Sunday, August 30, 2020

Sorry You're Let Down By the Fed's Monetary Policy Review

On Thursday, the FOMC released a revised Statement of Longer Run Goals and Monetary Policy Strategy, and Jay Powell made a speech at the virtual Jackson Hole conference, explaining the changes in the FOMC's approach. The new statement is rather murky, though that's of course nothing new in the world of fedspeak. Why did the FOMC think these changes were needed, and what will they imply for monetary policy going forward?

We'll start with the statement itself. This document originated in 2012, and at the time was a venue for Ben Bernanke to set down an inflation-targeting goal consistent with the Fed's Congressional dual mandate. Subsequently, the FOMC revisited the Statement annually (more or less), and published revised versions every January. Those previous changes were fairly minor tweaks to the document. Revisions tend to be produced after rounds of haggling among FOMC members, which end when consensus is reached. As a result the document reads like what it is - the work of a committee. Individual words and sentences have been put in to appease one or another faction of the committee, and the result tends to be something that no one likes much. But they will hold their noses and agree to it.You might find it useful to read the annotated version, as it shows you all the changes from the last published Statement.

In the second paragraph of the new Statement, an important new element is a recognition of the role played by low real interest rates (low r*, in fedspeak) in monetary policymaking. You might wonder why that's in there, as it's not apparent what that has to do with stating the FOMC's objectives. First, the Statement says

The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average.

That's just recognition that, over the long run, if the real interest rate is lower, and the inflation target stays at a fixed 2%, this implies a lower average fed funds rate, by the logic of Irving Fisher. The fed funds rate will then more frequently encounter the zero lower bound (ZLB), under the assumption that nominal interest rate variability is about what it was in the past. The conclusion? 

 ...the Committee judges that downward risks to employment and inflation have increased.

I've seen that idea frequently, both in research done at the Board, and public statements by Fed officials. The reasoning comes from Keynesian economics. In a Keynesian world, the zero lower bound is a constraint on policy, and there's a Phillips curve. Nominal interest rate reductions make output and inflation go up, according to Keynesian logic, so if the nominal rate hits the ZLB, the central bank can't increase output and inflation as appropriate. So, if the Fed is encountering the ZLB more frequently, it's running into that problem more frequently, by Keynesian logic. So average inflation and output could on average be too low. But, you might wonder how that's consistent with the previous quote, which says that low r* implies a low average fed funds rate. If inflation and output are on average too low, it seems we could raise the average fed funds rate, have inflation closer to target on average, and have higher average output as we're encountering the ZLB less often.

But, again, what is the discussion about low r* doing in the Statement? Is this just providing cover for the possibility that the Fed chronically undershoots the 2% inflation target and gets stuck at the ZLB indefinitely?

The third paragraph addresses issues related to the second part of the Fed's dual mandate - "maximum employment." The old Statement made reference to "normal" levels of growth in output and employment, the idea being that the economy could be above or below what might be considered normal. The Committee now appears to think that the relevant metric is the shortfall relative to maximum employment, with maximum employment being some sort of optimal state that we never achieve. In any case, the FOMC does not want, for good reasons I think, to define maximum employment, or to provide measures of it. But then why go to the bother of changing the language? We'll be able to answer that when we get to Powell's speech.

A key change that might, in principle, amount to something substantive is in the paragraph on inflation:

In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

So, that doesn't appear to commit to anything. If the FOMC were committing to an inflation averaging procedure, it would have to specify at least three things - and maybe more, depending on how complicated they wanted to get. Specifically, first we would need to know over what period the FOMC was averaging over past inflation rates to determine what needs to be made up. Second, the Statement would need to specify the length of the future period over which the FOMC intended to make up the missing inflation. And third, the FOMC would need to specify what the average inflation target would be. They've given us the third number, 2%, but not the other two. To see how actual inflation targeting would work, suppose the FOMC specifies a rolling window relative to the current month, over which it is going to average. For example, if the FOMC chooses a window that goes 2 years into the past, and 2 years into the future, then at each point in time, it would calculate average inflation over the past two years, and then plan to make it up over the next two years, in such a way that average inflation from two years ago to two years hence is anticipated to be 2%. This implies that the target inflation rate will change month-to-month. That's pretty complicated, and hard to explain - which is an argument against inflation averaging - but if you're going to do it, you might as well do it properly.

So, what we have in the above quote is some half-assed inflation targeting, which one could argue is worse than what was in the statement before. Someone even added the word "likely," so they're telling us they might do it, but maybe not. Great. Finally, the averaging isn't really averaging, as it's not symmetric. Nothing is said about what happens when inflation has been running above target. You might think this is a way of slipping a higher inflation target past you, without saying so. Maybe so, but not to worry, for reasons I'll give you in what follows.

There is some more language in the Statement about how the FOMC's inflation and maximum employment goals fit together. And the Statement finishes off with a commitment to do a thorough policy review every five years, which seems like a good idea - though if this sort of thing is the result, maybe we would be better off without the review.

But, on to Powell's speech. Powell says there are four things that are driving the change in the FOMC's Statement (using my words here):

1. Low productivity growth and demographic factors have lowered the average growth rate of real GDP.

2. r* is expected to remain persistently low.

3. As of February 2020, the labor market had become unusually and unexpectedly tight, with a very low unemployment rate and a very high vacancy rate.

4. The Phillips curve is flat.

And, as further motivation for why the Fed needs to reconsider what it's doing, Powell addresses inflation undershooting, and why that's a bad thing. According to him, here's what can go wrong:

Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.

So, that's an instability story, which crops up from time to time. Basically, the narrative goes, we can get into a deflationary black hole, with inflation falling forever. What causes the deflationary black hole to materialize? According to Powell, it's inflation below the "desired level." So, what central bankers wish for seems to matter for deflationary black holes. Whichever staff members helped write this speech weren't quite doing their jobs in this section. 

The deflationary black hole narrative has been around for a long time. I think I saw it for the first time when nominal interest rates were low in the early 2000s. For example, in 2002, Ben Bernanke gave a speech about deflation, which didn't quite go full deflationary-black-hole, but warned of the dangers of deflation that could arise at the zero lower bound. People worried about deflation again in 2008-2009, because of zero lower bound issues, but given that the sustained deflation never materialized, I thought the concern had gone away. Problem is that the deflationary black hole is something we've never seen. Nominal interest rates at or near zero in Japan for 25 years have produced inflation that has averaged about zero. And mainstream theory won't give you a deflationary black hole, though I've seen it in some examples with very sticky prices and very sticky expectations.

So, what concerns does low inflation raise for Powell?

...if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates.

When I first read this, I thought that "interest rates would decline in tandem" meant long bond yields. That is, anticipated inflation falls, which reduces the inflation premium on long-term bonds. But I think it's clear he means that a drop in anticipated inflation causes the FOMC to drop its fed funds rate target. So that's a strange argument - the problem has to do with our policy response, he's saying. That may actually sense to you, if you've read Benhabib/Schmitt-Grohe/Uribe (2001) on "Perils of the Taylor Rule."  The idea is that an aggressive Taylor-rule central banker, who cuts the nominal interest rate target more than one-for-one when he or she sees a shortfall in inflation relative to target, can get on a path that leads to perpetually low nominal interest rates and inflation. That is, if the central banker sees inflation below target, he or she drops the nominal interest rate rate target. But, the central banker doesn't understand the Fisher effect. The drop in the nominal interest rate results in a decrease in inflation, the decrease in inflation results in lower interest rates, etc., and the rest point is the effective lower bound on the nominal interest rate. Inflation stays below target until the central banker figures out how inflation dynamics work. To me, that seems a nice description of what's been happening in many countries since the financial crisis, and in Japan since about 1995. In practice, I don't think you necessarily need aggressive Taylor rule behavior to get chronic inflation-target undershooting. Probably it's enough that central bankers find few supporters for interest rate increases, and plenty of supporters for cuts. In fact, as I'll discuss later in this piece, the policy trap - perpetually low inflation and low nominal interest rates - could arise if the central bank only cuts and hikes interest rates in response to the unemployment rate, so long as the response is asymmetric.

This is one of the few cases in economics I know of where a basic, well-entrenched misconception can actually lead to tolerably good results. Low inflation, in contrast to what Powell seems to think, is generally fine. The only cost is to the reputations of central bankers who consistently promise 2% inflation and deliver less.

The rest of Powell's speech deals with the new statement, and how it reflects these new issues, as Powell sees it. First, Powell thinks it's important that the new Statement says that the FOMC will use its "full range of tools," which it will need, he says, because low r* implies a frequently binding ZLB. It's not clear why this needs to be in the revised Statement, as the previous Statement gave essentially no information about how the Fed intended to realize its goals. Best guess is that the language on tools is in the Statement to allow the unconventional monetary policy enthusiasts on the committee to commit their colleagues to future actions.

This is more interesting, I think:

...our revised statement says that our policy decision will be informed by our "assessments of the shortfalls of employment from its maximum level" rather than by "deviations from its maximum level" as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.

So, Powell's view is that the Phillips curve is flat, thus low unemployment will not increase inflation. So, is the Fed abandoning its Phillips curve model of inflation, which appears to have been driving its decisions ever since I can remember? Apparently not. But if the Phillips curve is flat, so that unemployment is irrelevant for inflation, in the FOMC's view, then what determines inflation, and what does that tell us about how the Fed should control it? Seems part of the answer is in Powell's description of the costs of disinflation. That is, inflation expectations drive inflation. But how do changes in a nominal interest rate target affect inflation expectations, in the minds of FOMC participants? Inquiring minds want to know.

But, let's see if we can predict the implications of the last quote above for FOMC actions in the future. In the past, most of the short run variation in the FOMC's fed funds rate target has been due to short run variation in the unemployment rate. The FOMC typically finds it easy to cut interest rates in the face of increases in the unemployment rate - they get few arguments about that. It's difficult, however, to justify interest rate hikes. Particularly during the last tightening cycle, running from late 2015 to late 2018, inflation was mostly below target, and the interest rate hikes were justified as preemptive actions. Apparently, Powell is now judging 2015-2018 to be a mistake.

But it's hard to see what was wrong with the FOMC's performance in 2015-2018, given the observed outcomes and the previous Statement. At the end of the tightening cycle in December 2018, the unemployment rate had fallen to 3.9%, the lowest it had been since the 1950s, and the inflation rate was 1.9%, just shy of the 2% target. I'm having a hard time seeing a mistake.

Earlier in Powell's speech he tells us the current FOMC consensus on the "neutral interest rate" is that it's about 2.5%. That is, if the Fed is hitting its 2% inflation target consistently, and the economy is humming along at maximum employment consistently, then the fed funds rate should be about 2.5%, according to the FOMC. That is, the FOMC thinks r*, the long-run real rate of interest, is about 0.5%. The FOMC also thinks the Phillips curve is flat so, roughly, the FOMC thinks that, to achieve 2% inflation on average, the fed funds rate should average about 2.5%. The FOMC might also think that keeping the fed funds rate at zero will eventually make inflation go up, but that's not consistent with what we observe. The central banks that undershoot their inflation targets tend to be the ones that can't seem to get off the effective lower bound, the Bank of Japan being the prime example.

So it seems that, to sustain 2% inflation, the FOMC will sometimes have to find an excuse to increase its fed funds rate target. The usual excuse was the one they used last time, which is that a low unemployment rate tells us inflation is about to blow through the roof. That's actually baloney, as Powell recognizes, but it's a piece of fiction that served the purpose. It's hard to convince people that interest rate hikes are a good idea, but for some reason the specter of incipient inflation does the trick. The truth is that, to sustain higher inflation, you need a commitment to a higher nominal interest rate target. Like it or not, that's how it works.

In any case, the FOMC just denied itself license to use the standard excuse to hike interest rates. If we ever see another increase in the fed funds target range, I'll be amazed.

The last issue discussed in the speech is what most people have focused on, which is the quasi-inflation-averaging approach. As Powell points out,

...we are not tying ourselves to a particular mathematical formula that defines the average.

This means that the promise is empty, essentially. If it's not written down, the FOMC can't be held to anything.

But, the key problem Powell seems concerned with, and which is reflected in the statement, is below-target inflation, which needs to be matched by periods of above-target inflation. So how do we get above-target inflation?

...following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

Well, that clears it up. Seriously, I'm pretty sure I know what "appropriate" means. Given the new Statement and Powell's speech, it seems the FOMC thinks lower for longer will do the trick. As far as I can tell, though, this is just dooming the approach to failure. Lower for longer is just going to produce extended periods with below-target inflation. If no one believes the Fed is committed to increasing nominal interest rates sometime in the future, everyone believes inflation will stay low.

This is all somewhat depressing. I don't get the sense that the FOMC is learning and improving. This looks like a step backward. But probably they're not going to do any great harm. Low nominal interest rates and low inflation forever is fine. The only cost is that we're in for a long period of excuses for poor performance relative to the stated 2% inflation goal. Not to mention much unconventional (and ineffective, I think) monetary policy, and a large balance sheet that will never shrink. 


Monday, July 27, 2020

The Bank of Canada Dives Into Unconventional Policy

The Bank of Canada has been doing things that, for it, are unprecedented. And, since our new Bank fo Canada Governor, Tiff Macklem, has made his first policy decision on July 15, now would be a good time to figure out what the Bank of Canada is up to. Since late March, the Bank's target for the overnight policy rate has been at 0.25%, which Macklem referred to in his press conference last week as the "effective lower bound." That's not an effective lower bound in the usual sense, as it's clear that the Bank could go negative if it chose to. By saying "effective lower bound," I think the idea is to impress on you that the Bank won't go lower. The Bank has also engaged in a large balance sheet expansion, again since late March. Recall that this is a first for the Bank of Canada, which went through a short period from Spring 2009 to Spring 2010, where it ran a floor system. But during that floor-system period, the Bank only put enough overnight reserves (about $3 billion) in the system to peg the overnight rate at 0.25%. This time is different, in that the Bank now has assets of about 23.5% of annual GDP, as compared for example to a Fed balance sheet in the US of about 32.5% of GDP. In domestic GDP units, the Bank's balance sheet is growing at about twice the rate of the Fed's.

Let's look at some of the details. Here are the main items on the asset side of the Bank's balance sheet that have shown big increases.

There are some other asset purchases, including provincial bonds, corporate bonds, and commercial paper, but those are small potatoes, I think. The Bank has certainly not entered into the realm of credit allocation in a big way, as the Fed has, for example. The chart shows weekly data from the beginning of the year. A big difference here from typical central bank balance sheet expansions is that a large portion of the expansion consists of lending in the repo market, both term and overnight. Presumably that's intended as a crisis lending program that reaches into all the nooks and crannies of the financial system. The bank also lends at the "bank rate" (like discount window loans) only to Payments Canada large-value transfer system participants - there are 17 of those, including the chartered banks. Lending at the bank rate is minimal right now. As well, as Carolyn Wilkins (senior deputy governor) outlined July 15  in the press conference, purchases of government of Canada securities, which comprise most of the balance sheet increase, other than repos, have been conducted across the maturity spectrum and are not confined, as would be usual in these policy moves, to long-maturity government securities. Note in particular that the Bank has increased substantially its holdings of t-bills, which the Fed has not bought (on net) since March.
Early in the COVID-19 crisis, when Stephen Poloz was Governor, the justification for the balance sheet expansion - the purchases of federal government securities in particular - was to improve market function. As the July Monetary Policy Report states, markets in government debt, and financial markets more broadly, seem to be functioning well now, more or less. So, the Report lays out a fairly conventional rationale for unconventional asset purchases, as follows:

Large-scale secondary market purchases of Government of Canada bonds provide monetary stimulus through several channels and can be described as quantitative easing (QE). When markets are not functioning well, QE improves liquidity in the government bond market (liquidity channel). QE can also lower borrowing costs for businesses and households by putting downward pressure on government yields (interest-rate channel).8 Through the purchase of a large quantity of government bonds held by the private sector, QE reduces the relative supply of bonds and thus lowers their relative yields, leading investors to reallocate their portfolio to riskier assets (portfolio balance channel). In addition, some investors will adjust their portfolios to include more assets priced in other currencies, placing downward pressure on the Canadian dollar (foreign exchange channel). Markets generally interpret QE as a signal that rates will likely be at the lower bound for an extended period (signalling channel).

The "liquidity channel," is no longer an issue, as the Bank sees it, so what we're left with, from their point of view, is the "interest rate channel," the "exchange rate channel," and the "signalling channel." The interest rate channel basically involves a segmented markets or portfolio balance story. This was the main justification given by Ben Bernanke for the several rounds of QE in the US, post-financial crisis. According to this view, we can think of the demand for government debt as being segmented by maturity. So, if you buy that idea, the central bank can purchase long-maturity bonds, sell short maturity bonds, and thus increase the prices of long maturity bonds and lower the prices of short maturity bonds - flatten the yield curve. Or, in a floor system with short rates tied down to zero (or 0.25% in this case), the sale of short maturity assets is irrelevant, long bond yields fall, and the yield curve flattens, according to the story. The exchange rate channel is just part of the same phenomenon. If the central bank thinks it can play with the yield curve, it can also move other asset prices in the process, including the exchange rate. The signalling channel, from the Bank's point of view, seems to depend on inferences people make about future policy based on the current state of the balance sheet. I guess we're supposed to view growth in the balance sheet as a commitment to accommodative policy for the indefinite future.

On the balance sheet, the Bank has committed to purchasing government of Canada securities at a rate of $5 billion per week until the recovery is well underway. For context, QE3 in the US, which ran from 2012-2014, involved asset purchases of $85 billion (US) per month. So, adjusting for exchange rates and size of the economy, the current Canadian program is roughly twice the size of QE3, so in principle it's a big deal - though more about this below.

So, what questions might we want to ask about this?

1) What's the exit strategy?  To date, central banks that have dived into quantitative easing (QE) in a big way have never exited. The Fed outlined exit strategies from its large balance sheet state as early as 2011, but never did it, other than to allow a bit of runoff. Basically, the more the Fed lives with its large balance sheet, the more it likes it, for no good reasons as far as I can tell. In the Bank of Canada's case, the structure of the balance sheet increase seems designed for somewhat easy exit. Repos can disappear quickly, and t-bills will also mature quickly or could be sold, presumably without capital losses, if the balance sheet exit occurs before liftoff in the policy interest rate. But, given the accounting standards the Bank has adopted, it seems that government bonds are classed as "held to maturity," are carried at book value, and can't be sold. If asset purchases proceed at the current rate, then by the end of 2020 government bonds held by the Bank will be about 12% of GDP. That's compared to Bank of Canada assets which are normally around 5% of GDP. So, if interest rates go up, say 2 years from now, the Bank will have quite low interest earnings on an asset portfolio that is being financed by maybe 50% currency (at 0%), and 50% reserves (at the policy rate). So that would put a dent in the transfer the Bank makes to the federal government. Under some scenarios, that transfer could hit zero, which would be problematic.

2) If the "interest rate channel" is so important to the Bank, why is it purchasing t-bills? Basically, there's an exchange of reserves for t-bills going on, which doesn't accomplish anything, and could actually be harmful (more below). If the Bank really buys the segmented markets story, it should be purchasing long-maturity government bonds, and lengthening the average maturity of the assets in its portfolio. But maybe it's up to something else. If so, someone should let us know.

3)What's going on with the government of Canada's account balance with the Bank? Here's what's happening on the liabilities side of the Bank's balance sheet:

There's been unusual growth in currency outstanding, but that's not a big deal relative to what you see in the chart, which is growth in reserve balances - overnight balances of LVTS participants with the Bank of Canada earning 0.25%. What's really weird here - and you see this in the US now as well - is that the federal government is holding a very large and growing balance with the Bank. So, in an environment in which it's claimed that the market in government debt isn't working properly (at least through some of the period in the chart), the federal government is issuing so much debt that it's not spending all the proceeds from its issuance, and instead parking the cash at the Bank of Canada. In addition, in the first chart, since April 1, t-bills and bonds held by the Bank have increased by about $216 billion - that's a swap of reserves for $216 billion in government securities - while the federal government has proceeded to swap $154 billion in government securities for reserves. So, this isn't much of a QE program, if that's the intention, as the federal government and the Bank seem to be working at cross purposes. But we know that the Bank and the Department of Finance are on good terms, and there's a regular conversation going on. So what have they agreed to? Inquiring minds want to know.

4) Who says QE works anyway? QE is essentially debt management - the central bank making choices about how much interest-bearing overnight reserves are in the market, relative to government securities or other assets of various other maturities. A move by the central bank to engage in protracted QE is then a move by the central bank to take on the debt management role normally assigned to the central government. In Canada, the line between the Bank of Canada and the Department of Finance is blurry. Debt management policy seems to be something that is worked out jointly between the Bank and the Department Finance - for example I have talked to economists at the Bank who think about nothing but debt management. Once debt management policy is decided, the Bank implements it. As well, management by the Bank of the government of Canada's cash balances is an integral part of day-to-day monetary policy intervention, at least in normal times. In the past, there has been some worry that QE would be inflationary. You heard that a lot in the US post-financial crisis - from what remains of the monetarist contingent. The alleged inflationary effects of QE have also been put forward as justification for the use of QE, particularly by the Bank of Japan, beginning in 2013. The BOJ tried to use QE as a means for getting inflation up to its 2% target, which was a failure. Typically, low-nominal-interest rate environments just produce low inflation - that's Japanese experience since the mid-90s, and what we've seen in Europe and elsewhere since 2008. So, with the policy rate at zero or below, currency outstanding is driven by the demand for it at a zero nominal interest rate, inflation is low, and QE simply changes the composition of the outstanding consolidated government (central government plus central bank) debt. More overnight reserves, and less of whatever the central bank is buying. So why should we think that having more interest-bearing reserves in the banking system, and less government debt in financial markets should stimulate anything? To help get at that, let's look at money market interest rates in Canada.

Day 60 is late March, when the interest rate on reserves (balances of LVTS participants held with the Bank) went to 0.25%. Early in the year, you can see a normal configuration of interest rates in Canada - typically t-bill rates (1 month and 3 month) are lower than the overnight repo rate. You can see the period of market turmoil after day 60, when t-bill rates are typically at or above the repo rate, and the repo rate is below the interest rate on reserves. Then, things eventually settle down, getting into July. The repo rate is now at the interest rate on reserves, as it should be in a well-operating floor system, and t-bill rates are lower than the overnight rate, though the margin is not as large as pre-COVID-19. The current configuration of interest rates might make you wonder why swapping reserves for t-bills is a good idea. Apparently the Bank has to give the chartered banks a premium to hold reserves rather than t-bills, implying that reserves are inferior to t-bills. Now think about long-maturity government bonds. Essentially, the Bank is swapping reserves for long-maturity government debt, and the chartered banks are taking reserves and turning them into bank deposits. Of course, chartered banks can hold long-maturity government bonds directly and turn them into bank deposits, so why isn't the Bank of Canada just a redundant middleman in this operation? You might argue that the Bank is unloading risk from the chartered banks, but what risk? Given the Bank's forward guidance, we're expecting short rates to stay low for a long period of time, and so we should expect little variability in long bond prices. Further, these are large Canadian banks, and their ability to bear a small amount of risk on government debt is pretty good, I think. Here's what's happening with the chartered banks:

In this chart, I've shown only bank deposits, which have increased substantially since March (sorry the hash marks on the horizontal axis divide a year into fifths), and illiquid assets, which have not. As you might imagine, on the asset side, banks are holding much more liquid assets:

Chartered banks are holding much more reserves, but also much more t-bills, and somewhat more government bonds (less than and more than 3 years to maturity). So, the question would be: What difference would it make to these chartered banks if they had less reserves and more government debt on the asset side of the balance sheet? Basically, QE involves stuffing the banking sector with overnight assets, while taking safe assets widely used as collateral out of the market, so it's hard to see why we would think of QE as accommodative.

5) Aren't bond yields pretty low anyway? With the overnight rate at 0.25%, the current 2-year government bond yield is 0.268%, the 5-year is at 0.342%, the 10-year is 0.50%, and the 30-year is 0.975%. The Bank thinks it can squeeze a few more basis points out of the 10-year bond yield for example? And what would that accomplish?

So, you can tell that I'm not too excited about the Bank's QE program. On the positive side, the interest rate policy looks OK. It's hard to see what else the Bank should do other than keep the policy rate at zero, or close to it, for the foreseeable future. Forward guidance is perhaps overemphasized as a policy tool I think - it's best for a central banker to take an action, make it well understood why the action was taken, and then trust people to understand how the state of the world maps into policy actions - but the Bank's interest rate guidance is fairly innocuous, as these things go. The July policy statement says:
The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.
There are things I don't like about that, but it's a piece of fiction that allows the Bank to justify interest rate hikes when the time comes. The Bank is telling you that there's a Phillips curve (that's the fiction), and that the way to control inflation is to control an output gap, say as measured by the unemployment rate. As I argued in this paper, what the Bank has typically done in the past is to raise and lower its interest rate target in response mainly to the unemployment rate. As long as the Bank gets the average level of the policy rate about right, in the process they can successfully hit a 2% inflation target, as they've done since 1991. Best guess is that the right average policy rate is where it was before COVID-19, at 1.75% or thereabouts. To sustain 2% inflation, the Bank has to get back up to that level sometime in the future. But, inflation targeting is off the table right now, for good reasons, though Tiff Macklem wants to reassure us, in line with the Bank's agreement with the federal government, that he has the 2% target on his mind. Problem is, as the Bank recognizes in its report, that the CPI measure used by the Bank as their inflation measure was designed to be useful only if expenditure shares don't vary much. That's not the case now, so standard inflation measures won't have much meaning for a while. In any case, we should expect inflation to be fairly low and stable, though below target for some time. Take my word for it, that's just a feature of low-nominal-interest-rate environments, large central bank balance sheet or small.

Monday, March 16, 2020

What Sort of Financial Panic Is This?

Well, as you know, things are changing by the day in financial markets, and central banks are moving quickly to keep up. Most central banks have taken aggressive action recently. After a between-meetings policy rate cut of 50 basis points on March 3, the Fed yesterday reduced its target range for the fed funds rate to 0-0.25%. More to the point, the interest rate on the Fed's overnight reverse repo facility is set at 0%, the interest rate on reserves is 0.10%, and the interest rate on primary credit at the discount window has been reduced to 0.25%. The interest rate target moves, in timing and magnitude, are very aggressive. This was done on a Sunday, before financial markets opened on Monday, and amounted to a 100 basis-point drop in the target range. The discount window rate (the rate at which the Fed lends to Fed member financial institutions) was cut even more, as this rate moved from 50 basis points above the top of the fed funds rate range to the top of the range.

There's more. The Fed lists actions that are intended to enhance the functioning of credit markets, though some of these "actions" are simply encouragement to banks to use the Fed's credit facilities - the discount window and intraday central bank credit - and to lend in instances where the bank has liquidity and capital in excess of regulatory mandates.

One item that stands out is the discontinuation of reserve requirements in the United States. Reserve requirements were dropped long ago in some countries, and currently Canada, the UK, New Zealand, Australia, Sweden, and Hong Kong, are without reserve requirements. In the US, reducing required reserve ratios to zero is essentially a formality. US financial institutions have figured out workarounds, including sweep accounts, that allow them to skirt the effects of reserve requirements, and the Fed's large balance sheet has made reserve requirements non-binding for most banks. The elimination of reserve requirements in the US is long overdue, but why now? Possibly what's going on is that liquidity requirements (the liquidity coverage ratio requirement, for example) exclude required reserves, so eliminating the reserve requirement does in fact relax a constraint on banks, and could encourage them to acquire other assets - loans or asset-backed securities, for example.

Closer to (my) home, the Bank of Canada has reduced its policy rate by 100 basis points, to 0.75%, in two steps, and has announced some moves to enhance market liquidity, as outlined here. But I'll focus on the US, where most of the action is.

What is the Fed responding to? Most people are aware of the downward slide in the stock market, which continues today. But there are various other signs of distress in financial markets. This has little in common with traditional banking panics, such as what the US banking system encountered in the Great Depression, or prior to the founding of the Fed, between the Civil War and 1914. The primary feature of such panic episodes as the 1907 panic was runs on retail bank deposits, and disruption of retail payments. In principle, such panics could be mitigated, or stopped entirely, through central bank lender-of-last-resort lending, for example through the discount window in the United States. Indeed, a principle function of the Fed, as the authors of the Federal Reserve Act intended, was to lend to banks during financial crises. The Fed could lend to banks, replacing the outflow of deposits, and could finance this lending by issuing more currency, thus giving consumers a safe means of payment to flee to. But what we're seeing now is certainly not a flight from bank deposits to currency.

The current panic does have something in common with the financial crisis of 2008, though there are important differences. During the 2008 financial crisis, the origin of the crisis was in the financial sector. Incentive problems in the mortgage market ultimately led to a loss in confidence in the value of a class of asset-backed securities, which fed through to drops in asset prices, a flight to safety in financial markets, and chains of defaults and potential defaults. The current crisis is rooted in the non-financial sector, but some of the same elements are in play. The reduction, or anticipated reduction, in income flows for businesses and individuals, has caused those businesses and individuals to re-evaluate their portfolios, generating a desire to trade in asset markets. But at the same time, everyone is very uncertain about outcomes, and where the risks are. So perceived risk is high, in general, market participants are fleeing to safe assets, and people also want to sell liquid assets to adjust their portfolios in ways they perceive as optimal. What's happening? First, as in the financial crisis, there's been an increase in interest rate spreads. Here's the difference between the 3 month commercial paper rate and the T-bill rate:
You can see that this spread has increased substantially, but it's nowhere near as large as at times during the 2008 financial crisis. Similarly, if we look at a risky corporate bond spread, we get the same story, more or less:
Though note that the data in the last 2 charts only runs to late last week, so things could have changed for the worse.

As well, markets in US government Treasury securities are not functioning normally. Apparently the bid-ask spread in markets for Treasury securities has widened, and volume has declined, making it more difficult to buy and sell Treasuries. The liquidity of this market is important. There has to be some asset that is easy to buy and sell, at a predictable price, and if government debt is not filling that role, then nothing is.

Which brings us to a key part of the Fed's announced intervention plan, which is the resumption of quantitative easing (QE), after a sort-of hiatus of five years or so. Over the next several months, the Fed plans to purchase at least $500 billion in Treasury securities, across maturities, and $200 billion in agency mortgage-backed securities. That's a program about the size of QE2, which ran from 2010-2011, but not as large as QE1 (2009-10) or QE3 (2012-14). This program would amount to a nominal increase of about 18% in the Fed's asset portfolio, or about 3.2% of annual GDP. Not small potatoes, but the Fed has done this on a larger scale before. What's the rationale? The Fed has already expanded its repo program. The Fed is currently lending in excess of $100 billion in the overnight repo market every day, and is also lending substantially in term repo markets. So, if you want to unload some Treasuries and are having trouble doing it, the Fed will lend you the cash. Similarly, the Fed's reverse repo facility is still in place, so if you want to buy Treasuries, but are having a hard time doing it, you can lend the cash to the Fed through the reverse repo facility, say if you're a money market mutual fund, or you can just hold interest-bearing reserves if you have a reserve account.

But, possibly there's a role for QE in purchasing on-the-run Treasury securities that financial markets are having a hard time absorbing. In this case, the purchases of Treasuries potentially make life easier for the Treasury. The Fed purchases the Treasury securities, increasing the balance in the Treasury's general account (TGA) with the Fed, and as the Treasury spends the balance, these funds end up in bank reserves. But the Treasury is currently holding a balance (as of last week) of about $380 billion in the TGA account, which is enough to fund Treasury outlays for a typical month. So, the Treasury has a substantial buffer if it has trouble selling its debt, and such difficulties aren't likely to last long.

So, why are we into another QE episode? Principally, the FOMC thinks this is an accommodative policy - it's supposed to increase real GDP and inflation. Of course there's no evidence for that - from experience in the US or elsewhere. And QE could actually be harmful, in that it's fundamentally a swap of less useful assets - reserves - for more useful assets - Treasuries and MBS. It's possible that more reserves and less Treasuries and MBS in the market right now would be a good idea. But why commit to this asset purchase program over the next several months? The Fed could at least hold off decisions about continuation of the program until we have more information.

Here's what I'm afraid of. The Fed's actions may be appropriate in the moment, but I'm worried about how we get back to some semblance of normal again. The Fed had a set of normalization plans as early as 2011, to undo policies that were put in place during the financial crisis. But the FOMC never followed through on that normalization plan, and ultimately chose to stick with its large balance sheet. Interest rates were never normalized, in the sense of attaining a level that would sustain inflation at 2% indefinitely. Now we're back at the zero lower bound, with plans for a substantial Fed balance sheet increase, no solid science telling us why this is a good idea, and no plans for getting out of this once this virus gets out of town.

Thursday, March 5, 2020

Coronavirus and Monetary Policy

On Tuesday, the FOMC voted to reduce the Fed's range for the fed funds rate by 50 basis points, to 1.00-1.25%, and on Wednesday, the Bank of Canada followed suit with a 50 basis point cut in its overnight interest rate target, from 1.75% to 1.25%. As you know, 50 basis point cuts by central banks are aggressive, particularly in the Fed's case where the cut occurred outside a regularly scheduled FOMC meeting. Other central banks might be doing the same - if their policy rates were not already at or close to zero, if not negative.

What's going on? Well, Jay Powell and Steve Poloz have told us why they're doing what they're doing. What do they have to say? First, in the FOMC statement that Powell and his colleagues issued, it says that the "fundamentals of the US economy remain strong," but the coronavirus "poses evolving risks." The FOMC is cutting 50 basis points "in support" of the Fed's dual mandate. There's no information beyond that. In his short press conference, Powell didn't really add to that. Basically, the cut is to lend "support," apparently, and there are no promises about where the Fed goes from here. And, by the way, this has nothing to do with what Donald Trump wants, according to Powell.

So, that doesn't enlighten me much. An extreme action has been taken, but it's not based on anything that's actually showing up in the data yet. This is based solely on speculation about the effects on economic activity of a contagious virus that is going around. About which we know more than we did a couple of months ago, but much less than we would like to know. So, from all evidence, the Fed is taking a shot in the dark.

But maybe Steve Poloz knows something that Powell doesn't know? The Bank of Canada statement certainly has more information in it than does the FOMC statement, in part because the Bank of Canada made its decision in a regularly-scheduled policy meeting. There's a review of current conditions, which basically looks like more of the same. Current inflation (headline CPI) is above target at 2.4%, the labor market looks good, but there is some weakness in 4th quarter 2019 real GDP growth. Otherwise, like the US, the fundamentals are strong, but the statement seems to go out of its way to suggest that there's some weakness, presumably to justify the big reduction in the target rate. With regard to the coronavirus, the statement says: activity in some regions [of the world] has fallen sharply and supply chains have been disrupted. This has pulled down commodity prices and the Canadian dollar has depreciated. Global markets are reacting to the spread of the virus by repricing risk across a broad set of assets, making financial conditions less accommodative. It is likely that as the virus spreads, business and consumer confidence will deteriorate, further depressing activity.
So, I think that's really the guts of the information that's supporting the policy decision. We know there's something going on with respect to the real side of the economy. Anecdotal evidence tells us that supply chain disruptions, originating mainly in China, could be a serious problem for domestic economic activity. We're also seeing large asset price movements. Stock prices are down, and prices of government debt are up. We're expecting to see some negative information in soft data - business and consumer confidence - but we're not measuring that as yet.

But, we still don't have so much to go on. No hard data, really. Asset prices have been known to move by large amounts in the past, without any central bank response. But what's this about financial conditions becoming "less accommodative." I've heard that comment elsewhere, and I'm not sure what it means. The idea seems to be that financial markets get "tight" on their own, and then it's the job of the central bank to loosen things up. Maybe I can see some sign of "tightening" financial conditions in stress indices, or financial conditions indices. Here's the St. Louis Fed's financial stress index:
And here's the Chicago Fed's financial conditions index:
Those two charts show basically the same thing. Not much going on. Maybe people have something else in mind? There certainly have been large movements in the prices of Treasury securities in the US:
The chart shows the 3-month T-bill rate, and the 10-year bond yield, both of which have dropped even more than the drop in the Fed's policy rate. The Fed moved down 50 basis points, but the whole Treasury yield curve has shifted down by much more than that. But why would I call that financial tightening? Looks like easing, don't you think?

Another interesting phenomenon in US financial markets is what's going on in overnight markets. Since last fall, the Fed has been purchasing Treasury bills, and now has a stock of about $280 billion in T-bills. As well, to maintain its overnight fed funds target, the Fed has been intervening in the overnight repo market, on the lending side. On February 27, there was about $140 billion in repos outstanding (overnight and term). However, on Tuesday and Wednesday of this week, the Fed's lending on the repo market expanded substantially. In fact, demand for overnight repos apparently exceeded the Fed's $100 billion cap. So, overnight Fed repos on Tuesday and Wednesday were $100 billion, where last week overnight repos were running roughly $30-$50 billion per day. So, something is causing high demand for overnight credit, and upward pressure on the overnight repo rates, while Treasury yields at all maturities are dropping like rocks. So, two issues here. First, why is the Fed capping its overnight repo lending? If it's so important to hold down short rates, the Fed should lift the cap. Second, the drop in Treasury yields in part reflects a high demand for safe assets. Why is the Fed continuing to buy T-bills? The market wants them, so the Fed should be selling T-bills or, short of that, stopping its purchases.

What does history, and theory, tell us about what central banks should be doing now, in response to the coronavirus? History doesn't give us a lot to go on. In modern times, we haven't had to deal with a global pandemic of this type, with this level of potential widespread economic disruption. But, is this like dealing with other types of large shocks? First, is this like a financial crisis? No. The financial crisis originated as disruption in the financial sector. As such, it had historical precedents, and there is a wealth of experience concerning how a central bank should deal with a financial panic. In a financial crisis, the standard responses involve central bank lending, and bailouts. There is of course plenty of judgement that comes into play concerning who to lend to and how, who to bail out and how, and what the costs and benefits are. But, in general, this is all relatively well-understood. I know policymakers got plenty of flack in the last recession, but in general they were following a time-worn script. Not so much after the recession was over, but that's another story.

Second, for policy purposes, is the coronavirus anything like a war? No. Wars involve a reallocation of labor and capital across sectors, as human beings go into the armed forces, peacetime production goes away, and wartime production ramps up. There are important questions concerning how the expenditure on the war machine is financed. Little of that is going on here, as what policymakers are dealing with is a general cutback in across-the-board economic activity, and a reduction in time devoted to market activities. Public spending comes into play, but it's not of the magnitude that we observe in a war. So, I don't think we can learn anything from wars in this case.

Finally, what about natural disasters? Is that similar? Maybe. Floods and hurricanes, for example, can destroy aggregate economic activity temporarily, so that looks similar. And public spending is required to deal with the disaster. But if we take that seriously, this might tell us that monetary policy should do nothing and central bankers should sit on the sidelines. You may remember some monetary policy response to a hurricane or flood, but I don't.

But what would theory tell us? There are of course plenty of Keynesian models - both new and old - in which output is demand-determined, and therefore output contractions occur because "demand" falls. I guess what people mean when they say the coronavirus is a "supply" shock and not a "demand" shock is that Keynesian models are not equipped to help us understand what is going on in this instance, so let's forget about that stuff. Some people -Roger Farmer for example - like to think about multiple equilibrium models. In a multiple equilibrium world, what policymakers say, or what they commit to, can make a difference. So, perhaps the large moves by the Fed and the Bank of Canada this week could be seen as bolstering confidence. But, those aggressive moves could also cause people to think that a disaster is looming. Maybe the central bankers know something we don't, and we should panic. Go buy toilet paper, instead of that new car.

But, there are regular declines in economic activity that we deal with on a regular basis, apparently without any discretionary response from the central bank. Those regular declines are due to weekends, and seasonals. Every weekend a lot of people produce no market output. Every winter, some types of economic activity become more costly to undertake. Every summer a lot of people go on vacation. But, we've all become so accustomed to staring at seasonally adjusted data, that we forget a lot of that. There's a substantial amount of seasonal variation in a many macroeconomic time series. For example, here's US employment, unadjusted:
Typically, there's a big dip in employment in January, and a smaller one in August. The drop in employment from the busiest month to the least busy month isn't as large as the drop in employment during the last recession, but it's about 25% of that drop, typically, and it happens every year. And, importantly, the central bank is responding to that. Part of what the central bank does is to smooth out seasonal variation in interest rates, and also to smooth out bumps in the payments system, that is predictable disturbances that have to do with the month, the day of the week, or the season. An important part of central bank activity (though increasingly less important) is to supply currency elastically on weekends, in the holiday season, etc., to accommodate demand.

So, that's all just happening automatically, as a result of standard central banking procedure - pegging an overnight nominal interest rate. And that will happen while the coronavirus is making us sick. The key question is whether the central bank should be doing more. Should the central bankers have done what they did - aggressively cut interest rate targets as if they were dealing with a financial crisis, or a large drop in (seasonally adjusted) employment at the onset of a recession?

Jay Powell says that the interest rate cut will "support" the economy. Steve Poloz says that the interest rate cut will help consumer and business confidence. But how? Central bankers are always telling us about Friedman's "long and variable lags." The usual claim is that it takes a long time - maybe up to a couple of years - for monetary policy to have its effects. I don't know whether that's true or not, but it's a standard part of central banking lore. But, if the effects of the coronavirus are going to be temporary - a few months - why do anything if it's not going to matter within the relevant time frame? Maybe the interest rate cuts are supposed to inspire confidence. Typically, we think that interest rate cuts are going to tip the balance for consumers thinking about buying consumer durables and houses, or for firms making investment decisions. But, if the message I'm getting from the central bank is that things could get really bad, I'm going to be inclined to hunker down and postpone big spending decisions. So, it's hard to see what got accomplished this week on the monetary policy front.

Finally, there's the issue of leaving policy space to deal with whatever future shocks might be thrown at us. Central bankers find it very easy to cut interest rate targets, and very hard to increase them. It's clear that, now these rate cuts are in place, central bankers will be slow to move up again, after the coronavirus passes. Non-neutralities of money are temporary - we don't get permanently lower output by having low nominal interest rates forever. So, once we cut rates now, we can't cut them later, and the real effects, such as they are, will dissipate.

So, I'm inclined to think that the Fed, and the Bank of Canada, did the wrong things this week. The potential benefits are too small, and the potential costs too large. At the minimum, central bankers could have waited for more information, or cut less aggressively.

Tuesday, February 18, 2020

Is Inflation Targeting the Best We Can Do?

In the U.S., the Fed is considering modifications to its longer-run goals and monetary policy strategy, and last year Fed officials went on a listening tour to hear public views on its approach to monetary policy. This is new territory for the Fed, but the Bank of Canada does this sort of public outreach on a regular basis, in between renewals of its policy agreement with the government of Canada. The Bank conducts in-house research, runs conferences, and interacts with the public in various ways, to get a fix on whether the Bank's approach needs to be changed. Since 1991, the BoC has had a 2% inflation target, specified in its agreement with the federal government, and changes to that agreement since 1991 have been minor. In "The Role of Central Banks," I discuss the BoC's inflation-targeting history, and evaluate potential modifications to the Bank's approach. My conclusion is that the BoC's performance has been excellent over the last 29 years, and that it is difficult to make the case that any changes to their approach are necessary.

But what about the Fed, which operates under a different mandate, and potentially faces different issues than do other central banks? Since 2012, the FOMC has articulated its approach to fulfilling its Congressional dual mandate in its statement on longer-run goals and monetary policy strategy, which is typically updated each January (with the exception of January 2020). The Fed now has an explicit 2% inflation target, but one could argue that, implicitly, the 2% target was in effect long before 2012. For example, if we plot the path for the PCE deflator from 1995 through the end of 2019, relative to a 2% trend, here's what it looks like:
This is perhaps surprising. The Fed actually does quite well relative to a 2% price level target, but starts to miss on the low side in 2012 - just when it makes the 2% inflation target explicit. Since 2012, average inflation has been 1.4%. Not great, but not bad either, relative to the sated goal.

So, could the Fed do better? The Fed's dual mandate is a constraint of course, but Congress wrote the law in a sufficiently vague fashion that the constraint shouldn't bind if the Fed plays its cards correctly. Indeed, the FOMC's "Statement of Longer-Run..." skirts around the the second part of the mandate, which Fed officials typically state as "achieving maximum employment," without quantifying the concept. The Fed could change its goals, that is it could specify a different objective rather than 2% inflation - an NGDP (nominal GDP) target for example. It could change its policy rule, that is the mapping from observables to a target for something the Fed can control. For example, the policy rule could be a Taylor rule, which dictates a target for the fed funds rate as a function of current inflation and aggregate output. The Fed could also change its implementation strategy, for example the specific actions or mechanism for achieving a specific fed funds rate target.

Potential changes that appear to be taken seriously inside the Fed system are relatively minor tweaks to the Fed's goals, principally makeup-strategy modifications of inflation targeting. These could be categorized as price level targeting and inflation averaging. Under conventional inflation targeting, history is irrelevant. For example, if P(t) is the price level, and i* is the inflation target, then in an period t the target for next period's price level is

(1) P*(t+1) = (1+i*)P(t)

Or, in logs (approximately),

(2) p*(t+1) = i* + p(t).

An advantage of this conventional approach is that there is only one number that describes it, i*. That's easy for a central banker to understand, and it's easy for the central banker to communicate what policy is about to the public. Given i*, it's easy to evaluate the central bank's performance. If p(t)-p(t-1) deviates from i*, the central banker needs to explain why, and specify what corrective action is to be taken, if any. Maybe there's some transitory reason for the deviation, and the central banker can provide that reason to justify doing nothing.

But, it's possible that there could be some advantage to makeup inflation-targeting strategies, under which history matters. For example, price level targeting can be specified in terms of a base year b, a rate of adjustment a, and an inflation rate i*, which implies (see my paper) that next period's price level target is (in logs),

(3) p*(t+1) = (1-a)p(t) + ap(b) + [1+a(t-b)]i*.

In theory, we can find good reasons why price level targeting, embodied in (3), would be preferable to standard inflation targeting, as in (2). In principle, people care about inflation at all horizons. That is, if we think that the most important nominal contracts are intertemporal contracts - debt contracts of different maturities - then price level targeting has nice properties. Over any future horizon, if the price level target is well-understood, people know what inflation rate to expect, provided the central bank knows how to control the price level relative to the target. But, with standard inflation targeting, given that the central bank does not make up for past misses, the deviation from i* over a long horizon could be substantial, as was the case over the last 6 or so years.

Two problems with price level targeting, though. First, it takes three parameters to describe the price level target - one needs to specify a base period, a rate of adjustment to the desired price level path, and a target rate of inflation. But, for conventional inflation targeting, I need to know only one number. With price level targeting, the target rate of inflation over the upcoming period is constantly changing, and that has to be understood by the central banker and communicated to the public.

The second problem with inflation targeting lies not with the goal itself, but with the policy rule that goes along with it. People who think that price level targeting would be a good idea typically are not arguing that this will make credit markets more efficient by making inflation predictable over any future horizon. More typical is a type of forward guidance argument, for example Ben Bernanke's argument for temporary price level targeting. Roughly the argument is that, in a recession, if inflation is below target, and the central bank has driven nominal interest rates to the zero lower bound, price level targeting implies a commitment to making up for misses on low side, and this will cause the central bank to take appropriate actions - staying lower for longer, or QE, for example. Such polices are supported by New Keynesian forward guidance arguments, but ignore Taylor-rule-perils problems. That is, in contrast to what central bankers and most macroeconomists want to believe, in theory and practice, following a Taylor rule prescription for monetary policy can lead to a policy trap in which central banks keep nominal interests rates low in the face of persistently low inflation. Basically, this is due to the force of the Fisher effect. If the central bank cuts the nominal interest rate more than one-for-one in the face of below-target inflation, this tends to reduce inflation even further, leading to further rate cuts, etc., stopping only when the central bank reaches the zero lower bound, or effective lower bound on nominal interest rates. In the limit, every country looks like Japan. The problem with price level targeting, motivated in the way that Bernanke motivates it, is that this just compounds the Taylor-rule-perils problem. Rather than producing higher inflation in a recession than might be the case with standard inflation targeting, the policy just increases the chances the central bank gets stuck in the low-inflation policy trap. The central banker will not be achieving his or her goals, and a frustrated central banker doesn't behave well.

But, if Taylor-rule-perils are a problem, why didn't the Fed get stuck at zero after the last recession, or long before that? Does this mean that Benhabib et al. (2001) were wrong? No. The Fed doesn't follow a Taylor rule. Suppose we look at HP-filtered monthly data for 1995-2019 on the fed funds rate, R(t), the inflation rate, i(t), as measured by the year-over-year percentage increase in the pce deflator, and the unemployment rate, u(t), so as to capture short run policy responses to inflation and unemployment. The next chart shows deviations from trend in the fed funds rate vs. deviations from trend in the inflation rate:
The correlation coefficient is positive, but small, at 0.3, and the chart does't show evidence of a large response of the fed funds rate to deviations of inflation from trend. If we look at deviations of the fed funds rate from trend vs. deviations of the unemployment rate from trend, we get:
In this case, the correlation coefficient is -0.5. The most striking thing about this last chart is the absence of observations in the northeast quadrant - the Fed doesn't raise its fed funds target rate when the unemployment rate is above trend. If we run a Taylor-rule regression, we get

(4) R(t) = 0.06i(t) - 0.71u(t)

So, we could interpret the regression as telling us that the fed funds rate target responds mainly to short-run movements in the unemployment rate. Why does this work? To come close to its inflation target, the average level of the nominal interest rate has to be consistent with the target inflation rate. By Fisherian logic, if the average real interest rate is lower, the average nominal interest rate should be lower. If the target inflation rate is higher, the average nominal interest rate has to be higher. But, given the inertia in inflation, the Fed can engage in countercyclical policy without causing untoward variability in inflation. And countercyclical policy gives the Fed an excuse to, on occasion, hike interest rates. In general, a monetary policy rule has to dictate that the nominal interest rate target increase in some states of the world, otherwise the central bank is doomed to perpetually undershooting its inflation target.

What about inflation averaging? How does that differ from price level targeting? Inflation averaging is a makeup strategy, but with a moving base year. One way to specify this is to say that the central bank makes up for inflation targeting misses over the last s periods by compensating for these misses over the next s periods. This yields a target for next period's price level,

(5) p*(t+1) = (1-1/s)p(t) + (1/s)p(t-s) + 2i*

Note that (5) is just (3) with a = 1/s and b = t - s. That is, the size of the window, 2s, determines both the speed of adjustment to the desired inflation path, and the base year. Though defining the makeup strategy in this way economizes on parameters - there are two instead of three - inflation averaging has basically the same drawbacks as price level targeting. Inflation averaging is hard for central bankers to understand, and it would confuse communication with the public. And, given the arguments of the promoters of such approaches, it seems clear that inflation averaging would make low-inflation policy traps more likely.

Finally, let's deal with NGDP (nominal GDP) targeting. If nothing else, a change in the current regime to either NGDP growth or level targeting attracts the most passionate supporters, who include George Selgin (Cato Institute), David Beckworth and Scott Sumner (both George Mason University, Mercatus Center). That these people are all associated with right-wing think tanks is helpful in understanding what motivates NGDP targeters, though adherents of the approach are certainly not confined to the right. But, roughly, an NGDP targeter appears to be a modern-day monetarist. Monetarism, as practiced by the Volcker Fed, was successful in bringing down inflation, but central banks found that monetarist approaches failed in achieving low and stable inflation on an ongoing basis. Post-1980, changes in regulation and technology created a weak relationship between money growth and inflation, causing central bankers to abandon money growth targeting in favor of direct inflation targeting. A monetarist interpretation of the history might start with the equation that defines the income velocity of money,

MV = PY,

where M is some measure of money, V is the income velocity of money, P is the price level, and Y is real GDP, so PY is nominal income. One could say that Friedman's argument was that V is predictable, implying a predictable relationship between the money stock and nominal income, but Friedman went further. Friedman's writings indicate that he thought that instability in M caused instability in both P and Y. In practice, V proved to be unstable, which presented a problem for monetarists. But then people sympathetic to monetarism, for example Ben McCallum in the 1980s, argued that, in face of V instability, the central bank might just as well target PY, which would solve the problem.

What does NGDP targeting have going for it? It's certainly simple, in the same way a money growth target is simple. We measure nominal income on a quarterly basis, it's easy to describe what the goal is, and it's easy for the public to evaluate performance. It's also connected to the Fed's dual mandate, in that nominal income could be a summary statistic that tells us all we need to know about price stability and the real performance of the economy. But, the key questions are:

1. What's the connection between nominal income and the things the Fed should actually care about?
2. Is it even feasible for the Fed to achieve an NGDP target, with some reasonable degree of accuracy?

In an NGDP targeting regime the central bank would first have to choose a trend growth rate. Then, either this is a simple NGDP growth rate strategy, much like current inflation targeting schemes where history does not matter, or it's a makeup scheme, similar to price level targeting or inflation averaging. As such, any NGDP makeup strategy suffers from the some of the same problems as inflation targeting makeup strategies. First, such strategies are hard to understand, and hard for central bankers to explain. Second, part of the motivation for NGDP targeting comes from an assessment that monetary policy has been too tight in downturns, particularly during the last recession. Actually, Fed intervention, beginning in late 2007, and continuing through late 2015 and beyond, was massive in this episode, and to claim that more should have, or could have, been done seems silly. The Fed cut the target fed funds rate by 325 basis points from July 2007 to May 2008, set up the Term Auction Facility and lent substantially in early 2008 through that facility, and through the discount window. Overnight rates were essentially at zero for seven years, from fall 2008 to December 2015, and there was an unprecedented and large increase in the Fed's balance sheet.

It's useful to consider the following experiment. At the beginning of 1995, suppose that the Fed had chosen an NGDP level target, and had conducted policy in the same way as they actually did. How would we be evaluating their performance, and what might they have done differently to achieve the NGDP target? From 1947 to 1995, real GDP grew at about 3.5% per year, so suppose that in 1995 the Fed had set a target path of 5.5% for nominal GDP. The next chart shows actual nominal GDP and the 5.5% target path from 1995-2019.
Until the 2008-09 recession, the Fed would have been doing quite well according to this criterion, but then things would have gone awry. But surely the Fed could, and would, have changed policy to achieve the target, right? I don't think so. Given conventional policy thinking, and what appears to be the mindset of anyone advocating NGDP targeting, to achieve the target path in the last chart, the Fed should have been more accommodative - more interest rate cuts and more unconventional easing. But short rates were at zero, and it's not clear that QE was doing much of anything at the time - more QE would likely have meant more nothing. So, having adopted the 5.5% NGDP target, the Fed's failures would be worse in terms of the alternative target, and the Fed would be suffering even more complaints than they are now.

A key problem with NGDP targeting is that it requires that the policymaker take a stand on the the future trend growth rate in real GDP, which macroeconomists have no ability to predict. As well, problems can ensue due to short run fluctuations in real GDP. In the worst-case scenario in which monetary policy has no real effects, a nominal GDP target, if achievable, involves forsaking price stability. Thus, to the extent that price stability is desirable, economic welfare declines. The likely outcome, however, is related to what we see in the last chart. It is unlikely that the Fed would actually behave differently in a recession with an NDGP target than with an inflation target. If a recession happened next month, the Fed would cut its policy rate, and then start buying assets when the policy rate hit the zero lower bound, under the current regime, or under NGDP targeting. But, as in the last recession, the Fed would be missing on the low side much more substantially with an NGDP target than with a price level target, which would create pressure to stay lower for longer. Just as with inflation targeting, the result is to increase the chances the Fed gets stuck in a low-inflation policy trap.

Advocates of NGDP targeting make three claims:

1. The costs of variable inflation are negligible.
2. Inflation-targeting central banks - the Fed in particular - are singularly focused on inflation control.
3. There are large untapped welfare gains from output stabilization.

It seems to me the weight of theory and evidence tells us all three claims are wrong. First, it's no accident that legislation constraining central bank behavior typically mandates that the central bank concern itself with price stability. That extremely high and variable inflation is destructive is self evident. And moderately high inflation in North America in the 1970s produced a consensus in favor of taking action to bring inflation down. The success of inflation targeting is reflected in the lack of attention paid to inflation currently by most individuals. But perhaps macroeconomists have paid insufficient attention to examining why low and stable inflation are beneficial. For example, New Keynesian theory tells us that unpredictable inflation is costly because it creates relative price distortions. But, it seems more likely that inflation variability reduces performance in credit markets. High variability in inflation, combined with nominal debt contracts with various maturities, creates uncertainty for borrowers and lenders in credit markets - uncertainty that is costly, and can be mitigated by the central bank.

Second, most inflation-targeting central banks have other important concerns than controlling inflation - they worry in particular about GDP growth, the state of the labor market, and financial stability. The Fed takes its dual mandate seriously, and I showed above that short run movements in the Fed's policy rate are primarily explained by deviations of unemployment from trend.

Third, that the Fed could be doing more to stabilize output seems a difficult case to make, particularly as regards the financial crisis and the ensuing recession. In general, the ability of the Fed to affect real outcomes in a good way is limited. Some macroeconomic shocks are not amenable to mitigation by the central bank. Our knowledge of how the economy works is rudimentary. Macroeconomic measurement is not all it could be. Data is not available on as timely a basis as we might like. Decision-making is cumbersome and takes time.

Conclusion: The FOMC's "Statement of Longer-run Goals and Monetary Policy Strategy" is fine for now. No need for changes.

Friday, January 10, 2020

The FOMC: Where It's Come From, and Where It's Going

After three reductions of 25 basis points each in its fed funds rate target range since the middle of last year, the Fed seems to be on pause. What is the FOMC concerned about, and why, and what's in store for the rest of the year?

What does the data look like? First, the labor market has become increasingly tight:
The unemployment rate is lower than it's been for a very long time, and the job openings rate is higher than at any time since the BLS started collecting the vacancy data. Most people, me included, have been surprised by how low the unemployment rate has fallen, but possibly that's because our experience with expansions of this length is limited to non-existent. Real GDP growth has been consistently strong, if we adjust for the moderate average growth we have been seeing since the 2008-2009 recession:
In particular, recent observations in the chart are close to the 2.3% year-over-year average since 2010. Finally, according to standard measures, inflation is close to, though slightly below, the FOMC's 2% inflation target.
In the last three years, inflation has been close to 2%, and the most recent observations for headline PCE, core PCE, headline CPI, and core CPI, are 1.4%, 1.8%, 2.4%, and 1.8%, respectively.

So, relative to the objectives the FOMC laid out for itself in the Statement of Longer-Run Goals and Monetary Policy Strategy, it is doing well. This is an economy that has not experienced a large shock for a long time, and is growing smoothly with no apparent unemployed resources - at least, unemployed resources of the sort that monetary policy could put back to work. In terms of what monetary policy can hope to accomplish, there's nothing to do, which should be a wonderful state of affairs for American central bankers. Of course, people being what they are, you can find complainers, both inside and outside the Federal Reserve System.

The only fault we could find here is that inflation is below the 2% target. According to the inflation measure the FOMC chose for itself - the raw PCE deflator - inflation is at 1.4%, year-over-year. We can temper our criticism with the fact that a miss of 0.6 percentage points isn't so bad in inflation-targeting circles and also, as I showed in the last chart, by other measures inflation is closer to target. But there's more going on here. Concern with below-target inflation was part of the motivation for the three interest rate reductions that occurred last year, in three consecutive FOMC meetings. And part of the concern about inflation is focused on anticipated inflation measures, for example the 10-year breakeven rate:
At 1.8%, that's not so low, but it's lower than seems consistent with 2% inflation over a 10-year horizon.

The troubling part is that the typical FOMC member seems willing to admit that he or she does not understand the connection between FOMC actions and inflation. For example, Mary Daly, President of the San Francisco Fed, is quoted in the January 4 New York Times as saying, at the ASSA meetings, that:
We don't have a really good understanding of why it's been so difficult to get inflation back up...
And, this makes here want to predict that:
...this new 'fighting inflation from below' is going to be with us, I would argue, for a longer period of time than just a few years.
She also concludes that:
...a new policy framework will likely be required...
So, that seems correct - if the FOMC feels its chronically failing on some dimension, it should change what it's doing. Of course, it will help if the Fed understands the problem first.

I've been saying this for a long time (e.g. this paper in the St. Louis Fed Review, this one in the CJE, and numerous blog posts), but it bears repeating. For some reason, central bankers have a hard time understanding Fisher effects. There's ample empirical evidence that low (high) nominal interest rates induce low (high) inflation, and that's what essentially all of our mainstream dynamic macroeconomic models tell us. For about 20 years we've known about the perils of Taylor rules. The idea is that a Taylor-rule central banker, observing inflation below target, will cut the nominal interest rate target, which reduces inflation, which produces further rate cuts, until the central banker hits the zero lower bound (ZLB), or possibly a lower effective lower bound. This behavior fits some recent central bank experience - the Bank of Japan in particular.

We can think of the long-run problem of an inflation-targeting central bank as one of finding the average nominal interest rate target that is consistent with hitting the inflation target, on average. The problem for the FOMC, post-financial crisis, is that it is hard to know what that average nominal interest rate is. It's certainly lower than in the past - worldwide, we have observed falling real interest rates on safe debt since about 1980. But, the post-financial crisis period was not such a bad one for sorting this out, for the FOMC. Basically, "normalization" was proposed by the FOMC as a sorting-out - let's increase the policy rate until we find the sweet spot that sustains 2% inflation. The FOMC engaged in a somewhat leisurely tightening phase, with an ultimate target of about 3% for what the Fed thought was a "neutral" rate - roughly, the rate that would be consistent with 2% inflation, provided the economy never saw another large shock again. This approach seemed OK, as the FOMC could take its time to see the effects of tightening policy work themselves out, and decide when to stop (possibly before reaching 3%) based on observed inflation.

The FOMC developed a case of the heebie jeebies in mid-2019, however, brought on in part by Donald Trump - his criticisms of the Fed and his trade "policy" - and by inflation falling below the 2% target. In hindsight, I think the interest rate cuts were wrong. I'd argue that nominal interest rates at the current level are too low to be consistent with 2% inflation over the long run, and nothing was achieved on the real side of the economy. If the fed funds rate target were still at 2.25%-2.5%, the real economy would be performing about the same, inflation might be on target, and the FOMC would have another 75 basis points that they could cut in the event that something bad actually coming to pass.

Since the July 2019 FOMC meeting, the Committee has had a running discussion which you'll find under "Review of Monetary Policy Strategy, Tools, and Communication" in the published FOMC minutes. To summarize, the Board staff and the Committee appear to recognize that low real interest rates are a persistent phenomenon, and that this implies that nominal interest rates have to be low in order for the Fed to be achieving 2% inflation. This then implies that, if the Fed engages in countercyclical policy to the same extent as in the past, then the FOMC will more frequently encounter the ZLB. What then to do at the ZLB? Should the Fed engage in unconventional monetary policies? If the answer is yes, then what? Also, should this state of affairs imply some change in the Fed's inflation-targeting approach?

The FOMC seems to like unconventional policies - at least the ones it's experimented with. It doesn't like negative interest rate policy, though, which is fine with me. The FOMC seems very confident that quantitative easing (QE) and forward guidance are effective policies. However, in several meetings worth of discussion, as reported in the FOMC minutes, it's hard to see how the Fed learned anything from its experience with QE and forward guidance after the financial crisis. The theory has not advanced, and the evidence to support the use of such policies to further the Fed's goals is lacking. With respect to QE, it seems hard to argue that replacing US Treasury securities with bank reserves is a useful thing to do - this amounts to swapping a crappy asset for a good one, basically. And there's no evidence that QE helps in terms of achieving the Fed's ultimate goals. Ask the Bank of Japan, which has tried in vain, through a massive increase in its balance sheet, to get inflation up to 2% in the last 7 years. Forward guidance, while in principle unobjectionable if it serves only to clarify the nature of the FOMC's policy rule, was a bust in the post-financial crisis period. If someone characterizes the Fed's forward guidance over that period as anything but confusing, they need to explain - carefully.

A significant portion of the discussion of new approaches to policy in the FOMC minutes relates to possible modifications of the FOMC's inflation targeting approach. Standard inflation targeting has an important defect, which is that past inflation is a bygone - under inflation targeting, the central bank cares only about how its policy rule allows it to control future inflation. In principle, depending of course on why we think inflation is costly, it's possible that "makeup strategies" might be superior. The FOMC considers a couple of these, which are price level targeting and inflation averaging. I discuss both of these in more detail in this paper. Price level targeting essentially involves the choice of three parameters: a base year, an inflation rate, and a rate of adjustment. The idea is to calculate, given the base year, and the inflation rate, a target inflation path, and to then conduct policy so that the price level adjusts to the target path at the required adjustment rate. Inflation averaging is related, but uses a rolling base year. In this case, policy is conducted so that inflation misses over some past period of time are made up over some future period of time.

Both of these approaches have something going for them in theory, but in practice there are problems. Both makeup strategies are difficult to explain to the public, as they imply that the target inflation rate needs to change over time. This creates internal decision-making problems as well, since a more complicated rule permits slippage between stated and unstated goals in policy discussions, and can only bog down a committee. The most important problem, though, is that support for makeup policies tends to come from people who believe strongly (as I think they should not) in Phillips curve theories of inflation. These proponents typically think that price level targeting or inflation averaging would lead to more stimulative policy in a recession. Also typically, I think, what people have in mind is that price level targeting or inflation averaging will imply lower rates for longer during a recession. What this would lead to is actually worse performance relative to the target - more undershooting of inflation targets, however specified. This is just part of the "Taylor rule perils" problem - policy rules that produce permanently low nominal interest rates and low inflation. It's not the goal that's the issue here, but the policy rule that people have in mind to achieve the goal.

An interesting exercise is to look at the time path of the price level (as measured by the PCE deflator) in the United States for a long period of time, and see how the Fed did relative to a 2% path for inflation. We'll take a "long time" to be the last 25 years:
Up until the last recession, performance was pretty good, and you can see the undershooting since 2009. Even so, the current deviation from the 25-year 2% inflation path is only about 5%, which seems pretty good. What does this say? Clearly, the Fed hasn't been following a Taylor rule as this would have turned the US into low-inflation low-nominal-interest-rate Japan long ago. What's going on? I ran the following regression on monthly data for the US:

r(t)=a + bu(t) + di(t),

where a is a is a constant, b < 0, d > 0, and r(t), u(t), and i(t) are, respectively, the nominal fed funds rate, the unemployment rate, and the pce inflation rate, all hp-filtered. That is, we're estimating the response (in a crude way, of course) of the deviation in trend from the Fed's policy rate to the deviation from trend in the unemployment rate, and the deviation from trend in the inflation rate. The OLS estimates are b = -0.95, d = 0.13, and a = 0 by construction. This says that, indeed, the Fed has not been a Taylor-rule central banker, which would imply d > 1. The Fed responds strongly to deviations of the unemployment rate from trend, and in a minor way to deviations of inflation from trend. So, that approach seems to have been successful in achieving a 2% inflation target - supposing that the implicit target was 2% even in the Greenspan era. Maybe getting too bothered by inflation isn't such a great idea (in the short run), even if you're an inflation-targeting central bank. Though of course long-run policy is important for hitting the inflation target.

What's the upshot? If central banks want to hit inflation targets, they have to find reasons to increase nominal interest rate targets in the face of below-target inflation. The Fed, and other central banks have used an incipient-inflation argument in the past - basically, inflation is just around the corner unless we increase interest rates now. Unfortunately, that argument seems to lose steam if the central bank tries to do the interest rate hikes in a leisurely fashion. But, if central banks undershoot inflation perpetually, who cares? Probably only the central bankers, as no one outside of direct financial market participants is paying attention. That the central bankers care can be a problem, as they seem to like QE and forward guidance which, it seems to me, can be harmful policies. I could go on to complain about the Fed's floor system, but we'll leave that for another time. Have a good 2020.