policy rate. The previously-announced policy is that policy rate target will remain where it is (0-0.25% for the fed funds rate) at least until the unemployment rate passes the 6.5% threshold. Bernanke clarified the forward-guidance policy in his press conference following the FOMC meeting.
First, today the Committee reaffirmed its expectation that the current exceptionally low range for the funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, so long as inflation and inflation expectations remain well-behaved (in the senses described in the FOMC’s statement). As I have noted frequently, the phrase “at least as long” in the Committee’s interest rate guidance is important; the economic conditions we have set out as preceding any future rate increase are thresholds, not triggers. For example, assuming that inflation is near our objective at that time, as expected, a decline in the unemployment rate to 6-1/2 percent would not lead automatically to an increase in the federal funds rate target, but rather would indicate only that it was appropriate for the Committee to consider whether the broader economic outlook justified such an increase.

2. Quantitative easing (QE) Recall that the Fed embarked on "operation twist" in September 2012, which evolved into outright asset purchases of $85 billion per month - $40 billion per month in mortgage-backed securities, and $45 billion in long-maturity Treasuries. Since March, the FOMC's stated policy is that these asset purchases should be explicitly contingent on the state of the world, much as policy-rate changes are contingent in "normal" times:
The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.
Bernanke added some more detail in his press conference:
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains—a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.

So, given the stated policy rule, how would a rational forecaster have updated his or her forecast given recent information? The key news is that:

1. The measured inflation rate has fallen, as shown in the chart.

2. Anticipated inflation, as measured by breakeven rates (nominal Treasury yield minus TIPS yield for the same maturity) has fallen, as shown in the next chart.

3. In case you missed it, Bernanke's press conference contained a key policy change, related to Fed's "exit strategy."
One difference is worth mentioning: While participants continue to think that, in the long run, the Federal Reserve’s portfolio should consist predominantly of Treasury securities, a strong majority now expects that the Committee will not sell agency mortgage-backed securities (MBS) during the process of normalizing monetary policy, although in the longer run limited sales could be used to reduce or eliminate residual MBS holdings.

The first two pieces of news might make a rational forecaster predict a more accommodative policy, given the announced policy rule. Inflation is lower, and expected to be lower, so we should anticipate, from the forward guidance language, that the policy rate should stay where it is for a longer time beyond the point at which the 6.5% unemployment rate threshold is crossed. But, given the QE language, we would expect that a lower current inflation rate would produce an upward adjustment in the size of asset purchases, and that wasn't in the FOMC statement. Maybe the rational forecaster might be a little confused. Adding to that confusion is this part of the FOMC statement:
... longer-term inflation expectations have remained stable.
Of course the word "stable" is open to interpretation, but it seems that a drop of about a half point in the breakeven rate could not be characterized as stability. A rational forecaster might think that the Fed is misrepresenting information, or not acting in a way consistent with its promises. Thus, more confusion.

The third piece of news (the likelihood that the Fed will never sell any of its MBS portfolio) is important if we buy the Fed argument that QE matters - for quantities and prices - and that monetary policy actions far in the future can make a big difference for current prices. If we accept all of that, policy just became more accommodative.

So all the news points to more accommodation, though perhaps in a muddled way. But the public - to the extent it cares - is drawing the opposite conclusion. What gives? There must be a communication problem. I'm guessing that's what Bullard's dissent is about:
Voting against the action was James Bullard, who believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings...
Bullard has been worried in past about low inflation (see this paper) and seems to have been a supporter of contingent QE. Maybe he was pushing for an increase in asset purchases in response to the recent news? In any case, Bullard is likely to comment publicly on his dissent soon, so watch for that.

My conclusion is that the monetary policy actions of the Fed, and the public statements of the FOMC and Fed officials, have become too difficult for the average person - or even the most sophisticated financial market participants - to process. Up against the zero lower bound on its policy rate, the Fed embarked on a bold experiment involving forward guidance and (very) large-scale asset purchases. Fed officials are perhaps as confused as everyone else about the effects of those policies. For example, this is an excerpt from an interview with Narayana Kocherlakota. He's discussing what we know about the effects of QE.
The benchmark thinking about QE, actually, was done by Neil Wallace and later by Gauti Eggertsson and Mike Woodford, following up on Neil’s work. And that baseline economic modeling would say these kinds of interventions should have no impact on yields and no impact on the economy at all.

Now, the empirical work that I mentioned has validated that there does seem to be an impact on yields. What that means in terms of the impact on economic activity, I’m still sorting through, to be honest. As of now, I would say that I think quantitative easing works in the right direction, but gauging the actual magnitude of its impact remains challenging.
With regard to the theory behind QE, the Wallace paper Kocherlakota is referring to is this one. Wallace writes down a model and derives conditions under which an open market operation is irrelevant (for prices and quantities). That does not relate specifically to QE - it applies to any open market operation. Presumably a model that would make sense out of QE would also tell us that "normal" monetary policy matters in the way the Fed thinks it does. The Eggertsson/Woodford paper doesn't help us much either. They work with a model where the only friction relates to sticky prices - hardly a good starting point for thinking about the effects of asset swaps by the central bank. So there is not theory to back up what the Fed is doing - and they are doing it in a big way. Kocherlakota seems to put some faith in the empirical evidence, but as he should know we can't interpret data without a theory. Conclusion: The people running the Fed know no more nor less about QE than anyone else. And what we know is: not much.