Tuesday, August 7, 2018

Fed's Portfolio Manager Says Not to Worry

I ran across an interesting talk by Simon Potter, who is responsible for the System Open Market Account at the New York Fed. Potter is a powerful person in the Fed system, as he looks after the specifics of monetary policy implementation. His talk addresses issues that I discussed in this previous blog post.

The first order of business in the talk is the phasing out of the Fed's reinvestment policy. Recall that, after the buildup in the Fed's balance sheet that occurred from 2009-2014, the size of the Fed's asset portfolio, in nominal terms, was held constant by purchasing new assets as the existing assets matured. In fall 2017, the FOMC began a phaseout of the reinvestment program which will be completed this fall. After that, the size of the balance sheet will continue to fall until the Fed either decides reduction should cease, or it resumes asset purchases. There have been no public statements about whether the Fed might choose to maintain a significant stock of excess reserve balances in the financial system (retain the current floor system) or revert to the system in place before the financial crisis, perhaps modified in some fashion.

Potter provides a useful figure that shows what happens as reinvestment is phased out, and after:
That's interesting, as it shows us how the caps on balance sheet reduction work. When the FOMC set up the phaseout in its reinvestment program, it included specific caps (increasing over time as shown in the figure) for Treasuries and for MBS. The caps limit the quantity of assets that can mature without triggering some reinvestment. Ultimately, these caps won't bind in the near term for MBS, but you can see that they matter for Treasury securities. Intuitively, caps might seem reasonable. You can see in the figure that Treasury securities on the Fed's balance sheet mature in a rather lumpy fashion, so smoothing might appear to be an OK idea. Indeed, as Potter says:
The cap-based program to normalize the balance sheet...is the mechanism by which the decline in the balance sheet is kept to a gradual and predictable pace.
But I'm wondering why this matters. The concern seems to be that if reserves fell by a large amount in a given month, this could be disruptive. Consider this though. Here's the Treasury's general account with the Fed:
Every time the balance in the Treasury's general account increases, reserves held in the private sector decrease by the same amount, everything else held constant. So, apparently reserves can move by two or three hundred billion dollars over a short time, and the Fed does not consider that disruptive, at the current time. So why do we need a cap on balance sheet reduction to prevent $20 or $30 billion of assets from running off? I think you could make a case that the caps are disruptive, as that means the Fed is engaging in on-again off-again purchases of on-the-run Treasury securities.

Next, there's an issue concerning the recent reconfiguration in overnight interest rates that I discussed in my previous post. Basically, the FOMC set up a system of monetary policy implementation with a target range of 25 basis points for the fed funds rate, bounded by the interest rate on reserves (IOER) on the high side and the interest rate on reverse repurchase agreements issued by the Fed (the ON-RRP rate), on the low side. But recently, the fed funds rate has moved up very close to IOER, and overnight repo rates have moved up close to IOER as well. Further, other than at quarter-end, there is essentially no takeup for the Fed's ON-RRPs, so the ON-RRP facility has become irrelevant - basically that "lower bound" on the fed funds rate isn't bounding anything.

What does Potter think is going on? Well, apparently he's sticking to the same story that appeared in the FOMC minutes for the June FOMC meeting, with some more details. That is,
...a shift in flows in the Treasury market had the effect of pushing both Treasury bill yields and repo rates higher in February and March. Figure 6 shows cumulative net Treasury bill issuance since the beginning of last year, as well as projections through the third quarter of this year as reported by a private-sector forecaster. The substantial run-up in net bill issuance over the past few quarters, along with other factors, contributed to notable growth in securities dealers’ inventory of Treasury securities, shown in Figure 7—inventories that likely required financing in the repo market.
Here's Figure 6, so you can see what he's referring to:
So, Potter's claiming that the reason that overnight rates tightened up around IOER is that there was a (possibly temporary) increase in the supply of Treasury bills, which increased the quantity of collateral available in repo markets, thus expanding the supply of overnight credit.

I'm not sure what to make of that argument, so I thought I would look at more details of Treasury issuance, and the composition of outstanding Treasury debt. Here's annual data on Treasury bills, notes, and bonds. If you're not familiar with the terminology, bills are 1-year maturity and less, notes are 2, 3, 5, and 10-year securities, and bonds are anything exceeding 10 years.
That data goes up to 2017, but currently the stock of bills outstanding is about $2.2 trillion, the stock of notes is over $9 trillion, and the stock of bonds is about $2 trillion. And that's a big difference from before the financial crisis - the average maturity of outstanding Treasury debt has increased considerably. Indeed, at the same time the Fed was attempting to reduce the average maturity of consolidated government debt outstanding, the Treasury was increasing it. So, a back-of-the-envelope calculation is that the Fed purchased about $3.75 trillion in long-maturity assets from before the recession through the end of 2014. From the last chart, it looks like those purchases were more than offset, in terms of average maturity of the outstanding debt, by what the Treasury was doing. So, if people try to tell you that QE worked in practice because it reduced the average maturity of Treasuries outstanding, that can't be correct - the combined effect of Treasury/Fed debt management was to lengthen average maturity. This point has been made by others - John Cochrane in particular I think - at least concerning an earlier period.

But the fact that the Fed's QE programs were not working the way Ben Bernanke envisioned - by reducing average maturity of the consolidated government debt outstanding - doesn't mean that these purchases didn't do something. Large scale asset purchases can have detrimental effects simply by replacing Treasury securities (useful collateral) with reserves, which are not so useful, at least as overnight assets. And flows seem to be important, as on-the-run Treasury securities are apparently a key form of collateral in repo markets.

We should check on the net flows of Treasury issuance, by type security. To provide some smoothing, I'll take 6-month moving averages:
Total net issuance of Treasuries will of course tend to move with the federal government deficit:
But the deficit numbers are seasonally adjusted. Part of what the debt managers in the Treasury department do is to smooth out effects due to lumpy incoming revenue by using Treasury bill issues as a buffer. For example, every February and March there are typically large issues of T-bills, which are then retired when you pay your income taxes in April. Thus, you can see in the second to last chart that T-bill issues (even though I've used moving averages) are quite volatile relative to notes and bonds. Net T-bill issuance has indeed been increasing on trend recently, but as I noted in my previous post, there's nothing so unusual about total net Treasury issuance, and good reasons to think that there's strong, if not increasing, demand for Treasuries in the market, in part due to regulatory reasons.

So, I'm inclined to think that it's the change in the Fed's reinvestment policy that's to blame for the tightening up in overnight interest rates - I don't think it's the Treasury's fault. But why won't the Fed admit it? Because it doesn't fit their narrative. QE was sold as a good thing - Bernanke claimed it would flatten the yield curve, reduce long bond yields, and increase spending. But it appears that QE may have sucked good collateral out of markets for secured overnight credit, thus reducing overnight secured rates relative to overnight unsecured rates. There's nothing good about that - it just reflects inefficiency.

Finally, Potter discusses what he calls a "technical adjustment" in administered interest rates. The range for the fed funds rate is 1.75%-2%, but currently the ON-RRP rate is set at 1.75%, and IOER at 1.95%, as there appeared to be some worry that the fed funds rate would trade above the stated range. Here's what's happened since the June meeting to the key overnight rates:
As you can see, the fed funds rate has settled in at four basis points below IOER, basically the narrowest persistent spread observed since interest rate hikes began in late 2015. But, in terms of control over the Fed's target interest rate, this looks like a big success. Under the current operating procedure the New York Fed can nail the fed funds rate target. The unexpected feature here, which Potter doesn't comment on, is that the ON-RRP program is irrelevant - the IOER is doing all the work.

An interesting feature of the last chart is that the repo rate, while much closer than it was to IOER and the fed funds rate, does not track IOER closely. That's a puzzle to me as, in other countries where central banks target a repo rate, for example in Canada, the interest rate on reserves essentially pegs the overnight repo rate (e.g. Spring 2009 to Spring 2010 in Canada) with a floor system.

Potter comments on the reasons for the "technical adjustment" of setting IOER five basis points below the upper bound on the fed funds target range:
The target range is an important feature of the FOMC’s public communications, and maintaining federal funds rates within it is therefore taken quite seriously. Public confidence in our ability to maintain rates within the target range is important for ensuring that expectations for the FOMC’s future policy stance are properly incorporated into the term structure of interest rates, and thereby appropriately affect financial conditions and the broader economy.
For me, the public confidence issue of whether the fed funds rate might exceed the top of the range by a few basis points is a minor one compared to what I've been discussing. No one in the Fed System, including the guy who implements monetary policy, can give a convincing story about why the whole target range approach still makes any sense, why the ON-RRP facility is now irrelevant, and why IOER, overnight repo rates, and the fed funds rate are now about the same. I'm feeling somewhat underconfident, and look forward to being enlightened.

Sunday, July 29, 2018

Should You Be As Excited About GDP Growth As Donald Trump Claims to Be?

In Friday's report on real GDP growth in the second quarter, the BEA reported a quarterly growth rate of 4.1%, which exceeds both the post-WWII US average growth rate of about 3%, and the average growth rate since the end of the last recession of about 2.2%. Trump seems to be claiming that recent GDP performance has been better than it was, and is hoping for future growth of 3% or more in real GDP. This seems more modest than his early 2017 claim that growth would proceed at 4% or more. What should we make of this?

It's always useful in these circumstances to remind yourself what is being reported. GDP is a flow - output per unit time - but the BEA reports a number which is seasonally adjusted at annual rates. That is, it's reported as if the seasonally adjusted flow had continued for a year, instead of just for a quarter. So, what we're supposed to get excited about is that real GDP for the second quarter is measured to be about 1% higher (seasonally adjusted) than it was in the first quarter. The average quarterly growth rate since the end of the last recession has been 0.55%, so we got an extra 0.45 percentage points in growth relative to the recent average, which might not seem so exciting.

Further, quarterly real GDP growth rates are quite noisy. There's substantial measurement error, due to imperfect raw data, and imperfect seasonal adjustment. Here are the quarterly growth rates since the end of the last recession - seasonally adjusted at annual rates:
The noise is obvious, I think. Over the last 36 quarters, growth rates have exceeded 4% on five occasions. With one observation exceeding 4% in his 6 quarters in office, Trump is doing about average in post-recession excess-of-4% terms.

We might look at year-over-year growth rates, which will smooth out some of the noise. Here's what that looks like:
Current year-over-year growth is 2.8%, which exceeds the post-recession average of 2.2%, but 2.8% isn't unusual in the second chart.

Finally, just to cover all the bases, we could look at the whole post-recession time series of real GDP, and the 2.2% trend:
So, real GDP is a little above trend, but there's nothing in the behavior of the time series to indicate a sustained upside departure from the 2.2% trend.

Thus, any hope that Trump has of seeing 3+% sustained real GDP growth is yet to be realized. What would we tell the Donald about the future, if he asked, and had the attention span required to take in the information? This is where we get into measures of potential GDP (see also this piece by Paul Krugman). What's potential GDP? Depends who you're asking. The OECD, in its "Glossary of Statistical Terms," defines potential GDP to be:
Potential gross domestic product (GDP) is defined in the OECD’s Economic Outlook publication as the level of output that an economy can produce at a constant inflation rate. Although an economy can temporarily produce more than its potential level of output, that comes at the cost of rising inflation. Potential output depends on the capital stock, the potential labour force (which depends on demographic factors and on participation rates), the non-accelerating inflation rate of unemployment (NAIRU), and the level of labour efficiency.
Whatever good reputation the OECD has, it didn't earn it by writing definitions, apparently. The OECD says that, if inflation is constant for an unspecified period of time, then we're observing potential output, whether the inflation rate is 5,000% per annum or 2%. That can't be right.

What's the goal here? The idea is to make a long-term forecast for the growth path of real GDP, over the next two to five years. Further, this forecast is going to be made under the assumption that there are no events that will happen over this future period that would cause a major disruption - no financial crisis, no recession. A crude approach would be to observe what is going on in the last chart, and forecast that real GDP will follow a 2.2% growth path. In the past, sometimes that approach would have worked well. For example, in first quarter 1960, we would have observed that average real GDP growth over the last 10 years was 4.1%. If we took that as a forecast growth path for the next 5 years, here's how we would have done:
Excellent! Dish out the advice in 1960, and in 1965 everyone's calling you a genius. Unfortunately, that won't work every time. In fourth quarter 2007, average real GDP growth over the previous 10 years was 3.0%. Forecast a 3% growth path five years ahead, and here's what it looks like:
Dish out that advice in 2007, and by 2012 people are laughing at you.

Potential GDP measures, such as the CBO's potential GDP measures, aren't so different from that, and the CBO made errors on the order of what is in the last chart in forecasting the recovery from the recession. The CBO's approach to long-term forecasting is more or less consistent with what conventional models of economic growth predict. In a neoclassical growth model with exogenous labor force growth, exogenous total factor productivity (TFP) growth, and constant returns to scale, the economy converges to a steady state in which output grows at the TFP growth rate plus the growth rate in the labor force. So, the CBO makes long-run forecasts based on an assumption about the aggregate production function, and projections for TFP growth and labor force growth. Here's actual year-over-year real GDP growth, and year-over-year growth in the current CBO potential GDP measure.
Currently the CBO potential year-over-year growth rate is 1.9%, and the potential growth rate is lower than actual growth has been, on average, as the CBO does not think that 2.2% growth can be sustained. Presumably that's mainly because unemployment has been falling as employment has been growing, since the end of the recession. Employment growth is ultimately bounded by growth in the labor force (employment plus unemployment), and labor force growth in turn is bounded by growth in the working age population.

To see what has been going on, let's look at employment growth (establishment and household survey measures) and labor force growth:
Since the last recession, payroll employment (establishment survey) grew on average at 1.5%, household survey employment grew on average at 1.2%, and the average labor force growth rate was 0.6%. Labor force growth (year over year) and growth in working-age population (also year over year) look like this:
Recently, labor force growth has increased somewhat to around 1%, while working-age population growth (no idea exactly how these numbers are constructed - growth rates look a little odd) has been on a secular decline and is currently in the neighborhood of 0.5%.

What about productivity? John Fernald, at the San Francisco Fed, has constructed TFP series for the United States that are adjusted for capacity utilization. As far as I know, this is the state of the art, though I know people get in heated arguments about this. Here's the growth rate in Fernald's annual TFP series, 1948-2017:
That's somewhat depressing. Since the recession, TFP growth has mostly been lower than the post-WWII average growth rate of 1.3%. The average since the last recession is 0.3%.

So, the most pessimistic scenario is that TFP continues to grow at 0.3% per year, employment grows at the working-age population growth rate of 0.5%, and we get sustained growth of 0.8% per year in real GDP. TFP growth, as we know from growth economics, is key though. Higher TFP growth means higher growth in real wages, which means higher growth in the labor force (labor supply effect - provided the substitution effect is large on the extensive and intensive margins). And then higher TFP growth and higher labor force growth both contribute to output growth. But, optimistically, supposing TFP grows at 1% (just short of the post-WWII average) and the labor force grows at 1%, that only gives us 2% growth in real GDP. To get to 3% or, more outlandishly, 4%, requires a serious miracle.

So, where could a miracle come from? Well, people are always inventing things, and the miracle could be the implementation of a new technology. There's plenty of debate about this, indicating that economists aren't much better at predicting technological innovations five or ten years hence than your average person. Are we going to get a government-induced economic miracle? From the current US government, that would be another kind of miracle altogether. Some people think that regulation is a big deal - excessive regulation leads to inefficiency and lowers TFP. But regulation can cut both ways. Remember the financial crisis? If we unwind financial regulation that was introduced to prevent crises, that of course won't help the average rate of economic growth. Some people think that taxation is a big deal. The US tax code could in principle be redesigned to collect the same amount of revenue in a far more efficient way, potentially increasing TFP and the size of the labor force. But it's hard to argue the the tax changes recently passed by Congress would do much in this respect. Further, tariffs are indeed taxes, and the way these ones work isn't going to grease the wheels of the US economy.

Governments can potentially increase productivity through policies related to public education. But apparently the US Secretary of Education thinks public education is a waste of resources. Governments can provide public infrastructure that makes the private sector more productive. Haven't seen much of that. Donald Trump likes to spend on the military and keeping people out of the country, neither of which is going to contribute to measured GDP.

It would be nice to be more optimistic, but it looks like what you see is what you get.

Sunday, July 8, 2018

Don't Fear the Inversion - It's the Short Rate That Kills You

Nick Tamaraos has a nice summary of issues to do with the flattening US Treasury yield curve, and the implications for monetary policy. Some people, including Tim Duy, and some regional Fed Presidents, are alarmed by the flattening yield curve, and the issue entered the policy discussion at the last FOMC meeting.

What's going on? While it's typical to focus on the margin between 10-year Treasuries and 2-years, I think it's useful to capture the very short end of the yield curve as well. I would use the fed funds rate for the short end, but that's sometimes contaminated by risk, so the 3-month t-bill rate, which most of the time seems to be driven primarily by monetary policy, seems like a good choice. Here's the time series of the 3-month T-bill, the 2-year Treasury yield, and the 10-year:
What people have pointed out is a regularity in the data. A flat or inverted yield curve tends to lead a recession. In the chart above, we're looking for compression in the 3 time series I've plotted. You can certainly see that compressions tend to lead the NBER-dated recessions (the shaded areas). To get a closer look at this, plot the difference between the ten-year yield and the 2-year yield, and the difference between the 2-year yield and the 3-month T-bill rate:
In this second chart, you can see that those two interest rate differentials go negative before recessions. But there are a couple of episodes in the sample, in 1996 and 1998, when the yield curve is pretty flat, but there's no ensuing recession. What's different about those two episodes is that (see the first Chart) the compression is caused more by long bond yields moving down, rather than the short rate moving up, as we observe in the cases where compression precedes a recession. If you were worried about an oncoming recession right now, based only on yield curve observations, you shouldn't be. All the recent flattening in the yield curve is in the long end. The margin between the two-year yield and the three-month T-bill rate hasn't been falling, as it did prior to previous recessions.

I think it's fair to conclude that what's going on in the data isn't a phenomenon related to the slope of the yield curve at the long end (2 years to 10 years), but at the short end. Recessions tend to happen when the short rate goes up a lot, and that's driven by monetary policy. As an alternative recession indicator, let's look at the real interest rate, measured by the difference between the three-month T-bill rate and year-over-year core inflation:
Typically, when the real interest rate moves from trough to peak by a large amount, a recession happens. That seems to work pretty well, except during the 1980s disinflation. So, for example, from trough to peak, the real rate moves about 420 basis points before the 2001 recession, and about 400 basis points before the 2008-09 recession. Recently, the movement from the trough to where we are now is about 200 basis points, so by that criterion, it's not time to worry yet.

What's the policy issue here? Well, apparently some members of the FOMC are starting to question whether continued rate hikes are a good idea, and are looking for arguments that will convince their colleagues to hold off. For example, in a talk at the end of May, Jim Bullard gave three reasons for holding off on interest rate increases: (i) inflation expectations are about where they should be; (ii) the Fed is achieving its goals; (iii) the yield curve is flattening. One measure of anticipated inflation is the breakeven rate - the margin between a nominal bond yield and the TIPS yield for the same maturity. Here are the five-year and 10-year breakeven rates:
Both of those have moved up above 2%, and the increase in the five-year breakeven is particularly important, as that's telling you more about near-term inflation expectations. As well, for good measure, the Philadelphia Fed's survey of forecasters gives a measure of anticipated CPI inflation for the next year:
That measure has also moved well above 2%, in line with 2% inflation - more or less - in terms of the Fed's inflation target measure, the PCE deflator. In terms of achieving its goals, the Fed is essentially nailing its inflation target, and the labor market is tighter than anyone would have imagined possible a few years ago. But what about the flattening yield curve, the third item on Jim Bullard's list?

There was a discussion about the flattening yield curve at the last FOMC meeting, as documented in the most recent FOMC minutes. Here's the relevant paragraph:
Meeting participants also discussed the term structure of interest rates and what a flattening of the yield curve might signal about economic activity going forward. Participants pointed to a number of factors, other than the gradual rise of the federal funds rate, that could contribute to a reduction in the spread between long-term and short-term Treasury yields, including a reduction in investors' estimates of the longer-run neutral real interest rate; lower longer-term inflation expectations; or a lower level of term premiums in recent years relative to historical experience reflecting, in part, central bank asset purchases. Some participants noted that such factors might temper the reliability of the slope of the yield curve as an indicator of future economic activity; however, several others expressed doubt about whether such factors were distorting the information content of the yield curve. A number of participants thought it would be important to continue to monitor the slope of the yield curve, given the historical regularity that an inverted yield curve has indicated an increased risk of recession in the United States. Participants also discussed a staff presentation of an indicator of the likelihood of recession based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead derived from futures market prices. The staff noted that this measure may be less affected by many of the factors that have contributed to the flattening of the yield curve, such as depressed term premiums at longer horizons. Several participants cautioned that yield curve movements should be interpreted within the broader context of financial conditions and the outlook, and would be only one among many considerations in forming an assessment of appropriate policy.

What's going on here? The flattening yield curve is being used as an argument for a pause in interest rate hikes, so the people in favor of more interest rate hikes are looking for reasons why things are different now, and the drop in the margin between the 10-year yield and the 2-year yield doesn't mean what it used to. People may be able to come up with explanations about what's going on with respect to the 10-year vs. the 2-year Treasury bonds, but as I discussed above, that's not really important - it's what's going on at the short end of the yield curve that matters. The key question is: What are the benefits and costs of further rate hikes, given the current state of the economy? In evaluating the costs, we need to be concerned about the effects of these hikes on real economic activity. What's it take for the Fed to kick off a recession, and does the Fed really want to do the experiment to find out, if everything looks OK? As a side note, I thought the part of the FOMC discussion where the staff gives a presentation relating to an alternative indicator - the difference between the current fed funds rate and what the market thinks the future fed funds rate will be - was good for a chuckle. If the FOMC thinks the market knows more about what it's going to do than what it knows about what it's going to do, we're all in trouble.

What's the bottom line here? The case for continued rate hikes the FOMC has made is based on a faulty theory of inflation. The Fed thinks that tightness in the labor market will inevitably cause inflation to explode, and it thinks that increasing unemployment will keep inflation on target. But: (i) Phillips curve theory is not a theory; (ii) the central bank does not control inflation by controlling the unemployment rate; (iii) there is no such thing as an overheating economy. There is some question about what real interest rate we would see when the US economy settles down - supposing monetary and non-monetary factors don't change from what they are currently. Possibly that real interest rate - r* if you like - has increased somewhat from where it was earlier this year due to the phasing out of the Fed's QE program. But, given the current state of the economy, I think the onus should be on members of the FOMC who want further hikes to justify them, not the other way around.

Friday, July 6, 2018

Fed Balance Sheet Policy, and Treasury Debt Management

I happened to be entertaining myself, reading the FOMC minutes from the June 12-13 meeting, when I ran across this, in a discussion led by the people from the New York Fed who manage the System Open Market Account (SOMA):
The deputy manager followed with a discussion of money markets and open market operations. Rates on Treasury repurchase agreements (repo) had remained elevated in recent weeks, apparently responding, in part, to increased Treasury issuance over recent months. In light of the firmness in repo rates, the volume of operations conducted through the Federal Reserve's overnight reverse repurchase agreement facility remained low. Elevated repo rates may also have contributed to some upward pressure on the effective federal funds rate in recent weeks as lenders in that market shifted some of their investments to earn higher rates available in repo markets.
First, it seems a good sign that the Fed is paying attention to Treasury debt management. After all, the large asset purchase programs the Fed engaged in from late 2008 to late 2014 were a form of debt management. The Fed conducted assets swaps of short-maturity reserves for long-maturity Treasuries and mortgage backed securities, and swaps of shorter-maturity Treasuries in its portfolio for long-maturity assets. In so doing, the Fed wanted to change relative asset supplies at different maturities with the purpose of altering the term structure of interest rates - basically, flattening in the yield curve. Or, that was the theory, at least.

But in conducting its quantitative easing (QE) programs, the Fed appeared to be paying no attention to what the Treasury was doing. That's somewhat disturbing, as one of the Treasury's jobs is to manage the government debt - to decide when to issue debt, how much to issue, and what maturities to issue. If the Fed wants to manage the government debt, maybe it should be coordinating with the Treasury, or maybe it should ask Congress to add debt management to the Fed's job description.

But, back to the FOMC minutes. The quote is factually correct, in that there was larger issuance of Treasury securities in the first part of this year:
You can't quite see it in that chart, but it helps to take a 6-month moving average:
So, indeed, average issuance over the last six months took a jump of about $100 billion per month early this year, relative to last year. If you thought about that in the context of a reduction in the Fed's uptake of Treasuries and close substitutes, with the reduction in that monthly uptake currently capped at $30 billion, then it might seem like the Treasury's activities are more important. In my last post, I was blaming the cessation of the Fed's reinvestment program for the tightening up of overnight interest rates. That is, all overnight interest rates - repo rates, the fed funds rate - are close to the interest rate on reserves (IOER) currently, and that's a new phenomenon. In the quote above, it looks like the SOMA people are blaming the Treasury for this. A bit of an odd tactic that, as one might think the Fed would take the blame when their floor system starts to work the way it should.

But, that increase in new Treasury issues in January through May of this year didn't occur for no reason. When the Treasury has a month when a lot of government debt matures, it will issue more Treasuries to finance the principal payments and to fill the holes in financial markets left by the departing Treasuries. We should actually be more interested in net Treasury issue - the value of new securities sold minus the outflow from maturing debt. Here's what that looks like:
So, nothing particularly unusual going on there recently. Just for good measure, we'll look at a 6-month moving average as well:
That spikes up in the first part of this year, but it was also way down in the last part of last year. Also, note the quantities here. The cap on the value of securities in its portfolio the Fed will allow to mature is currently $30 billion, and that will increase to $40 billion in July, and finally $50 billion. The net flow of new Treasuries has averaged about $60 billion since 2014, so $30-$50 billion is large relative to that and, I think, consistent with the idea that it's the Fed's non-reinvestment policy that's mitigating a scarcity of safe collateral in the repo market. We have to account for mortgage-backed securities in the calculation, but I don't think that changes the story.

Wednesday, July 4, 2018

Fed Balance Sheet News

There have been some interesting developments in US financial markets over the last few months, that I think have an important bearing on how we should be thinking about large central bank balance sheets, quantitative easing, and the choice between floor systems and corridor systems for central banks. To really do a good job on this issue, one needs to know monetary economics, financial economics, and the intricacies of institutional details and regulation in overnight markets, but I'll do the best I can, and maybe some people can help fill in the spaces.

This post is a bit on the long side. If you want the executive summary, here goes. Recently, overnight financial markets have tightened up considerably, in the sense that the interest rate on excess reserves (IOER) is close to all overnight interest rates. The floor system of central bank intervention that the Fed designed, before interest rates went up in late 2015, is now working as floor systems should. Why are things working better? Because the Fed is finally phasing out its big-balance-sheet program, which was hindering the functioning of overnight markets. The FOMC has not seen the light yet, though. They love QE, and seem to be on a road to permanent big-balance-sheet.

First, let's review where the Fed's balance sheet was, where it is, and where it might be going. Between late 2008 and late 2014, the Fed purchased a large quantity of long-maturity Treasury securities and mortgage-backed securities (MBS), while paying interest on reserve balances at the IOER rate of 0.25%. Here's the time series of securities held outright by the Fed:
The more-than-five-fold nominal increase in the Fed's securities holdings, along with near-zero nominal interest rates, was viewed by the FOMC as an emergency policy, which it would ultimately exit from - in some fashion.

Well apparently that emergency lasted a very long time. The Fed did not begin increasing its target range for the fed funds rate until late 2015 - seven years after the financial crisis. And the reinvestment policy which held the nominal stock of the Fed securities constant was kept in place until October 2017. At that date, the Fed implemented a modest plan to reduce the size of the balance sheet through a phaseout in the reinvestment program. That is, there would be caps on the quantity of securities the FOMC would allow to mature without replacment, with the caps set to rise from $10 billion in October 2017 to $50 billion in October 2018. A $50 billion cap would bind infrequently given the current size of the Fed's portfolio, and would stop binding entirely as the size of the portfolio falls. As you can see from the chart, the balance sheet reduction program has become visible, but it will still take years for the balance sheet to fall to the point where it looks like pre-financial-crisis days, i.e. excess reserves close to zero.

But that gets us to the liabilities side of the Fed's balance sheet, which is actually where the action is, particularly in terms of this post. Before "liftoff" happened in October 2014, I wrote about how the implementation was supposed to work, in a large-balance-sheet world. The FOMC was uncertain about how liftoff would work, as they had never done anything like this before, and some idiosyncratic features of US financial markets made liftoff a tricky business. In theory, a floor system - when there are excess reserves outstanding in the financial system - should work in a very straightforward way. The Bank of Canada did this for a year-long period from Spring 2009 to Spring 2010, with no problems. In a floor system, the central bank sets IOER, and arbitrage in the overnight market should more-or-less equate all safe overnight interest rates to IOER.

But, in the US, some ill-informed people in Congress wrote the amendment to the Federal Reserve Act authorizing payment of interest on reserves in such a way as to deny government sponsored enterprises (GSEs) - including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks - interest on reserves. So, every day GSEs are looking for a place to park their overnight funds to earn some interest, rather than having these balances sit in reserve accounts earning zero. Over time, the arrangement that developed was for the GSEs to lend overnight on the fed funds market to whoever would give them the best price. Fannie Mae and Freddie Mac apparently dropped out of that game, leaving a fed funds market dominated by arbitrage trading between Federal Home Loan Banks, as lenders, and branches of foreign banks in the US, as borrowers. Why foreign banks? Because they had the lowest costs. This arbitrage was subject to frictions, thought to be "balance sheet costs." For example, a commercial bank that borrowed on the fed funds market and put those funds in its reserve account would have higher assets, and would therefore pay a higher deposit insurance premium, or would have to worry about satisfying capital requirements or other regulatory constraints. A foreign bank in the US has no retail deposit business, and thus is not paying a deposit insurance premium, implying lower costs of borrowing fed funds.

When liftoff occurred, the big concern was whether the fed funds rate would actually go up when IOER went up. In the immediate pre-liftoff period, the effective fed funds rate was typically in the range of .05-.15%. The IOER/fed funds rate differential of 10-20 basis points was thought to reflect balance sheet costs. But, would this differential persist, would it decrease, or would it increase? That uncertainty caused the Fed to buy insurance, in the form of the overnight reverse repurchase agreement (ON RRP) program. Every day, the Fed conducts a fixed-rate full-allotment program under which specified counterparties lend to the Fed, mainly overnight, with the lending secured by securities in the Fed's portfolio. Until recently, the ON-RRP rate was fixed at 25 basis points below IOER, the idea being that this puts a floor under the floor in the Fed's floor system - a subfloor, as it were. If you think that's unusual, you would be right.

So, what has been happening in overnight markets since December 2015? First IOER has been increased seven times. The first six were 25-basis point increases, and the last increase was 20 basis points, to 1.95% on June 15.
A key feature in the last chart is that, initially, the IOER/fed funds rate differential was 10 to 13 basis points, but that shrunk to about 9 basis points, and stayed at roughly that level through the period when IOER was 1.5%, but since the March 22 hike, the differential fell to 5 basis points and then to 3-5 basis points after the June 15 increase. The fed funds rate is currently at 1.91%, with IOER at 1.95%. Further, note that the downward spikes in the fed funds rate that occurred at every month-end have disappeared. The spikes were presumably due to accounting reasons. Borrowers in the fed funds markets wanted to fix up their balance sheets for month-end, and lenders had to find other places to park their funds overnight - I'm assuming in the repo market, at lower rates.

We can get more detail on the fed funds market from the New York Fed. The effective fed funds rate is an average (which only included brokered trades in the past, but I'm not sure what the coverage is now). There is always dispersion in interest rates in the market, and dispersion can get high when there is significant counterparty risk, as happened in the financial crisis. As you can see in the table, focusing on the last trading day listed, July 2, most of the trades are close to the mean. The effective fed funds rate was 1.91%, and 50% of the trades were within one basis point, plus or minus. But the 99th percentile was 2.06%, i.e. 15 basis points above the mean, which is substantial. That's also 11 points above IOER. What's going on here is that, in a system still flush with reserves, most trading on the fed funds market is between GSEs and banks that can earn interest on reserves. But there are still some banks that need to borrow overnight to meet a reserve requirement, for example. A bank might have to make a large payment late in the day, find itself short, have to scramble to find a lender, and end up paying a premium above IOER.

Also, here's the volume of daily trade on the fed funds market.
Volume is lower than before the financial crisis (as, again, the system is flush with reserves), and somewhat lower than late last year or early this year, but about the same as a year ago. Though fed funds are trading close to the top of FOMC range, which is currently 1.75-1.95, the tightening in the differential between the IOER and the fed funds rate isn't associated with markedly different trading volume in the fed funds market.

What's been happening with the Fed's ON-RRP facility?
That's just since the end of 2017, but it shows the volume of ON-RRPs dwindling to close to zero, except at the quarter-end in June. But note that even the quarter-end spike is small relative to volumes of $500 or $600 billion that have occurred in the past. Unfortunately, the Fed seems to have discontinued some ON-RRP time series, or FRED is not carrying them, so I can't show you the historical data. Take my word for it, though. Volume in the ON-RRP facility was typically much higher - on the order of $60 billion to $100 billion daily, and spiking substantially at quarter-ends, before this year.

Here's something interesting. The Fed is sustaining a substantial quantity of ON-RRPs to foreign entities - primarily official ones, i.e. governments and central banks:
Since liftoff, that has settled in at about $240 billion daily.

Other than ON-RRPs, the primary liabilities on the Fed's balance sheet are currency and reserves:
So, though the reinvestment program was holding the size of the balance sheet constant in nominal terms, growth in the nominal stock of currency has been kicking along at a good pace, so that the stock of reserves has been falling. At $2 trillion, this stock is still very large, however.

Another interesting feature associated with the Fed's large balance sheet is the post-financial-crisis behavior of the Treasury's General Account with the Fed.
The General Account is the Treasury's reserve account with the Fed. This account was carefully managed before the financial crisis, as an increase in reserves held by the Treasury will, everything else held constant, reduce reserves held by the private sector. But, with a large balance sheet, even large movements in Treasury reserve balances are of essentially no consequence. So, the balance in the General Account has been much larger, and very volatile. For some reason the average balance in the account has increased since liftoff, with the balance at a substantial $374 billion on June 27.

Of key interest are recent developments in overnight markets, related to some issues we have already discussed concerning the ON-RRP facility. Here, I'll use a figure from a paper by Sam Schulhofer-Wohl and James Clouse at the Chicago Fed:
This shows the fed funds rate, a repo rate, and the FOMC's target range for the fed funds rate from liftoff to early April. This shows how the margin between the fed funds rate and IOER (at the top of the band) has shrunk, and how the repo rate, which used to trade close to the ON-RRP rate (at the bottom of the band) began tracking the fed funds rate and IOER after the March FOMC meeting.

Taking a closer look, the New York Fed has begun publishing data on repo rates and trading volume. Here's what the repo rate looks like from April 2 to July 2:
Note that I've used a different rate than the one in the Schulfhofer-Wohl/Clouse paper, but I don't think it makes much difference. For good measure, here's the time series for the 1-month T-bill and the fed funds rate:
As you can see, there used to be a substantial margin between the fed funds rate and the one-month T-bill rate, but that essentially went away after the March FOMC meeting.

What's Going On?
It's clear that all overnight interest rates have tightened up. What was once a floor-with-subfloor, a leaky floor, or whatever, is now behaving like a floor system should, with IOER tying down overnight interest rates. And the ON-RRP rate, at 20 basis points below IOER now, is not attractive to overnight lenders. The ON-RRP program could now be discontinued, and it would make no difference.

Why is this happening? Well, you don't have to think too hard to figure that out. The tightening up of the overnight market coincides with the phasing-out of the Fed's reinvestment program. From the very first chart, you wouldn't think that would make much difference, if you thought that what is important about the big balance sheet is only its size. But clearly the flow of asset purchases by the Fed matters, and a cessation of the reinvestment program makes a big difference for this flow, which in turn has a large effect on the stock of on-the-run safe assets - which are the primary fodder for the overnight repo market. Thus, what we have been observing in overnight markets from liftoff until early this year was due to a shortage of collateral. This shortage was keeping the repo rate low relative to IOER, and causing anomalies in the behavior of the fed funds market. The IOER/fed funds rate margin was not caused primarily by "balance sheet costs," but by lack of good alternatives to the fed funds market for overnight lenders. Now that repo rates are close to IOER, the fed funds market has become more competitive.

The bottom line is that quantitative easing was messing up overnight markets. A program intended to ease something was just gumming up the financial plumbing. Low real interest rates (or a low neutral rate, as it's sometimes called in the Fed system) was stemming in part from what the Fed was doing to itself.

So, how is the Fed reacting to this? From the May FOMC meeting minutes:
The deputy manager then discussed the possibility of a small technical realignment of the IOER rate relative to the top of the target range for the federal funds rate. Since the target range was established in December 2008, the IOER rate has been set at the top of the target range to help keep the effective federal funds rate within the range. Lately the spread of the IOER rate over the effective federal funds rate had narrowed to only 5 basis points. A technical adjustment of the IOER rate to a level 5 basis points below the top of the target range could keep the effective federal funds rate well within the target range. This could be accomplished by implementing a 20 basis point increase in the IOER rate at a time when the Committee raised the target range for the federal funds rate by 25 basis points.
Later in the minutes, it's stated that FOMC members thought such a change
would simplify FOMC communications and emphasize that the IOER rate is a helpful tool for implementing the FOMC’s policy decisions but does not, in itself, convey the stance of policy.
The key problem here is that announcing the policy as a target range for the fed funds rate is starting to look silly. The cure for that problem isn't reducing IOER to five basis points below the top of the range. Further, the idea that that IOER does not "convey the stance of policy" is false. That's how a floor system works, and this one now appears to be approaching the point where it's working fine.

The FOMC's focus on the fed funds rate as a policy rate has always been questionable, and seems particularly wrongheaded in the large-balance-sheet period. The fed funds rate is unsecured, and so reflects substantial counterparty risk in times of crisis. In pre-crisis times the New York Fed intervened in the repo market (a secured credit market) to target the fed funds rate. That's pretty weird. Why not just target an overnight repo rate, like most other central banks do? Repo rates are safe rates of interest, uncontaminated by risk, and the New York Fed could pretty much nail the target every day through a fixed-rate full-allotment procedure.

In the post-crisis period, it got even worse, as trading in the fed funds market consists mostly of arbitrage trading, and the rate doesn't mean what it did pre-crisis. Some people in the Fed system seem wedded to the fed funds rate as a policy rate, but they should give that up and move on.

Finally, this recent WSJ article by Nick Timiraos discusses balance sheet issues. I thought this quote from Bill Nelson, in the article, was interesting:
“But it’s possible, to everyone’s surprise,“ he said, that reserves are in fact growing scarce, which would mean ”they’ve reached the point where they will need to stop the run-off."
As well, Jim Bullard, President of the St. Louis Fed is quoted as follows:
Maintaining the existing framework “certainly looks like that’s the way we’re headed, but we should still have the debate.”
First, no one should be thinking of this as a "scarce reserves" situation. Two trillion dollars of reserves is still a massive quantity of reserves. That's about 11% of annual GDP. I think people are looking at how overnight interest rates are tightening up and thinking that this somehow looks like pre-financial crisis times, which people often call (misleadingly) a regime of "scarce reserves." As I discussed above, what we're seeing isn't a problem of scarce reserves. It's a good thing - the scarcity in safe collateral is going away.

Unfortunately, FOMC decision-making is still being driven by the people who decided to implement the Fed's quantitative easing (QE) programs, and bought into those programs in a big way. Like Ben Bernanke, who continues to defend QE, the proponents seem not to have learned much from the episode. This was an experiment, and I think I'm learning that it was a mistake. The Fed could stick with a floor system, protect Bernanke's legacy, and live in denial. There are circumstances in which a large balance sheet could be useful. But not if that means turning good collateral into inferior bank reserves.

Saturday, June 23, 2018

Jawboning Makes a Comeback

What's jawboning? Well, this Smithsonian Institution piece claims that, in the early part of the Great Depression, Herbert Hoover resorted to jawboning. Specifically,
...he convened a series of “conferences” with business leaders urging them to maintain wages and employment through the months to come.
In the article, it's claimed that:
Hoover’s overriding commitment in all his years in government was to prize cooperation over coercion, and jawboning corporate leaders was part of that commitment.
Jawboning was a practice later on as well. This op-ed in the New York Times in 1978, by Russell Baker is a commentary on the jawboning practices of then-President Jimmy Carter:
Better economists than I are saying President Carter is going to have to start jawboning if he wants to Stop inflation. All very well for a President who can jawbone like a champion, but veteran jawbone writers doubt that Mr. Carter has what it takes.

The NBC Nightly News showed films the other night comparing President Carter's jawboning with President Kennedy's. One film showed Mr. Kennedy jawboning the steel industry about a price increase in 1962, and the other showed Mr. Carter jawboning the steel industry about a price increase last Wednesday.

All you could say after watching the Kennedy performance was, “They don't make jawboners like that any more.” What Caruso was to opera, what Babe Ruth was to bats, Jack Kennedy was to jawboning. By comparison, Jimmy Carter sounded like a hambone the steel tycoons might toss into the soup.
So, from Baker's point of view, JFK was really good at the practice of jawboning, which in the early 1960s involved persuading steel industry executives to forego price increases. Baker reasoned, as others did at the time, that Carter should start talking inflation down, presumably by convincing producers to forego price increases.

An approach to controlling inflation that involves talking to the people who set price and wages in order to convince them of the errors in their ways might seem odd in a modern context. We all know that it's the central bank's job to control inflation, right? But, that certainly wasn't a widespread view, or even a majority view, in 1978. Here's one of my favorite James Tobin quotes, from this 1980 Brookings paper:
...it is not possible to do the job [disination] without effective wage and price controls of some kind...there could be worse prospects, and probably they include determined but unassisted monetary disinflation.
Here, Tobin's not discussing jawboning, otherwise known as moral suasion, but outright wage and price controls. He's saying you can't bring inflation down ("it is not possible") through monetary policy alone. But Paul Volcker proved Tobin wrong by engineering an unexpectedly rapid disinflation in the United States. That, more than anything I think, convinced everyone that we should make clear that inflation control is a job for the central bank, and to hold central bankers to account if they don't do a good job.

It may come as a surprise to you (and I missed this myself when it first made the news) that Prime Minister Abe of Japan is attempting jawbone-inflation-control.This story from last December indicates that, in contrast to disinflationary jawboning, Abe wants everyone to increase nominal wages at 3% per year, so as to increase inflation. The reasoning seems to be that, if productivity is going up at a rate of 1% per year, then 3% nominal wage growth will cause firms to increase prices at about 2% per year, and the Bank of Japan will then be achieving its inflation target.

Just in case you haven't been following this, the last 22 years or so of inflation in Japan looks like this - relative to the US:
Since early 2013, the Bank of Japan has had an explicit 2% inflation target, and has tried everything that a conventional central banker might try to get inflation to go up - including policies once thought "unconventional." The BOJ has kept short-term interest rates low - even going into negative territory - and has expanded its balance sheet massively through large-scale asset purchases. It has even pegged the 10-year government bond rate to zero. All to no avail, apparently, as the chart shows no sign of a sustained inflation developing. The American experience since 1996 is indeed a mild, sustained inflation, and the CPI path is not far from a 2% inflation path for the whole 22-year period. Surprisingly, the Fed didn't actually have an explicit 2% inflation target until 2012, but I don't think the US inflation performance is an accident. It seems reasonable to infer that the FOMC was implicitly following a 2% target.

So what does Governor Kuroda of the Bank of Japan think of Prime Minister Abe's jawboning? Well apparently he's more than OK with it. Kuroda is quoted as saying:
The government request for 3 percent wage increase is quite appropriate...
Maybe he's just being polite, but the worst interpretation of Kuroda's comments is that he's abandoning responsibility for his inflation target. Maybe he's willing to think that inflation results from a self-sustaining wage-price spiral, and if inflation stays low, and the BOJ falls short of its 2% inflation target, then that's the fault of the people who set the prices and wages. But who knows?

In any case, when central bankers can't do what they claim to be able to do - control inflation - you can see how all hell can break lose. Before we know it, Japan could have wage and price controls, which have a rather sorry history, including the Anti-Inflation Board (1975-1979) in Canada.

I hate to repeat myself, but what the heck. Monetarism works as an approach to disinflation. Reducing the rate of growth in total central bank liabilities in a sustained fashion has to reduce inflation. Unfortunately, increasing the rate of growth in central bank liabilities is not a sufficient condition for inflation to increase. A necessary and sufficient condition for inflation to increase in a sustained fashion is a permanent increase in short-term nominal interest rates. Balance sheet expansion with the interest rate on reserves kept low will increase central bank liabilities alright, but will not increase inflation - this just amounts to a swap of interest bearing (albeit at low or negative interest rates) central bank reserves for other interest-bearing assets (or even ETFs, in the BOJ case), and can't doing anything to create a sustained inflation. That's more than obvious from Japanese experience. The BOJ can't increase inflation by staying the course (more quantitative easing, continued low or negative interest rates). It has to increase its policy rate - nothing more complicated than that - and sustaining that increase in the policy rate will induce higher inflation. Easy.

Tuesday, June 19, 2018

What Does "Serious" Mean?

A week ago I wrote this in a tweet:
I'm puzzled by the infatuation with NGDP targeting. We have good reasons to care about the path for the price level and the path for real GDP. Idea seems to be that if you smooth Py that you get optimal paths for P and y. That's hardly obvious, and doesn't fall out of any serious theory I'm aware of.
The proximate cause of that outburst was this blog post by David Beckworth who, as you might know, is a proponent of nominal GDP (NGDP) targeting.

I've written before about NGDP targeting - for example I found this post from six years ago. It turns out that not much has changed since then. My views haven't changed, and the promoters of NGDP targeting are more or less the same ones that were around six years ago - and I don't get the sense they've come up with anything new to tell us. In any case, though, I wanted to find out for sure, and that's what my tweet was about. It basically says: "I don't think you have a good argument, but in case you do, please tell me about it." I tried to provoke Beckworth a bit to get an answer out of him, but he just called me a troll.

But, at last, some degree of success, as George Selgin has gone to considerable trouble to research the economics literature to come up with what he thinks are "serious" arguments that would support NGDP targeting. The first order of business for George is to complain about my use of the word "serious:"
I'm not exactly sure what Stephen means by a "serious theory." But if he means coherent and thoughtful theoretical arguments by well-respected (and presumably "serious") economists, then there are all sorts of "serious theories" out there to which he might refer, with roots tracing back to the heyday of classical economics. Indeed, until the advent of the Keynesian revolution, a stable nominal GDP ideal, or something close to it, was at least as popular among highly-regarded economists as that of a stable output price level, its chief rival.
"Serious" means that a good case has been made, where "good" means a theory with conclusions that follow from reasonable assumptions, and some notion that this works empirically. Good science basically. Unfortunately, in economics there is plenty of bad science to wade through, and some of that bad science finds its way into reputable journals, and is written by economists with fancy titles working at reputable academic and non-academic institutions. That's why I qualified my statement with "serious." I know there's a mountain of economics writing arguing that NGDP targeting is the cat's meow. But anyone could find mountains of writing in economics about any number of crappy ideas. I want to know about the good stuff. And I'm not going to be convinced by the reputations of the people promoting the ideas or the popularity of the ideas. Everyone has to make their case, and we don't do science by opinion poll.

So, what's an example of a serious idea, related to monetary policy rules? Well, one of these is Friedman's constant money growth rule. Friedman had a theory to back that up in "The Role of Monetary Policy." That's a coherent theory, but it's all in words. Like many things that Friedman did, you can also formalize it, which is - more or less - what Lucas did. There was also a formidable empirical project, Friedman and Schwartz's Monetary History of the United States, which Friedman used to support the theory. With everything laid out like that, we're able to argue about the assumptions, the conclusions, and the evidence. Serious stuff. Friedman was convincing enough that central banks actually implemented his ideas. Some of that was a success (the Volcker disinflation) and some was not (ongoing inflation control).

We're now in a world in which most "serious" central banks are inflation-targeters. Typically, they're targeting inflation at 2%, and manipulating a short-run target for an overnight nominal interest rate to hit the inflation target. Some central banks - the Bank of Canada in particular - have have been successful inflation targeters. The Bank of Canada has been doing this since 1991, and they haven't deviated much from a 2% inflation path over the last 27 years. This chart shows just the last 20 years, as I was comparing Canada to Japan in a talk I gave:
In the inflation targeting game, that's pretty good. In Canada's case, inflation targeting has proved to be feasible, it's easily understood, it's conducted in a way that promotes central bank independence, and it appears to be compatible with good economic performance in other dimensions.

So what's to complain about? I think we can make a case that central banking should be conservative - this isn't a venue where we should treat experimentation lightly. To change procedure we have to think that something's going wrong with the current approach, and that switching gears is highly likely to give us an improvement. In Canada, the Bank reviews its agreement with the government of Canada every 5 years, and thinks about whether it's doing the right thing. The agreement won't be reconsidered until 2021, but the Bank is already mulling this over - a process which involves economic research and consultation with the public. Serious work, I think.

Is the work that George references in his blog post serious? George thinks so, but of course George's and my views of what is serious might differ. I may not be as ignorant of the work as George thinks - I've already seen much of it - so you might guess that I'm putting some or all of it in the non-serious bin. To take some examples:

1. McCallum 1987: McCallum was an early promoter of NGDP targeting. From the paper, this looks like some kind of modified monetarism. McCallum won't write a model down. He says we don't have agreement on what the model is, so apparently his policy rule is somehow agnostic. But he goes ahead anyway to run an "atheoretical" regression, and uses the estimated coefficients to simulate the performance of his rule. Yikes. Definitely not serious - a multitude of sins in that one.

2. Garin, Lester, Sims: This starts with a boilerplate New Keynesian (NK) model and ultimately expands this into a "medium scale" model. This is complicated enough that's it's not going to be amenable to analysis - pencil and paper techniques. The authors estimate and calibrate the parameters in the model and then evaluate the performance of alternative policy rules, according to the welfare loss relative to what would occur in an identical economy with flexible wages and flexible prices. So, this is serious work. There's a model that is formally laid out, there are references to the related literature, there is an attempt to measure the welfare effects of alternative policy rules given the model at hand. The authors report, in Table 7, that the welfare loss for NGDP targeting is .11% of GDP, from inflation targeting .86%, from output gap targeting .03%, and from a Taylor rule .24%. So, if we were living in this model NK world, then the best we could do is to target the output gap. This of course makes perfect sense, since the output gap is the deviation of output from output in the flexible wage/price equilibrium, so the welfare criterion is in fact the output gap. And NGDP targeting is second best, and certainly much better than pure inflation targeting or a Taylor rule.

But, once we're past the actual exercise at hand we can start to ask questions. What's the model leaving out that might be germane to the problem at hand? What else could we do with this model that might lead us to different conclusions? First, the model has sticky-price and sticky-wage frictions, but we know there are other frictions of importance for monetary policy - financial frictions in particular. Surely we don't think that this NK model will tell us anything about what to do in a financial crisis, for example. I might like to know what would happen under a naive policy. That's a little difficult here as we have to worry about determinacy issues, but indeterminacy isn't stopping most NK modelers. They typically ignore the global indeterminacy that's staring them in the face. The naive policy would be a useful benchmark, as this would give us a measure of how costly price and wage stickiness is. My guess is the welfare loss in these models is very small - not enough to justify the cost of running the Fed, I think.

The big difficulty here, I think, is indeterminacy. In simple NK models - Benhabib et al. for example - we know that a Taylor rule central banker can get stuck at the zero lower bound. The alternative policy rules considered in the paper are, as the authors argue, alternative Taylor rules - set the nominal interest rate with a particular target in mind, and alternative coefficients. For NGDP targeting, in the model the central bank sets the nominal interest rate each period to peg NGDP to a constant. I would like to know exactly what sort of rule that produces, and I would like to know about the global properties of the model - not just an approximation around the steady state. The indeterminacy issue is important, as "Taylor rule perils" can explain why some central banks have had trouble hitting inflation targets (the Bank of Japan in particular). NGDP targets aren't going to do any better if they are subject to the same perils - a problem not addressed in the paper. So, the jury is out on Garin-Lester-Sims.

3. Sheedy 2014: What I like about this paper is that it takes nominal intertemporal contracts seriously. My suspicion is that NK people are barking up the wrong tree in emphasizing potential inefficiencies in nominal spot market contracts (and it's not like labor contracts are typically spot contracts anyway). Debt contracts at, for example, 3-month, 1-year, 10-year, or 20-year horizons are subject to inflation risk for those horizons. So, if the central bank can make prices predictable over long horizons, that should reduce risk in credit markets substantially, and should make those markets work more efficiently. But in Sheedy's model, smoothing nominal income is apparently a good way to insure against this uninsured risk. And Sheedy's model is quite special. Indeed, it's addressing a monetary policy issue in a 3-period model - that's not a serious approach to monetary economics in my opinion. It's hard to model valued central bank liabilities in a sensible way in a finite horizon model. My guess is that, if you developed this idea in a serious monetary model, that an optimal policy rule might look like price level targeting. Someone would have to do the work though.

Conclusion? Well, some seriousness alright, but I still don't see NGDP targeting "falling out of any serious theory." I'm not yet ready to tell any central bankers (in case they're asking) that they should drop their inflation targets and adopt NGDP targeting.