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Friday, January 31, 2014

The Two Big Failures of the Bernanke Fed

The Bernanke era at the Fed came to an end today and many are already opining on what it means. Many smart things have been said about the Bernanke Fed, but most accounts have overlooked two of its biggest failures. No assessment of the Bernanke Fed is complete without recognizing them. So what were these two failures?

First, the Bernanke Fed never tried Abenomics. That is, for all the Fed has done over the past five years it never tried to do the kind of monetary regime change now being done by the Bank of Japan. A year ago, Japanese monetary authorities shook things up by credibly committing to permanently raising the nominal size of the Japanese economy. The evidence so far shows this program to be a smashing success. From the start, the Bernanke Fed took the opposite approach. It credibly committed to a temporary expansion of its balance sheet. The U.S. monetary injections, therefore, were never intended to be permanent and this makes all difference in the efficacy of monetary policy.

So for all the praise the Bernanke Fed gets for preventing the second Great Depression, it should be equally noted that it allowed the long slump. By failing to do Abenomics for the U.S. economy, the Bernanke Fed effectively kept monetary policy tight for the past five years. There is no other way to say it.

Okay, maybe there is another way to say it. The Bernanke Fed failed to meaningfully address the endogenous fall in the money supply and the decrease in money velocity. The Bernanke Fed could have done an American version of Abenomics, like nominal GDP level targeting, that would have arrested these developments. Instead, it did not and passively allowed total dollar spending to remain depressed. This failure to act is no different than an explicit tightening of monetary policy in terms of damage done to the economy. The only difference is that the public is more aware of the explicit form.

In my view, this is the biggest failure of the Bernanke Fed. It had  many opportunities to do it and much encouragement (e.g. Christina Romer's call for Ben Bernanke to have a a Volker Moment). But it was not the only serious failure. There was another big one that preceded it. 

Tuesday, January 28, 2014

When Monetary Superpowers Flex, Emerging Market Investors Flee

A common theme on this blog has been that the Federal Reserve is a monetary superpower. Consequently, it has had an outsized role in shaping global liquidity conditions. Here is how I explained it before:
I have made the case many times that the Federal Reserve is a monetary superpower. The Fed has this power because it manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. As a result, its monetary policy gets exported to much of the emerging world. The ECB and Bank of Japan are also influenced by the Fed's decisions because they are careful not to let their currencies becomes too expensive relative to these dollar-pegged currencies and the dollar itself.  U.S. monetary policy, consequently, gets exported to the Eurozone and Japan as well.  

This understanding helps explains why there was a global liquidity glut during housing boom period and suggests that some of the "global saving glut" was simply a recycling of loose U.S. monetary policy.  It also implies that the Fed could now do a lot of good for both the U.S. and Eurozone economies if were to adopt something like a NGDP level target.  Based on this view, the global economy sorely needs the Fed to wake up from its slumber. Fed Chairman Ben Bernanke admitted as much in one of his classroom lectures earlier this year
Lars Christensen makes a compelling case that China also acts as a monetary superpower, at least for the emerging markets and commodity exporters. The actions, then, of both the Federal Reserve and the People's Bank of China (PBoC) matter immensely to the rest of the world. This seems especially true now as the expected tightening of monetary policy by these central banks is hitting emerging market hard. Ambrose Evans-Pritchard reports :

Turkey, India, Brazil and a string of emerging market countries are being forced to tighten monetary policy to halt capital flight despite crumbling growth, raising the risk of a vicious circle as debt problems mount.

[...]

The emerging market bloc makes up half the world economy, far higher than in any previous crisis. The International Monetary Fund warns that the sheer weight of these countries' rate raises could lead to a “blowback” effect that ultimately hits the US, Europe and Japan as well.
“The epicentre of the global financial storm had shifted to emerging markets from Europe, and this third phase of the global financial crisis is intensifying. We are still in the very early stages,” said Stephen Jen from SLJ Marcro Partners.

[...]

Simultaneous monetary tightening by China’s central bank and the US Federal Reserve has been the trigger for latest rout, so any sign that either Beijing or Washington is having second thoughts is an instant tonic for investors.

“We have all these countries in trouble like Argentina, Ukraine and Thailand that are each local cases, but behind the whole emerging market story is Fed tapering and worries about slowing Chinese growth,” said Lars Christensen from Danske Bank. “China is now a global monetary superpower, co-leader with the US. When China tightens, that hits trade and commodities across the world.” 
Even though the actions of the Federal Reserve and the PBoc may have been the catalyst to these latest worries, the emerging markets could have been better prepared for the inevitable tightening:
“Emerging economies squandered precious opportunities in the past decade to reform and restructure for the new globalised world. Instead, they rode on the coattails of China and ample global liquidity,” said Mr Jen, a former IMF firefighter.
Be that as it may, the interesting question going forward is how policymakers will respond. India and Brazil have already incrementally raised their policy interest rates. And today we learned that Turkey decided to one-up them by going the "shock and awe" route: it raised its interest rate target from 7.75% to 12.00%. I am all for utilizing the power of expectations, but this sharp rate hike could end badly. Will the Federal Reserve also respond to these developments? We find out tomorrow.

Addendum: The growing importance of the emerging markets to the world economy can be seen in the figure below.




Monday, January 27, 2014

The Fed's Foward Guidance is Not Truly State Dependent

In my previous post I criticized the Fed's forward guidance without explicitly getting into the difference between time dependent and state dependent forward guidance. Time dependent forward guidance is when a central bank attempts to shape the expected path of interest rates without conditioning on the state of the economy. Sate dependent forward guidance does condition on the state of the economy. The latter approach is better and is what the Fed claims to have been doing since December, 2012 when it adopted the Evans Rule. Still, there is much to be desired about the Fed's forward guidance. First, the Fed's forward guidance focuses too much on the expected path of the interest rates and not enough on its target. In terms of my earlier analogy, the ship's captain worries excessively about expected path of the rudder and too little about the ship's destination. This can be seen in the Fed's qualification of its inflation and unemployment thresholds. Here, for example, is how the FOMC described it forward guidance at the December, 2013 meeting. 
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Note that the FOMC says its highly accommodative stance of monetary policy will persist for a "considerable time after" the economy recovers and that the current low rates will be appropriate "at least as long" as the breaching of its thresholds. The Fed is saying here that its accommodative stance, including the low policy interest rate, will not be shaped by the state of the economy alone. It also will be shaped by time. The Fed's forward guidance, then, is not truly state dependent. This makes the forward guidance time-inconsistent and not credible for the reasons laid out in my last post.

Second, the Fed's use of the unemployment rate as a threshold is problematic. Central banks should never target real variables unless they are certain they know its market clearing or 'natural rate' value. Determining natural rate values, however, can be challenging if not impossible to do in real time. Consequently, it is far better and easier for central banks to target nominal variables. I made the case it should be nominal GDP and that doing so would accomplish what forward guidance is trying to do. Jeff Frankel agrees:
The Federal Reserve and the Bank of England have each recently backed away from “forward guidance” that they had given earlier in the form of thresholds for the unemployment rate.   As a result of their changes in emphasis, they are both being accused of confusing the financial markets.
[...]
There was another way.  A year or two ago, many of us were suggesting that the monetary authorities could announce a target or threshold for Nominal GDP, instead of for inflation, real income, unemployment, or other alternatives.    Some of us explicitly warned that a threshold phrased in terms of the unemployment rate would be vulnerable to extraneous fluctuations such as workers exiting the work force, and argued that a nominal GDP threshold would be more robust with respect to such unforecastable developments.

Just over a year ago, for example, I wrote in favor of “a commitment to keep monetary policy easy so long as nominal GDP falls short of the target.  It would thus serve a purpose similar to the Fed’s December 12, 2012, announcement that it would keep interest rates low so long as the unemployment rate remains above 6.5% - but it would not suffer the imperfections of the unemployment number (particularly its inverse relationship with the labor force participation rate…).”  [Central Banks Can Phase in Nominal GDP Targets without Losing the Inflation Anchor blog, December 25th, 2012.]
This is yet another instance of a long-standing point: if central banks are to focus attention on a single variable, the choice of Nominal GDP  is more robust than the leading alternatives. A target or threshold is a far more useful way of communicating plans if one is unlikely to have to violate it or explain it away later.
It is time for the Fed to scrap forward guidance and adopt a NGDP level target.

Friday, January 24, 2014

Forward Guidance is Hard. So is Navigating a Ship By Focusing on the Expected Path of its Rudder


Forward guidance took a beating this week. First, San Francisco Fed President John Williams said its use is often oversimplified, easily misinterpreted, and time-inconsistent. Next, an important Blooomberg editorial argued that forward guidance should be dropped because it lacks credibility and at best confuses investors. Finally, the Bank of England decided to abandon forward guidance altogether once it realized its unemployment threshold would be reached well before a full economic recovery.

This spate of bad news for forward guidance should not be surprising. For it is like trying to navigate a ship by focusing on the expected path of its rudder. No ship captain can credibly commit to a certain rudder path across the ocean because water currents and wind conditions are bound to change. A captain, however, can credibly commit to a destination and do whatever it takes to get there. In this case, the rudder is not the focus and is adjusted as needed to offset the unexpected changes in current and wind conditions so that the ship stays on course.  

Similarly, a central bank cannot credibly commit to a certain path for its policy rate if it wants to hit its destination. For most central banks that means full employment and stable inflation. Forward guidance commits the central bank to a path of low policy rates beyond this destination in order to get more stimulus today. That is akin to a captain saying it will keep his rudder and ship on a certain path even after they make it across the ocean. No one would take that claim seriously. The ship has to stop when it hits the shore. Likewise, a central bank cannot commit to a flexible inflation target and at the same time credibly commit to a path of policy rates that would violate this monetary regime. This is why markets are now challenging the FOMC's forward guidance on interest rates. They see an economic recover that will force the Fed to raise interest rates faster than the FOMC says it will.  

This creates a dilemma for central banks. How can they credibly commit to the monetary policy needed for a more robust recovery while still remaining committed to long-run price stability? If forward guidance cannot cut it, what will? The answer for the captain of the ship was to focus on the destination. The same is true for central banks. Focus on the destination or target of monetary policy.

The target, however, needs to be the right one. Market monetarists have been making the case that a nominal GDP level target (NGDPLT) is just the one. It allows the short-run monetary policy flexibility on both sides of the business cycle while still anchoring long-term inflation. It would solve the dilemma now facing central banks that use forward guidance. Here is how I described it before:

Under a NGDP level target a central bank would commit to keeping aggregate nominal spending on some targeted growth path, say 5%.  Such a rule would, therefore, anchor long-run inflation expectations.  It would also allow for aggressive catch-up growth (or contraction) in NGDP so that past misses in aggregate nominal spending growth would not cause NGDP to permanently deviate from its targeted growth path.  In other words, past NGDP growth mistakes would be corrected.  The following figure illustrates this idea:


The black line has NGDP growing at a 5% annualized rate.  Then, at time t a negative aggregate demand (AD) shock causes NGDP to contract through time t+1.  There is now an a NGDP shortfall.  To make up for it, the Fed must actually grow NGDP  significantly faster than 5% to return aggregate nominal spending to its targeted level.  For example, if NGDP fell 6% between t and t+1 it is now 11% under its trend.  Next period the Fed must make up for the 11% shortfall plus the regular 5% growth for that period.  In short, the Fed would need to grow NGDP about 16% between t+1 and t+2 to get back to trend.  This temporary burst in NGDP would probably make the inflation critics nervous, but they shouldn't be. There might be temporarily higher inflation as part of the rapid NGDP growth, but over the long-run a NGDP level target would settle back at 5% growth.  Nominal expectations would be firmly anchored.  
Note that by stabilizing nominal spending growth, the Fed would also be stabilizing nominal income growth. That leads to a related point:
Under a NGDP level target any temporary easing (or tightening) in the short-run is very time consistent, because it is returning nominal income to the Fed's long-run growth path target.  That's kind of the point of level targeting, it coordinates short-run policy moves with long-run policy objectives. Under a NGDP level target, everyone understands the "catch-up" nominal income growth is temporary and tied to an objective. The public would also understand that once the target path was hit, nominal income growth would slow to trend. They would come to expect it.  In other words, there are no inconsistencies between the short-run and long-run.
So we market monetarists believe NGDPLT would accomplish what central banks are now trying to do with forward guidance. It appears that others are now taking a second look at NGDPLT for this reason. For example, San Francisco Federal Reserve Bank President John Williams had this to say in his critique of forward guidance (my bold):
One lesson from the recent past is the difficulty in anchoring policy expectations when the short-rate is at the ZLB. Although quantitative forward guidance has proven a useful tool, it suffers from a number of limitations. Experience has shown that it is impossible to convey the full reach of factors that influence the future course of policy. As a result, forward guidance ends up being overly simplified and prone to misinterpretation. Moreover, forward guidance several years in advance may not be credible, especially in light of the change in policymakers over time. In theory, alternative frameworks such as nominal GDP targeting, if fully understood by the public, could help resolve these communication difficulties
An even stronger endorsement of NGDPLT was made by the Bloomberg editorial that criticized forward guidance (my bold):
The world’s most powerful central banks are struggling with their approach to “forward guidance” -- what they tell investors about their plans for monetary policy. A practice meant to give the markets more clarity is causing confusion...

In all this, there’s an underlying dilemma for the central banks: If forward guidance is to provide additional stimulus, the central banks have to change investors’ understanding of how interest rates will respond to economic conditions. Yet, for the sake of credibility, the Fed and the others want investors to see monetary policy as steady and consistent. Much of the effort to get forward guidance right is a doomed effort to have it both ways...

A more radical alternative is also worth considering: replacing inflation targets with targets for growth in total demand, also known as nominal gross domestic product. This would allow for temporary overshoots in inflation in response to periods of very low demand, thus providing extra short-term stimulus, without unsettling long-term inflation expectations. And unlike ad hoc targets and thresholds, it’s a framework that stays in place throughout the economic cycle.   
Well said. Foward guidance is hard, NGDPLT is easier. Here is hoping the Janet Yellen will have her 'Volker Moment' and be the Fed chair who ushers in NGDPLT.

Update: If you think this analysis does not apply to the Fed since its forward guidance is state dependent, think again. In a new post I argue there that even now with the Evans Rule the Fed's forward guidance is not truly state dependent.
1Technically, the federal funds rate is an intermediate target and bank reserves are the operating instrument.

Tuesday, January 21, 2014

My Interview on RT

What is market monetarism and what are its implications for monetary policy? Those were the big questions I discussed recently with Erin Ade on the RT show Boom Bust. The interview can be seen here or in the embedded video below. I wanted to follow up with a few comments on some of the points I made.

First, I explained that market monetarist believe money matters to the business cycle. Any sudden shock to the supply or demand of money will cause will cause swings in economic activity. I noted that we believe there were large shocks to money during the crisis. In particular, institutional money assets were hit hard.  The figure below shows just how bad it was for these money assets. It shows the M4 money supply measure broken down into institutional and retail money assets. The figure includes the monetary base for comparison.


Second, I also made the point that even though we take monetary shocks seriously we do not advocate targeting the broad money supply. Most money assets are "inside money" created by banks and other financial firms. They are not created by the Fed. Therefore, we believe the Fed's job is to create an environment that is conducive to both the stable creation of inside money and the stable demand for it by firms and households. Market monetarist believe this is best accomplished by the Fed targeting the growth path of total dollar spending or nominal GDP. By doing so, the Fed will stabilize the expected growth path of total dollar income and that will feed back into stable money demand. Targeting the growth path of NGDP would also go along ways in spurring a more robust recovery for reasons laid out here and here.

Here is the video. My interview starts about 15 minutes into the clip.

Miles and Scott's Excellent Adventure

A journalist recently reminded me of how important the blogosphere has become for shaping conversations on macroeconomic policy. Everything from TARP to shadow banking to quantitative easing have been vetted in the blogosphere over the past few years. Often these conversations have influenced policymaking. Paul Krugman recently commented on this development:
[T]here has been a major erosion of the old norms. It used to be the case that to have a role in the economics discourse you had to have formal credentials and a position of authority; you had to be a tenured professor at a top school publishing in top journals, or a senior government official. Today the ongoing discourse, especially in macroeconomics, is much more free-form...at this point the real discussion in macro, and to a lesser extent in other fields, is taking place in the econoblogosphere...
Alex Tabarrok made a similar point at an AEA meeting when he said the blogosphere has become the "first place for policy debate and policy development." There are many examples of this, but here I want to recognize two potential solutions to the zero lower bound (ZLB) problem that got a wide hearing because of the blogosphere. These solutions were not new, but because of blogging and the personalities behind them, they became more widely understood and influenced policy.

The two solutions are implementing negative policy interest rates via electronic money and nominal GDP level targeting (NGDPLT). Miles Kimball pushed the former while Scott Sumner was behind the latter. Both individuals first pushed these ideas in the blogosphere. Miles Kimball's idea spread rapidly from his blog to other media outlets to central banks where he made multiple presentations to monetary authorities. Arguably, the Fed and ECB officials began talking more seriously about negative interest rates because of his efforts. Scott Sumner's relentless efforts for NGDPLT also began on his blog and are considered by many to be the reason the Fed finally did QE3, a large scale-asset purchasing program tied to the state of the economy.  Miles and Scott's success is a testament to their hard work, but also to disruptive technology that is the blogosphere.

I bring up their contributions, because they provide a nice conclusion to my previous two posts that looked at the ZLB. In those posts I looked at the claim that slump has persisted for so long because the nominal short-term natural interest rate has been negative while the actual short-term interest rate has been stuck near zero. It is stuck near zero because individuals would rather hold paper currency at zero percent than to invest their money at a negative interest rate. The ZLB is preventing short-term interest rates from reaching their output-market clearing level. The long slump is the result. Miles and Scott both have a solution for this problem. Unsurprisingly, both view the ZLB as a self-imposed constraint that can be easily fixed.

There are two key parts to Miles Kimball's solution. The first part is to make electronic money or deposits the sole unit of account. Everything else would be priced in terms of electronic dollars, including paper dollars. The second part is that the fixed exchange rate that now exists between deposits and paper dollars would become variable. This crawling peg between deposits and paper currency would be based on the state of the economy. When the economy was in a slump and the central bank needed to set negative interest rates to restore full employment, the peg would adjust so that paper currency would lose value relative to electronic money. This would prevent folks from rushing to paper currency as interest rates turned negative. Once the economy started improving, the crawling peg would start adjusting toward parity. More details on his proposal can be found here.

There is much to like about his proposal. It is effectively how a free-banking, profit maximizing system would solve the ZLB, as shown by JP Koning. Holding risk constant, it would move all interest rates down and maintain spreads so that financial intermediation would not be disrupted. It would also eliminate the illusion that liquid short-term debt contracts are risk-free. Most importantly, it would allow short-tern nominal interest rates to better track their natural interest rate level.1

The figure below shows how how Miles Kimball's solution would provide an escape route from the ZLB problem. It shows a situation where there is a negative output gap and a  negative short-turn nominal natural interest rate. Miles would have the Fed would lower its policy interest rate down to the natural interest level at time t. The output gap would start to close and consequently, the natural interest rate would start to rise. The Fed would follow suit and start raising its policy interest rate in line with the natural rate. Eventually, the economy would return to full employment and the nominal interest rates would settle at their long-run values (which typically are positive). The escape from the ZLB would be complete.


Scott Sumner's solution to the ZLB provides another escape route from the ZLB. His approach is to "shock and awe" the economy with a regime change to monetary policy that would catalyze a sharp recovery. This recovery would pull the natural interest rate back into positive territory and eliminate the ZLB problem. Scott would implement his "shock and awe" program by having the Fed announce a NGDPLT (or total dollar spending target) and credibly committing to do whatever it takes to make it happen. 

This amounts to the Fed committing to a permanent expansion of the monetary base, if needed. That is, a NGDPLT creates the expectation that if the market itself does not self correct through a higher velocity of base money, then the Fed will raise the  amount of monetary base as needed to hit higher level of NGDP. If credible, this becomes a self-fulfilling expectation with the market itself doing most of the heavy lifting. In other words, the regime change would spark a major portfolio rebalancing away away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand. It would be similar in spirit to what monetary policy portion of Abenomics is now doing in Japan. 

The figure below shows how Scott's solution would provide an escape route from the ZLB. Like before, the figure shows a negative output gap and short-run nominal natural interest rate that is negative. At time t, Scott would have the Fed introduce NGDPLT. The output gap would begin shrinking and put upward pressure on the natural interest rate. Eventually the natural interest rate would broach zero and the Fed would have to start raising its policy rate in line with it. Finally the economy would return to full employment and the natural interest rate to its long-run positive value. The escape from the ZLB would be complete.2


So these are the two solutions to the ZLB problem. They have received a wide hearing and to some extent influenced policymaking because of Miles and Scott's efforts in the blogosphere. Thanks to this disruptive technology and the conversations it started the world is a better place.

1Bill Woolsey has a similar proposal. He would  transfer paper currency production to private banks and allow them to determine whether they want to produce paper money. Private banks would then determine the exchange rate between deposits and paper currency. 
2To be clear, Scott Sumner would do away with interest rate targeting altogether and his push for NGDPLT is more than about escaping the ZLB. It is about setting up a credible and effective target for monetary policy. I too am a big proponent of NGDPLT for this reason.

Friday, January 17, 2014

Has The Natural Interest Rate Been Negative for the Past Five Years?

In my last post I raised the question of whether the nominal natural interest rate has been negative since the crisis started. Many observers say yes and point to it as the reason why the economic slump has persisted for so long. For if this output market-clearing level of the interest rate has been negative while actual interest rates have been stuck near zero, then a general glut is the inevitable consequence. Others find this hard to believe. Even if the natural interest rate turned negative in 2008-2009, they question how it could remain negative for five years.

So is the nominal natural interest rate really negative five years after the crisis started? To answer this question we need to first recognize there is an entire term structure of natural interest rates. This means there is both a long-term and short-term nominal natural interest rate. The former is the determined by structural trends in the economy while the latter is driven by the business cycle.

More specifically, the long-term nominal natural interest rate is determined by trend changes in the expected productivity growth rate, the population growth rate, and household time preferences given well-anchored inflation expectations. Productivity matters because it affects the expected return to capital and expected household income. Faster productivity growth, for example, translates into a higher expected return on capital and higher expected household incomes. In turn, these developments should lead to less saving/more borrowing by firms and households and put upward pressure on the natural interest rate. The opposite would happen with slower productivity growth. Population growth matters because it too affects the expected return to capital. More people means more workers and output per unit of capital. For example, the opening up of China and India's labor supply to the global economy, meant a higher expected return to the global stock of capital over the past decade. That should put upward pressure on interest rates and vice versa. Finally, for a given level of expected income, a change in households time preferences means a change in their desire for present consumption over future consumption. This, in turn, affects households' decision to save and borrow. If households, say, start living more for the moment there would be less saving, more borrowing, and upward pressure on the natural interest rate.

Some like Paul Krugman and Larry Summers believe these determinants have changed enough such that the long-term nominal natural interest rate has been negative. I am not convinced and hope to explain why in a subsequent post (if you cannot wait, see my views in this twitter discussion). In my view, then, the important question is whether the short-run nominal natural interest rate has been negative since the crisis started.

So what do we know about the short-run nominal natural interest rate? It is shaped by aggregate demand shocks that create temporary deviations of the economy above or below its  full-employment level (i.e. output gaps). For example, a large negative aggregate demand shock that temporarily weakens the economy will put downward pressure on interest rates. This happens because firms do less investment spending and therefore less borrowing in anticipation of lower future profits. It also happens because households, particularly credit and liquidity constrained ones, save more and borrow less in anticipation of lower future incomes. In short, aggregate demand shocks that create output gaps will also push the short-run nominal natural interest rate in a procyclical direction. This is a natural process that allows the economy to heal itself. What is not natural is when interest rates are prevented from fully adjusting to their market-clearing levels. That happens when interest rates are pinned down at the ZLB. See this earlier post for a graphical representation of this ZLB problem.

So is this happening now? Is the short-term nominal natural interest rate negative after all these years, while actual short-term rates are at or near zero? We cannot directly observe the natural interest rate, but there is evidence of ongoing slack in the economy. And since slack--or a negative output gap--is a key determinant of the short-run natural interest rate, it is reasonable to believe the natural interest rate has been depressed over the past five years.

The figure below supports this view. It indicates that when the crisis broke there was a sharp increase in slack that is still unwinding. This figure shows the BIS ouput gap, the unemployment rate, and the NFIB's measure of small business concerns over weak sales. There is a striking correlation among these measures. The most straightforward interpretation of it is that if some shock causes firms to expect weaker (stronger) sales they decrease (increase)  production, employment, and begin operating below (above) capacity. Collectively, these firms are creating a negative (positive) output gap. Since these series all appear to be mean reverting to the lines, this suggest the shocks have only temporary effects. It seems, then, that the shocks driving this figure are largely aggregated demand shocks. 


Given the large amount of slack during the crisis, it seems reasonable that the market-clearing nominal interest rate could have turned negative during this time. This understanding is also consistent with the fact that the large run up in U.S. public debt was readily funded by investors at record low interest rates. Note that most of the investors buying the debt were individuals, their financial intermediaries, and foreigners. It was not the Fed as seen below:

The Fed was not the great enabler of the large budget deficits as some claim. In short, the large amount of economic slack and seemingly non-satiable, non-Fed appetite for safe U.S. treasuries all point to a depressed and maybe even negative short-term nominal natural interest rate. 

The next figure shows my crude attempt to estimate it. To do this, I first identified a period where it is generally believed that the Fed did a good job moving its target federal funds rate in line with changes in the short-run nominal natural interest rate. Following John Taylor, I chose 1984-2002 as that period. The assumption I make is that this period's ex-ante real federal funds rate is a good indicator of the short-run real natural federal funds rate. Consequently, I regressed the ex-ante real federal funds rate on measures of slack and the demand for safe assets for this period. I then plugged in more recent measures of slack and safe asset demand to estimate the current ex-ant real natural interest rate. I then added one-year inflation forecasts to this estimate to get the nominal natural interest rate that is graphed below. (More details are in footnote 1.)




This figure also includes Fed Chair Janet Yellen's "Balanced Growth Path" measure which can be viewed as another attempt to estimate the output market-clearing level of the nominal federal funds rate (HT Michael Darda of MKM Capital). Both measures show that the short-run nominal natural interest rate turned negative and remained there for many years. Only now does it appear to be getting close to the actual federal funds rate.

A more sophisticated attempt to measure the nominal natural interest rate was presented by Robert Barsky et al (2014) at the AEA meetings a few weeks ago.  Using a rich DSGE model, they produce the following figure. It too shows a protracted period of negative nominal natural rate values for the federal funds rate. (Note that they graph interest rates on a quarterly not annualized basis.)



Both approaches point to a sustained period of negative values for the natural nominal federal funds rate. Given the improved economic outlook, I suspect it has risen a lot over the past six months and may have even broached zero as seen in my figure above. Still, it remained negative for many years while the actual federal funds rate was pinned at zero percent. The long economic slump was the result. This begs the question of whether there was more the Fed could have done to avoid this gap between the natural and actual federal funds rate from emerging.

In my next post I will present two ways to eliminate this interest rate gap that were proposed by bloggers but never tried.   

P.S. Miles Kimball provides a nice discussion of the natural interest rate here. Also see this Bruegel Blog Review on previous blogosphere discussion of the natural interest rate.

Update: On twitter Miles Kimball mentions the importance of the risk premium on the natural interest rate. I did not discuss this explicitly in the post, but it alluded to it in my reference to safe asset demand. For a more on this issue see here.


1For the period 1984:Q1-2002:Q4 I estimated the following equation:
  Ex-Ante Real Federal Funds Ratet =B0+B1Output Gapt-1+B2Average Unemployment Rate Forecasted for Next Two Yearst + B3Risk Premiumt-1+ B4 Current Account Balance/GDP +ut  
The first two regressors are included to measure current and expected slack. The last two regressors are used to capture demand for U.S. safe assets. The risk premium measure is Moody's BAA yield minus 10-year treasury yield. All regressors were significant and the R2 was roughly 70%.

Wednesday, January 8, 2014

The Real Scandal at the Federal Reserve

Many observers have been making the case that the zero lower bound (ZLB) on nominal interest rates is the reason for the ongoing economic slump. That is, because nominal interest rates cannot go below zero--it would pay more to hold cash so no one would lend at negative interest rates--they have not been able to fall to the level needed to clear output markets. The ZLB, therefore, is acting like a price floor that is artificially propping-up short-term interest rates and, as with any binding price floor, is creating a surplus. In this case the surplus is a general glut. This price floor is preventing the Federal Reserve from spurring a robust recovery.1

Implicit in this view is the belief that the short-term market-clearing nominal interest rate is negative. Many have a hard time believing this equilibrium or 'natural rate' value of the interest rate can be negative. Others might accept that it was negative in 2008-2009, but not five years later. So is the short-term natural interest rate really negative five years after the crisis started?

The answer to this question would go a long ways in ending much confusion. If the answer is yes, then it would not be true that Fed has been 'artificially' suppressing interesting rates as many have claimed. Nor would it be true that the Fed has been enabling the large budget deficits with low financing costs for the treasury department. Finally, it would reveal that U.S. monetary policy has not been that loose despite the Fed's various QE programs.

So why has the Federal Reserve not published real-time, monthly estimates of the short-run natural interest rate? The Fed has a huge research staff, lots of resources, and is capable of providing this important information. It should be a scandal that the Federal Reserve, an interest-rate targeting central bank, does not regularly publish the natural interest rate. One cannot intelligibly talk about the stance of monetary policy for an interest-rate targeting bank without first knowing the natural interest rate level. 

It is true that estimating the natural interest rate is tricky. But the Federal Reserve could provide a range of estimates as it apparently does sometimes for the FOMC meetings (here is an example from 2005). It could also collect and provide a consensus view of the current and expected natural interest rate path from market participants. The key point is that the Federal Reserve sorely needs to start publishing at least a monthly estimates of the short-run natural interest rate. And, as long it is attempting to manipulate long-run interest rates, it should probably provide estimates of the entire term structure of natural interest rates.

Again, it is in the Fed's own interest to start doing this. Imagine, for example, how much different the tapering incident in 2013 would have unfolded if the public better undestood that natural interest rates were rising due to the improving economy. The Federal Reserve's tapering actions were merely a response to these developments. Being able to respond with more clarity about the stance of monetary policy would do wonders in muting unfounded criticisms of Fed policy. It would also make it easier to hold the Fed's feet to fire if indeed monetary policy were too loose or too tight. I hope one of Janet Yellen's first actions will be to fix this scandal.

We are still left wondering, though, if the natural interest rate really has been negative for the past five years. In my next post I will attempt to provide an answer to this question.

P.S. I have actually submitted a request (via Congress) to the Federal Reserve that it start providing this information. I am still waiting to hear back.

1Of course, all of this could be avoided if the Federal Reserve simply moved away from a short-term interest rate target. Market monetarists, for example, would have monetary authorities adjust the monetary base as needed to manage expectations in a manner consistent with hitting a NGDP level target.

Sunday, January 5, 2014

Paul Krugman Plugs Market Monetarism

No, seriously. He has done it before, so it should not be surprising. This time, though, the plug is subtle and requires a little detective work. To see it, first recall how he observed that one of market monetarism's big claims--that monetary policy could offset fiscal policy even at the zero lower bound--was being put to the test in 2013. That year the sequester was tightening fiscal policy and at the same time the Fed was easing monetary policy with QE3. These two developments provided a nice natural experiment. Here is Paul Krugman in early 2013:
On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
I agreed at the time that this would provide a natural experiment to test our claims, but cautioned that it only was a test of how effective QE3 would be against the sequester. It was not a test of my ideal of a NGDP level target against fiscal austerity. Still, Paul Krugman was correct that an interesting experiment was under way.

As in most experiments, this one had a tricky measurement question: how best to measure fiscal austerity? Fortunately, Paul Krugman explained how to carefully measure the impact of fiscal austerity upon an economy:
Now, measuring austerity is tricky. You can’t just use budget surpluses or deficits, because these are affected by the state of the economy. You can — and I often have — use “cyclically adjusted” budget balances, which are supposed to take account of this effect. This is better; however, these numbers depend on estimates of potential output, which themselves seem to be affected by business cycle developments. So the best measure, arguably, would look directly at policy changes. And it turns out that the IMF Fiscal Monitor provides us with those estimates
The nice thing about the IMF's measure is that it includes all levels of government--local, state, and federal--when calculating the government balances. It is a thorough measure. Now note that Paul Krugman stresses the use of policy changes rather than the level of policy. That is, one must look at the change in fiscal austerity, not the level to properly ascertain its effect on the economy. 

Given these instructions from Paul Krugman, I put together the following figure using the latest IMF Fiscal Monitor. It shows the 2013 changes in fiscal policy for the three largest advanced economies. A negative number means fiscal policy tightened, while a positive one means it was expansionary:

This figure is striking. It shows that in 2013 the sharpest change in fiscal austerity was in the United States.

Now let us put this all together. The Fed QE3 program was pitted against the sharpest change in fiscal austerity across the largest advanced economies. Many observers predicted this fiscal austerity would lead to a recession. Other predicted it might costs as many as 700,000 jobs. Market monetarists like Scott Sumner and myself were more optimistic. 

So how did this natural experiment turn out in 2013? Not all the number are in, but what we do know is that economy did better than expected and outpaced 2012. Here is Michael Darda, Chief Economist for MKM Capital, on 2013:
Despite a two-year contraction in nominal federal outlays for the first time in more than five decades and a raft of tax hikes starting in early 2013, job gains are running slightly ahead of the 2012 pace. Non-farm payrolls (+203K in November and 200K in October) have averaged 189K during the first 11 months of 2013, ahead of the 179K 11-month average in November 2012 and the 170K average for November 2011. Over the last 12 months, non-farm payrolls have averaged 191K, also above the 12-month averages for the last three years. Indeed, year-to-year gains for overall payrolls and private sector jobs have been very steady despite the most intense fiscal consolidation since the Korean War demobilization. Many observers late last year were of the mindset that the fiscal cliff and/or sequester would either throw the U.S. economy back into recession, or slow it materially. It has done neither because, in our view, the Fed has offset it. Although monetary policy has beenfar from perfect, allowing the financialsystem to crash in 2009 (instead of doing QE1), allowing low inflation to morph into deflation in 2010 (instead of initiating QE2) and allowing the full force of the sequester/tax hikes to hit in 2013 (rather than rolling out QE3) do not seem like particularly desirable outcomes. The Fed has managed much better than the ECB and that is the proper counterfactual. 
In other words, market monetarism passed the test. And since Paul Krugman pointed out and discussed the implications of the natural experiment, he implicitly plugs for market monetarism given the outcome. There is no way to get around this implication, no matter what he now says.

P.S. Here is Scott Sumner's reply to Paul Krugman.