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Wednesday, January 24, 2018

Summer Program on Monetary Policy for Students

Here is a great summer program for advanced undergraduate or beginning graduate student that are interested in monetary economics. Scott Sumner and I will be presenters and St. Louis Fed President Jim Bullard will be the keynote speaker. Your travel and lodging will be covered, but you need to apply by January 31. 
Alternative Money University (AMU) is an academic workshop for advanced undergraduate and beginning graduate students with a particular interest in monetary economics. During three days of intensive seminars, students will learn from leading scholars in the field about subjects not typically addressed in undergraduate or graduate economics courses — including topics in monetary history, the theory and practice of monetary policy, and the workings of unconventional monetary arrangements. Between them, the subjects covered and the seminar-style of the sessions are intended to provide students with a solid foundation upon which to build their own, future contributions to the field.
Held in Washington, DC, expenses for attending AMU — including travel and accommodations — will be covered by Cato’s Center for Monetary and Financial Alternatives. Admission is limited to 30 students, who must be in or about to enter either their ultimate year of undergraduate study or their first year of graduate studies. Selections will be based on students’ academic records and demonstrated interest in monetary economics.
Click here for more information. I hope to see you there!

Sunday, January 14, 2018

Do Changes in Potential Output and Data Revisions Make NGDP Targeting Impractical?

It's Back...
Over the past few months there has been increasing chatter about the need for a new framework for U.S. monetary policy. The Peterson Institute for International Economics (PIIE), for example, recently had its Rethinking Macroeconomic Policy conference where, among other things, Ben Bernanke called for the Fed to adopt a temporary price-level target. PIIE also launched Angel Ubide's new book  on reforming monetary policy. Similarly, at the AEA meetings there was a session titled Monetary Policy in 2018 and Beyond where Christina Romer again made the case for a NGDP level target. Likewise, the Brookings Institute held a recent conference on whether the Fed should abandon its 2 percent inflation target. There, Jeff Frankel shared the arguments for a NGDP level target and Larry Summers endorsed it. Others at the conference, like San Francisco Fed President John Williams called for a price level target.

I am glad this conversation is happening. It is not new--some of us have been having it since 2009--but I get the sense that it is gaining traction. The turnover at the Fed and the opportunity it creates for new thinking makes this conversation about new monetary policy frameworks incredibly important now. 

As this conversation continues to grow, so will the interest in the options available including nominal GDP level targeting (NGDPLT). Obviously, I have much to say here, but for now I want to respond to two critiques often applied to NGDPLT: (1) changes in potential output and (2) data revisions make NGDPLT an impractical rule to implement. I think these concerns are misplaced as explained below.

Critique 1: Changes in Potential Output: A Feature or a Bug for NGDPLT?
Since NGDP growth is approximately the sum of real GDP growth and inflation, many observers are concerned that changes in potential output will cause wide swings in inflation. Here, for example, is Goodhardt et al. (2013):
[A]ny overestimation of the sustainable real rate of growth... could force [a central bank], subject to a level nominal GDP target, to soon have to aim for a significantly higher rate of inflation. Is that really what is now wanted? Bring back the stagflation of the 1970s...?
Put differently, some worry that a NGDP target will not provide a stable nominal anchor. For these folks this is a bug in NGDPLT. This concern is unwarranted for several reasons.

First, a NGDPLT target does provide a nominal anchor. It pins down the long-run growth path of nominal income. Put differently, it approximately stabilizes the growth path of nominal wages. Yes, it will allow more flexibility with inflation but as argued later that may be a good development.

Second, on a practical level, a NGDP target would never have generated 1970s-type swings in inflation given the actual history of potential output growth. The figure below illustrates this point. It assumes a 5% NGDP target and takes the year-on-year growth rate of the CBO's potential real GDP measure (blue line) as given. The trend inflation rate (black line) implied by this counterfactual monetary policy is plotted in the figure.


In this counterfactual, the inflation trend rate averages 1.97 over the entire 1960-2017 period. At most, it temporarily hits just above 4 percent right after the crisis. There is no 1970s inflation. Fears that a NGDPLT will bring back 1970s-type inflation is a red herring.

Interestingly, this counterfactual would have led to lower inflation in periods of high-trend real GDP growth periods like the 1960s and led to higher inflation in low-trend GDP growth periods like the present. To the extent there is hysteresis and potential real GDP is not truly exogenous to monetary policy, the counterfactual higher inflation (as a symptom of higher nominal demand) may have actually reduced the collapse in potential output over the past decade.In any event, a NGDPLT since 1960 would not have led to soul-crushing swings in inflation that some claim.

What many observers miss is that with a NGDPLT target the central bank does not need to worry itself over the latest changes to potential output. As the chart shows above, these changes happen fairly regularly. A NGDPLT lets these potential output changes be absorbed through reasonably-sized changes in the inflation rate. Inflation flexibility provided by a NGDPLT is a virtue here.2

Monetary policy, as it is currently practiced, does not have freedom. Most inflation-targeting central banks loosely follow something like a Taylor rule where they need to know the output gap in real time. That requires knowing both real GDP and potential real GDP in real time--an impossible task.

A NGDPLT acknowledges this ignorance and says to simply focus on stabilizing nominal demand. Potential output changes are therefore a feature rather than a bug for NGDPLT.

Critique 2: Data Revisions Make NGDP an Impractical Framework
There are two replies to this. First, as noted above, inflation targeting as it currently practiced requires real-time knowledge of both real GDP and potential real GDP.  This Taylor-rule framework is therefore is also subject to data revisions. Moreover, it subject to two of them. A NGDPLT target, on the other hand, only faces one variable subject to data revisions. So if data revisions make NGDPLT impractical even more so for the current inflation targeting framework.

Second, as Josh Hendrickson and I show in a recent paper, the Fed's forecast of NGDP for the current period is not biased (i.e. the forecast error is stationary). That means even if there are data revisions to the official statistics, the Fed can rely on its forecasts of NGDP to avoid this challenge. Below is chart from our paper that captures this ability of the Fed:


We also show in the paper that the Fed's forecast of the potential GDP is biased (i.e. the forecast error has a unit root). Consequently, the data revision argument against NGDP is not a convincing one, while it is a serious one for flexible inflation targeting.

For me, then, I do not worry about the above two critiques. The real issue with NGDPLT, in my view, is how to credibly implement it. But that is a topic for another post.

Update
As commentator John notes, these problems could also be addressed by Scott Sumner's NGDP futures contracts idea. I would also note that directly targeting a monthly nominal wage index in the manner outline by George Selgin would be another fix.

Related Links
NGDPLT and the Problem of Permanent vs Temporary Monetary Base Injections 
NGDPLT and the Eurozone Crisis

1 A forceful case for hysteresis in the U.S. economy is made by Reifschneider, Wascher, and Willcox (2013)J.W. Mason (2017), and Coibion, Gorodnichenko, and Ulate (2017).
2There are other reasons why the countercyclical inflation created by a NGPDLT would be beneficial. It would lead to better risk-sharing between creditors and debtors as shown in Koenig (2013), Sheedy (2014), and Bullard et al. (2015).

Wednesday, January 10, 2018

Yes, IOER Continues to be Bad Political Optics

So the Federal Reserve is reporting that interest on excess reserves (IOER) payments hit $25.9 billion in 2017. This amount is more than double the dollar size of the IOER payments in 2016 as seen below. 


This increase is understandable given the rise in the Fed's short-term interest rate target and the size of its balance sheet. But, as I have noted before, this is horrible optics. For the largest recipients of the IOER payments are large domestic banks and foreign banks. As seen in the figure below, they hold most of the excess reserves and therefore earn most of the IOER payments. 


Put differently, the systematically-important or "too-big-to-fail" banks that were bailed out during the crisis and are still implicitly subsidized by the government as well as foreign banks are the main recipients of IOER. It gets worse. Note in the table above that the higher IOER payments are associated with declining remittances to the Treasury Department. The Fed, in other words, is allocating more funds to big banks and less to the public. This is easy fodder for the "Wall Street vs. Main Street" critics. Because of this, I suspect the IOER in its current form will be increasingly a tough sell to make to Congress.

There is an easy fix to this problem. The Fed can move from its current floor system to a corridor system. Under the latter, the balance sheet can shrink down so that there are few reserve balances in the banking system1. The Fed can still have IOER, but it would be less than short-term market interest rates.2 The IOER would set an floor for short-term interest rates and the Fed's lending rate would be the ceiling for short-term market interest rates. Together this would constitute a corridor system and give the Fed ample control over interest rates. 

Update: To clarify the difference between a corridor and floor system, here is a figure distinguishing the two approaches from the NY Fed. Note in both cases the IOER remains.


1Just because a corridor system would have fewer reserves does not mean it would necessarily be a "scarce-reserve" balance sheet. Reserve scarcity is not about the quantity of reserves, but about their supply relative to their demand. All a smaller Fed balance sheet does is affect the supply of reserves. The Fed can also reduce reserve demand by lowering IOER. Depending on how it adjusts IOER will determine whether there is reserve scarcity. Consequently, observers need to be careful to avoid automatically associating small reserve balances with reserve scarcity.
2In the current floor system, IOER is above short-term market interest rates and is the source of many problems with the system. 

P.S. George Selgin in Congressional testimony today makes the case for the Fed moving to a corridor system. Norbert Michel also makes the case in his testimony. 

Monday, December 25, 2017

Christmas Economics 2017


We are replaying our special Christmas podcast. The guest are Anna Goeddeke and Laura Birg, two economists from Germany. Together they coauthored an article in Economic Inquiry titled “Christmas Economics—a Sleigh Ride” that surveys the literature on the economics of Christmas. We covered a number of interesting topics like the seasonal business cycle, the deadweight loss of Christmas, and charitable giving during the holidays. 

Below is an excerpt from an earlier post when the episode first ran that touches on on the business cycle issues surrounding Christmas:
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. 
There is much more in the show. Merry Christmas everyone!

Monday, December 11, 2017

Yes, Occupational Licensing is Making the U.S. Economy Less of an OCA

From a new working paper by Janna E. Johnson, Morris M. Kleiner:
Occupational licensure, one of the most significant labor market regulations in the United States, may restrict the interstate movement of workers. We analyze the interstate migration of 22 licensed occupations. Using an empirical strategy that controls for unobservable characteristics that drive long-distance moves, we find that the between-state migration rate for individuals in occupations with state-specific licensing exam requirements is 36 percent lower relative to members of other occupations. Members of licensed occupations with national licensing exams show no evidence of limited interstate migration.
Not only does this development have implications for workers, it also has macroeconomic implications. For the decline in interstate labor mobility, caused in part by occupational licensing, is making the U.S. economy less of an optimal currency area. From an earlier post:
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.
Johnson and Kleiner provide evidence that that suggests more licensing reciprocity agreements among states could increase interstate mobility. That, in turn, would help push the U.S. economy back in the direction of an OCA. 

HT Tyler Cowen

PS Here is my interview with David Schleicher on declining labor mobility. We discuss its implications, including the gradual retreat of the U.S. economy from the OCA criteria as noted above. Our conversation was based on his paper "Stuck! The Law and Economics of Residential Stability".

Why You Should Care about Divisia Monetary Aggregates

I recently had Bill Barnett on my podcast to discuss his work on Divisia monetary aggregates. Below the fold is a tweetstorm by Josh Hendrickson on why we should care about this work.

Thursday, December 7, 2017

Clashing Over Commerce


Doug Irwin's new book on the history of U.S. trade policy, Clashing Over Commerce, is now available for purchase. You may recall that I interviewed him about the book in this recent podcast. The podcast is embedded below. My colleague Dan Griswold has a nice review of the book over at National Review.  I learned a lot from the book and my conversation with Doug. I highly recommend it.