Monday, March 31, 2014

Taylor Rules

John Taylor has a blog post which reviews the origin of the Taylor rule and why we should think it's good guidance for central bankers. In making his points, Taylor quotes from a reply I made to a comment on one of my posts, so I'll supply that reply in full:
When Taylor first wrote down his rule, he didn't make any claims that there was any theory which would justify it as some welfare-maximizing policy rule. It seemed to capture the idea that the Fed should care about inflation, and that there exist some non-neutralities of money which the Fed could exploit in influencing real economic activity. He then claimed that it worked pretty well (in terms of an ad hoc welfare criterion) in some quantitative models. Woodford used the Taylor rule to obtain determinacy in NK models, and even argued that it was optimal under some special circumstances. But NK models are very special. Typically they ignore financial factors that I think we can agree are important, and certainly don't address issues to do with what you're calling "financial stability."

So what's optimal? I don't think we have a good grip on this. I don't think we understand fully the nature of the central bank's influence on real economic activity, and we don't fully understand the costs of inflation. 2% inflation is optimal? Why?

You might hope that we could muddle along with a simple Taylor rule driving central bank behavior. It's simple, and maybe close enough to optimal, given what we know. But it's well-known that it can have bad long run properties. For example, the Fed can think that 2% inflation is optimal, but converge to a long-run equilibrium in which inflation is too low. Or the Fed can have incorrect beliefs about the long-run real interest rate, or the output gap, which will imply that the policy is wrong.
Taylor seems to agree with some of that, but he clearly has some differences. Let's focus on his last paragraph:
Later research (which Steve mentions) was very important. The proof of exact optimality of the rule in certain simple models as shown by Mike Woodford (and also Larry Ball) helped improve people’s understanding of why the rule worked well. Finding robustness to a surprisingly wide variety of models was quite useful, as was the historical finding that when monetary policy was close to such a rule, performance was good and when it departed, performance was not so good. But this all depended strongly on the economic theory and policy optimization results in the original research.
What Taylor does not mention is the evidence, for example from Benhabib et al., that Taylor rules can yield unintended consequences - convergence to steady states with inflation below the central bank's target. People might have thought of those results as theoretical curiosities, but some central banks in the world appear to be in danger of exactly that unintended consequence. For example, in the United States, the recent path for the year-over-year pce inflation rate looks like this:
The FOMC took great pains to explain its Taylor rule in the last FOMC statement. But, in spite of the fact that the FOMC's target inflation rate is 2%, and Keynesian output gaps are falling, inflation has been falling for two years, and is well below 2%. Seems not to be working according to plan, don't you think? It's surprising though, that this should surprise anyone.

John Cochrane has more on this in a post from last week. Basically, he sketches a theory to make sense of the notion that, in order to raise the inflation rate to achieve its target, the Fed will have to raise it's nominal policy rate. As he points out, it's important to be specific about the relationship between monetary and fiscal policy. What's left out of his story is the determination of the real interest rate, which is important, but of course John is just giving us a sketch.

Thursday, March 27, 2014

Money Creation: Propagating Confusion

I'm a little late on this, but I saw some commentary on this Bank of England article by McLeay, Radia, and Thomas, "Money Creation in the Modern Economy." The article appears intended for lay people, as a basic introduction to how banking, money, and monetary policy work. If this accurately represents how Mark Carney thinks about these things, we're in trouble.

The article's authors claim that there are some popular misconceptions about how money creation works, and the central bank's control over that process. They seem to want to clear things up for us. Some people have had strong reactions to the article, and Simon Wren-Lewis links to some of that. It's a confused article, so it's really not surprising that it's lead to confused reactions.

As the authors cite Tobin's Commercial Banks as Creators of "Money," and refer to it extensively, it's useful to start there. Tobin's paper, written in 1963, is one of my favorite papers in monetary economics. You can guess where Tobin is going from the scare quotes in the title. Here are Tobin's conclusions:
The key insight - as important today as in 1963 - is that we sometimes take the word "money" far too seriously. In reality, assets exist on a spectrum in terms of what we think of as liquidity, and there is not much point in drawing some arbitrary line between what is money and what is not. Further, we should not draw a line between financial intermediaries that issue highly-liquid liabilities, and those that do not. Particularly given the financial crisis, I think it is now more widely understood that the financial system works as a whole - it can't be compartmentalized into institutions that the central bank should be concerned with, and those it should not.

For the arguments in the article, Tobin's point 4 is particularly important. Tobin thought it best that we think of commercial banks as financial intermediaries and, as such, to analyze their role in terms of normal economics. Indeed, people lose their grip on reality when they start thinking of central banking, and "money" creation, as some kind of hocus-pocus.

So, McLeay, Radia, and Thomas (MRT) begin their article by clearing up two "misconceptions." The first one is:
...that banks act simply as intermediaries, lending out the deposits that savers place with them.
Well, that's a really bad start, as that's not a misconception, but a very useful way to begin thinking about what a bank does. A bank is indeed a financial intermediary - it borrows from one set of people and lends to another set of people. The second "misconception": that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.
I'm on board with that. The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system - such as what exists in Canada, the UK, or New Zealand - where there are no reserve requirements, and they won't be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.

But, though MRT recognize that the money multiplier story may not be illuminating, that traditional story is actually part of their anti-misconception for "misconception" #1. The authors state:
...rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
Well, in the money multiplier stories I heard, that actually seemed to be important. In the traditional textbook account, the central bank conducts an open market operation by purchasing government debt with reserves. Banks have more reserves, which they cannot collectively rid themselves of, but they start lending more, as they have reserves in excess of their reserve requirements. When a bank makes a loan, it simply gives the borrower a deposit at the bank. The borrower will presumably spend the funds in the deposit account, but the deposit balance stays in the banking system, and the multiplier process continues until the reserve requirement binds.

That's essentially the story that MRT are telling, but without the initial reserve injection. I think Tobin would object just as strongly to what MRT are saying as to the money multiplier story that he wrote about in 1963. Here's why. Lending by a bank does not somehow create the deposit liabilities that support that lending. For example, suppose bank 1 makes a loan for $20,000, and credits $20,000 to the borrower's deposit account. Then, the borrower purchases a car for $20,000, and when the transaction clears the borrower's deposit account at bank 1 is debited $20,000, and the deposit account of the car dealer at bank 2 is credited $20,000. Bank 1 also receives a debit of $20,000 to its reserve account, and Bank 2 receives a credit of $20,000 to its reserve account. Now, suppose that the car dealer withdraws the $20,000 from its deposit account in cash. Now, bank 2 is in the same position as before - there is no net change in its deposit liabilities or its reserve account balance. At bank 1, liabilities are no different than initially, but the composition of assets has changed. Reserves are now $20,000 lower, and loans are $20,000 higher. But, suppose that the car dealer who sold the borrower the car had taken out a loan from bank 1 in order to finance the car as inventory. Further, suppose the car dealer pays off the loan - with $20,000 in cash. So loans fall by $20,000 and reserves rise by $20,000 at bank 1. So now the banking system looks exactly the same as initially.

I just made up a series of transactions, but that story makes as much sense as what MRT describe as a "money creation" process. The story simply is not helpful. It would be much more useful to tell a story for lay people that focuses on the bank as a financial intermediary, with deposits and loans determined jointly by the behavior of depositors, borrowers, and banks. Basically, it's a general equilibrium problem, and we have to get this across in a way that people will understand. Making up stories about transactions and balance sheets doesn't help.

Then, once people understand something about financial intermediation and asset transformation, it's more straightforward to tackle central banking and what that is about. Basically, the central bank is just another financial intermediary, that competes with private sector intermediaries. To the extent its actions matter, that's because the central bank has some special advantages or powers in providing intermediation services.

MRT go further astray when they discuss how monetary policy works. Again, it seems their intention is to clear up a misconception:
Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices — setting interest rates.
And again, they don't get it right. My understanding of the Bank of England's operating strategy is that the Bank sets the Bank Rate, which is the counterpart of the U.S. discount rate, and also the interest rate on reserves. Correct me if I'm wrong, but this is a channel system with no channel - effectively the overnight rate, the central bank lending rate, and the interest rate on reserves, are identical. So, in pre-financial crisis times, the overnight rate target was the Bank Rate, and the Bank of England would hit its target through intervention in the repo market. So, pre-financial crisis, the Bank did not literally "set" the overnight rate. It achieved a particular market outcome through a standard type of intervention, which would literally adjust the quantity of outside money to hit the target. So, the Bank of England seemed to have been doing what its economists said it was not doing.

Post financial crisis, you can see the state of the Bank of England's balance sheet here. As in the U.S., the central bank's balance sheet has grown, as has the stock of reserves. It therefore appears that (and this may not be quite correct, as I had trouble finding detailed Bank of England balance sheet information - please help me out if you know where to find it), as in the U.S., the interest rate on reserves determines the overnight rate, and repo market intervention (at the margin) is irrelevant. So, the current environment comes somewhat closer to what MRT are describing, though their view of bank behavior leaves a lot to be desired.

My last complaint is about MRT's analysis of the effects of QE (quantitative easing). The example they give again involves balance sheet entries. You can find this in the section beginning on page 8 of the article. It turns out they want us to think of QE as a central bank action that "creates broad money directly." What a funny idea. In the example, illustrated on Figure 3 on page 11, the Bank of England purchases government debt from a pension fund, which has no reserve account. The effect of the central bank action is to reduce the pension fund's holdings of government debt, and increase the pensions fund's bank deposits. In turn, the pension fund's bank sees an increase in its deposit liabilities and an increase in its reserve balances. Then the claim is that the pension fund proceeds to readjust its portfolio, which it is now apparently unhappy with, so QE has some effect.

Well, hold on. By this logic, if the Bank of England purchased T-bills from the pension fund, this would have the same effect. But MRT's argument is based on being in a liquidity trap. So, they have to show why it makes a difference that the asset purchases are of long-maturity government debt rather than short maturity government debt. Further, suppose that the pension fund has a reserve account, so that the asset purchase is a swap of reserves for government debt. Surely that can't make a difference to the ultimate effect of the purchase, but clearly MRT think it's critical that inside money increase as a result of the purchase in order for it to have an effect.

If you find that weird, then you'll also find "Quantitative Easing Explained," from the Bank of England's website, just as weird:
This policy of asset purchases is often known as 'Quantitative Easing'. It does not involve printing more banknotes. Furthermore, the asset purchase programme is not about giving money to banks. Rather, the policy is designed to circumvent the banking system. The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds to stimulate spending and keep inflation on track to meet the government’s target.
Central bankers in the U.S. typically use market-segmentation stories as arguments for why QE works. But in those stories, there is segmentation in the market for government debt - by maturity. The Bank of England is telling us that there are two key segments to the financial market - banks and non-banks. The banking sector is not integrated with the non-banking sector perhaps, as MRT seem to want to argue, because banks have reserve accounts and non-banks do not. That's wrongheaded. Either you knew this before the financial crisis (for example by reading Tobin's 1963 paper), or you learned it during the financial crisis: It's foolish to draw a line between financial intermediaries that are "banks" and those that are not; indeed it can get us into big trouble.

Wednesday, March 19, 2014

The March 19 FOMC Statement

As anticipated, the FOMC statement contains new forward guidance language. The language is vague, and rather loquacious. If I'm not mistaken, this is the longest post-FOMC-meeting press release on record.

The important novelties in the statement are in paragraphs 5 and 6. Paragraph 5 reads:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
Any numerical targets - except a reaffirmation of the 2% inflation goal - are now left out, which I think is a good thing. The FOMC is telling us that it will look at everything, and that the policy rate will likely stay where it is well into next year. We're basically back to "extended period" language, but it seems to have taken many more words to get that idea across.

Paragraph 6 is:
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Paragraph 5 told us something vague about when "liftoff" will occur - the date at which the policy rate starts to increase. Paragraph 6 concerns post-liftoff Fed behavior. The "balanced approach" is outlined in this 2012 speech by Janet Yellen. "Balanced" means following a Taylor rule derived from a loss function with equal weights on squared deviations of the unemployment rate and inflation, respectively, from their targets. In Yellen's speech, she used 5.5% as an unemployment rate target and 2% as an inflation rate target. But the second sentence in the paragraph also tells you that, for a period of time after liftoff occurs, the policy rate will be less that what the balanced approach implies. Presumably that's to fulfill the commitment implied by the old forward guidance language (see my last post).

Two comments:

1. It's clear what the model is here. It's a 3-equation reduced form New Keynesian model ("IS" curve, Phillips curve, Taylor rule). It's the Phillips curve which is driving the Fed's inflation forecast. Essentially all of the regional Feds and the Board have inflation increasing very gradually to 2% in the long run. Thus, the Fed expects that, given the policy rule laid out in paragraphs 5 and 6, that it will be getting close to its targets of 2% inflation and (presumably) 5.5% unemployment in a couple of years. One problem is that the Phillips curve hasn't been doing so well lately as an inflation predictor (as if it ever did well), what with inflation and unemployment both falling. A second problems is that, if inflation continues to be low, that will extend the tapering period, and extend the period until liftoff. This, as we know, just leads to self-fulfilling low inflation. There is no recognition of that possibility in the statement.

2. Why use so many words to say so little?

Note that Kocherlakota dissented:
Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.
I don't quite understand his objection. If he thinks the statement implies an overshooting of the 2% inflation target (which I assume he doesn't like), that's in the second sentence of paragraph 6, not in 5. Maybe he just wanted to include an explicit 5.5% unemployment rate threshold in paragraph 5. Better left out, I think.

Tuesday, March 18, 2014

The Labor Market and the FOMC Meeting

The FOMC will meet today and tomorrow. Given that there has been little news that would change the economic forecast, the Fed is likely to continue "tapering" - the monthly reductions in the size of asset purchases that began in December. This meeting may be important though. First, this will be the first FOMC meeting chaired by Janet Yellen. Second, with the unemployment rate at 6.7% and falling on trend, the Fed's 6.5% threshold will soon be passed, so the FOMC will have to come up with a new framework for forward guidance.

In this Q&A with John Williams, President of the San Francisco Fed, he was asked about potential changes in forward guidance:
Q. You have advocated replacing the Fed’s current guidance on interest rates, which is linked to a specific unemployment rate, with a less specific description of objectives. Isn’t that necessarily a less effective kind of guidance?

A. Back in 2011 the qualitative guidance wasn’t strong enough and so we went to the data-based concrete guidance and I thought that whole period was very successful. We had a disconnect between our views of where the policy was going and what the market thought. We used some pretty strong language saying what our intentions were and that seemed to work pretty well. I think that was really helpful and in many ways successful. As we’ve gotten away from truly extraordinary times and we’re in a transition toward somewhat more normal times, then the argument for trying to put out this really strong signal about, ‘We’re not going to raise interest rates until we see this one thing happen or this other thing happen,’ I don’t think is the right approach because it puts way too much attention on one aspect of the data. My preference would be to see us moving to describing our policies in our statements much more consistently and clearly. Here are our objectives, here’s where we are relative to them, and given this progress that we’ve made, here’s the policy stance we’re taking and here’s how we’re going to adjust this going forward. If that’s more the approach we’re going to take it would be vaguer or more general than a number. But I think it would be more accurate.
So, Williams says that we went through some "extraordinary times" that required unusual forward guidance. According to him, that unusual forward guidance worked. But now times are not so extraordinary any more, so we need more ordinary forward guidance. This forward guidance will be "vaguer" but will somehow reveal how the Fed thinks about the world, so that private sector decision makers can confidently predict how the Fed will behave in particular situations.

This speech by Charles Plosser, President of the Philadelphia Fed, comes to much the same conclusion, though by a different route. Plosser says:
Economists have learned that expectations play an important role in determining economic outcomes. When businesses and households have a better understanding of how monetary policy is likely to evolve, they can make more informed spending and financial decisions. If policymakers can reduce uncertainty about the course of monetary policy, the economy is likely to perform more efficiently.
So, that seems like the kind of forward guidance that Williams wants now. But Plosser also says:
A somewhat different rationale or view of forward guidance is that it is a way of increasing accommodation when the policy rate is at or near the zero lower bound. Some models suggest that when you are at the zero lower bound, it can be desirable, or optimal, to indicate that future policy rates will be kept "lower for longer" than might otherwise be the case. Thus, policymakers may want to deliberately commit to deviating from what they would otherwise choose to do under normal conditions, such as following a Taylor-like rule. In these models, such a commitment would tend to raise inflation expectations and lower long-term nominal rates, thereby inducing households and businesses to spend more today.
That's the forward guidance for extraordinary times that Williams discussed. Plosser does not seem to think that was such a good idea:
The FOMC has not been clear about the purpose of its forward guidance. Is it purely a transparency device, or is it a way to commit to a more accommodative future policy stance to add more accommodation today? This lack of clarity makes it difficult to communicate the stance of policy and the conditionality of policy on the state of the economy.
So, Williams thinks that extraordinary forward guidance was a success, but apparently Plosser doesn't agree. He thinks that, in the private sector, people were confused - they couldn't figure out whether the Fed was speaking ordinary forward guidance or extraordinary forward guidance. Here's what I think is going on. Post-financial crisis, the Fed was under a lot of pressure to do something about the state of the labor market. At the zero lower bound, "doing something" meant doing something extraordinary, and one of the extraordinary policies the Fed adopted was a form of forward guidance. That policy received support from the academic work of Mike Woodford and coauthors. In New Keynesian (NK) models, forward guidance is a commitment to future policy actions that are not time-consistent - once the future arrives the central bank would choose a different policy action if it could. To provide stimulus at the zero lower bound, according to NK models, the central bank would need to commit to a future path for the nominal policy rate that would remain lower than it would otherwise be (given previous Fed behavior) for a longer period of time.

It could be that the Fed's motivation was wrong. Maybe NK models are a poor guide for monetary policy. But, suppose that we think NK models are the cat's meow. Then, for forward guidance to work, the FOMC would have had to clearly communicate: (i) what they were committed to; and (ii) that they were committed. The FOMC first announced that the policy rate would be low for an extended period; then, the policy rate was to be low at least until some calendar date; then that calendar date changed; then a threshold was announced in terms of the unemployment rate; then the FOMC started saying things about how the threshold didn't matter, and Fed officials began discussing other labor market indicators - the participation rate, the employment/population ratio - that might matter for its decisions. So, private sector individuals who care about these things would have a right to be confused about whether any commitment existed, and what the commitment was about. Thus, I'm very puzzled as to why Williams is calling the FOMC's extraordinary forward guidance experiment a success.

But, extraordinary forward guidance is now history, and hopefully we'll never revisit that experience. The FOMC is currently concerned with the nature of current and future ordinary forward guidance. If we want to make a prediction about the nature of what will show up in the FOMC statement on Wednesday, a good guess is that this will the "vague" guidance that Williams envisions. Plosser, who is on the other end of the spectrum from Williams, seems on board with that. In my opinion, vague language is exactly what is required. The FOMC should avoid making any commitments to numerical targets or thresholds for things it cannot control over the long run, and over which it may sometimes have little influence in the short run.

Here's something interesting in Williams's Q&A with the New York Times:
Some economists see evidence that inflation is tied to short-term unemployment. Right now we have a lot of long-term unemployment and a lot of people who have stopped looking for work. That suggests you could start to see wage and price pressures before the economy has returned to full employment.
So, let's explore that idea. This is what the recent time series of unemployment and vacancy rates looks like:
So, as the FOMC statement says, the unemployment rate remains elevated, relative to the sample in the chart, but the vacancy rate is back up to 2004 levels. If we look at this in the form of a Beveridge curve relation, with the points representing pre-recession observations, and the line connecting observations after that, the data looks like this:
In the chart, you can see the shift to the right in the Beveridge curve, but the recent data is not as far off the pre-financial crisis relationship as it was.

But Williams is arguing that there are differences if we look at short vs. long-term unemployed. If we examine unemployment rates by duration of unemployment (number of unemployed divided by total labor force), the data looks like this:
For those unemployed less than five weeks (currently about one quarter of all unemployment) the unemployment rate is the lowest it has been since late 2000. For those unemployed 5-14 weeks, the unemployment rate is lower than in 2002-04, and for 15-26 weeks, the unemployment rate is almost down to 2002-04 levels. Thus, the elevated unemployment rate is coming almost exclusively from the very long term unemployed - 27 weeks or more.

If we plot Beveridge curves by duration of unemployment, we see another version of the same story. For those unemployed less than 5 weeks, the most recent observation is well to the left of the pre-financial crisis cloud:
For 5-14 weeks, the Beveridge relationship looks stable:
For 15-26 months you can observe the rightward shift in the relationship:
And this is even more pronounced for 27+ weeks unemployed:

What about Phillips curves? At the aggregate level, using the same sample as for the Beveridge curves, except quarterly rather than monthly data, with inflation measured as the annualized quarterly percentage change in the PCE deflator:
So, you may see a Phillips curve relation in that chart, but I don't - particularly in the recent data, where we have seen falling unemployment and a falling inflation rate.

But what if we disaggregate? Here's a Phillips curve for those unemployed less than five weeks:
Maybe there's something going on there, but I wouldn't want to base a policy decision on what I see in that chart. Seems like the observed Phillips curve predicts about 3% inflation given the current unemployment rate, but we're seeing about 1%. So much for that. Here are the other Phillips curve relations - not much going on there either:

When Williams says that "some economists see evidence that inflation is tied to short-term unemployment," he may mean Robert Gordon. But I think Williams and Gordon should read this JEL paper by Mavroeidis, Plagborg-Møller, and Stock. The upshot of that work is that Phillips curve coefficient estimates are extremely sensitive to specification and changes in the data set. The conclusion that one should draw, I think, is that econometricians estimating Phillips curves are not estimating anything useful - the estimates cannot be taken seriously in a policy exercise.

As should be clear from Williams's Q&A, recent FOMC statements, and public statements by Fed officials, the Phillips curve is alive and well in policy circles. But the weight of the empirical evidence (also see my charts in this post) makes one wonder what some people on the FOMC could be thinking. The idea that some measure of slack in the economy can help explain inflation, or predict it, appears rather foolish.

In the past, however, the Phillips curve has been a convenient fiction, which allowed the FOMC cover to increase the overnight nominal interest rate target. A persistently low nominal interest rate target ultimately produces low inflation. That's a prediction common to a wide class of mainstream monetary models, and the Fisher relation is a strong empirical regularity. If the FOMC argues that a "tight" labor market predicts higher future inflation, and that the nominal interest rate should go up when the labor market is tight, that ultimately becomes self-fulfilling. But in our current circumstances, even if we're seeing "tightness" in terms of short-term unemployment, we're not going to see significantly higher inflation as long as the policy rate remains low.

Thus, it's possible that sentiments like Williams's could lead the Fed to do the right thing for the wrong reason. If the Fed wants higher inflation, the policy rate needs to rise, and this may happen if the idea catches hold with the FOMC that the labor market is tight. My guess, however, is that the idea won't actually take hold. But listen to what Janet Yellen says tomorrow. That should tell us a lot about where the committee is headed.

Tuesday, March 11, 2014

Why are Canadians Working So Much More Than Americans?

If we track real GDP in the United States and Canada since the beginning of the last recession, the history looks similar.
I have normalized real GDP to 100 for each country in 2007Q4. You can see that the recession proceeded in similar ways, with Canada coming out a bit better. Real GDP was 1.4% higher in Canada in 2013Q4 relative to the U.S, as compared to 2007Q4. However in per capita terms, the U.S. did a bit better than Canada, as population growth 2007-2014 was more then two percentage points higher in Canada than in the U.S. (due to higher immigration).

But labor market conditions in Canada and the U.S. look very different, as David Andolfatto has pointed out. I'm going to use those differences to help sort out some of the issues raised by John Cochrane regarding the behavior of the employment/population ratio in the United States.

Though I want to focus on employment, it's useful to look first at unemployment rates in Canada and the U.S., to see some of the important differences.
As you can see, from the early 1980s until 2007, the unemployment rate was substantially higher in Canada than in the U.S. - at times by as much as four percentage points. But during the recession, Canada and the U.S. reversed roles. From trough to peak, the unemployment rate increased about six points in the U.S., and by about three points in Canada. During the recession, the unemployment rate was higher in the U.S., and unemployment rates are currently about the same in the two countries.

Next, let's look at aggregate employment/population ratios.
Here, you can see that employment/population ratios were similar in Canada and the U.S. before the recession, but the ratio dropped about two percentage points in Canada, and about four in the U.S. Currently, adjusting for the size of the working age population, the number of workers is close to 5% higher in Canada than in the U.S. That's a big number.

If we look at the whole time series in the last chart, there are some interesting things going on. In particular, before 1990, the behavior of employment/population ratios in the two countries was similar, with employment a little higher in the U.S. Then, in the early 1990s, Canada experienced a drop in the employment/population ratio of a similar magnitude to what occurred in the U.S. in the last recession. Indeed, we can just reverse the labels for post-1990 and post-2007, and the behavior looks much the same. In the early episode there is a small decline in the U.S. and a big one in Canada, and the opposite occurs in the later episode. A key point here is that large and persistent declines in employment are nothing new for rich countries, and need not have anything to do with financial crises.

Next, I'll show you the differences in behavior by gender.
So, just as in Olympic hockey, the Canadian men and women are both outdoing their U.S. counterparts. Interestingly, the current gap is much larger for women than for men. And, if we look at the whole time series, we can see similar patterns in the early 1990s episode and the recent recession. In the early 1990s, there is a large decline in employment in Canada, but the drop is larger for men than for women. And in the recent recession, the employment decline for men is larger than for women in the U.S. Note that this is also true for Canada. During the last recession, the employment/population ratio declined for men, but was roughly flat for women.

Finally, we'll look at the cross-country differences by age, with 15-24 first.
(Note here that I'm using annual data instead of monthly as in the previous charts. This is just what I could easily get access to). For the young, the difference between Canada and the U.S. is currently huge. Before 1980, both countries look about the same, then employment falls for the 15-24 group in Canada, but remains stable in the U.S. However, after 2000 there is a precipitous decline in youth employment in the U.S. There is a decrease in employment in Canada in this group during the last recession, but the decline is much larger in the U.S.

Next are the prime-age workers, aged 25-54.
Here again, the current difference between employment in Canada and the U.S. is huge, though not as great as the difference for 15-24. Something that shows up quite clearly in this chart is the secular decline in the U.S. employment/population ratio that begins about 2000. This secular decline is interrupted by a period of growth that corresponds roughly to the U.S. housing boom.

Finally, the old geezers (including yours truly), aged 55-64.
(Here we're back to monthly data, but with shorter time series, starting in 1995 instead of 1976). In this age group, you see only a small decline in employment in the U.S., and the recession is not even discernible in the Canadian data. But, what was a large employment gap between the U.S. and Canada in 1995 has declined to essentially zero.

It's important to understand what is driving the trend increase in the employment rate of older workers in Canada. That's due primarily to the changing behavior of older women over time. The labor force participation rates of younger women have increased on trend since Word War II in Canada. Thus as these women move through the age cohorts, average labor force participation has increased over time. In the sample depicted in the last chart, baby boom women, who have higher labor force participation than older cohorts, are accounting for an increasing larger fraction of the 55-64 group.

People are trying to get a grip on what caused the dramatic decrease in the employment-population ratio in the U.S. during the last recession, and why that ratio has shown little increase since the recession ended. So, in light of what we have learned from the above charts, let's run through some possible explanations.

1. Aggregate demand is persistently low. In hardcore Keynesian thinking, real GDP is demand-determined. Thus, the path of real GDP is determined by aggregate demand. But, look at the first chart. In the hardcore Keynesian mind, aggregate demand has been roughly the same (adjusting for population growth) in Canada and the U.S. since the beginning of the last recession. The North American economy is highly-integrated. Yet, what we see in the third chart is a difference of about 5% in employment between Canada and the U.S. So, I'm going to dismiss this explanation as a non-starter.

2. Taxation. As Noah Smith points out, it seems this should go the other way. Apparently marginal income tax rates are higher in Canada than in the U.S., so according to Ed Prescott, maybe Americans should be working harder than Canadians. But, perhaps we should expand our notion of what "taxation" is. In Canada, there is socialized medicine, financed through the tax system. In the U.S. - at least until Obamacare came into effect - most Americans were getting health care through private insurance provided as a benefit of employment. But from my point of view, the way I pay for health care looks just like a tax. When I lived in Canada, my federal and provincial income taxes would be withheld from my paycheck. In the U.S., my health insurance premium is a before-tax deduction from my paycheck.

So, suppose I think of the resource cost of health care in the U.S. as being like a tax. From the World Bank, in 2011 Canadian taxes were supporting health care expenditures of 11.2% of GDP, while U.S. "taxes" were supporting expenditures of 17.9% of GDP. So, I think if we did the calculation, we would find a substantially higher "tax" burden in the U.S. than in Canada. In the U.S., health care is a substantial inefficiency burden on the U.S. economy. The World Health Organization tells us that Canada is #12 in the world on the life expectancy scale (80.4 for men; 84.6 for women), while the U.S. is #35 (77.4 for men; 82.2 for women). For the U.S., this is much like having a larger government that delivers a lower quality of service.

But how does inefficient health care delivery affect labor supply decisions in the U.S.? First, consider pre-Obamacare arrangements. Paying a health insurance premium through my employer is like paying a tax, but I only get the benefit if I'm working. Thus, on net, the way health care was financed in the U.S. may have served to increase employment relative to Canada. As well, the tax was lump-sum, conditional on working, so it didn't affect my choice of hours of work - the intensive margin. Indeed, the negative wealth effect would tend to make me work harder. Post-Obamacare, it's a different story. Now, I get the healthcare benefit whether I work or not, which looks more like Canada. So, this should reduce labor supply by discouraging labor force participation - the extensive margin.

The direct effects of health care inefficiencies seem not to help us in explaining employment differences in Canada and the U.S., unless perhaps those inefficiencies are reflected in relative wages, which in turn affect labor supply. For example, protection for the health care sector (monopoly power; patent protection for drug manufacturers, for example), tends to inefficiently allocate capital in the economy toward the health care sector. This makes wages lower than they would otherwise be outside of the health care sector, which reduces non-health care labor supply, and health care labor supply is constrained by the medical profession. I am not aware of any work that measures this kind of effect.

3. Demography. This paper by Kapon and Tracy at the New York Fed suggests that the decline in the employment/population ratio in the U.S. could be explained by demographics. As the population ages, on average, labor supply declines. The problem with that idea is that the age structure of the population in Canada and the U.S. is very similar. Since World War II, fertility rates in Canada and the U.S. have been roughly the same. There are differences in immigration, certainly - Canada admits more immigrants, and its immigration policy is very different - but that's not going to explain the differences in behavior post-2000 in the two countries.

4. The Financial Crisis. Canada experienced only a mild decline in housing prices and residential construction during the recent recession. Thus, though we see a similar decline in real GDP in the two countries, the differences in sectoral composition of output could be important for the labor market. There also may have been greater dispersion in the decline in aggregate activity within the U.S. as opposed to within Canada during the recession. You may not think residential construction is a large enough sector to account for the differences in employment, but if we consider all the ancillary sectors - consumer durables and services, for example - related to housing, the effects could be large in the labor market.

4. Pre-Crisis Sectoral Issues. First, it would be useful to know what caused the large drop in the employment/population ratio in Canada post-1990 (see the third chart). That might give us some clues. Second, one possible story about the U.S., post-2000, is that there was an important secular sectoral shift that commences around 2000, but was masked by the post-2000 housing boom, which was essentially construction under false pretenses. If the sectoral shift is what was driving what we see in the time series, it had to affect men more than women, the old not at all, prime age workers somewhat, and young workers a lot. This also must have been a sectoral shift that affected the U.S., but not Canada.

I'm not sure where this leaves us. As John Cochrane says, you can't work all of this out in blog posts.

Sunday, March 9, 2014

Monetary Policy and the Financial Crisis

The FOMC transcripts for 2008 are indeed interesting reading. If you want to dip into these, I would recommend skipping some of the talk at the regular scheduled meetings, some of which is just formal statements by the participants, and pay close attention to the inter-meeting conference calls.

It's clear from the transcripts that the FOMC was dealing with situations for which it was unprepared. Even for people with a knowledge of historical financial panics - the National Banking era panics (1863-1913) and the Great Depression - what happened in 2008 was unprecedented. The fact that the dysfunction was centered in very large financial institutions, and in the financial markets in which they were active, rather than in retail commercial banking, made all the difference. I'm going to focus on two main (and related) points: (i) Decisions by the FOMC about the fed funds rate target during most of 2008 ultimately mattered little for the effects of monetary policy, or for the unfolding crisis, during 2008; (ii) Effective power in the Federal Reserve System during the crisis was concentrated at the New York Fed and the Board of Governors. The Presidents of the regional Feds had little influence on the big decisions that drove the response to the crisis.

Monetary Policy and the Fed Funds Market

During the September 16 FOMC meeting, which occurred the day after the Lehman failure, Bernanke said the following:
We have been debating around the table for quite a while what the right indicator of monetary policy is. Is it the federal funds rate? Is it some measure of financial stress? Or what is it? I think the only answer is that the right measure is contingent on a model. As President Lacker and President Plosser pointed out, you have to have a model and a forecasting mechanism to think about where the interest rate is that best achieves your objectives. It was a very useful exercise to find out, at least to some extent, how the decline in the funds rate that we have put into place is motivated. In particular, the financial conditions do appear to be important both directly and indirectly—directly via the spreads and other observables that were put into the model and indirectly in terms of negative residuals in spending equations and the like. The recession dynamics were also a big part of the story. I hope that what this memo does for us—again, I think it’s extraordinarily helpful—is to focus our debate better. As President Plosser pointed out, we really shouldn’t argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate.
The "quick move" Bernanke was referring to here was the 3/4% drop in the fed funds rate target (to 2.25%) on March 18, following the assisted merger of Bear Stearns with JP Morgan Chase on March 16. At the September 16 FOMC meeting, in spite of the Lehman collapse, Bernanke seemed confident that a 2% fed funds rate target could be maintained through the crisis, as he stated later in the FOMC conference call on October 7:
On the economic growth side, what is particularly worrisome to me is that, before this latest upsurge in financial stress, we had already seen deceleration in growth, including the declines, for example, in consumer spending. Everyone I know who has looked at it—outside forecasters and the Greenbook producers here at the Board—believes that the financial stress we are seeing now is going to have a significant additional effect on growth. Larry gave some estimates of unemployment above 7 percent for a couple of years. So even putting aside the extraordinary conditions in financial markets, I think the macro outlook has shifted decisively toward output risks and away from inflation risks, and on that basis, I think that a policy move is justified. I should say that this comes as a surprise to me. I very much expected that we could stay at 2 percent for a long time, and then when the economy began to recover, we could begin to normalize interest rates. But clearly things have gone off in a direction that is quite worrisome.
Of course we know that things were about to go off in an even more worrisome direction, and a forecast in October 2008 of unemployment slightly above 7% for a couple of years was way off the mark.

So, was the decision to hold the fed funds rate target at 2% at the September 16 meeting a big mistake? On September 16, the most recent information the FOMC had was the July year-over-year PCE inflation rate, which was 4.2%, and the August unemployment rate number, which was 6.1%. Suppose the FOMC had been following Janet Yellen's "balanced" approach, i.e. a Taylor rule with equal weights on squared unemployment deviations and squared inflation rate deviations from their respective targets. Also assume, following Yellen, a target unemployment rate of 5.5% and a target inflation rate of 2%. Then, if the FOMC were thinking in terms of a long-run real interest rate of 2%, Yellen's rule would have dictated a fed funds rate target in excess of 4% in mid-September. Adjust downward for financial market stress (as Yellen would be inclined to do), and a 2% fed funds target does not look unreasonable. On September 16, the FOMC participants seemed to be thinking that financial market disruption would be on the order of what occurred in March 2008 when Bear Stearns was taken over. It's hard to argue why they should have thought otherwise, given what they knew at the time.

Thus, in order to make the case that the FOMC goofed on September 16, we would have to argue that Janet Yellen's view of the world is/was wrong. I don't think the people castigating the Fed for too-tight monetary policy in the face of the crisis want to make that argument.

But I think we can argue that the FOMC did not quite have a grip on how to read developments in the overnight financial markets, and the meaning of the fed funds rate at the time. To see this, first consider the time series for the effective fed funds rate and the 1-month T-bill rate (the shortest-maturity interest rate on U.S. government debt).
You can see that, before late 2007, the 1-month T-bill rate tracks the fed funds rate reasonably closely (with fluctuations in the difference that I don't quite understand). But, note that the margin between the two rates becomes more volatile from late 2007 through 2008. If we look at the difference between the two rates, we can see that more clearly:
Clearly there is a large margin, on average, and a lot of volatility, from late 2007 to mid-2008, and again around the Lehman failure. If we look only at 2007-08, the two interest rates look like this:
The fed funds market is unusual, relative to overnight markets that exist in other countries, and it has features that make it an awkward forum for central bank intervention, particularly in times of crisis. Trading in the fed funds market is over-the-counter, and some of it occurs through brokers, with the brokered transactions being the only ones that are accounted for in the calculation of the effective fed funds rate. Fed funds trades are unsecured. That's important, as in times of crisis, the interest rate on an individual fed funds market transaction will reflect counterparty risk associated with the borrower.

What do we know about the quantity of trading on the fed funds market? Perhaps not so much. This paper by Afonso, Kovner, and Schoar, at the New York Fed, measures fed funds quantities and prices using the "Furfine algorithm," which looks for patterns in payments through Fedwire that look like fed funds market transactions. The measurement is far from perfect, but the authors give us two important findings: (i) There was a substantial increase in the dispersion in interest rates across federal funds transactions following the Lehman collapse; (ii) there was only a small reduction in the quantity of fed funds market trading, post-Lehman. Thus, activity in the fed funds market reflected a substantial increase in counterparty risk after mid-September 2008, but the fed funds market did not "freeze."

The key measure of the effect of conventional monetary policy is the riskless overnight interest rate. That was certainly not the fed funds rate, especially during the financial crisis. Afonso, Kovner, and Schoar find a high degree of dispersion in fed funds transactions prices in fall 2008, reflecting substantial counterparty risk. But there seems to be something else going on, stretching back into 2007, which shows up in the charts in the time series for the 1-month T-bill rate and the fed funds rate. Unless there is something peculiar about 1-month T-bills, I think we can infer that the risk free overnight rate had fallen substantially below the fed funds rate as far back as mid-2007. Here's what the two interest rates look like from August-December 2008:
So, note that the 1-month T-bill rate is in low territory post-Lehman. It's at most 1%, and is typically under 50 basis points. Further, we can see in the next chart that payment of interest on reserves (initially different rates on required and excess reserves) beginning in October 2008 failed to put any kind of floor on the 1-month T-bill:
Therefore, given the actions of the Fed, including lending through the discount window, lending through the TAF (term auction facility), lending to AIG (beginning September 17, 2008), etc., the effective policy rate appears essentially to have gone to zero when Lehman failed - and stayed there. Some people on the FOMC appear to have been thinking the same thing, as is evident in the October 7 conference call:
MR. LACKER. ...I think it would be worthwhile, as we go on with financial markets in such turmoil, to reflect on whether ... our lending is the equivalent of pushing on a string, to use another metaphor from the Great Depression.
CHAIRMAN BERNANKE. Quoting Keynes, I see, Jeff.
Once the riskless overnight rate goes to zero, there's a liquidity trap. Broad-based lending programs or overnight repo transactions by the Fed will have no effect, though if trading has indeed ceased in segments of the financial market, or financial insitutions are indeed facing liquidity crises, then targeted lending or targeted asset purchases by the Fed can matter. You'll note in the quote above that central bankers can have a little fun while dealing with financial crises, apparently. Lacker is known for being on the laissez faire end of the central-bank-intervention spectrum, and Bernanke is kidding him for sounding like a Keynesian (though there is actually nothing particularly Keynesian about a liquidity trap).

So, what to make of this? There are hints that, when the Fed achieves "liftoff" (an increase in the Fed's policy rate above 0.25%), the New York Fed's standard day-to-day intervention mechanism will change. In particular, it seems the Fed plans on having a substantial quantity of reverse repos on its balance sheet on a regular basis, and may target an overnight repo rate rather than the fed funds rate. This will require that the Fed have timely information on overnight repo transactions on some homogeneous set of repos - e.g. those collateralized with a standard class of Treasury securities. I'm not sure if such information is readily available, but it needs to be for this to work. This will eliminate the effects of counterparty risk on the targeted overnight rate, and other features that were creating the margin between the fed funds rate and Treasury securities in 2007-8. This can only make monetary policy more effective when the next financial crisis happens. As well, repo market intervention by the Fed would tighten up arbitrage in the overnight market of interest for the Fed, for reasons discussed here.

Financial Crisis Intervention and the Distribution of Power in the Fed System
As I've mentioned before, the key policy decisions made by the Fed during the financial crisis related to lending programs (discount window and TAF), institution-specific interventions (e.g. related to the Bear-Stearns merger and lending to AIG), and unusual asset purchases (e.g. of commercial paper). Some of the regional Fed Presidents played some role in these decisions. For example, the Richmond Fed President would have played some role in the takeover of Wachovia (headquartered in Charlotte, NC) Wells Fargo, and the Boston Fed President would have been consulted in relation to intervention with respect to money market mutual funds (headquartered in Boston). But, much of the intervention involved only decisions by the Board of Governors and the New York Fed, or day-to-day judgement calls by the New York Fed. For example, the lending program to AIG, announced September 16, resulted from a decision by the Board, in consultation with the Treasury.

Some FOMC participants were worried about the ad hoc nature of the interventions, particularly with regard to large financial institutions. This statement by Bernanke is particularly revealing:
I have been grappling with the question I raised for President Lacker, and I would be very interested in hearing other views either now or some other time. The ideal way to deal with moral hazard is to have in place before the crisis begins a well-developed structure that gives clear indications in what circumstances and on what terms the government will intervene with respect to a systemically important institution. We have found ourselves, though, in this episode in a situation in which events are happening quickly, and we don’t have those things in place.
We don’t have a set of criteria, we don’t have fiscal backstops, and we don’t have clear congressional intent. So in each event, in each instance, even though there is this sort of unavoidable ad hoc character to it, we are trying to make a judgment about the costs—from a fiscal perspective, from a moral hazard perspective, and so on—of taking action versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action. Frankly, I am decidedly confused and very muddled about this. I think it is very difficult to make strong, bright lines given that we don’t have a structure that has been well communicated and well established for how to deal with these conditions. I do think there is some chance—it is not yet large, but still some chance—that we will in fact see a much bigger intervention at the fiscal level. One is tempted to argue that by doing more earlier you can avoid even more later, but of course that is all contingent and uncertain. So we will collectively do our best to deal with these very stressful financial conditions, which I don’t think will be calm for some time.
The idea that a consistent policy framework for crisis intervention did not exist at the Fed, and that the absence of such a framework may have contributed to the severity of the crisis, is an idea that has been explored, post crisis, by Jeff Lacker.

Here's something I think is interesting. The next chart shows repurchase agreements and reverse repurchase agreements on the Fed's balance sheet.
For the Fed, a repo is an asset - a secured loan to a private sector financial institution. Similarly, a reverse repo is a liability for the Fed - a loan by a private sector financial institution to the Fed. Repos can be overnight assets, or of longer maturity. As is evident in the chart, before the financial crisis the Fed was typically on both sides of the repo market on a given day, but there was much more variability in repos than in reverse repos. Thus, day-to-day intervention by the New York Fed consisted primarily of variation in the quantity of overnight repos to hit the fed funds target rate. Beginning in late 2007, and in a more pronounced way in 2008, the Fed began taking a large net position in the repo market, to the point where it was lending about $80 billion on net in the repo market in mid-2008. Presumably this was intervention intended to inject liquidity into the "shadow banking" system.

Next, look in more detail at only 2008:
Here, note that the New York Fed engineered a large increase in reverse repos after the Lehman collapse, to the point where it essentially became a large repo financial intermediary, borrowing from one set of repo market participants and lending to another set. Further, from early October 2008 until the end of the year, Fed repos were constant, and all the variation in Fed repo market activity was in reverse repos. In the second-to-last chart, you can see that repo holdings went to nil early in 2009, and reverse repos have increased, most recently to an average of about $200 billion, as the Fed experiments with what is likely to form the basis for a new operating strategy.

The New York Fed has a substantial amount of latitude in how it manages the System Open Market Account (SOMA). For example, the decisions about the repo market interventions that we can see in the last two charts appear to have emanated from the New York Fed. Over time, power in the Fed has become increasingly concentrated in Washington and New York. During the financial crisis, there was even more relative power wielded by the New York Fed in particular, given its proximity to Wall Street, and the nature of the policy interventions. Further, I think the crisis produced a permanent increase in the power of the Board of Governors and the New York Fed relative to the rest of the Fed system. I haven't looked at these numbers, but my guess is that we would see a substantial shift in resources - wages and other costs - in terms of what is spent in Washington and New York, vis-a-vis the regional Feds. That should certainly cause some concern in the regional Feds, and I think it's also a public concern. Part of the strength of U.S. central banking is (was?) decentralization.