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.

Wednesday, June 13, 2018

Sovereign Money, Narrow Banks, Digital Currency, etc.

The recent Vollgeld (full money) or sovereign money referendum in Switzerland, which was just voted down, is quite interesting, as it raises several fundamental issues in monetary economics and central banking. What's money? Is "money" a useful concept to be bandying about? Who should have the right to issue money? What's a bank? Are banks inherently unstable? What's a central bank for anyway?

I read a few blog pieces and news reports on Vollgeld. Some of the blog pieces, like David Beckworth's, contained essentially nothing I could agree with. Others, like one by Morgan Ricks, were pretty interesting.

What was the Vollgeld proposal? In Switzerland, as you may know, they like referenda. These are conducted for all three levels of government, and there are typically several a year at the federal level. If you're upset about something, and can get enough people to sign a petition, the initiative is sent to the electorate (you won't have to wait for an election), and it's either voted up and made law, or voted down. This specific initiative - Vollgeld - was a proposal that would have banned private banks from the retail payments business. Under Vollgeld, a private bank could still issue various liabilities - long-term debt, short-term paper, savings accounts, for example, but presumably not accounts subject to payment by debit card or check. What was the reasoning? Apparently, we shouldn't trust private banks. They're risky - I assume in both the institutional and systemic sense. And there seems to be some notion that giving a private financial institution the right to issue "money," is giving it monopoly power. Why should we be endowing these elite bankers with special privileges?

But what are people to do if the banks can't provide them with transactions services? The Vollgeld proposal was to transfer that provision to the central bank, which would be then be in the business of setting up accounts, issuing debit cards, making sure accounts aren't overdrawn, filling ATMs with cash, etc. And why not, the Vollgeld proponents might say. After all, those elite bankers have had checking accounts (i.e. reserve accounts) with the Swiss National Bank since that institution was set up. Surely it would be more democratic if reserve accounts were available to everyone.

On the face of it, Vollgeld seems not so different from traditional narrow banking proposals, which have been around for a coon's age. The weird thing is that narrow banking proposals usually came from the right wing, while Vollgeld appears to be a lefty proposal. Milton Friedman, for example, had a narrow banking proposal - the 100% reserve requirement. Friedman thought that controlling the stock of money is everything, and if each unit of transactions deposits were backed by one unit of central bank reserves, the central bank could perfectly control the total stock of money - reserves plus transactions accounts plus central bank-issued currency. So, with Friedman's proposal the private banks could still issue the transactions accounts, not the central bank, but it's effectively the same as a Vollgeld-type proposal. And the rationale isn't so different. The Vollgeld people are concerned that a private institution is issuing what they think is a public good - money - and Friedman agrees, basically (or would if he were still with us).

Narrow Banking in its extreme form has from time to time entered the realm of economic quackery. Murray Rothbard, for example, not only did not trust private banks to create money, he didn't trust the central bank either. Rothbard apparently had some influence on Ron Paul and the End the Fed movement. Basically, Rothbard wanted to re-establish the gold standard, and have a 100% reserve requirement - in gold.

The typical benefits attributed to narrow banking - other than what Friedman had in mind - can be found in some of the concerns of the Vollgeld proponents. Banking is sometimes thought to be inherently unstable - an idea that might occur to you if you were a student of US banking history, for example. A remedy for this problem, instituted first in the United States, is deposit insurance. But, we know that deposit insurance breeds another problem - moral hazard. Banks will take too much risk, if they're not somehow prevented from doing so. So one regulatory intervention breeds others - capital requirements for example. Solution: Adopt narrow banking and transactions deposits are safe - you can do away with deposit insurance.

What's the problem with that? Well, in typical narrow banking proposals, a concern is that the legal restriction on banks makes financial intermediation less efficient. That is, through the wonders of asset transformation, conventional private banks convert illiquid loans and other illiquid assets into liquid transactions deposits. This intermedation process is an efficient way to channel savings into productive investment. If people are forced to hold their transactions balances in accounts backed by central bank or government liabilities, then real interest rates will be higher on loans and other private debt instruments, and there will be less capital accumulation.

The other problem is that narrow banking rules, including Vollgeld, can be skirted by private financial intermediaries. This is a standard game in the financial sector. Some regulator puts restrictions on some type of financial intermediary activity, and some enterprising banker finds a way to design a financial product that performs roughly the same function as what is being regulated, but the new product falls outside of the regulation. In the United States, money market mutual funds came into being because of regulations on transactions deposits at commercial banks. Sweep accounts were devised to get around reserve requirements and the prohibition of the payment of interest on demand deposits. The shadow banking sector grew because costs were lower than in regulated commercial banking.

A curious feature of Switzerland is that, if the Swiss National Bank were to issue transactions accounts, this would actually not be narrow banking in the usual sense. To illustrate why, consider Canada (if you dare). In Canada, for example, most of the assets held by the Bank of Canada are obligations of the government of Canada, and the balance sheet is small, at 6.5% of GDP. So, if the Bank of Canada issued transactions accounts to consumers, that would be a narrow banking activity, provided nothing changed in the composition of the Bank's asset portfolio. The Swiss National Bank, by contrast, holds a portfolio that includes a large amount of equity, and the majority of the portfolio is not denominated in Swiss currency. The Swiss National Bank holds the sovereign debt of other countries in Europe, North America, and Asia, and it holds private debt. Further, the balance sheet of the Swiss National Bank is very large, at 117% of Swiss GDP at the end of 2017.

So, if Vollgeld had passed, what the SNB would be doing would not be narrow banking as traditionally envisioned. In fact, the Swiss National Bank, given its large and unusual asset portfolio, wouldn't look like any bank I know of under Vollgeld. It would have been some sort of stock mutual fund/foreign currency-denominated bond fund offering transactions accounts. Though the Swiss National Bank is currently well-capitalized, I doubt if it would pass the regulatory scrutiny of any bank regulator. In any case, the Swiss National Bank campaigned actively against Vollgeld.

Another curious aspect of Vollgeld was that the movement was driven in part by the idea that banking should be democratized. Somehow private banks were thought to be falling short in the public service department. But the residents of Switzerland already have the option of holding transactions accounts - and savings accounts too - in a government financial institution. If you've been to Switzerland, you should know what this is - it's the Swiss post office, Swiss Post. From their web site, it appears that Swiss Post also offers financial services related to pensions and real estate. Wikipedia says Swiss Post is the country's second-largest employer, and Post Finance, its financial arm, is the fifth largest retail financial institution in Switzerland. So, given that there is already a government-owned option in retail payments services, why would the Vollgeld people want to take the extra step of banning private retail payments outright? Beats me.

For all central banks in the world, changing technology, and evolution in retail payments has become an important issue - if not the key issue for the future of central banking. Central-bank-issued currency is losing ground to debit and credit cards in retail payments, in spite of the fact that currency outstanding has in some instances increased. Here's the currency/GDP ratio for the US:
So, that bottomed out at about 4.1% in the 1980s, and currently stands at 8.1%. But, about 80% of that is in $100 denominations. As people like Ken Rogoff like to point out, the primary liability of most central banks - what finances the asset portfolio of a small-balance-sheet central bank like the Bank of Canada - is being used as a means of payment and store of wealth by criminals. Getting rid of large denominations, or withdrawing all currency from circulation, would increase the cost of committing crime, and might make us all better off (except the criminals of course).

But, currency is still used intensively, in legitimate ways, by a significant fraction of the population, who tend to reside in the bottom tail of the income distribution. And currency can be useful when everything else fails - computer networks go down, or the power fails altogether. We don't want to shortchange the poor (literally), or shoot ourselves in our collective foot. A possibility is that central banks could issue some form of digital currency, which is what most people are considering, I think, when they discuss "sovereign money," not the more draconian Vollgeld approach.

So, if central banks were to issue a new type of liability, what form could that take? Well, it could be a kind of cryptocurrency. As with Bitcoin, for example, central banks could issue a liability that could be exchanged in decentralized fashion, on a distributed ledger. While central banks may be able to correct some of the potential stumbling blocks associated with cryptocurrencies, what we know about blockchain technology currently suggests that it can't handle a large volume of transactions, and that it is far too costly - in pure energy costs - to provide the correct incentives. So, a central bank digital currency would have to be centralized - a stored-value-card technology for example. But then the central bank would have to provide an interface whereby value could be downloaded and uploaded at decentralized locations. Possibly this could be done through the private banking system, and possibly central bank digital currency could compete with privately-issued digital currencies.

But why should the central bank be in the business of retail payments at all? Why not leave that entirely to the private banking system? Indeed, there were historical instances of stable and successful private money systems. For example, before 1935 in Canada, retail means of payment consisted of small denomination government of Canada paper notes and coins, larger denomination paper notes issued by private chartered banks, and transactions deposits at those same chartered banks. If currency is an anachronism, we could do away with it, and leave the retail payments market to private financial institutions, perhaps with some constraints requiring that basic services be provided to low-income people.

What would monetary policy be in a world in which the central bank doesn't issue liabilities that Milton Friedman would recognize as "money?" Here, it's helpful to get away from the idea that there is some stuff we should call "money," and that such stuff is produced through magic - creation from "thin air," apparently. Those ideas - propagated sometimes by otherwise-respectable economists - aren't helping us much, and are seriously misleading. In reality, assets exist on a multidimensional spectrum, and the central bank's ability to execute what we think of as monetary policy - inflation control, crisis intervention, smoothing of financial conditions to enhance real economic activity - could be unimpeded even if the central bank does not issue a retail payments instrument.

Central banking works because the central bank is transforming assets - its a bank after all, which has assets and liabilities that differ according to maturity and liquidity. As long as the asset transformation is something that can't somehow be undone by private actions, it works. Governments issue interest-bearing debt for which close private sector substitutes don't seem to exist. For example, in the US, the repo market loves Treasury securities. So, we might imagine central banks issuing an array of interest bearing obligations - from overnight assets like the reverse repos issued by the Fed, to three month bills, to 10-year bonds - to finance a portfolio of government debt. In principle, those central banks should be able to target short-term market interest rates, just as they do now.

I've touched on a host of questions that central banks need to know the answers to, and there is some urgency in providing answers. Unfortunately, we can't get the answers by running a regression, as these are fundamental questions having to do with institutional design and technologies that we have little or no experience with. This is where theory comes in, and part of why it's useful - sometimes the only game in town. Get out your models, monetary theorists!

Monday, May 21, 2018

Inflation, Interest Rates, and Neo-Fisherism In Turkey

In most respects, President Erdogan of Turkey is not known for his progressive instincts, but in economic policy he may be the only convinced Neo-Fisherite on the planet who potentially has any power over monetary policy decisions. Erdogan has been at odds with the Central Bank of Turkey, and seems intent on changing the Bank's approach to inflation policy. In a recent interview in the UK, and recent speeches, Erdogan has made clear that he thinks that high nominal interest rates are the cause of high inflation in Turkey, and that disinflation can be achieved if the Central Bank reduces its policy rate.

Erdogan's views have been derided by market participants, and some panic ensued, manifested in a depreciation in the Turkish currency. But, apparently Erdogan's ideas aren't coming out of thin air, as his economic advisor Cemil Ertem has written a defense of Erdogan's views, which does a good job of finding the relevant supporting evidence. He cites John Cochrane's work, and speeches by central bankers, including Jim Bullard, that support neo-Fisherite ideas.

So, what's been going on in Turkey? Here's the time series of CPI inflation rates:
Turkey had very high inflation from the early 1980s until 2002, with the inflation rate sometimes exceeding 100% per annum. But, there was a large disinflation, with the inflation rate falling from a peak of 73% in 2002 to 7% in 2004. Since 2004, inflation has been much lower than over the previous 20 years, and much more stable. However, if we compare the path of recent inflation in Turkey with the United States, the picture looks like this:
So, inflation in Turkey is still considerably higher than in the United Stages, averaging about 8% since 2004, and it has recently been creeping up above 10%. Further, the Turkish central bank has had inflation targets that it has been persistently overshooting for more than 10 years:

What has the Turkish central bank been doing, and what does it propose to do in an attempt to hit its inflation target? From the central bank's most recent Inflation Report:
Given a tight policy stance that focuses on bringing inflation down, inflation is projected to converge gradually to the 5-percent target...
And:
...the disinflation process will continue in 2018 due to the decisive implementation of the tight monetary policy and convergence of economic activity and loan growth to a milder growth path.
So, that seems like boilerplate central banking. "Tight" monetary policy, i.e. a high nominal interest rate target, will lower inflation, and this disinflationary process will get some help from the Phillips curve, i.e. "a milder growth path" will reduce inflation, according to the central bank.

This is the Turkish central bank's inflation forecast:
So, in a little over two years' time, the central bank thinks it will have inflation down to its 5% target. Of course, that's what it thought in 2016:
In contrast to that optimistic forecast, inflation went up, not down, in the intervening period, and is currently well outside what was denoted the "forecast range" in the 2016 forecast.

So, you might conclude that the Turkish central bank is not capable of reducing inflation. But that's a puzzler. A central bank that could reduce inflation by about 66 percentage points in a two-year period from 2002 to 2004 can't get inflation down from 7% to 5% from 2016 to 2018? What's that about? Well, what did the central bank do to produce the 2002-2004 disinflation? Let's look at the path for short-term interest rates and inflation over the same period as in the first chart. Here I'm using an overnight interbank nominal interest rate (the only short-term interest rate I could find for Turkey - if you know where to find other interest rate data, please let me know):
So, in that chart we're seeing a typical Fisher effect - higher inflation is associated with higher nominal interest rates. The spikes in the overnight rate occurred during 1994 and 2001 financial crises in Turkey. Next, let's focus on the disinflationary period and after:
As we all know, if central banks can do nothing else, they are at least capable of pegging short-term interest rates. So, the path we see in the above chart for the overnight rate was determined by the central bank of Turkey. Did the central bank engineer a disinflation by keeping the nominal interest rate high? No. Monetary policy acted to reduce short-term nominal interest rates, and the inflation rate fell.

I'd say President Erdogan isn't as nutty as people are making him out to be - at least in the inflation policy realm. And Turkey is a very interesting example, as it appears to be following the orthodox central banking rulebook: Phillips curve, Taylor rule. There are plenty of countries - Japan being the most extreme - where inflation has been chronically below central bankers' inflation targets, so if Turkey is following the standard rulebook, why is inflation chronically above the inflation target there? Well, that's exactly what mainstream theory predicts. A central banker who blindly follows a Taylor rule (with the Taylor principle in place - more than one-for-one response of the nominal interest rate to changes in inflation) reduces the nominal interest rate target when inflation is low, believing that this will increase inflation, but inflation falls, and the central banker gets stuck in a low-inflation policy trap. Similarly, a Taylor rule central banker who sees high inflation increases the nominal interest rate target, believing that this reduces inflation, but inflation goes up. If the central banker followed the Taylor rule blindly, then inflation would increase indefinitely. But in Turkey's case that may not happen, even without President Erdogan in the mix, due to public resistance to higher interest rates.

There's a lesson here for countries like Canada and the United States, where central bankers are currently hitting their inflation targets. The Bank of Canada and the Fed avoided becoming Japan - falling into the low-inflation policy trap - because they either kept nominal interest rates off zero (Canada), or lifted off from zero (US). But interest rate hikes can be overdone - the risk as that you become Turkey.

Wednesday, May 9, 2018

Natural Rates

The natural rate of unemployment is not something we hear a lot about in academic circles these days, and it's out of fashion even in some central banks. I was out of town when this happened, but when I was working for the St. Louis Fed, Larry Meyer showed up at the Fed to talk to economists in the Research Department. One of things he wanted to know was our estimate of the natural rate of unemployment. Meyer seemed offended, apparently, that we had never thought about it. He didn't know that it's hard to find anyone at the St. Louis Fed who would take the Phillips curve, let alone the natural rate of anything, seriously.

I was reading Paul Krugman's blog, and he is saying that recent evidence "seems to have brought skepticism about the natural rate to critical mass." That sounds promising, so I thought I would like to understand what Krugman is getting at.

Krugman thinks that the "natural rate hypothesis," which he attributes to Milton Friedman, was an influential idea that we should re-assess. So, what did Friedman actually have to say about this? If you read Friedman's "The Role of Monetary Policy," you'll find that the natural rate hypothesis is no more nor less than the long-run neutrality of money. Friedman argued that the central bank could control nominal quantities - the nominal quantity of central bank liabilties outstanding, the price level, inflation, for example - but that it would fail in any attempt to permanently control real magnitudes. To get that idea across, Friedman told a story. That is, there exists a natural rate of unemployment - roughly, the rate of unemployment that would exist in the long run in the absence of aggregate shocks - and if the central bank endeavors to force the unemployment rate to be higher or lower than the natural rate then this would lead to ever-decreasing or ever-increasing inflation, respectively (though in the ever-decreasing case, presumably there would be a lower bound due to the lower bound on the nominal interest rate). A key part of the story is a theory of the short-run nonneutrality of money. For Friedman, this is a theory of money surprises, relying on adaptive expectations. Workers supply labor based on the real wage they expect, so if higher-than-anticipated money growth causes growth in nominal wages and prices to exceed what is expected, then workers supply more labor, thinking their real wage is higher, and firms hire more labor, as they know that real wages have fallen. That's a theory of Phillips curve correlations. Money surprises cause output and inflation to move in the same direction.

Lucas constructed a closely related theory of money surprises and nonneutrality, and in the process introduced rational expectations to the macro profession. Lucas has a theory of Phillips curve correlations, and can also say something about how the Phillips curve shifts with the monetary policy rule. For example, the slope of the curve changes with the degree of noise in the policy rule. New Keynesian (NK) models can of course produce Phillips curve correlations as the result of sticky prices. Expectations are rational in such models (the baseline ones anyway), and there is no imperfect information about aggregate shocks, but monetary policy is not neutral because some prices are locked in from past decisions. Unanticipated monetary expansions then lower relative prices for firms which cannot change prices in the current period, and those firms increase output to meet demand.

In principle all these Phillips curve models - Friedman, Lucas, NK - can give rise to the process Friedman describes, i.e. a process by which monetary policy can mess things up when the central bank attempts to peg real quantities. In NK models this would require some work. But the idea might be to have pricing rules respond to observed central bank behavior. The central bank tries to peg the path for aggregate output, but then firms change their pricing behavior in response, and this leads to either increasing or decreasing inflation.

In any case, I cannot find any evidence in Friedman's work that he thought measuring the natural rate of unemployment would be a useful thing to do, or that shocks independent of monetary policy causing movements in the unemployment rate would necessarily lead to movements in the inflation rate in the opposite direction. So those ideas are coming from somewhere else, and they are well-entrenched in the thinking of central bankers. Paul Krugman believes this too, as he says:
I’d say that the preponderance of evidence still supports the notion that high unemployment depresses inflation, low unemployment fosters inflation.
That's a particularly poor way to think about inflation. As David Andolfatto likes to tell us, unemployment does not cause inflation. Some shocks to the economy cause unemployment and inflation to move in opposite directions, for example in the Spanish example that Krugman shows us in his post. In other cases - for example during most of the post-2009 period in the United States - inflation and unemployment move in the same direction, more often than not.

Further, the prevalent idea in central banks currently is that, once the unemployment rate falls below the natural rate, inflation will take off. This idea is built on a misunderstanding of Friedman's thought experiment in his 1968 paper. The results of a monetary policy experiment don't tell us how inflation responds to other types of shocks that could be moving the unemployment rate around.

Saturday, May 5, 2018

Neo Fisherism: Look, it Works!

We know that Neo-Fisherism works in our models. In baseline macroeconomic models in which money is neutral, increases in inflation and increases in nominal interest rates go hand-in-hand. If we incorporate standard types of frictions that give rise to monetary non-neutralities in our models, for example New Keynesian sticky prices or segmented markets, an increase in the central bank's nominal interest rate target will in general raise inflation - in the short run and in the long run. See for example Cochrane (2016), Rupert and Sustek (2016), and Williamson (2018). And note that these theoretical predictions don't come from some freakish concoction of a demented neo-Fisherian, but from the mainstream modern macroeconomic models widely used by academics and central bankers.

But these predictions run afoul of standard central banking practice. I have yet to meet a policymaking central banker who thinks that inflation goes up if the central bank "tightens," in the usual sense in which that word is used. Standard central banking practice is of course enshrined in basic Taylor rules, which dictate increases in the central bank's nominal interest rate target when the inflation rate increases. In fact, the "Taylor principle" implies a more-than-one-for-one increase in the nominal interest rate target in response to an increase in the inflation rate.

Standard theory is pessimistic about the ability of a Taylor-rule central banker to successfully control inflation. Given a fixed inflation target, the Taylor-rule central banker can get stuck in a policy trap in which the nominal interest rate is as low as the central banker wants it to go, inflation is lower than the inflation target, and low inflation continues in perpetuity. But apparently real-world central bankers don't follow a rigid Taylor rule. For example, central bankers in the United States and Canada have recently raised their interest rate targets in the face of inflation that was falling below the inflation target. The Fed and the Bank of Canada, in their public statements, have both used what an Incipient Inflation Argument (IIA) in order to extract themselves from the low-inflation policy trap. That is - as they argue - inflation may not be high today, but given a tightening labor market, the Phillips curve will surely reassert itself, and we have to get ahead of the curve. If we don't get ahead of the curve then, as the argument goes, we'll have to tighten at a higher rate later on, with dire consequences.

The IIA allows the central banker to do the right thing - the neo-Fisherian thing, basically - while not abandoning the Phillips curve in some obvious way. To quote yours truly from September 2015:
What are we to conclude? Central banks are not forced to adopt ZIRP [zero interest rate policy], or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world's central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target - zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require "tightening" in the face of low inflation.
At the time, there was no shortage of opinion to the contrary. As Larry Summers wrote in the Washington Post in August 2015:
The Fed, like most central banks, has operationalized price stability in terms of a 2 percent inflation target. The dominant risk of missing this target is to the downside — a risk that would be exacerbated by tightening policy.

In December 2015, as you may recall, the Fed in fact began tightening in the face of low inflation. Here's what happened:
So much for downside risk. It took a while, but raising the Fed's nominal interest rate target coincided with an increase in inflation, to the point where the Fed has now hit its 2% PCE inflation target. So, the Fed's policy moves have been a success, and those who feared that interest rate hikes would take the US economy over a cliff should have calmed down and slept more soundly. After six 25-basis-point increases in the fed funds rate target range, the unemployment rate has fallen from 5.0% to 3.9%.

Should central bankers just declare neo-Fisherism a success, throw away their Phillips curves, and move on? Phillips curves should have of course been thrown out long ago, but we want more evidence to convince people that changing the sign in the policy rule (increasing the nominal interest rate target when inflation is below target) is the right thing to do. The recent US experience is only one episode, and there are many factors other than monetary policy (oil prices, factors affecting the real rate of interest) that affect inflation over the short term and the long term.

What has happened in other countries over this same period (2012 to present)? Here's Canada:
The Bank of Canada has a 2% inflation target, in a range of 1-3%, so as you can see the Bank has not been outside its target range much in the last six years. Average inflation has been below 2%, but the current inflation rate in Canada is currently at 2.3%. In terms of interest rate hikes, the Bank is one behind the Fed, with its target rate at 1.25%, as compared to the ON-RRP rate in the US (the comparable secured overnight rate), which is pegged at 1.5%. The Bank of Canada was one of the first central banks in rich countries to increase its policy rate after the financial crisis, though the interest rate target dropped after the fall in oil prices (associated with a drop in real activity in Canada). Overall, inflation performance in Canada relative to the US is consistent with neo-Fisherism. After the financial crisis, the Bank of Canada didn't set its nominal interest rate target as low for so long as did the Fed, and inflation has been on average somewhat higher in Canada.

In most of the other rich countries in the world, central banks have kept their nominal interest rate targets close to zero or below zero for a considerable time. I've selected five key ones: the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Japan, and the Swedish Central Bank. Here are the inflation time series (from 2012) in those countries:
In this picture, the UK stands out as having inflation above the 2% Bank of England inflation target for more than a year. Of course the Pound has also depreciated by about 20% against the US dollar since 2014, for reasons having little to do with monetary policy. In Sweden and the Euro Area, inflation has at times been at the 2% target, though inflation is now softening in those jurisdictions, particularly in the Euro area. Inflation has come up in Switzerland and Japan, but is still well short of 2% in both countries. As well, we could look at a scatter plot of inflation vs. the overnight nominal interest rate in each of the seven countries we have been looking at:
So, that's a nice neo-Fisherian picture. If good labor market performance produces high inflation, why is inflation so much lower in Japan and Switzerland than in Canada? If unconventional monetary policies make inflation go up, why are the countries with the most extreme unconventional policies (negative nominal interest rates, quantitative easing) - Japan, Switzerland, and the Euro area - the ones with the lowest inflation in the picture? Canada, which didn't indulge in any unconventional policies, but has a higher short-term nominal interest rate than all these countries but the US, has an inflation rate of 2.3%. How come? Neo-Fisherite policy works, that's why.

But I think (in part because I've been told) that central bankers are skeptical that they could ever sell a neo-Fisherite monetary policy rule to the public. No one gets excited about higher interest rates, and the average layperson has been conditioned by decades of central banker dialogue about heating the economy up, cooling it down, taking away the punch bowl, etc. It's much easier to swallow higher interest rates if your neighborhood central banker is telling you that this keeps the economy from overheating. We know what happens when things overheat. They break down and explode. In some theories (New Keynesian models, old money surprise models) you can have too much output, but in practice I think this is nonsense. The unemployment rate can't be too low, unless there's some long-run inefficiency at work. The overheating economy is simply part of the IIA argument. That is, a tight labor market is excellent cover for interest rate hikes, which are going to bring inflation up to target. Jim Bullard likes to say: "tighten on good news."

So what's the harm in using the IIA argument, if it's just carrying out the neo-Fisherite program in a more palatable way? First, there are circumstances in which it would be optimal to increase inflation, even if real activity is sub-par. The right thing to do could be to raise the interest rate target, but if the economy isn't "heating up," the IIA argument can't be used. Second, central bankers can run through the story so many times that they believe it. In current circumstances, the risk is that central bankers end up exceeding their inflation targets because of a misunderstanding of the effects of their policies. For example, officials at the Bank of Canada and the Fed think of their current policy settings as "accommodative." From the April 18 Bank of Canada statement:
Inflation is on target and the economy is operating close to potential. That statement alone underscores the considerable progress seen in the economy over the past 12 months. That said, interest rates remain very low relative to historical experience. This is because the economy is not yet able to remain at full capacity on its own.
And from the May 2 FOMC statement:
The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.
Policymakers at the Bank of Canada and the Fed think in very similar ways. In both places, policymakers think of policy in terms of a neutral nominal rate of interest (NNRI) which is thought to be in the range of 2.5-3.5%. According to their thinking, if the central bank's nominal interest rate target is less than the neutral rate, this puts upward pressure on the inflation rate and downward pressure on the unemployment rate. So, the ultimate goal is to raise the nominal interest rate to the NNRI, at which point the economy will be operating at potential and inflation will be at its target.

The key problem with this reasoning is that, if the central bank holds the nominal interest rate constant for a long time, policy ceases to be "tight" or "loose." For example, if the Bank of Canada had pegged its interest rate target to 2% in 2009 and kept it there, real economic activity in Canada today would be indistinguishable from what we're seeing. But inflation would be higher. In Canada and the US, nominal interest rates have been low for going on 10 years, and those interest rates are moving up. So the Bank of Canada and the Fed aren't removing accommodation - they're tightening. And tightening means a negative effect on real economic activity and a positive effect on inflation. The Bank of Canada is achieving its goals. The Fed is achieving its goals. Time to stop tightening.