Tuesday, June 21, 2016

Attitude Adjustment

For this post, note the disclaimer at the top of the page. I'm just speaking for myself here, and my views do not necessarily reflect those of the St. Louis Fed, the Federal Reserve System, or the Board of Governors.

This is a reply to Narayana's recent Bloomberg post, which is a comment on this St. Louis Fed memo.

First, Narayana says that Jim Bullard thinks that
... the economy is so weak that a mere quarter-percentage-point increase would be enough for the foreseeable future.
I don't think the memo actually characterizes the economy as "weak" - it's not a pessimistic view of the world as, for example, Larry Summers or Robert Gordon might see it. As I noted in this post, one would not characterize the labor market as "weak." It's in fact tight, by conventional measures that we can trust. The view in the St. Louis Fed memo is that growth in real GDP, at 2% per annum, is likely to remain lower than the pre-financial crisis trend for the foreseeable future - i.e. "weaker" than we've been accustomed to. But "so weak" is language that is too pessimistic. And there remains the possibility that this will turn around.

Second, Narayana says:
Bullard’s rationale focuses on productivity...
That's not correct. The memo mentions low productivity growth, but a key part of the argument is in terms of low real rates of interest. According to conventional asset pricing and growth theory, low productivity growth leads to low consumption growth, which leads to low real rates of interest. But that effect alone does not seem to be strong enough to explain the fall in real interest rates in the world that has occurred for about the last 30 years or so. There is another effect that we could characterize as a liquidity premium effect, which could arise, for example, from a shortage of safe assets. I've studied that in some of my own work, for example in this paper with David Andolfatto. In recent history, the financial crisis, sovereign debt problems, and changes in banking regulation have contributed to the safe asset shortage, which increases the prices of safe assets, and lowers their yields. This problem is particularly acute for U.S. government debt. A key point is that a low return on government debt need not coexist with low returns on capital - see the work by Gomme, Ravikumar, and Rupert cited in the memo.

Third, Narayana thinks that:
Bullard uses a somewhat obscure measure of inflation developed by the Dallas Fed, rather than the Fed’s preferred measure, which is well below 2 percent and is expected to remain there for the next two to three years.
"Obscure," of course, is in the eye of the beholder. Let's look at some inflation measures:
The first measure is raw pce inflation - that's the Fed's preferred measure, as specified here. The second is pce inflation, after stripping out food and energy prices - that's a standard "core" measure. The third is the Dallas Fed's trimmed mean measure. Trimmed mean inflation doesn't take a stand on what prices are most volatile, in that it strips out the most volatile prices as determined by the data - it "trims" and then takes the mean. Then we calculate the rate of growth of the resulting index. One can of course argue about the wisdom of stripping volatile prices out of inflation measures - there are smart people who come down on different sides of this issue. One could, for example, make a case that core measures of inflation give us some notion of where raw pce inflation is going. For example, in mid-2014, before oil prices fell dramatically, all three measures in the chart were about the same, i.e. about 1.7%. So, by Fisherian logic, if the real interest rate persists at its level in mid-2014, then an increase in the nominal interest rate of 50 basis points would make inflation about right - perhaps even above target. Personally, I think we don't use Fisherian logic enough.

Finally, Narayana says:
...the risk of excess inflation is relatively manageable.
That's a point made in the memo. The forecast reflects a view that Phillips curve effects are unimportant, and thus an excessive burst in inflation is not anticipated.

Here's a question for Narayana: Why, if a goal is to have "capacity to lower rates" in the event of "say, global financial instability," does he want rates reduced now?


  1. FWIW, I always enjoy your blog. And that was a great post.

    Doncha think, though, that the answer to your concluding rhetorical question is obvious? For good or ill, NK is not NeoFisherian. He wants higher inflation to create some distance from the lower bound on nominal rates and he thinks the path there is a lower, not higher, fed funds rate now.

    1. Well, maybe he can change his mind. He's done it before.

  2. Some say real rates are already negative. Too bad we can't fix all this by getting money into the hands of ordinary people. Too much at the top. Negative IOR would be a stimulus but real non bond exchanged helicopter money would be better, like Lonergan speaks to. Labor market being tight seems to be doing nothing like it did in the past. There is not enough money on main street. Perhaps serious followers of Friedman would put their monetarism where their mouths are and fix the inequality which is slowing the real economy. But then, since banks all bet on low rates and slow growth, the Fed is afraid it would destroy the entire banking system through a little stimulus. We are all, including the banks, prisoners of derivatives and collateral for them. The Fed can't do a Volcker and raise rates when necessary because all the banks would die of margin calls on collateral. It is a shame, really, that we have arrived at this place.

  3. I just want to add that it appears monetarism is ill equipped to deal with this collateral issue, this shortage of collateral as explained by Jamie Dimon and Larry Summers. Shortage of collateral drives yields down. Collateral for derivatives markets is gobbling up all the bonds. Monetarism was formulated before people even worried about bonds falling through the black hole of intense demand. Scott Sumner won't even talk about collateral. I don't think New Monetarists speak much about the subject either, but maybe someone could show me differently!