Tuesday, January 24, 2017

Macro Musings Podcast: Gauti Eggertsson

My latest Macro Musings is with Gauti Eggertson. Gauti is a professor of economics at Brown University and formerly worked in the research departments of the International Monetary Fund and the Federal Reserve Bank of New York. He has written widely on liquidity traps, deflation, and the zero lower bound (ZLB) and joined me to talk about these issues.

This was a fun conversation and a good look back at the challenges and shortcomings of macroeconomic policy since the crisis in 2008. One of the big takeaways from our conversation, at least for me, is that central banks during this time ignored many of the key findings in the literature when it comes to best practices at the ZLB.

Before getting to these missed opportunities, it is worth recalling the nature of the ZLB problem. It emerges when there has been a severe recession that forces down the 'natural' or market-clearing level of short-term interest rates to a level well below 0%. The Fed's normal response, lowering interest rates to the level of the natural interest rate, does not work here because the Fed will run up against a lower bound where people would rather hold cash than earn a negative interest rate on their deposits. This lower bound is effectively a price floor that prevents the economy from properly healing and quickly returning to full employment. 

So what can policymakers do? Gauti's work gives an answer. Specifically, his 2003 paper with Michael Woodford (which builds upon Paul Krugman's 1998 paper) shows that policymakers need to credibly commit to an expected path of interest rates that will restore the pre-crisis path of the price level. Put differently, Gauti's work implies the best defense against and escape from a depressed economy is some kind of level targeting. Gauti favors an output-gap adjusted price level target. As Michael Woodford noted in his 2011 talk, this effectively amounts to a nominal GDP level target or restoring the growth path of nominal spending. 

One implication of this understanding is that if there is any disinflation or deflation from a collapse in aggregate demand during a recession there needs to be an offsetting period of reflation to restore the aggregate demand growth path. This did not happen after 2008 and implies aggregate demand growth was persistently weak. This was a missed opportunity by the Fed.

The Fed, instead, tried various rounds of QE. And it did so in exactly the manner that Eggertson and Woodford (2003) and Krugman (1998) said would lead to the famous  'irrelevance results'. That is, the Fed did these programs using temporary monetary base injections, whereas only permanent injections matter. 

What is truly surprising about this observation is that the permanent injections point is widely understood. For example,  here is a list of prominent New Keynesians who acknowledge it (including former Fed chair Ben Bernanke). And here is a list of quantity theory advocates making the same point.

To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment. 

So why did the Fed ignore the literature and fall right into the irrelevance results trap? I have a working paper that takes a stab at this question. I argue there were both external forces (public's fear of inflation vented via Congress) as well as internal ones (Fed still fighting the last battle and suffering from loss aversion) that kept the Fed timid. In our interview, Gauti made an interesting observation related to this point. The Fed seemed okay being aggressive with QE, but not with reflation. It is a bit of puzzle why it was so bold in the former but timid in the later. 

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Gauti and I also touched on how best to sell level targeting to policymakers and the public. Here is a recent Bloomberg article that looks at Gauti's innovative attempt to do so at the New York Fed in 2010 using 'Inflation Budget Accounting". Below is an excerpt:
We suggest that the FOMC keeps track of the extent to which it has "missed" its inflation target. Let us call these accumulated misses "inflation debt". Hence if the inflation target is 2 percent, and inflation is at 1 percent for two years in a row, then the accumulated "inflation debt" is 2 percent. 
The FOMC would then announce an "easing bias" until the inflation debt accumulated in the current recession has been extinguished. If this is credible, a deflationary reading of the data would signal a larger "easing bias" going forward.
As I note in my working paper mentioned above, the Fed has been explicit about its plan to eventually shrink its balance sheet. It said so in its exit strategy plans reported in the June 2011 and September 2014 FOMC meetings. Janet Yellen recently reiterated those plans in her August 2016 Jackson Hole speech (see footnote 13). More recently, the Federal Reserve updated its basic guidebook to monetary policy in October 2016. Here too it stresses the balance sheet will be reduced:
As the policy normalization process proceeds, the Federal Reserve’s securities holdings—and the supply of reserve balances—will be reduced in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the portfolio...
The FOMC intends that the Federal Reserve will, over the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities (p.52)
And if there were any questions about what this means, the Fed later notes that "no more securities than necessary" means doing away with the overnight  reverse repurchase facility:
During normalization, the Committee is using an overnight reverse repurchase (ON RRP) facility as a supplementary tool as needed to help control the federal funds rate... The FOMC plans to use the ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate (p.51).
I would also add from a political economy perspective that the balance sheet will have to be reduced given IOR. The increasingly bad optics of the Fed paying banks larger interest payments as interest rates go up  will force the Fed's hands on reducing its balance sheet.

Sunday, January 22, 2017

Note to President Trump: It's Policy Divergence, Not China, Driving the Dollar

President Trump is worried about the strong dollar:
In his interview with the Journal on Friday, Mr. Trump said the U.S. dollar was already “too strong” in part because China holds down its currency, the yuan. “Our companies can’t compete with them now because our currency is too strong. And it’s killing us.”
The real issue is not China but the diverging of the current and expected paths of monetary policy among the major advanced economies, particularly the United States and Europe. The Fed has been tightening and is expected to continue do so with further rate hikes in 2017. The ECB, on the other hand, is still running its QE program and is keeping it short-term policy rates pegged close to zero. 

This policy divergence can be seen in the figure below. It shows the 6-month interest rate, 6 months ahead for the United States minus the same measure for the Eurozone (blue line).1 Ever since mid-2014 this spread has been rising--with a brief plateauing in 2016--and the trade weighted dollar (red line) has closely followed it.

Part of the divergence between the expected paths of monetary policy comes from the belief that Trump's policies will spur robust growth. This belief may prove premature, but if it does come to fruition it will only reinforce the policy divergence by pushing interest rates higher.  Going after China will not change this policy divergence. 

The surging dollar, if anything, creates more problems for the rest of the world than for the U.S. economy.  It is something to worry about, as I have noted before, because there is a lot of foreign debt denominated in dollars and because other currencies tied to the dollar will also strengthen.  But this is a very different problem than the one President Trump sees with the strong dollar. 

1 I calculate this 6 month interest rate, 6 months ahead as follows.

Friday, January 20, 2017

Macro Musings Podcast: Anat Admati

My latest Macro Musing podcast is with Anat Admati. Anat is a professor of finance and economics at Stanford University. Since the crisis in 2008, she has also been a fervent advocate of banks using more equity and less debt to fund their investments. As part of this effort, Anat coauthored the book "Bankers' New Clothes: What's Wrong with Banking and What to Do About it". She joined me to talk about these and other issues related to the stability of the U.S. banking system.

It was a fun and interesting conversation throughout. We covered everything from the distortions created by the Basel bank regulations to the still inordinate amount of bank leverage to the prospects for a safer financial system. One of the more sobering implications of our discussion is that the U.S. banking system is not much safer today than it was in 2008. This is a point also made by Larry Summers in a recent Brookings Paper

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Anat Admati Homepage
Anat Admati Twitter Account
Paper - It Takes a Village to Maintain a Dangerous Financial System
Paper - Contingent Liability, Capital Requirements, and Financial Reform

Friday, January 13, 2017

Macro Musings Podcast: Allan Meltzer

My latest Macro Musing podcast is with Allan Meltzer. Allan is a professor of economics at Carnegie Mellon University and a visiting fellow at the Hoover Institution. He is also a well-known monetarist and author of the authoritative multi-volume history of the Fed

We had a wide-ranging conversation on everything from Allan's role in the Monetarist's Counterrevolution to his reinterpretation of Keyne's General Theory to his take on current Fed policies. Among other things, I learned that Allan formerly worked under Paul Volker in the Kennedy Administration.  

This was a fun interview and Allan showed he still has a lot of spunk in him. The interview taped live in front of audience at the Southern Economic Association meetings last November. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Friday, January 6, 2017

Macro Musings Podcast: Ylan Mui

My latest Macro Musings podcast is with Ylan Muy of the Washington Post. She was the Fed beat reporter for several years and now covers economic policy at the White House. She joined me to discuss what it was like covering the Fed and what we might expect going forward from President Trump's economic policies.

This was a fascinating conversation throughout and we covered everything from the tight security of FOMC press meetings to the future of the Fed's balance sheet to whether the Fed will ever have a truly symmetric 2% inflation target. We also considered whether Trump's economic policies will truly live up to the market's expectations for them. One thing we do know for sure is that 2017 will be an interesting year for U.S. economic policy and Ylan will have much to cover for the Washington Post.

Ylan also shared that she is working with the Brookings Institute on a book about negative interest rates as a tool for monetary policy. It sounds interesting and I look forward to reading it.

Finally, Ylan and I discussed the lack of women in macroeconomics. A recent article in the Journal of Economic Perspectives reminded us that a disproportionately small share of women are in the economics profession. This problem seems to be even more pronounced in macroeconomics. Ylan shared her observation on this challenge and talked about her related work on Janet Yellen breaking barriers in macroeconomics.

This was great episode to start the new year. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Ylan Muy's articles at the Washington Post
Ylan Muy's Twitter Account

Friday, December 23, 2016

Macro Musings Podcast: Xmas Economics

My latest Macro Musings podcast is a special holiday edition on the economics of Christmas.Two special guests joined me all the way from Germany to discuss this topic. My first guest was Anna Goeddeke, a professor of economics at ESB Business School in Reutlingen, Germany. My second guest was Laura Birg, a postdoctoral researcher at the Center for European, Governance, and Economic Development Research, University of Göttingen 

Together they coauthored an article in Economic Inquiry titled “Christmas Economics—a Sleigh Ride” that surveys and summarizes the economics literature on Christmas. It is a great read for this time of the year and was the basis of our conversation. We touched on a number of interesting topics like the seasonal business cycle, the deadweight loss of Christmas, and charitable giving during the holidays.

The seasonal business cycle discussion was particularly fascinating for me. There is a literature that starts with Barksy and Miron (1989) (ungated version) that shows most of the variation in aggregate economic measures like GDP comes from seasonal fluctuations. Yet most macroeconomists, myself included, typically start our analysis with seasonally-adjusted data. Here is a Barky and Miron summarizing their findings on GDP for 1948:Q2-1985:Q5:
The standard deviation of the deterministic seasonal component in the log growth rate of real GNP is estimated to he 5.06%, while that of the deviations from trend is estimated to be 2.87%. Deterministic seasonal fluctuations account for more than 85% of the fluctuations in the rate of growth of real output and more than 55% of the (percentage) deviations from trend. Business cycle fluctuations and/or stochastic seasonal fluctuations represent a relatively small percentage of the fluctuations in real output. Plots of the log level of real output (Figure 1) and the log growth rate of real output (Figure 2) make this point even more clearly. The seasonal fluctuations in output are so large and regular that the timing of the peak or trough quarter for any year is rarely affected by the phase of the business cycle in which that year happens to fall. 
Unfortunately, the BEA no longer makes available non-seasonally adjusted GDP data. However, we can look at other times series to see how large seasonal swings can be relative to recessions. For example, below is retail sales:

What makes this really interesting is that these wide swings in economic activity are not matched by similarly-sized swings in the price level. Most of the seasonal boom is in real activity. Put differently, there is an exogenous demand shock every fourth quarter where prices remain relatively sticky so real activity surges. This is a microcosm of demand-side theories of the business cycle. It seems, then, that more could be learned about broader business cycle theory from studying GDP and other time series in their raw non-seasonally adjusted form. That will have to wait, however, until the BEA starts releasing the data.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more shows are coming.

Monday, December 19, 2016

The Trump Shock and Global Interest Rates

One more quick note on the Trump shock and interest rates. For some time I have been following the global safe asset shortage problem and how it has created a downward march of safe assets interest rates. This can be seen in the figure below:

The latest development in this story is that the safe asset interest rates have all started heading up, as seen in the above figure. Even Japan's which is supposed to be targeted at 0 percent but has climbed to 0.8 percent. Now these yields have a long ways to go before reaching normal levels and they started rising before Trump's election. But since the election the ascension of these interest rates has accelerated in many cases. This is a bit puzzling. It is one thing to think the Trump shock has changed the growth and inflation outlook in the United States so that treasury yields are now going up, but why the other advanced economies?

As you may recall, the safe asset shortage story says there has been a price floor (ceiling) on safe asset interest rates (bond prices) that has kept the market for safe assets from properly clearing. (See this pre-2008 figure and post-2008 figure for a graphical representation of this story.) The shortage was a big deal because these securities functioned as transaction assets for institutional investors. The shortage, therefore, amounted to an effective shortage of money that was evident in the below trend growth of broad monetary aggregates that measure both retail and institutional money assets. 

There were there three solution paths that could solve this problem: increase the supply of safe assets, decrease the demand for safe assets by improving the economic outlook, or do negative interest rates. These three paths are depicted below:

The Trump shock seems to be working through the first two options for U.S. treasuries. First, the Trump infrastructure plans and tax cuts imply larger budget deficits. Second, the spending and supply-side reforms suggest an improved economic outlook that is decreasing demand for treasury securities. This story, though, only explains the U.S. situation. 

What is puzzling is why the Trump shock seems to be causing foreign safe assets yields to rise. Maybe it is the reverse of the Caballero, Fahri, Gourinchas (2016) story that says shortage of safe assets problem will spread from one country to another. That is, the easing of safe asset pressures in the United States is causing an easing of safe asset pressures elsewhere. But that story runs up agains the potential global economic downside from a stronger dollar that will result from a stronger U.S. economy. So I am left a bit puzzled.