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Thursday, September 21, 2017

The Future Path of the Monetary Base and Why It Matters

Now that the shrinking of the Fed's balance sheet has been announced, I thought it worth nothing what it means for the future path of the monetary base. Drawing upon the Fed's median forecast of its assets through 2025 that comes from the 2016 SOMA Annual Report, I was able to create the figures below. 

The figures show the trend growth path of currency and a series I call the 'permanent monetary base' extrapolated to 2025. The latter series is the monetary base minus excess reserves. This measure has been used by Tatom (2014) and Belongia and Ireland (2017) as a more reliable indicator of the monetary base that actually matters for monetary conditions. These two measures, which reflect the liability side of the Fed's balance sheet, are plotted along side the projected path of the asset side of the Fed's balance sheet. The first figure below shows this exercise in terms of dollars and the latter one is in log-levels.

What is interesting is that the Fed's median forecast of its assets eventually converges with the trend growth of currency which historically has made up most of the monetary base. Unsurprisingly, the permanent measure of the monetary base also tracks currency's trend path. Jim Hamilton does something similar here.  

So what are the takeaways? First, the Fed is expecting to confirm the temporary nature of the monetary expansion  under the QE programs. That is, the only major growth in the monetary base the Fed expects to persist is that coming from the normal currency demand growth that follows the growth of the economy. This endogenous money growth would have happened in the absence of QE. 

Second, the temporary nature of the QE programs, implied by these figures, is a key reason why these programs did not spur a robust recovery. For reasons laid out in this blog post and in this forthcoming article, there needed to be some exogenous permanent increase in the monetary base to spur robust aggregate demand growth. It never happened and neither did the much-needed recovery.  Instead we got the monetary regime change we never asked for.





Update I: See George Selgin's take on why QE was not very effective.

Update II: Brian Bonis, Jane Ihrig, and Min Wei from the Board of Governors just posted a note with the latest forecast of the Fed's balance sheet. It is updated to include the latest information from the recent FOMC meetings. My figures come from an earlier forecast and are a bit dated relative to these numbers. Their forecasted end value for the SOMA holdings ranges from $2.6 to $3.2 trillion. The median forecast I used above ends up at $3.2 trillion. So my trends would fit their high end estimates. 

However, their note is more nuanced than my graphs above. While they recognize that currency demand growth will be a big determinant of the future size of the Fed's balance sheet, they also recognize that depending on what the Fed does and what happens to banking regulation there could be an additional buffer in the Fed's balance sheet from excess reserves. Here is an extract:
Normalization of the size of the balance sheet occurs when the securities portfolio reverts to the level consistent with its longer-run trend. This trend is determined largely by the level of currency in circulation and a projected longer-run level of reserve balances. There is a great deal of uncertainty about the longer-run level of reserves, which could be affected by factors such as structural changes in the banking system, the effects of regulation on banks' demand for reserves, and the Committee's ultimate choice of a long-run operating framework. We show two scenarios. We assume that the longer-run level of reserve balances is either $100 billion (as in our April 2017 projection) or $613 billion (the median response from the Federal Reserve Bank of New York's June 2017 Survey of Primary Dealers and Survey of Market Participants)
Here are the relevant charts from their note:



The Political Economy of Shrinking the Fed's Balance Sheet

Most folks know the arguments for and against shrinking the Fed's balance sheet on purely economic terms. For a good recap of these arguments see Cardiff Garcia, Henry Curr, and Nick Timiraos. There are however, other political economy forces at work that potentially play into the Fed's decision to shrink its balance sheet.

Most folks do not go there because it is a controversial approach. For it takes a more cynical view of government officials. It goes beyond the view of the Fed as a technocratic institution filled with saintly people doing their best to stabilize the business cycles. It recognizes that people are people no matter where they work and are responsive to political incentives. Now to be clear, many good people work at the Fed because they believe in the mission. But to say the mission is the only thing they consider would be naive. Fed officials, like most people, also care about their own well-being. On the margin, this influences their decision making at the Fed.

This political economy critique of the Fed is not a new one. Mark Toma has entire book on the topic. But most observers, including myself, rarely apply it to the Fed. This includes recent discussions about the Fed's decision to shrink its balance sheet.

I wrote an OpEd for The Hill that bucks this trend. It looks at two countervailing political economy forces weighing on the Fed's decision to shrink its balance sheet. The first force incentives the Fed to keep its balance sheet large:
The large-scale asset purchasing program, better known as quantitative easing, caused the Fed’s balance sheet to grow from roughly $900 billion in late 2008 to $4.5 trillion. 
This vast expansion, combined with the introduction of the Fed’s program to pay interest on excess reserves (IOER) to banks, effectively transformed the Fed from a standard central bank into one of the most profitable financial firms on the planet... 
Over the past few years, it has averaged near $100 billion in profits. Prior to the crisis, its profits averaged only $25 billion per year. The Fed’s profitability has allowed its budget to grow 4.1 percent per year between 2007 and 2017, compared to 2.4 percent for the federal government. 
Given the profitability, prestige and jobs created by maintaining the Fed’s large balance sheet, it will not be painless for the Fed to shrink it.
Yes, the Fed remits most of its profits to the Treasury, but its own budget has grown relatively fast under its large balance sheet as noted above. Here is a chart from the Fed's 2016 annual report that illustrates this development:



Now some may say this increased spending is due, in part, to the new regulatory responsibilities the Fed has taken on since the crisis. Maybe so, but the Fed has been one of the biggest champions of its new regulatory role. Whether you believe the Fed is a good regulator or not, it has an incentive to expand its budget, prestige, and influence over finance via its regulatory role. Keeping its balance sheet large helps facilitate this expansion. So this is a political economy force for keeping its balance sheet large.

The second force I note in my OpEd incentives the Fed to shrink its balance sheet:
[T]he Fed may be eager to unwind its balance sheet [because] it is bad optics politically. The large expansion of the Fed’s asset holding accompanies a similar-sized expansion of its liabilities. 
Most of the increased liabilities have been in the form of banks’ excess reserves. Banks deposit these at the Fed and earn the IOER payment. As seen in the figure below, almost all of the excess reserves parked at the Fed are cash holdings of foreign and large domestic banks. 


That means foreigners and the U.S. banks bailed out during the crisis are getting most of the interest payments from the Fed. If the Fed’s balance sheet was maintained and short-term interest rates eventually rose to 3 percent (as expected), these banks would get approximately $66 billion a year from the Fed. 
To illustrate this point, we again go back to the Fed's 2016 annual report. It shows the Fed's net expenses jumped from roughly $11 billion in 2015 to $17 billion in 2016. That is a huge percentage increase. Almost of all it came from the large IOER payments the Fed had to pay in 2016 because of higher interest rates. Specifically, the IOER payment went from $6.8 billion in 2015 to $12.1 billion in 2016. This is horrible optics: the Fed's expenses are ballooning because it is paying more to foreign banks and the large U.S. banks we bailed out. The Fed can avoid this controversy by shrinking its balance sheet.

As I note in the piece, it is not often that an important government agency voluntarily agrees to actions that will reduce its budget and reach. Yet, the Fed is doing just that by shrinking its balance sheet. It suggests to me that the IOER issue, in conjunction with the other reasons stated by the Fed for shrinking its balance sheet, may be more important than many observers now realize. 

P.S. The above assumes the Fed actually goes through with shrinking its balance sheet. I mention in a previous post that the IOER-treasury bill spread if left uncheck may prevent that from happening.

Monday, September 18, 2017

Is Larry Summers a Fan of Nominal GDP Level Targeting?



You are going to have listen to my podcast with him to find out the answer. Here is a hint: we spent a portion of the show talking about NGDP level targeting (NGDPLT) and what it would take to actually get it implemented it at the Federal Reserve. So listen to the show to find out Larry's thoughts on NGDPLT as well as his views on secular stagnation, Fed policy since the crisis, and macroeconomic policymaking in real time. It was a fun interview. 

P.S. You can also read the transcript of our interview.
P.P.S. For those interested in NGDPLT here is my latest policy brief on it and here is a longer research paper on it.

Will Shrinking the Fed's Balance Sheet Matter?

This week the Fed is expected to announce it will begin shrinking its balance sheet. Will it matter? 

To answer that question it is useful to first recall how and why the Fed's balance sheet was expanded. Between December 2008 and October 2014 the Fed conducted a series of large scale asset purchases (LSAPs) that expanded its balance sheet from about $900 billion to $4.5 trillion. That is an expansion of about 500 percent. 

The Fed turned to LSAPs for additional stimulus when its target for the federal funds rate—the traditional tool of U.S. monetary policy—hit the zero lower bound in late 2008. The main theory the Fed used to justify the LSAPs was the portfolio balance channel. It says that because of market segmentation the Fed's purchase of safe assets would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower long-term interest rates, and push up asset prices. This would help the recovery. 

LSAPs were supposed to trigger the portfolio balance channel by reducing the relative supply of safe assets to the public. This reduction in safe asset supply to the public can be seen by looking at the growing share of safe assets held by the Fed under the various QE programs. The Figure below shows this development for marketable U.S. treasury securities:


This figure also shows another development that has taken place since late 2014: the Fed's share of treasuries has been shrinking. I call this the Fed's "reverse QE" program. Per the portfolio channel, this should be a passive tightening of monetary policy as the Fed's share of safe assets has fallen. Put differently, this should be portfolio rebalancing in reverse that causes long-term treasury yields to rise. 

The figure below, however, shows the opposite has happened under "reverse QE". Other than the Trump bump, 10-year treasury yields have been heading down. Even if we focus just on the ZLB period of "reverse QE"--October 2014 through December 2015--we still see this pattern:



So what does this all mean? It suggests that outside of the 2008-2009 crisis period the portfolio balance channel never really mattered. There are good theoretical reasons for this conclusion as noted by Michael Woodford, John Cochrane, and Stephen Williamson.1 It is not clear, then, that QE2 and QE3 made much difference to the recovery. To be clear, there is some empirical evidence that shows some small-to-modest results for these programs. Even if these results are taken as given, however, most evidence points to this success coming from the signaling channel rather the portfolio balance channel.2

This implies the Fed's shrinking of its balance sheet should not be a big deal. The Fed has been signaling for some time it would start shrinking its balance sheet this year. It even released a detailed plan in June of how it will happen. So there should be no surprises--the Fed is carefully using the signaling channel to keep markets calm. Given this signaling and the lack of a binding portfolio balance channel,  the concerns about the shrinking of the Fed balance sheet causing monetary policy to tighten are mostly noise.

I say mostly noise because there is one potential concern. It is the financial pressure caused by the new regulatory demands of the liquidity coverage ratio running up against the spread between IOER and treasury bills. I wrote about this issue awhile back in an OpEd:
The second reason the scaling back of the Fed's balance sheet may be challenging is that post-2008 regulation now requires banks to hold more liquid assets. Specifically, banks now have to hold enough high-quality liquid assets to withstand 30 days of cash outflow. This liquidity coverage ratio has increased demand for such assets of which bank reserves and treasury securities are considered the safest. So, in theory, as the Fed shrank its balance sheet, the banks could simply swap their excess reserves (that the Fed was pulling out of circulation) for treasury bills (that the Fed was putting into circulation). The challenge, as observed by George Selgin, is that the Fed's interest on excess reserves has been higher than the interest rate on treasury bills. This creates relatively higher demand for bank reserves.  
Banks would not want to give up the higher-earning bank reserves at the very moment the Fed was trying to pull them out of circulation. This tension could create an effective shortage of bank reserves and be disruptive to financial markets. The solution here would be for the Fed to lower the interest on excess reserves to the level of treasury bill interest rates.
The figure below illustrates this potential problem. It shows the Fed's upper and lower bounds on the federal funds rate and the 1-month treasury bill interest rate. These upper bound is the IOER and the lower bound is the reverse repo rate. The reverse repo rate has (sort of) anchored the 1-month treasury bill yield, but the issue is the spread between it and the IOER. Why would  banks want to give up bank reserves for treasury bills when reserves earn at least 25 basis points more than treasury bills? The Fed will be pushing against this demand when it tries to pull the excess reserves out of the banking system. Good luck wth that. 


To summarize, we need not worry about the portfolio balance channel kicking into reverse as the Fed begins shrinking its balance sheet. We should, however, worry about the distortions created by the positive IOER-treasury bill yield spread as Fed unwinds its asset holdings. The Fed can fix this problem by equalizing IOER and short-term market interest rates.

Update: Cardiff Garcia reviews a research note by Nomura's Lew Alexander on shrinking the Fed's balance sheet. Also, Nick Timiraos has a nice long piece on the Fed's LSAPs in the WSJ.
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1Theoretical Problems with the Portfolio Balance Channel. The portfolio balance channel as envisioned by the FOMC relied on controversial assumptions about segmented markets and the Fed being a more efficient financial intermediary than other financial firms. On the first assumption, if the Fed can truly affect long-term treasury interest rates because the long-term treasury market is segmented from other markets, then by definition actions in the treasury market should not spill over into other markets. Put differently, portfolio rebalancing cannot take place in truly segmented markets. On the second assumption, if the Fed takes duration risk off of private-sector balance sheets via LSAPs, the risk really has not gone away since those long-term assets are now on the Fed’s balance sheet which, in turn, is backed-up by the tax payer. The private sector is still bearing the risk. The Fed, in other words, is not some special financial intermediary that can transform and diversify away the riskiness of the assets it purchases. This is the Modigliani-Miller theorem critique applied to central bank asset purchases as shown by Wallace (1981). Ben Bernanke acknowledged this theoretical tension by famously quipping that the “problem with QE is it works in practice not in theory.”

During the financial crisis the above assumptions were probably reasonable when markets froze up and the Fed become the lender of last resort. So QE1 probably made a meaningful difference. But after the crisis it is hard to make a convincing case for the assumptions holding. That is why QE2 and QE3 probably did not pack much punch. See Stephen Williamson, John Cochrane, or Michael Woodford (p. 61-65) for more on the theoretical problems with the Fed's understanding of the portfolio balance channel.

2The signaling channel is based on the idea that the LSAPs indicate a firm commitment by the Fed to keep interest rates low for a long period that would not be evident in the absence of the LSAPs.

Friday, September 15, 2017

Monetary Regime Change: Mission Accomplished

Christina Romer, former CEA chair, called for a monetary regime change several times between 2011 and 2013. It is now several years later and it appears we did finally get a monetary regime change. Unfortunately, it is not the kind of regime change Christina advocated and actually goes in the opposite direction. 

Christina called for the Fed to adopt a nominal GDP level target that would restore aggregate demand to its pre-crisis growth path. Instead, we got a regime change that has effectively lowered the growth rate and the growth path of aggregate demand. This regime change, in my view, is behind the apparent drop in trend inflation that Greg Ip recently reported on in the Wall Street Journal. 

It is not easy to change trend inflation--just ask Paul Volker--but the Fed and other forces seemingly accomplished just that over the past decade. Since the end of the crisis, the average inflation rate on the Fed's preferred measure of inflation, the core PCE deflator, has fallen to 1.5 percent The headline PCE deflator average has fallen to 1.4 percent over the same period. Both are well below the Fed's target of 2 percent. 

This persistent shortfall of inflation has received a lot of attention from critics, including me. Lately, some Fed officials are also beginning to see the inflation shortfall as more than a series of one-off events. Governor Lael Brainard's recent speech is a good example of this change in thinking with her acknowledgement that trend inflation may be falling.

Still, there is something bigger going on here that is being missed in these conversations about the inflation rate. A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.



The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  

Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path. 

Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. So this is a joint monetary-fiscal problem that has effectively created a monetary regime change.

So yes, we got a monetary regime change, but no it is not the one Christina Romer and most of us wanted. 

Tuesday, August 22, 2017

The IOER Debate Redux

Back in the glory days of macroeconomics blogging there was a lot of electronic ink spilled over interest on excess reserves (IOER). Commentators, including myself, debated whether IOER mattered to the recovery or if it was just another innocuous tool for the Fed to control interest rates. 

I generally argued that the IOER did matter for the economy--it was more than just a new tool. It began with a call I  made in October 2008 that the introduction of IOER that month was likely to be contractionary. In later conversations, I acknowledged that, yes, the Fed does sets the aggregate level of reserves. Even so, I retorted, banks could still influence the composition of all those reserves based on their investing decisions. These decisions, in turn, could be influenced by the level of IOER. That is, if IOER were set high relative to other safe asset yields then banks might decide to invest in excess reserves rather than in other safe assets like treasury bills. This could stall the 'hot potato' process and affect the recovery. For example, imagine the economy starts heating up and, as a result, the demand for loans picks up. Banks facing this increased pressure for money creation might opt to invest in excess reserves instead of loans if the risk-adjusted return on excess reserves were high enough. That could happen by raising IOER sufficiently high. Consequently, IOER mattered to macroeconomic policy and needed to be set appropriately.

The above paragraph roughly summarizes my position during the many IOER debates that took place over the past decade. Needless to say, I got plenty of pushback and there were many spirited debates. These exchanges sharpened my thinking on the topic. Here, for example, is a long write up from Cardiff Garcia at FT Alphaville on one such debate in 2012. Those were fun times, but folks generally moved on to other conversations.  

One person, though, who kept the IOER conversation going is George Selgin. He has written extensively on IOER, most recently in a 60-page testimony to the House Committee on Financial Services. In it, Selgin argues that the Fed has, in fact, set the IOER too high and this has been a drag on the recovery. Along these lines, he presented a chart on page 20 that shows what appears to be a systematic relationship between (1) an IOER and comparable market interest spread and (2) the relative demand for excess reserves. 

The chart was intriguing, but its sample period did not span the whole IOER period. So I wanted to see if the relationship was robust across the period. Also, I thought it would be useful to look at the actual holders of the excess reserves. The figure below shows the combined cash assets of "large domestically-charted banks" and "foreign-related" banks as reported in the Fed's H8 report. These combined cash assets track excess reserves fairly closely. These two types of banks, then, are the main holders of excess reserves.


Following Selgin's example, I plotted the (1) spread between the IOER and the overnight LIBOR and (2) cash assets as percent of total assets. I did so for both the foreign-related and large domestic banks. If the IOER spread does in fact cause banks to hold more excess reserves relative to other assets, then we would expect the banks share of excess reserves in the portfolios to go up with the spread. 

The figure below confirms that this is the case for the foreign-related banks for the period December 2008 - July 2017. The relative yield on excess reserves does seem to influence the real demand for excess reserves. 


The next figure puts these two series together in a scatterplot. The IOER - excess reserve relationship is strong with a R2of 73%.



Next, I looked at domestically-chartered banks. There is still a positive relationship here, but it is weaker as seen in the next two figures.




The last figure shows the relationship is not trivial--it has an R2of 41%--but it is nowhere near the strength of the foreign banks. So for some reason the IOER-Libor spread  creates a stronger incentive for foreign banks to hold comparatively more excess reserves.  That is an interesting observation worthy of future exploration.

The main takeaway, though, from the above figures is that it appears Selgin's claim is correct. A rise in the IOER spread does seem to influence the relative demand for excess reserves, with the effect being  strongest for foreign banks in the United States.This implies the IOER is more than just a new interest rate tool for the Federal Reserve. George Selgin may have just rekindled the IOER debate. 

Friday, July 21, 2017

Assorted Musings

Some Assorted Musings:

1.  I have a new policy brief at the Mercatus Center that makes the case for a Nominal GDP level target from the knowledge problem perspective. It is a non-technical paper meant to be accessible by policy makers and lay people. It echoes some of the  more technical arguments made in this paper by Josh Hendrickson and myself. 

 2. George Selgin testified this week before the House Financial Services Committee as part of the hearing Monetary Policy v. Fiscal Policy: Risks to Price Stability and the Economy. His testimony is a tour de force through the issue of interest on excess reserves

3.  Scott Sumner pushes back against all the macro moralists waving their finger at Germany for running current account surpluses. He argues it is mistaken to blame Germany's current account surplus for dragging down global demand growth. 

4. Is any part of potential GDP endogenous to the level of aggregate nominal demand? This is a question we have looked at before on this blog. A new paper reexamines this issue and concludes the answer is yes. Below are the key figures from the paper. The first one shows the standard CBO potential GDP estimates over time against a new estimate. Matthew Klein reports on the paper. 



Wednesday, July 5, 2017

An Alternative to Raising the Inflation Target

Ramesh Ponnuru and I have a new article in the National Review where we make the case that a better alternative to a higher inflation target is a NGDP level target:
Does the U.S. economy need more inflation? A group of 22 progressive economists has written a letter to the Federal Reserve urging it to appoint a blue-ribbon commission to study whether the central bank should raise its target for inflation above its current 2 percent. Fed chairman Janet Yellen, in her press conference following the latest interest-rate increase, called it “one of the most important questions” facing the organization. The economists’ advice shouldn’t be rejected out of hand, but it should be rejected. They make some valid points in their diagnosis of the ills of the current monetary regime. But the Fed can and should address these problems without raising inflation...  
These arguments for a higher inflation target are reasonably strong if you accept the premise that keeping inflation stable should be the Fed’s principal task in the first place. There is, however, a superior alternative. That alternative would stabilize the growth of nominal spending: the total amount of dollars spent throughout the economy...  
This policy would capture the benefits of inflation targeting...A key difference between the two policies is that a nominal-spending target would allow inflation to fluctuate over the short term in response to movements in productivity. 
In general, a nominal GDP level target allows for more inflation flexibility than is currently seen in practice while keeping the growth path of nominal demand stable. This rule would also improve over  current approaches by better risk-sharing in the financial system, better aligning of the Fed's interest interest rate with the natural interest rate, and better maintenance of money neutrality. Finally, its an target that invokes the imagery of Chuch Norris and Jean-Claude Van Damme.

Friday, June 16, 2017

Monetary Disequilibrium



This week on the podcast I had a great time talking the monetary disequilibrium view of business cycles with Steve Horwitz. This perspective sees the deviation between desired and actual money holdings as the cause of business cycles.  Since money is the one asset on every market, all one needs to do is disrupt monetary equilibrium and you have disrupted every other market. This is not true for any other asset. The monetary disequilibrium view, in short, takes money seriously.

This understanding is different than the dominant view today that sees business cycles being the result of deviations between the expected paths of the natural and actual real interest rate. After the show I asked Steve if there was mapping between these these two views and he said yes. The views should be complementary. Nonetheless, the monetary disequilibrium view rarely get a hearing so I was really glad to do this interview with Steve. 

I have also posted below a presentation I used to give my undergraduates on monetary disequilibrium. It provides some of the graphs Steve mentioned in the interview. Finally, I highly recommend Leland Yeager's book The Fluttering Veil: Essays on Monetary Disequilibrium. Yeager was a leading advocate of this view and his book provides an accessible introduction to the topic. [Update: for those wanting a formal treatment see this Josh Hendrickson paper (ungated version)]

Wednesday, June 14, 2017

Musings on June's FOMC Meeting

The FOMC decided today to raise its target interest rate so that it now sits in the 1.00-1.25 percent range. This move was largely expected and the FOMC continues to signal via its economic projections that it wants one more interest rate hike this year. Nothing terribly new here, but there were several developments today that caught my attention and are worth considering.

First, the FOMC released a surprisingly detailed plan of how it will unwind its balance sheet later this year. Fed chair Janet Yellen also said during the press conference these plans could be "put in effect relatively soon" if the data come in as expected. The announcement today can be seen as part of the FOMC's ongoing efforts to get the markets ready for the shrinking of its balance sheet. 

To shed light on this development, recall that the main theory the Fed used to justify the the large scale asset purchases was the portfolio channel. It says the Fed's purchase of safe assets would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower long-term interest rates, and push up asset prices. In turn, these developments would support the recovery.

A key step in this story was the Fed reducing the relative supply of safe assets to the public. One way to see it is through the growth of the Fed's share of marketable treasury securities. This can be seen in the figure below. 


In addition to the QE programs, the figure reveals a rather striking development. Since about September 2014 the Fed's share of marketable treasury securities has been falling. This has been a passive development for the Fed--it has maintained a fixed level of treasury holdings while total government debt has grown--but it is effectively QE in reverse. Per the portfolio channel, this reverse QE should have caused long-term treasury yields to rise. Instead, they have more or less been falling over this period:


Put differently, the Fed has been effectively shrinking its balance sheet for several years now and it has been much ado about nothing. Whatever influence QE had, its seems to be dwarfed by other economic forces driving long-term treasury yields.

It should not be surprising, then, that the Fed's announcement today about how it plans to shrink its balance sheet and Janet Yellen's follow-up comments did not create another taper tantrum. Yes, the Fed has been conditioning the market for the eventual reduction for several months, but maybe the bigger story here is that QE really did not have that big of an effect on interest rates and the recovery in the first place. Jim Hamilton reaches a similar conclusion:
[T]oday’s evidence seems to reinforce the conclusion that many have drawn about the effects of the Fed’s large-scale asset purchases–whatever effects these may have had on long-term interest rates were likely less important than other fundamentals. That appeared to be the case on the way to building up the Fed’s balance sheet, and so far appears to be the case in the long process of bringing the balance sheet back down.
To be clear, QE1 probably had a meaningful effect since it was applied in the midst of the financial crisis. However, I am becoming less convinced that QE2 and QE3 mattered much except for signaling purposes. As I have written elsewhere, the fundamental flaw with these programs was that they were beholden to the Fed's desire for rigidly low inflation and therefore consigned to be temporary monetary injections. Which leads me to the other development that really caught my attention.

Second, during the FOMC press conference, Fed chair Janet Yellen once again attributed the unexpectedly low inflation in recent months to one-off events.  She specifically attributed the below-target inflation to lower prices for cell phones and pharmaceutical. Here was my real-time response on twitter:


Yep, either the Fed is the most unlucky institution in the world or the Fed has a problem. I think the latter. The Fed appears to have begun having a problem with 2 percent inflation around the time of the Great Recession. This can be seen in the FOMC's summary of economic projections (SEPs) figure below. It shows for each FOMC meeting where SEPs were provided to the public the central tendency forecast of the core PCE inflation rate over the next year. The horizon for these forecasts depend on the time of the year they were released and range from one year to almost two years out. The forecast horizons are long enough, in other words, for the FOMC to have meaningful influence on the inflation rate.


The figure shows that since 2008, the FOMC has consistently forecasted at most 2 percent inflation. Note that The FOMC’s description of the SEP states (emphasis added) “Each participant's projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant's assessment of the rate to which each variable would be expected to converge under appropriate monetary policy…” As former FOMC member Naranaya Kocherlakota notes, this means the projections reflect what members think inflation should be if they had complete control over monetary policy over the forecast horizon. It reveals their preferences for the future path of monetary policy. Consequently, the central tendency of FOMC members since 2008 indicates that they see the optimal inflation rate not at 2 percent, but at a range between 1 and 2  percent. 

The actual performance of the Fed's preferred inflation measure, the PCE deflator, has been consistent with this view. It has averaged about 1.5 percent since the recovery started in mid-2009. That is a revealed preference, not a series of accidents caused by bad  luck.

To be clear,  the Fed has only been explicitly targeting inflation at 2 percent since 2012, but many studies have shown it to be implicitly doing so since the 1990s. So this truly has been an eight-year plus problem for the Fed and one that makes Janet Yellen's remarks all the more disappointing to hear. One would think after almost a decade of undershooting 2 percent inflation there might be an acknowledgement from the FOMC like the one that came from Minneapolis Fed President Neel Kashkari (my bold):
[O]ver the past five years, 100 percent of the medium-term inflation forecasts (midpoints) in the FOMC’s Summary of Economic Projections have been too high: We keep predicting that inflation is around the corner. How can one explain the FOMC repeatedly making these one-sided errors? One-sided errors are indeed rational if the consequences are asymmetric. For example, if you are driving down the highway alongside a cliff, you will err by steering away from the cliff, because even one error in the other direction will cause you to fly over the cliff. In a monetary policy context, I believe the FOMC is doing the same thing: Based on our actions rather than our words, we are treating 2 percent as a ceiling rather than a target. I am not necessarily opposed to having an inflation ceiling...  I am opposed to stating we have a target but then behaving as though it were a ceiling.
It is time for the FOMC to come clean on what it really wants to do with inflation. Until it does so continue to expect confusion and  repeated questions to Fed officials over the Fed's inflation target.

Wednesday, May 31, 2017

Is the United States Becoming Less of an Optimal Currency Area?

It took the United States roughly 150 years to become an optimal currency area (OCA), according to economic historian Hugh Rockoff. This long journey meant that it was not until the late 1930s that a one-size-fits-all monetary policy made sense for the U.S. economy. Since then the U.S. economy has often been held up as the best example of a currency union that meets the OCA criteria. This especially was the case when comparisons have been made to the Eurozone, like in this classic Blanchard and Katz (1992) paper.  But all is not well in this land of the OCA.

Declining Labor Mobility
Since the 1980s there has been a decline in labor mobility across the United States.  This can be see in the figure below:

A number of explanations have been given for this decline, but in my view the best one is found in David Schleicher's paper titled "Stuck! The Law and Economics of Residential Stability". Schleicher makes the case that land-use regulations, occupational licensing, non-compete clauses, and other regulations are making it harder for individuals to pick-up and move to better jobs.  A spate of recent news stories reinforces how consequential the these labor market constraints are for many people. Schleicher notes that they are particularly onerous for those individuals that need to move the most, the folks from lower socioeconomic groups most affected by regional economic shocks. 

The recent Autor et al. papers on the China shock vividly illustrate this point. On the surface these papers speak to how big and persistent the China shock was on certain local U.S. economies. But their deeper finding, in my view, is that they point to declining labor mobility in the United States. For they show the China shock had little effect on local population flows in the affected communities. That is, the unemployed in the affected regions did not readily move away to jobs elsewhere. 

The above papers are consistent with a recent IMF study that revisited the Blanchard and Katz (1992) paper and concluded the following (my bold):
[A] given regional shock has triggered less interstate net migration, and a larger response of regional unemployment and participation in the short-run. That is, following the same negative shock to labor demand, affected workers have more and more tended to either drop out of the labor force or remain unemployed instead of relocate...
Tyler Cowen's new book, The Complacent Class, also speaks to this development. His argument is that U.S. culture has become increasingly risk averse. The higher risk aversion explains the growth of the labor market constraints listed in the Schleichner paper as well as the declining desire to pick up and move to better opportunities.

Implications for the United States as an OCA
So why does the decline in labor mobility matter for the U.S. economy? To answer this question, recall that the Fed is doing a one-size-fits-all monetary policy for fifty different state economies. That is, the Fed is applying the same monetary conditions to states that often have very different economies, both structurally and cyclically. For example, Michigan and Texas have had very different trajectories for their economies. Does it really makes sense for them both to get the same monetary policy? 

According to the OCA, the answer is yes under certain circumstances. The OCA says it makes sense for regional economies to share a common monetary policy if they (1) share similar business cycles or (2) have in place economic shock absorbers such as fiscal transfers, labor mobility, and flexible prices. If (1) is true then a one-size-fits-all monetary policy is obviously reasonable. If (2) is true a regional economy can be on a different business cycle than the rest of currency union and still do okay inside it. The shock absorbers ease the pain of a central bank applying the wrong monetary policy to the regional economy. 

For example, assume Michigan is in a slump and the Fed tightens because the rest of the U.S. economy is overheating. Michigan can cope with the tightening via fiscal transfers (e.g. unemployment insurance), labor mobility (e.g. people leave Michigan for Texas), and flexible prices (workers take a pay cut and are rehired). 

To be clear, a regional economy is not making a discrete choice between (1) and (2) but more of a trade off between them. Michigan, for example, can afford to have its economy a little less correlated with the U.S. economy if its shock absorbers are growing and vice versa. There is a continuum of trade offs that constitutes a threshold where it makes sense for a regional economy to be a part of a currency union. That threshold is the OCA frontier in the figure below: 



Circling back to the original OCA question, the decline in labor mobility documented above matters because it means that certain regions in the United States are becoming less resilient to shocks.This is especially poignant given the findings in Blanchard and Katz (1992) that interstate labor mobility has been the main shock absorber for regional shocks. Consequently, monetary policy shocks may prove to be more painful than before for some states. Unless increased fiscal transfers and price flexibility make up for the decline in labor mobility, the implication is clear: the U.S. is gradually moving away from being an OCA.

As it turns out, I have a 2010 paper in the Journal of Macroeconomics where I examined whether the U.S. economy is an OCA. Looking at state data for the Great Moderation period, I concluded that there might have been some gain for the Rust and Energy Belts regions having their own currency during this period. There also would have been additional costs so I do not actually endorse the break up of the dollar zone in the article. However, what is interesting in retrospect is that period I examined in the article coincides with the decline in interstate labor mobility. It is no coincidence, then, that I got the results I did.

The policy implications seem clear. Policy makers at the local, state, and federal level need to push policies that increase labor market mobility. There is a lot of work to do on this front, but it is important to do so to keep the United States an OCA. The Schleichner paper provides some suggestions and is good starting point for discussion.

Related Links
(1) I interviewed David Schleichner about his paper in a recent podcast.
(2) See Alex Tabarrok's take on the decline in labor mobility

Friday, May 26, 2017

China vs the Trilemma, Price Level Path, Balance Sheet Confusion, and FOMC Debates

Here are some assorted macro musings from the past week:

1.  Been there, done that, and it did not end well China edition. Once again, China forgets there is a macroeconomic trilemma. From the Wall Street Journal:
China’s central bank is effectively anchoring the yuan to the dollar, a policy twist that has helped stabilize the currency in a year of political transition and market jitters about China’s economic management.... 
The newfound tranquility may not last: The focus seen in recent weeks on stability against the dollar, whether it goes up or down, means pressure on the yuan to weaken could get dangerously bottled up, potentially bring bouts of sharp devaluation.
Pegging an exchange rate, tinkering with domestic monetary policy, and allowing some capital flows can be a dangerous game to play. Chinese officials should stare long and hard at the picture below and recall how by ignoring it they created a crisis back 2015



2. St. Louis Fed President James Bullard notices the U.S. economy is falling off of its trend price level path in a recent speech.




In short, the Fed’s normalization plan calls for it to prop-up banks’ demand for cash, as a prelude to reducing the supply of cash! That means tightening and more tightening. The rub, of course, is that conditions may never justify so much tightening. What's more, no plan for Fed normalization can work that would prevent the Fed from meeting its overarching inflation and employment targets.

4. Peter Ireland on what we can learn from the FOMC debates as seen in the latest minutes. Among other things, Peter notes the following:
Digging into the details of the FOMC’s debate reminds us, as well, of important lessons from economy history. Participants who warn that low unemployment today raises the risk of higher inflation in the future are organizing their thoughts around the idea of the Phillips curve, which describes an inverse relation between those two variables. One lesson from history, however, is that while data do often support the existence of a statistical Phillips curve, its fit is not nearly strong enough to serve as a fully reliable guide for monetary policymaking. The limitations of the Phillips curve approach became clear, for example, during the 1970s, when chronically high unemployment was accompanied by rising, not falling, inflation. Today, we may be seeing something similar: unemployment is below 4.5 percent, yet inflation continues to run below the Fed’s long-run target.     
In fact, as other participants in the debate point out, inflation has been below target for the past eight years. If one accepts Milton Friedman’s famous dictum, summarizing historical experience that “inflation is always and everywhere a monetary phenomenon,” it is difficult to escape the conclusion that, despite an extended period of very low interest rates, Federal Reserve policy over this period has been insufficiently, not overly, accommodative. This echoes another lesson from the past. Milton Friedman, Anna Schwartz, Allan Meltzer, and Karl Brunner all concluded, likewise, that very low interest rates during the 1930s accompanied, and indeed were the product of, monetary policy that was consistently too restrictive.  

Friday, May 19, 2017

Bad Optics: the Fed's Balance Sheet Edition

Despite the all Fed talk about shrinking its balance sheets, many observers are hoping the Fed keeps it large.  They want the Fed to maintain a large balance sheet for various reasons: it earns a positive return for the government; it provides a financial stability tool via provisions of safe assets; it needs to remain big and accommodative until the economy really starts roaring. There are also complications to shrinking the Fed balance sheet.

Whatever you make of these arguments they all ignore an important political-economy consideration: a large Fed balance sheet makes for bad optics because of interest paid on excess reserve (IOER). 

The figure below explains why. Using data from the Federal Reserve's H8 report, the figure shows the cash assets of "large domestically-chartered" banks and "foreign-related" banks.  The figure reveals the cash assets of these two bank categories combined tracks excess reserves fairly closely. They are, in other words, the main holders of excess reserves and consequently the main recipients of the IOER payment. 


Think about the implications: the banks that were bailed out during the crisis and the banks owned by foreigners are getting most of the IOER payment. This is a perfect storm of financial villains for both the political left and the right. That is why I agree with Ramesh Ponnuru that it politically naive to think the Fed can maintain a large balance. 

And note, the bad optics will only look worse if the Fed's balance sheet does not shrink as interest rates go up. For the IOER payment will go up too. Imagine Fed Chair Janet Yellen having to explain to Congress the growing dollar payments going to these banks.

That is not to say it will be easy to shrink the Fed's balance sheet. There will be big challenges as I have noted elsewhere. But the bad optics do mean that it is likely the Fed will be forced to shrink its balance sheet. 

Tuesday, May 16, 2017

Talking Monetary Policy with Paul Krugman

Paul Krugman joined me for the latest Macro Musings podcast. It was a fun show and we covered a lot of ground from liquidity traps to secular stagnation to fighting the last war over inflation. Paul and I have had conversations in the blogosphere since the 2008 crisis so it was real treat to finally chat with him in person.

In our conversation there were two issues brought up that deserved more time, in my view, than we could give on the show. So I want to address them in this post.

The first one is the important distinction between temporary and permanent monetary base injections. This distinction came up up in our discussion on what it takes to reflate an economy in a zero lower bound (ZLB) environment. Krugman's 1998 paper showed that to do so requires a permanent increase in the monetary base whereas a temporary one will not work. This 'irrelevance result' was further developed by Eggertson and Woodford (2003) who showed that QE programs that are temporary in nature will not spur rapid aggregate demand growth. Others have since built upon this point and there is also earlier monetarist literature that makes a similar argument (source). Here is an excerpt from a Michael Woodford FT piece in 2011 that nicely summarizes this view1:
The economic theory behind QE has always been flimsy. The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank's supply of base money. Because of this, at least in the long run, any increase in supply must raise prices proportionally. It followed that, in the short run, QE must also have an effect on spending levels, that will eventually tend to raise prices, even if the channels by which this occurs are obscure.  
The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan's experiment with QE, the added reserves were all rapidly withdrawn in early 2006. More worryingly for Mr Bernanke, whatever the long-run effects would have been, there was no increase in nominal growth over the five years of the experiment.  
The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.
Woodford acknowledges the Fed's large scale assets purchases can help when financial markets freeze up like during QE1, but beyond that will not create the kind of robust aggregate demand growth required to quickly escape a ZLB environment.

For me, the implication of this understanding is that the Fed should have aimed to return the price level (or nominal income) to its previously-expected growth path following the crisis. Krugman, on the other hand, is worried that might not be enough if secular stagnation is real. He, consequentially, prefers a permanently higher inflation rate whereas my approach would imply only a temporary one. In short, I want a level target for monetary policy whereas Krugman wants a higher inflation target.

I also want to be clear as to exactly what is a permanent monetary base injection. First, it is an (exogenous) injection beyond that warranted by normal money demand growth. That is, an increase above the regular growth created by currency demand, required reserves, and other normal (endogengous) sources of monetary base growth. Second, the actual permanent increase need not be very large given the long-run unitary relationship between the monetary base and the price level (after controlling for real growth). Third,  the permanent increase does not mean the monetary base injection is permanent throughout eternity. Only that it is permanent to the extent the current economic conditions that warranted the injection continues to hold. New economic developments may call for additional permanent changes to the monetary base. Finally, most central banks cannot credibly commit to such permanent increases in the monetary base, as evidenced by the record-low inflation in advanced economies since the crisis.  For more on these points see this recent paper of mine.

The second issue is my suggestion that fiscal policy could be used to stabilize the money supply. This came up near the end of the podcast when we started discussing the safe asset shortage problem. The key idea here is that the money supply properly measured includes both retail and institutional money assets. The Center for Financial Stability (CFS) has estimated such a measure. It is the Divisia M4 money supply which includes athe retail money assets in M2 plus institutional money assets. The latter include repos, commercial paper, institutional money market funds, and large-time deposits. 

As Gary Gorton and others have shown, there was a bank run on these institutional money assets during the financial crisis that led to a sizable and persistent reduction in their supply. This can be seen in the figure below which uses the M4 component data from the CFS:


This persistent shortfall in the privately-produced institutional money assets seen above was partially offset by the rise in treasury bills.  More of the shortfall could, in theory, be offset by the issuance of additional treasury bills. That was the point I was trying to make. The big question here is could the U.S. Treasury issue enough treasury bills to fill the institutional money asset shortfall without jeopardizing its risk-free status? I do not know. But it is one possible solution to the safe asset shortage problem.

The chart below builds upon the last figure by plotting the institutional money assets along side the retail money assets (or M2). Together they make up the M4 money supply. The figure reveals that even though the M4 money supply is now past its pre-crisis peak, is still far below its pre-crisis trend path. It never has fully recovered from the Great Recession. This could be part of the story for the weak recovery and, arguably, treasury could help.



Related Links
Permanent versus Temporary Monetary Base Injections: Implications for Past and Future Fed Policy
Scott Sumner on Paul Krugman's podcast

1 The Michael Woodford article ran in the Financial Times on August 26 and was titled "Bernanke Should Clarify Policy and Shrink QE3"

Friday, May 12, 2017

Dollar Domination, Robot Monetary Overloads, and Closing the AD Gap

Some assorted musings:

1. From this week's podcast with Ethan Ilzetzki comes this amazing figure. It shows that approximately 70% of world GDP is tied to the dollar. The implication is staggering: the FOMC is setting monetary conditions for much of the world.


2.  Greg Ip argues our robot fears are misplaced. If anything, we do not have enough robots destroying jobs:
From Silicon Valley to Davos, pundits have been warning that millions of individuals will be thrown out of work by the rapid advance of automation and artificial intelligence. As economic forecasts go, this idea of a robot apocalypse is certainly chilling. It’s also baffling and misguided. Baffling because it’s starkly at odds with the evidence, and misguided because it completely misses the problem: robots aren’t destroying enough jobs...  
This calls for a change in priorities. Instead of worrying about robots destroying jobs, business leaders need to figure out how to use them more, especially in low-productivity sectors.
Okay, what industries fit this description? Greg mentions the usual suspects: education, healthcare, and leisure and hospitality. Here is another one: central banking. It has not changed much in many decades and probably has low productivity. So maybe the hidden message of Greg's article is we need to get robots running the Fed?  My answer: sure, but only if they are targeting a NGDP futures market as proposed by Scott Sumner. This approach, after all, is fairly automatic by design and therefore conducive to our robot overlords taking over the Fed.

3. The CBO estimates the full-employment level of aggregate demand. They unfortunately call it "potential nominal GDP' which is horrific since the potential is truly infinite--think Zimbabwe's NGDP in 2008--so ignore the official name. The idea behind the measure is reasonable: what level of aggregate nominal spending is consistent with full employment. Here is the series lined up against actual aggregate demand as measured by NGDP. 


The figure indicates there was a sharp collapse in aggregate demand during the crisis and the full-employment level has only slowly converged to it. Therefore, there was both a sharp decline in aggregate demand (a cyclical shock) and a downward adjustment in the full-employment trend level of aggregate demand (a structural shock). This understanding is consistent with the recent Fernald et al. (2017) BPEA paper that found that there was both a demand shortfall (that ended by mid-2016) and a decline in potential real GDP. So the CBO's full-employment level of aggregate demand seems quantitatively reasonable.  


For fun, I plotted the difference between the full employment level and actual aggregate demand--the AD gap--against the latest hip labor market indicator. It is the working-age employment rate (a termed coined by Jordan Weissmann) which is more commonly known as the employment-to-population rate for prime-age workers (25-54 year olds). Nick Bunker has been a tireless advocate for using this measure to replace the unemployment rate as the headline labor market indicator. 

So how does the working-age employment rate measure up against the AD gap? Not too bad according to the figure below. The relationship is not perfect, but it is strong enough to indicate that the continued upward recovery of the working-age employment rate over the past few years has been largely due to cyclical factors.