Thursday, October 5, 2017

U.S. Monetary Policy: What's Up?

To frame the issues, let's look at some objective measures of the Fed's performance. Just to be fair, we'll evaluate performance in terms of the objectives laid out in the FOMC's January 2017 goals statement.

1. "...inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate." Note that the price index the Fed has chosen as most appropriate is the raw, headline pce deflator, not the pce deflator stripping out food and energy, the cpi, the core cpi, or any other measure. So we should hold them to that choice. Here's year-over-year inflation rates, since the last recession:
Obviously the Fed hasn't been hitting 2% inflation spot on, but what's actually feasible, or even desirable? The Bank of Canada, to take an example that's close at hand for me, actually sets a target band of 1-3% for inflation, so by that criterion the Fed has done pretty well - within the 1-3% band for most of the last seven years, except during 2015 after the fall in energy prices, which perhaps is understandable. The current inflation rate is 1.4%, which is tolerably close to the Fed's ideal. But the the Fed also has a "symmetric inflation goal." Missing the target sometimes is OK, but the FOMC would like to miss on the high side about as much as it misses on the low side - roughly, average inflation should be close to 2%. Over the last year, inflation was above 2% for two months, and below for 10 months, with an average of 1.6%. Not quite symmetric, but not so bad.

2. "... it would not be appropriate to specify a fixed goal for employment...Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published...For example, in the most recent projections, the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent." For good reasons, the FOMC doesn't want to be specific about numerical goals related to the second part of its mandate - sometimes called "maximum employment," whatever that is. There's a hint though, about what the FOMC members might care about, which is the "long run normal" or natural rate of unemployment. This is rather ill-defined and hard to measure. To my mind, the economics profession would be better off if we refrained from mention of "natural" anything. One danger associated with the natural rate, as for any other ill-defined and hard-to-measure variable, is that a policymaker can start making stuff up, so as to manipulate the policy discussion. In the FOMC's most recent projections, the range of estimates for a long-run unemployment rate fall in a range of 4.4%-5.0%, with a median of 4.6%, so notions of what is normal have fallen since January 2017, when the FOMC put together its long-run plans revision. Here's what the actual unemployment rate looks like:
The current unemployment rate, at 4.4%, is as low as any FOMC participant thinks is normal over the long run, conditional on things going really well, apparently. So, by that measure the Fed is doing great.

Just to check, we can look at another measure, which is a measure of labor market tightness (or it's inverse, as conventionally measured in the labor literature). This is the ratio of the number of unemployed to total job openings:
Shortly after the last recession ended, this measure peaked at about 6.6 unemployed people per job opening, and it's now down to close to 1 unemployed person per job opening. Indeed, that's close to the lowest reading since the BLS started collecting this particular job vacancy data. So, by conventional measures the job market is very tight, which should be viewed as extremely good performance on the Fed's part.

What about growth in real GDP?
If we think that part of the Fed's job is to smooth growth in real GDP, then that chart looks pretty good. I've put in a 2% growth path, and the deviations from that growth path are small. Of course, people might complain that 2% growth is lower than the 3% (roughly) post-WWII average, but that shouldn't be the Fed's concern. Received wisdom in the economics profession is that monetary policy can't do much for long-run growth, other than keeping inflation low and predictable.

So, what's to fix here? Inflation is tolerably close to 2%, the unemployment rate is very low, the labor market is extremely tight, and real GDP is growing smoothly. The only improvement to be made is some fine tuning so that inflation fluctuates symmetrically around the 2% target. How should that be done? I'll assume, consistent with my last post, that QE doesn't matter. So the only issue is what should be done to the fed funds target range (or, more accurately, the interest rate on reserves and the interest rate on overnight reverse repurchase agreements), so that the average inflation rate is 2%? Well, you don't have to be a neo-Fisherite to understand that, if inflation is persistently lower than what you want, on average, then the nominal interest rate needs to be, on average, higher in the future. What's needed here is some tweaking of the Fed's policy interest rate target. How much? As mentioned above, the average inflation rate over the last year is 1.6%, so one or two more interest rate hikes will do the trick. Twenty five to fifty basis points' increase in overnight interest rates is small potatoes for real economic activity - note that the labor market continued to improve in the face of the last four interest rate increases.

So, that's what I'd do. What does the FOMC have on its mind? In the last FOMC projections, the median long-run prediction of Committee members for the fed funds rate is 2.8%, with a range of 2.3%-3.5%. That's come down considerably, with recognition by the committee that the low real rates of return on government debt we are observing are likely to persist. A persistently low real rate of return on short-term safe assets implies of course that the nominal short term interest rate consistent with 2% inflation is low. I'm saying that what Janet Yellen would call the "neutral interest rate" (the interest rate target at which the Fed achieves its goals in the long run) is more like 1.5%, and not 2.3%-3.5%.

To get more information on what the FOMC is likely to do over the near future, we'll look at Janet Yellen's last speech on "Inflation, Uncertainty, and Monetary Policy." First, Yellen tells us how inflation has been low, and then says why she thinks low inflation is bad:
Sustained low inflation such as this is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions. In addition, a persistent undershoot of our stated 2 percent goal could undermine the FOMC's credibility, causing inflation expectations to drift and actual inflation and economic activity to become more volatile.
The second sentence is important. The Fed committed to a 2% inflation target because the assurance of predictable inflation minimizes uncertainty, and makes credit markets, and (by some accounts) the markets for goods and services work more efficiently. If the Fed consistently undershoots its inflation target, people will either think the Fed is incompetent, or that it is willfully abandoning its promises, neither of which is good - for the institution or the economy. But in this instance, the Fed isn't missing by much, so what's the big worry? As I mentioned above, this requires some fine-tuning, but don't get bent out of shape about it.

The first sentence in the quote was really interesting. She's got the causality backward. Pretty much all of us now accept that it's the central bank that controls inflation. That is, central bank actions or, more accurately, the central bank's policy rule, causes inflation to be what it is, combined of course with other factors outside the Fed's control - including the factors determining the long-run real rate of interest on government debt. So, low inflation does not lead to "low settings of the federal funds rate." It's the low settings for the fed funds rate that lead to the low inflation. In a world in which the central bank targets the nominal interest rate to control inflation, that's how it works, and central bankers would be wise to absorb that idea. Stop the neo-Fisherian denial, and get with the program!

The speech uses a two-equation model (written down in the appendix) to frame the issues. It's a Phillips curve model. Arrgghh. Even Larry Summers recognizes that Phillips curves are unreliable. As he says:
The Phillips curve is at most barely present in data for the past 25 years.
For example, in the recent post-recession period, here's what we get when we plot inflation against the measure of labor market tightness I used above (ratio of unemployed to job seekers):
The line connects the observations in temporal sequence from right to left. Over this period of time, I think the Fed would claim that inflation expectations are more or less "anchored." So, what we should see in the chart, if the Phillips curve is to be at all useful, is a set of observations tracing out a downward-sloping relationship. But, more often than not, inflation and my "slackness" measure are moving in the same direction. There's nothing new about macroeconomists raising issues with the Phillips curve as a cornerstone for policy. It's been in disrepute for much of the last 45 years or so, both on theoretical and empirical grounds. Unfortunately, the Phillips curve was dragged out of the gutter, dressed up, and rehabilitated by New Keynesians, which is another story altogether.

But, like a lot of people, Janet Yellen is a true believer, and her staff will aid her in that belief by going on a fishing expedition and finding a Phillips curve, and a sample period, for which all the signs in the regressions (if not the magnitudes) come out "right." Here, "right" is whatever conforms to the beliefs of the boss. Sure enough, in the appendix to Yellen's speech, there is a two-equation Phillips curve model. Core inflation is determined by past core inflation, inflation expectations, resource slack, and the relative price of imported goods, and core inflation, energy price inflation, and food inflation determine headline inflation. Yellen's worries about future inflation outcomes are essentially those of the true believer. Do we have the right slackness measure, or the right inflation expectations measure, and how much should we worry if expected inflation falls?

Though Yellen lays out an explicit model of inflation, she doesn't exactly tell us how policy is supposed to work within that framework. Even true believers will sometimes tell you that "the Phillips curve is now very flat," meaning that they think a tighter labor market will put little or no upward pressure on inflation. If we want to stick with the Phillips curve framework, what's left then? The Fed has to focus on anticipated inflation. But how do they move that around? Modern macroeconomics tells us that our views about future outcomes are shaped by what we know about policy rules, in a manner consistent with what we know about how the world works. I got no sense from Yellen's talk of how the Fed thinks its policy rule affects inflation expectations.

But here's the essence of the FOMC's current policy view:
...without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession.
So, in spite of the fact that the Phillips curve doesn't fit the data, the most recent manifestation being the failure of the very tight labor market to make inflation go up, policy going forward will be driven by the fear that the Phillips curve will somehow wake up and re-assert itself. Summers thinks that's wrong, and rightly so.

But, I think Yellen and her colleagues are actually following the right policy. Modest increases in the Fed's interest rate target in this context is the correct prescription. But doing the right thing for the wrong reason won't help you in the long run. We're fortunate, though, that not much is likely to go wrong here. If inflation stays low, and the FOMC loses its appetite for interest rate increases, so what? Low inflation is fine, and it's close enough to 2% as not to be embarrassing. No big deal.

Monetary policy is the least of our now-staggering problems. Unfortunately, the wingnut in the White House is busy creating more difficulty for us, and making the problems we have worse. Fortunately, he has as yet not screwed up the Fed, and the slate of would-be Fed Chairs doesn't include anyone outlandish. More on that later.

Wednesday, October 4, 2017

Whatever Happened to Normalization?

What's become of the Fed's normalization plans? To get this straight, recall what's been abnormal about Fed policy for the last nine years or so. Here's a chart of the effective fed funds rate, and securities held outright by the Fed:
Abnormal policy began at the height of the financial crisis in late 2008, when the FOMC agreed on a plan to target the fed funds rate in a range of 0-0.25% - a policy that continued until "liftoff" in December 2015. As well, beginning in early 2009, the Fed embarked on a sequence of quantitative easing (QE) exercises, which increased the quantity of securities held outright by a factor of more than five. Further, the Fed got rid of essentially all of its Treasury bill holdings, and increased the average maturity of Treasury bonds and notes held. The Fed also purchased a large quantity of mortgage backed securities (MBS) - close to $1.8 trillion. So, the Fed increased the size of its balance sheet substantially, lengthened the average maturity of securities held, and departed in a big way from a policy of "Treasuries only."

As outlined in this FOMC document, the FOMC began thinking seriously about how Fed policy might return to normal, and what "normal" might be, as early as June 2011. A formal normalization plan was posted by the FOMC in September 2014, and this is essentially what has been implemented since, more or less. The plan was:

(i) Begin increases in the fed funds rate target.
(ii) Reduce the size of the balance sheet by stopping the reinvestment policy, after increases in the target policy rate are well underway.

Increases in the fed funds rate target began in December 2015, and we have since had three more, with the target range increasing from 0-0.25% to 1-1.25% currently. Balance sheet reduction did not commence until October of this year, when the FOMC issued an addendum to the 2014 plan. The addendum contains explicit details about how the balance sheet reduction will occur. Reinvestment - a policy by which assets in the Fed's portfolio are replaced as they mature, holding the nominal size of the balance sheet constant - did not stop abruptly, but its cessation will be phased in. It appears that the New York Fed did not purchase assets with a view to smoothing quantities that mature over time, and the FOMC seems concerned that the balance sheet not decline in a lumpy fashion, as it would without the caps on portfolio reduction outlined in the addendum.

Some questions that might come to mind (or should) on normalization, along with my answers:

1. Why did normalization start with interest rate increases first, then reductions in balance sheet size? It might seem logical, since QE followed the reduction in the nominal interest rate target to zero (effectively), that the Fed would normalize by first reducing the balance sheet to a normal size, and then increase interest rates. Indeed, there are some good reasons why this is what should have happened. As short-term nominal interest rates increase, the profit that the Fed makes on the spread between the return on its assets and what it is paying out on its liabilities declines. As a result the Fed makes a smaller transfer to the Treasury each year. QE took place in the context of relatively low yields on Treasury bonds and MBS, and with a larger balance sheet, the asset portfolio is being financed by a larger fraction of interest-bearing reserves and a lower fraction of zero-interest currency. If short-term rates go high enough, transfers to the Treasury will stop. Economically, this is unimportant, as this amounts to the difference between interest paid on reserves by the Fed vs. interest paid on government debt by the Treasury, but politically this could be very dangerous territory. The Fed should not give ammunition to its enemies in Congress. Added to this is the argument that QE was an experiment, with poorly understood consequences. Thus, the sooner the Fed ended the program, the better. So why not reduce balance sheet size before engaging in liftoff? Likely, because the FOMC was spooked by its experience in 2013. At that time, after the FOMC meeting that ended on June 19, Ben Bernanke announced that a winding-down, or "tapering" of the Fed's QE program was likely to being later that year, and that the program would probably end in mid-2014. The financial market response to that announcement, and earlier public statements by Bernanke, is sometimes called the "taper tantrum:"
In the chart, you can see an increase of more than 100 basis points in the 10-year Treasury bond yield, observable in both the nominal yield and the inflation-indexed yield. Somehow, this wasn't the response the Fed expected, but if the market viewed Bernanke's statement as news about forthcoming interest-rate target increases, the reaction doesn't seem outlandish in retrospect. In any case, this experience appears to have colored FOMC views on the importance of QE, and made them skittish about unwinding the program. Thus the idea that interest rate increases should be well under way before the Committee would even think about balance sheet reduction.

2. What's different about raising interest rates when the Fed has a large balance sheet? In theory, when there are reserves in excess of reserve requirements in the financial system overnight, the interest rate on excess reserves (IOER) should determine the overnight rate. This is called a floor system, under which interest rate control is easy, as the overnight interest rate can be essentially administered by the central bank. But in the United States, things aren't so simple. For the details see this article, and this one. Basically, there are regulatory features of the US financial system that restrict arbitrage in the overnight market, so that the "effective" federal funds rate is typically lower than IOER. And, as was also the case before the Fed began paying interest on reserves in late 2008, all fed funds trades don't happen at one interest rate on a given day - indeed, much of the fed funds market is conducted over-the-counter. The Fed was concerned, before liftoff happened, about its ability to achieve a given target range for the fed funds rate - would the fed funds rate even go up with increases in IOER? To assure that this would happen, the Fed expanded the market for its liabilities by making use of an overnight reverse repurchase agreement (ON-RRP) facility. ON-RRPs are loans to the Fed, usually overnight, secured by securities in the Fed's portfolio. These Fed liabilities are just reserves by another name - they can be held, for example, by money market mutual funds, which are prohibited from holding reserve accounts with the Fed. Currently, IOER is set at 1.25%, the ON-RRP rate is set at 1.00%, and on most recent days the effective fed funds rate is 1.16%. Here's a chart showing what has happened with Fed interest rate control since liftoff:
The chart shows takeup on the ON-RRP facility (quantity of ON-RRPs outstanding) and the effective fed funds rate. Initially, the Fed was willing to commit up to $2 trillion in collateral to ON-RRPs, but takeup is typically in the range of $50 billion to $250 billion, running up to $400 billion to $500 billion only at quarter-end (this for regulatory reasons). As well, the effective fed funds rate has recently been coming in consistently at about 9 basis points below IOER (except at month-end, again for regulatory reasons), and more detailed data shows that most trades happen around the average. In one sense interest rate control since liftoff appears to be a success. But it's not clear that the ON-RRP facility is necessary for its stated purpose. The fed funds rate might be about where it is now even without an active ON-RRP facility. We could go further though, and question this whole operating strategy. There is no good reason for the Fed to focus on a fed funds rate target. Fed funds are unsecured, and currently most of the trade in this market is just a means for some GSEs to earn overnight interest on reserve balances. Even in pre-crisis times, it would have made much more economic sense if the Fed had announced its overnight interest rate target as a target for an overnight repo rate. In the current context, why isn't the ON-RRP rate set equal to IOER? Maybe that would kill the fed funds market, but so what?

3. What happens to reserves when Fed assets mature and there is no reinvestment? The balance sheet of the Fed balances, just as any balance sheet does, so for any transaction that occurs affecting either assets or liabilities, implying a debit or credit, there must be an offsetting debit or credit. Suppose first that the maturing asset is a MBS. The issuer of the MBS - which would be a GSE if the MBS is held by the Fed - pays the face value of the debt to the Fed, and the payment will be made by reducing the balance in the GSE's reserve account by that amount. But the MBS that the GSE issued is composed of bits and pieces of underlying mortgage debt. Suppose that the reason the MBS matured was that the underlying mortgage debt was paid off. Then, mortage payments are made to the GSE, and ultimately those payments will involve an increase in the GSE's reserve balances, and a reduction in reserve balances held by private financial institutions. So reserves held by private sector institutions (a Fed liability) and MBS holdings (a Fed asset) decrease by the same amount. Suppose, alternatively, that a Treasury security held by the Fed matures. The Treasury holds a reserve account with the Fed, and a maturing Treasury security implies that the Treasury's reserve account balance (the account is called the "General Account") falls by the face value of the debt. But that has no implications for the private sector - it's just an accounting transaction between the Fed and the Treasury, like internal budgeting transactions between the English department and the Economics department at the University (if such a thing ever happens). There would be implications for the private sector if the Treasury, now finding itself short of reserve balances to pay for stuff, issues more debt to replenish those reserve balances. Then, the new Treasury debt is purchased by the private sector (the Fed won't be buying it, as it's not reinvesting) with reserve balances, so reserves held in the private sector fall. If you think about this a bit, you'll see that, if we think the level of of reserve balances held by the private sector is part of monetary policy, then the Treasury can engage in monetary policy, by varying the quantity of reserves in its reserve account. Look at this:
Note that both the level and variability of balances in the Treasury's general account have increased by a huge amount since the financial crisis. Maybe the Treasury thinks this doesn't matter now, as it won't mess with monetary policy, but that view is at odds with what the Fed says - which is that QE matters in a big way. If QE matters so much, then the big increase in average balances in the General Account in 2016 should have been a significant "tightening" (because it implies a reduction in privately-held reserves) that the Fed would be concerned with. What's going on?

4. When will balance sheet reduction stop? What the FOMC's normalization addendum says is that they don't know, so let me fill you in on what the issues are. The Fed needs to decide on a long-run operating strategy for monetary policy. They could adopt a channel system for monetary policy, like what Canada has, for example. This would involve operating with a small balance sheet. For example, in Canada, where there are no reserve requirements, overnight reserves are essentially zero. The target overnight rate in such a system is bounded by the interest rate at which the central bank lends (the discount rate, for the Fed) on the high side, and IOER, on the low side. Alternatively, the Fed could stick with the floor system under which it operates now, according to which there are excess reserves in the system overnight. The question then is how much reserves you need to make the floor system work. Basically, financial institutions have to be more or less indifferent between lending to the Fed overnight, and lending to to private entities overnight, so that the interest rates on Fed liabilities determine all overnight rates. Evidence from the Canadian experience from Spring 2009 to Spring 2010 suggests that number is smaller than some people seem to think. Probably less than $100 billion. In addition there are issues concerning what overnight rate the Fed should be targeting. In many countries the central bank targets a repo rate, which makes sense, as the central bank should be interested in a secured overnight rate, that is not contaminated by risk. Why persist in speaking to a fed funds rate target, particularly in a financial crisis?

5. Did QE actually work? Don't expect to get good information from the Fed about this. Central bankers want to at least keep up appearances. Who wants a central banker who's not knowledgeable and trustworthy? As I mentioned above, the Fed has many enemies - in Congress and elsewhere - and it's typically optimal for the institution if Fed officials don't admit to not knowing stuff. Truth is that I've never seen any solid evidence that the people who implemented QE in the Fed system actually have a grip on how it might work - either in theory or in practice. Bernanke once said that"QE works in practice but not in theory." I've heard that repeated many times, usually by a person with a smug look on his or her face. Basically, the statement's B.S. The evidence that QE works is weak or nonexistent. I've written about this in more detail in this St. Louis Fed article. Most of the pro-QE evidence comes from questionable event studies, and the evidence we have seems consistent with QE having no effects for the Fed's ultimate objectives. For example, the Bank of Japan has for more than four years engaged in a massive QE experiment that has had no discernible effect on inflation. And QE does in fact work in theory - at least in the 1950s and 1960s vintage theories that Berananke trotted out to justify the policy in the first place. More careful thought might make one think that QE could actually be harmful, by withdrawing useful collateral from financial markets and replacing it with inferior reserves (talk to people who understand "financial plumbing," for example Peter Stella or Manmohan Singh) It's possible that QE could do some good, if the Fed had the proper liabilities at its disposal. QE is basically an attempt by the central bank to engage in debt management, which is the job assignment of the Treasury in the United States. Maybe the Fed can do a better job of debt management than the Treasury, but if so there should be a public discussion, and an explicit assignment of tasks. And if the Fed is doing debt management it needs to be able to issue tradeable debt instruments of all maturities.

So, where are we? With the unemployment rate at 4.4% and the inflation rate at 1.3%, the Fed is achieving its goals, within reasonable tolerance. We're no longer in emergency territory, yet the Fed has an emergency-sized balance sheet. The plan they have issued to reduce the balance sheet is overdue, and it's quite timid. For example, note that during the QE3 program (the final stage of the Fed's asset purchase program), the Fed bought $85 billion per month in long-maturity Treasuries and MBS and that, even after a phase-in period, under the disinvestment program the reduction will be $50 billion per month, at most. Chances are that, when a recession comes along, the balance sheet will still be large, the interest rate target will quickly go to zero, and asset purchases will resume. If the Fed's balance sheet achieves any semblance of "normal" in my lifetime, I'll be amazed.

Sunday, September 10, 2017

Lael Brainard: Phillips Curve Confusion

As background for this piece, you can read this forthcoming St. Louis Fed Review article,
"Inflation Control: Do Central Bankers Have It Right?"
and/or the accompanying slides from a presentation for the Australasian Macroeconomics Society in Canberra, August 2017. The paper gathers together informal stuff I have written on so-called Neo-Fisherism and monetary policy.

Conventional central banking inflation control is typically driven by Phillips curve (PC) theory. Roughly, PC theory says that current inflation increases as the difference between some measure of actual aggregate economic activity and some measure of potential economic activity decreases, and increases as some measure of anticipated inflation increases. I've never seen a central bank policy statement that didn't contain some explicit or implicit reference to the PC. For example, from the Bank of Canada's press release on September 6:
While inflation remains below the 2 per cent target, it has evolved largely as expected in July. There has been a slight increase in both total CPI and the Bank’s core measures of inflation, consistent with the dissipating negative impact of temporary price shocks and the absorption of economic slack. Nonetheless, there remains some excess capacity in Canada’s labour market, and wage and price pressures are still more subdued than historical relationships would suggest, as observed in some other advanced economies.
So, the Bank tells us that inflation is currently below its 2% target, but is expected to come back to target as "excess capacity" goes away - basically a PC mechanism.

In the old days, Lucas developed a theory of the Phillips curve, the upshot being that, as emphasized in the Lucas critique paper, policymakers should not be using observed PC relationships to guide policy, as such relationships are not structural. Indeed, the theory tells us that PC correlations could be positive or negative, and the slope of the PC curve depends on the policy regime in place. In more recent times, PC theory re-emerged in the New Keynesian (NK literature), but if we take NK models seriously, they give us more reasons to doubt the invariance of PC parameters to changes in policy rules (e.g. wage and price setting should change with policy).

In addition to theoretical concerns, the incoming data has not been kind to PC adherents. Lael Brainard, in her September 5 speech to the Economic Club of New York, recognizes this:
...what is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization.
If anything, this understates the case. Here's a plot of year-over-year headline PCE inflation vs. the difference between the unemployment rate and the CBO's measure of the natural rate of unemployment:
In the chart, the line connects post-recession quarterly observations, from right to left. That's certainly not tracing out a nice PC. More often than not, inflation and unemployment were actually moving in the same direction. And, in case you're thinking the most recent observations look more promising for the PC, consider the PCE deflator data, in levels:
In this chart, you can see a noticable recent reduction in inflation. Year-over-year, the inflation rate is 1.4%, and the average inflation rate since the beginning of 2017 is about zero. Consistent with what Brainard says, it appears the labor market is unusually tight. The unemployment rate is 4.4%, and the CBO claims that the natural rate of unemployment is 4.7%. If you really believe in PCs, that might make you think. Brainard says this is "troubling," which I guess means that the PC is in trouble, policymakers are in trouble, we are all in trouble, or some convex combination of the three.

As Brainard explains, if one has a PC view of the world, it's going to be hard to understand why inflation is so low. But she's going to give it a try:
In many of the models economists use to analyze inflation, a key feature is "underlying," or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.
This makes is sound like this "underlying inflation" thing resides in most of the models that macroeconomists work with. While some (most?) undergraduates are taught some version of IS/LM/PC with exogenous inflation expectations, no monetary economist I know tries to analyze inflation in a model with exogenous "underlying or trend" inflation. And that's certainly not a feature of typical NK models, except versions with sticky expectations. But trend inflation is indeed a variable in the Board's FRB/US model, if you have the patience to wade through the documentation. Indeed, essentially everything important in FRB/US (real GDP for example) ultimately reverts to some exogenous trend. Board governors and Board economists have certainly been known to treat FRB/US very seriously, so it's not surprising that Brainard is like-minded.

Do we think inflation expectations have fallen? Perhaps the best we can do is to rely on market-based measures, for example the 10-year breakeven rate (nominal 10-year Treasury yield minus 10-year TIPS yield) looks like this:
The most recent observation is about 1.8%, which is certainly lower than the 2.2%-2.7% we typically observed before the financial crisis, but 1.8% is not all that low. Accounting for the fact that TIPS are indexed to the CPI (rather than the PCE), and adjusting for risk and other factors, this might perhaps translate to an anticipated PCE inflation rate of 1.5% or thereabouts for the next 10 years. If people are actually anticipating 1.5% inflation, that would seem to call for a modest adjustment of some sort in monetary policy, as the clear intent of the Fed is that people should anticipate 2% inflation forever, and be pretty sure about it.

But what sort of policy adjustment are we talking about? Is inflation too low because the Fed has been doing a bad job? Brainard says no. According to her, the problem is that the Fed has been constrained.
[An] explanation may be the greater proximity of the federal funds rate to its effective lower bound due to a lower neutral rate of interest. By constraining the amount of policy space available to offset adverse developments using our more effective conventional tools, the low neutral rate could increase the likely frequency of periods of below-trend inflation. In short, frequent or extended periods of low inflation run the risk of pulling down private-sector inflation expectations.
What's Brainard saying? First, the real rate of return on safe assets is low. For example, here's the fed funds rate minus the 12-month inflation rate - a proxy for what we're interested in:
By this crude measure, the real rate of return on overnight fed funds averaged -1.20% post-recession, and the most recent observation is -0.25%. But Brainard doesn't make reference to the actual real interest rate. She has another animal in mind - the "neutral rate of interest." What's that? Central-bank-speak, basically. Start with a standard Taylor rule, for example,

(1) R = r* + i* + a(i - i*) + b(y - y*).

In equation (1), R is the central bank's nominal interest rate target, r* is the long-run real rate of interest (supposing this is a well-defined object), i* is the central bank's inflation target, y is some measure of aggregate economic activity, and y* is "potential" economic activity (assuming, again, that this is well-defined). According to the Taylor principle, a is a parameter larger than 1, and typically b is a positive parameter. Then, r* + i* is the neutral rate of interest - the central bank's nominal interest rate target when it is achieving all of its goals.

So, given the Fed's inflation target of 2%, if r* is lower, as is consistent with what we can see in the last chart, this means that the neutral rate of interest is also lower. If r* is low, we should observe a low nominal interest rate target, on average, with the Fed responding to random shocks and missing its ultimate inflation and output targets on the low and high sides. But, what's a good estimate of r*? For this we need a model. In standard neoclassical growth models with some sort of appended role for monetary exchange, r* is a constant, and in some models it's endogenous, and dependent on monetary policy, among other things. Certainly, if we want to explain what is going on in the last chart, we can't rely on a theory that implies constant r*.

But whatever is driving r*, (a shortage of safe assets for example), we can certainly agree that r* is low. If it's as low as what we see in the last chart, post-recession, then r* = -1.2%, and the fed funds rate is currently well above where it should be. If r* = 0, say, then the current fed funds rate, at about 1.2%, is only 80 basis points below what Brainard would consider neutral. That's certainly not the way the majority of the FOMC thinks about this problem, as you can see from the last submitted projections. Most committee members think the fed funds rate will be above 2% by the end of 2018, and about 3% in the long run. Of course, the FOMC's actual policy interest rate has come in well below its forecasts for some time, and whether the FOMC now knows its own mind remains to be seen. Thus, if the low inflation readings we have seen this year turn out to be transitory, and the FOMC finds reasons, as it has in the past, to forego interest rate increases, things should be just fine (barring some unforeseen disaster, in which case inflation control is out the window anyway).

But, and this is critical, what should the Fed do if inflation continues on the low side or, alternatively, jumps to the high side of 2%? The views of the FOMC are summarized, for the most part, in this sentence from the last FOMC statement:
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
That's basically PC logic. According to the Committee, inflation may be low, but "accommodative" monetary policy will further tighten the labor market and, through a Phillips curve mechanism, make inflation come back to 2%. Why should the Fed continue to raise its nominal interest rate target? According to the Committee, that's preventative medicine. Tightening needs to occur in order to ward off excessive inflation, according to the majority of FOMC members, apparently.

Brainard appears to be disagreeing with that view. According to her, the Phillips curve mechanism is inoperative. But what is she recommending?
If, as many forecasters assume, the current shortfall of inflation from our 2 percent objective indeed proves transitory, further gradual increases in the federal funds rate would be warranted, perhaps along the lines of the median projection from the most recent SEP. But, as I noted earlier, I am concerned that the recent low readings for inflation may be driven by depressed underlying inflation, which would imply a more persistent shortfall in inflation from our objective. In that case, it would be prudent to raise the federal funds rate more gradually.
Basically, Brainard wants to see the inflation before increases in the policy rate occur. If inflation comes up, then she's in agreement with the rest of the committee. If if it doesn't come up, she would rather not have interest rate hikes. But, if the PC is inoperative, how will low nominal interest rates make inflation go up? How do low nominal interest rates cure the problem of "depressed underlying inflation" that she thinks exists?

Brainard suffers from Phillips curve confusion, and so does the rest of the FOMC, though in each case it's a different form of the disease. As I summarize in my recent paper, central bankers generally have inflation control wrong. Mainstream macroeconomic theory tells us that a central bank that raises its nominal interest rate target permanently raises the inflation rate - in the short run and in the long run. These models also tell us that a central banker armed with a Taylor rule and following the Taylor principle inevitably falls into a pit of frustration featuring low nominal interest rates and low inflation. That's in accord with the empirical evidence - with adjustments for factors other than monetary policy that matter for inflation and real interest rates. But central bankers aren't really interested in mainstream macroeconomic theory - for some reason they prefer to be led astray by undergraduate IS/LM/PC models. Why? Beats me.

Monday, June 26, 2017

The 2% Inflation Target

There's been a lot of talk recently about the 2% inflation target, and whether or not it would be a good idea to raise it, or change the nature of the target - to price level or nominal GDP targeting, for example. It's instructive, I think, to use as a starting point the letter addressed to Janet Yellen and the Board, and signed by some of my friends, acquaintances, and people I know of but have never met.

The authors of the letter argue that it's a good time to revisit the Fed's 2% inflation target. In case you haven't been following this, the Fed is a latecomer to inflation targeting. The Reserve Bank of New Zealand appears to have been the first inflation-targeting central bank, followed by the Bank of Canada, the Bank of England, the ECB, the Swedish Riksbank, the Swiss National Bank, and the Bank of Japan (not necessarily in that order, chronologically), among others. There are few deviants from the 2% inflation target, though central banks differ according to the price index they have chosen to measure inflation. The Fed stated its inflation targeting policy in January of 2012, in its "Statement of Longer-Run Goals and Monetary Policy Strategy," most recently amended in January 2016. The amended statement reads:
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.
Here's the key takeaway from that:

1) 2% inflation is a "longer run" goal, so we should expect to see deviations from 2% inflation in the short run. How long do we have to wait for the longer run? How large are the deviations the FOMC is willing to tolerate? Not specified.
2) The chosen price index that is used by the FOMC to measure inflation is the headline PCE. Not the CPI, the CPI excluding food and energy prices (core CPI), the core PCE, the Dallas trimmed mean index, etc. The headline PCE, dammit.
3) The inflation target is symmetric. The FOMC thus states that it's just as bothered by 3% inflation as by 1% inflation.

What's left out?

1) What's the time horizon? It makes a big difference whether the FOMC is interested in year-over-year inflation (last 12 months), or average inflation over the last 10 years. If it's the former, then past inflation quickly becomes a bygone - no need to make up for a period of low inflation with higher inflation in the future. If it's the latter, then the central bank has to be much more concerned about making up for previous misses.
2) How is the FOMC going to achieve its target? Will it use monetary aggregates as instruments, as in the 1980s or will it use as an instrument an overnight nominal interest rate, as is currently the case? Should there be a large central bank balance sheet or a small-footprint balance sheet? And given the instrument or instruments, which way does the FOMC move each instrument, and how much, in response to deviations in the inflation target?
3) Why 2%? Why not 10%, 0%, -2%, 5%?

The authors of the aforementioned letter first seem to want to argue that it's about time that the Fed's inflation target was revisited - after all it's been 10 years since the onset of the financial crisis. But, as should be clear from the above discussion, the Fed has not been at this game (inflation targeting) for long, and they have actually thought carefully about it as recently as last year (note the amendment to the Statement). Why is the issue so pressing? Is the FOMC missing its inflation target? Let's look:
That's a conventional inflation measure - 12-month headline PCE inflation. Inflation was fairly low in 2015, but from late last year the FOMC has been doing well. Inflation even exceeded the target early this year, and the last observation is 1.7%. To give us a ballpark idea how we might evaluate that performance, consider that the Bank of Canada (inflation targeters since 1991) sets a target range of 1% to 3% (though they look at a whole set of inflation measures). So, by the Bank of Canada's criterion, the FOMC hasn't been out of the 1-3% range very much since the last recession. So, the FOMC's inflation targeting performance, according to the goalposts it set up for itself, has been pretty good over the last 7 or 8 years.

But maybe, in order to accomplish so much on the inflation front, the FOMC has been sacrificing a lot on some other front. What does the FOMC think it is trying to achieve in terms of the second leg of its mandate? Again, back to the Statement of Longer Run Goals:
The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC’s Summary of Economic Projections.
So, to paraphrase, the FOMC is worried about deviations from "normal" unemployment rates and rates of output growth, and cautions that there are forces outside the control of monetary policy that determine what those normal rates are.

So, what's the recent behavior of the unemployment rate? I'll even go one better and use a conventional measure of labor market tightness - the ratio of the number of job openings to the number of unemployed:
Since the BLS has been collecting job vacancy data, the only higher observation than the last one in April 2017 was in January 2001. Currently, what exists is an abnormally tight labor market. Real GDP growth, at about 2% per year since the last recession ended, is historically low, but it's well recognized that this ia due to low productivity growth - a factor outside the Fed's control. Some might argue that the employment/population ratio is abnormally low, or that U6 (including marginally attached workers, and part-time employed wanting full-time work) unemployment is somewhat abnormally high, but again it's hard to argue that's not due to factors (demographics, fiscal policy, skills mismatch) outside of the Fed's control.

Thus, in terms of the FOMC's own criteria, and qualifications to those criteria, there's nothing happening on the maximum employment front that somehow represents a sacrifice incurred in the fight to control inflation.

So what could the letter-writers be complaining about?
In years past, a 2 percent inflation target seemed to give ample leverage with which the Fed could lower real interest rates. But given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted. Such a reassessment is particularly appropriate when the lack of evidence that moderately higher inflation would harm Americans’ standard of living is juxtaposed with the tremendous evidence that a tighter labor market would improve Americans’ standards of living.
What's that about? First, as is widely recognized by now, real rates of return on safe government debt have been falling for some time, and that's a worldwide phenomenon. Here's a crude, but straightforward, measure of the overnight real interest rate - the nominal fed funds rate minus the PCE inflation rate (as a proxy for anticipated inflation):
I've used quarterly data to provide some smoothing. Even though this real rate measure is crude, I think it's about the best we can do. Some sophisticated measures that people have constructed require taking a stand on the theory, and the measure I've used is agnostic. Note that periods of low real interest rates are not uprecedented, but before the last recession, a low real interest rate tended to be temporary and associated with the tail end of a recession. A period of persistent negative real interest rates in a recovery period, as we've seen since 2009, is indeed unprecedented. The last observation (2017Q1) is -1.3%, and the average since the end of the last recession is -1.2%. Given what we know about the causes of low real rates (high demand and low supply of safe assets, low consumption growth), we have no reason to think that low real interest rates will not persist up to or beyond the time horizon that is relevant for monetary policy decisions. So, our first fact is:

1. The real overnight interest rate is persistently, and unprecedentedly, low. This could change, but there's no good reason to expect it to.

Then, as the letter-writers say, this means that the Fed no longer has "ample leverage" to "lower real interest rates." What could that mean? The Fed's key instrument is a nominal interest rate target. It's well-established that the Fed can lower real interest rates - but only in the short run - if it lowers its nominal interest rate target. So, the letter-writers must mean that, if the real interest rate is low, then with a 2% inflation target you can't lower the nominal interest rate target when you might want to. Why? Because it won't be very high, and there's an effective lower bound on how low the nominal interest rate can go (zero in the US under current rules - though that's subject to some debate). That's just basic Fisherian (or neo-Fisherian) logic, but I don't think I've ever seen an advocate of higher inflation targets say it that way. Something about using the word "Fisher," I guess. Go figure. Second fact:

2. A persistently low real interest rate implies that, to achieve a given inflation target - say 2% - the central bank must on average set its nominal interest rate target lower than was the case in days of yore when the real interest rate was higher.

So, with the current fed funds rate at 1.16%, if we suppose the real interest rate persists at about -1.2%, this should ultimately put inflation above its target, to about 2.4%, by Fisherian logic. In the last tightening cycle, the fed funds rate reached 5.25%, and the target was reduced beginning in September 2007, to essentially zero by the end of 2008. So, if we take seriously the power of monetary policy working through reductions in the nominal interest rate in bad times, then a fed funds rate of 1.16% (or possibly more appropriately 1%) doesn't give the FOMC much room to cut, should things go south. Of course, it's possible that the effects of changes in short-term nominal interest rates on real economic activity are small, even in the short run, and/or the key tool of the central bank in a crisis, for example, is lending to illiquid financial institutions. Unfortunately, as in much of macroeconomics we can't (perhaps surprisingly) say for sure.

But next, in the letter, it's stated: "...[as] the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted." First, "aggregate demand" is not something we observe - it's an undergraduate theoretical construct which, given its vagueness, shouldn't be bandied about by grownup economists. To be more precise, what the letter-writers have in mind, I think, is a Keynesian world with sticky wages and prices. In such a world "demand deficiency" is defined to be situations in which prices and/or wages are too high relative to efficient levels. So, (i) since the last recession (when the shock hit) is now going on 9 years in the rearview mirror, surely prices and wages have had time to adjust; (ii) the key symptom of "demand deficiency" is slack in the labor market. The chart above shows that the labor market is in fact unusually tight; (iii) I think the letter-writers think that a symptom of slack is inflation lower than the 2% inflation target. Low inflation is actually a symptom of persistently low short-term nominal interest rates. Ask, the Japanese about that (22 years with low interest rates and low inflation, and no sign of a sustained increase in inflation, even after throwing everything but the kitchen sink, i.e. higher nominal interest rates, at the problem), or read this accessible piece, or this one, which summarizes most of the more technical things I've written in blog posts. Basically, mainstream theory and the empirical evidence supports the neo-Fisherian view - that central bankers need to be more cognizant of the Fisher effect. That is, increasing (decreasing) the nominal interest rate makes inflation go up (down), and we can get this effect even in the short run.

The letter-writers recognize, implicitly, that the Fisher effect is important for inflation targeting. In fact, the crux of the argument is that a higher inflation target implies a nominal interest rate that is, on average, higher, implying that there is more room to cut interest rates in a recession. But, the letter-writers don't specify how we get from here to there. Seemingly, what they imagine is that, if the Fed keeps interest rates low, either by foregoing further tightening or even lowering the fed funds target, inflation will eventually take off. Then, supposedly, the Fed can get inflation under control by raising the nominal interest rate sufficiently to its new "normal" level, and we'll be set. If only the world worked that way. Again, persistently low nominal interest rates do not lead to persistently higher inflation, in theory or in practice. The way for a monetary policymaking committee to get around this, in the face of stubborn Phillips curve beliefs, is to raise the specter of incipient inflation - "horrendous inflation is just around the corner, and we have to tighten now to get ahead of the curve." It's not a lie as, by neo-Fisherian logic, it's self-fulfilling. Given the current policy debate, you can see how even that position is an uphill battle.

But, what about the 2% inflation target? Why keep it?

1. Many people have made this point, but it's the key one. The Fed has spent the time since Paul Volcker began his term in 1979 fighting for credibility. The view that the Fed will stick to 2% inflation forever is a strong belief - among financial market participants, economists, and lay people who are paying attention. We can't make a strong case for 2% vs. 4%, say, but we can make a very strong case that messing with the target is extremely dangerous, in terms of the potential for loss of credibility. And credibility is 90% of the game in the central banking business.
2. The Phillips curve model of inflation is basically a discredited theory. The parrot is dead. Admit it and move on. But, until that happens, people are being badly mislead by the dead parrot and its supporters. A central bank run by the letter-writers simply could not generate sustained 2% inflation, let alone anything higher, so they would be better off sticking with a low target, which they would undershoot anyway. The credibility problem again - better to miss by a little than a lot.

I'll leave you with one last chart.
This shows inflation averaged over the last x months, where x is measured on the horizontal axis. So, the time since the end of the last recession is 94 months, and average inflation over that period (again, measured by headline PCE) was about 1.5%. The price of crude oil fell at about 34 months back, and you can see that in the chart. Fed "tightening" began at 16 quarters back, at which time you can see cumulative inflation increasing. Aside from some volatility in the last couple of months (completely normal), that's consistent with a neo-Fisherian view of the world: supposed "tightening" makes inflation go up. It certainly ain't going down.

Thursday, April 13, 2017

The Zero Lower Bound and Monetary Policy

Ben Bernanke has written a couple of blog posts on the zero lower bound (ZLB) on nominal interest rates, and some implications for monetary policy going forward. The first deals with the extent of the ZLB "problem," and the second with monetary policy solutions.

In a previous post I wrote about the low-real-interest-rate phenomenon, and how central bankers view the implications for monetary policy. Basically, the real rate of return on government debt in the United States, and around the world, has been persistently low because of low productivity growth, demographic factors, and - most importantly, I think - the high demand and low supply of safe and liquid assets.

In his first piece, Bernanke is primarily interested in a paper written at the Federal Reserve Board by Kiley and Roberts, which I also commented on in my earlier post. Kiley and Roberts determine, based on simulations of the Board's FRB/US model, that if low real interest rates persist into the future, then US monetary policy will more frequently be constrained by the zero lower bound - assuming that negative nominal interest rates are not an option. The consequences, according to Kiley and Roberts, are that inflation will tend to fall short, on average, of the 2% inflation target, and - by Phillips curve logic - real output will fall short of "full employment" output.

But, Bernanke finds it puzzling that most of the measures of inflation expectations he has been looking at tend to be fairly persistent at about 2%. If the ZLB were such a big problem for inflation control, in the way that Kiley and Roberts envision, shouldn't market participants be predicting low inflation? Let's look at one measure of inflation expectations - the 10-year breakeven rate (the yield on a 10-year Treasury bond minus the yield on a 10-year TIPS):
Currently, that measure has dropped a bit below 2%. Recall that TIPS are indexed to CPI inflation, not PCE inflation, which is what the Fed targets. Here's the difference between CPI inflation and PCE inflation:
As you can see, the difference is on average positive, and quite variable. But, if the 10-year breakeven rate is biased upward as a measure of anticipated inflation, then maybe anticipated inflation is in fact substantially lower than 2%. So maybe Bernanke shouldn't be so puzzled.

But suppose that we take other measures of anticipated inflation seriously, as Bernanke does (and perhaps as we should not). For example, professional forecasters, rightly or wrongly, tend to persistently forecast 2% inflation over the medium term. Bernanke's interpretation is that Kiley and Roberts are doing the analysis right, but they're not taking into account other aspects of policy - forward guidance and quantitative easing (QE). That is, according to Bernanke, the Fed will "do what it takes" to maintain its 2% inflation target in the future - binding ZLB or not.

Perhaps unsurprisingly, Bernanke's advice for hitting the 2% inflation target given a frequently binding ZLB constraint is to do what he did:
One possibility, which seems desirable in any case, is just to build on and improve the approaches used between 2008 and 2015. Strategies the Fed used to address the zero lower bound included aggressive rate-cutting early on, quantitative easing, forward guidance about future rate paths, and a “risk-management” strategy that entails a very cautious liftoff from the zero bound when the time comes.

It seems to me that Bernanke has mischaracterized the problem and, given that, he's not going to do well in solving it. Here's my take on this:

1. A persistently low real interest rate, if it is a problem for inflation control, would imply that the central bank on average misses on the high side. This is just the logic of the Fisher effect. As Kiley and Roberts say,
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
But they don't seem to understand that a corollary is that, if the ELB (effective lower bound) is encountered more frequently, this implies that the nominal interest rate is on average higher than what is required to hit the 2% inflation target. So, "according to the Fisher equation," as they say, inflation will be higher, on average, than 2%, not lower.

I've written a paper about this. My model can accommodate a number of things - sticky prices, money, credit, open market operations, collateral, safe asset shortages. And it's got neo-Fisherian properties, as all mainstream macroeconomic models do. In the model, one can work out optimal monetary policy, and I do this in the context of different frictions, to separate out how these frictions matter for policy. With just a basic sticky price friction, the model exhibits a Phillips curve, and if the ZLB binds in the optimal monetary policy problem, due to a low real interest rate, then inflation and output are too high. If we take this version of the model seriously, an interpretation in terms of recent history, is that low real interest rates have not been impinging on monetary policy in the United States. Inflation has persistently come in below the 2% target, and the Fed was doing the right thing in raising nominal interest rates, so as to increase inflation.

2. If forward guidance works, it does so through commitment to higher future inflation. And this promise is carried out with a higher future nominal interest rate. Again, this is just standard neo-Fisherian logic. The current nominal interest rate determines anticipated future inflation. So, if the problem is a binding ZLB constraint, and current inflation is too high as long as the ZLB binds, then the central bank can reduce current inflation while at the ZLB by promising higher inflation when the ZLB no longer binds. But, according to the Fisher effect, the central bank achieves higher inflation through a higher setting for the nominal interest rate. That's in my paper too.

Conventional ZLB economics doesn't work that way. Work by Eggertsson and Woodford and Werning derives results that Bernanke describes as "make-up" policy. That is, the central bank makes up for a period during which the ZLB binds by committing to staying at the ZLB for longer than it othwerwise would. As far as I can make out, these results are particular to how these authors set up the problem. I can turn the results on their head in a model with sticky prices, demand-determined output, and a Phillips curve. And I can do it in a way that doesn't yield various "paradoxes" - a paradox such as less price stickiness being a bad thing (Werning).

But that's forward guidance in theory. I have yet to see forward guidance work in practice. Indeed, Bernanke's execution of forward guidance in the post-financial crisis period is an example of how not to do it.

3. Quantitative easing as an approach to inflation control? Forget it. A great example here is Japan, which I most recently discussed in this post. QE appears to be ineffective in pushing up inflation in a low-nominal-interest-rate environment - the solution if inflation is too low is what comes naturally: increase the nominal interest rate.

In conclusion, if low real interest rates persist, at the levels we have seen, then this should not be a problem for inflation control. The Fed can control inflation, albeit with a lower average level of short-term nominal interest rates than we have seen in the past. Potentially, problems could be encountered, not with inflation control, but in affecting real economic activity. Though neo-Fisherism says increases in the central bank's nominal interest rate target make inflation go up, these ideas do not suggest that an increase in the nominal rate makes output go up. The conventional notion that monetary stabilization policy is about reducing interest rates in the face of shocks that make output go down seems to be strongly supported by the data. Thus, if there is a problem for monetary policy in a low-real-interest-rate environment, it's that the nominal interest rate cannot fall enough in the face of a recession. Between mid-2007 and late 2008, the fed funds rate target fell from 5.25% to (essentially) zero. But, if the average fed funds rate is 3%, or 2%, it can't fall by 500 basis points or more in the event of a downturn.

But how do we know that historical Fed behavior was optimal, or even close to it? Standard New Keynesian theory says that, if the real interest rate is sufficiently low, then the nominal interest rate should go to zero. But in my paper, if we're explicit about the reasons for the low real interest rate - in this case a tight collateral constraint - then the low real interest rate implies that the nominal interest rate should go up. That is, a low real interest rate reflects an inefficiently low supply of safe collateral, and an open market sale by the central bank can mitigate the collateral shortage, which results in higher nominal and real interest rates.

Sunday, April 2, 2017

Plain Speaking

Andy Haldane, Chief Economist at the Bank of England, gave a speech last Friday at the San Franciso Fed titled "A Little More Conversation, a Little Less Action." What was Haldane trying to get across? He wants to build "trust and legitimacy" by "rethinking how and with whom central banks engage." Why should we do this?
...two recent developments mean that central banks’ engagement strategies may need to be widened and deepened. First, the global financial crisis has dealt a trust-busting blow to many institutions, including central banks. Second, the way trust is built has been fundamentally reconfigured. Where once trust was anonymised, institutionalised and centralised, today it is increasingly personalised, socialised and distributed.
Andy's speech was about central bank communication, but he started by saying something general about the place of institutions in contemporary society. First, according to Andy, the financial crisis changed things. With respect to central banks, there has been more questioning of what central banks and economists do. And a lot of the that criticism is coming from economists - including Andy Haldane himself. In this article, from earlier this year, Haldane is quoted as saying:
It’s a fair cop to say the profession is to some degree in crisis.
So, seemingly, one of the trust-busting punches to central banks and economists was thrown by Andy Haldane, and now Andy Haldane wants to tell us how we can built up the trust he is helping to destroy. Let me emphasize at this point that the economics profession is not in crisis. The profession is fundamentally healthy and, like any science, is constantly reinventing itself in its usual methodical ways.

Haldane's second point is... wtf? Let me repeat it again, so we can attempt to dissect it:
Second, the way trust is built has been fundamentally reconfigured. Where once trust was anonymised, institutionalised and centralised, today it is increasingly personalised, socialised and distributed.
What is trust? My online dictionary says:
firm belief in the reliability, truth, ability, or strength of someone or something.
So, trust cannot be "anonymous." It has to be attached to someone or something we can name - Andy Haldane, or the Bank of England, for example. Was trust "institutionalised?" What would that mean, exactly? As per the definition, we could trust an institution, such as the Bank of England, or we could think of trust being built up as a kind of implicit institution - the institution of trust, as it were. Is trust now "socialised?" Now I'm really befuddled. Is it distributed? Haven't a clue. Who would be doing the distribution? Does it distribute itself or what? You can see that, in giving a speech on how to communicate, Andy isn't exactly demonstrating the state of the art.

After the preliminaries, Haldane then settles in to what is, in part, a fairly conventional speech on central bank communication. He talks about some of the history of central bank communication and why we do it. Though he uses the word "trust" a lot, we could translate this into the standard language of "commitment," I think, without any loss. What are Haldane's recommendations for improvement in central bank communication? You could summarize this as:

1. Understand who you're talking to.
2. Speak and write simply and clearly.
3. Listen.
4. Be on the lookout for new ideas.
5. Tell people what you're doing.

And that's about it. This paragraph in the conclusion sums things up nicely:
It is an irony, and not one lost on me, that this speech is a classic example of one-way central bank communications. Worse still, it comes in at around 11,500 words, contains 2,000 adverbs and adjectives and has a reading grade score of around 11. Perhaps central bankers, like this one, have always been better at preaching than practicing. If so, that needs to change. And when better to change than now.
Yes, Andy, no time like the present. In plainspeak, cut the bullshit.

That said, Andy's topic is very important - communication is the key problem for central bankers, and we don't always do it well. In order to do our jobs, and to ensure that our institutions survive and thrive, we have to communicate well. How should we do it? In his speech, Andy mentions the songs of Elvis Presley. Though Elvis was indeed a great communicator, he didn't actually write songs. One song that Elvis sang but didn't write is "Baby, Let's Play House," written by Arthur Gunter. For "Baby Let's Play House," even the title communicates well - you know exactly what this song's about. Here's the first verse, the way Elvis sang it:
Oh, baby, baby, baby, baby baby. Baby, baby baby, b-b-b-b-b-b baby baby, baby. Baby baby baby. Come back, baby, I wanna play house with you.
Genius. Gunter - speaking through Elvis - tells you exactly what's on his mind. But he also wants to sell some records, and he knows he can't do that if he actually spells it out. He communicates precisely to the listener, but in a way that will slip by the censors. However, though 50s rock and roll is great communication, I don't think Janet Yellen would be bringing Elvis - or Arthur Gunter - to her press conferences to explain things, if they were still alive.

So, to get more specific about monetary policy, here's a piece of Fed communication, from the last FOMC statement:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
Who is the intended audience for this? Who should it be? Clearly, one would need to know some economics to understand the above paragraph - it can't be intended for the general public. Should it be targeted to a less-specialized audience? Probably not. Maybe it's better for the Fed to communicate in more simple, direct, language in other forums. That's typically done in talks given by Governors and Fed Presidents to lay audiences. Other people at the Board and the regional Feds do that too. But, in the FOMC statement, the language needs to be precise - the FOMC wants to get across to financial market participants, and others who care about the nitty gritty of monetary policy, why it is doing what it's doing, and what it intends to do in the future.

What does the paragraph say? I'll take a stab at translating it into plainspeak: The FOMC has interpreted its dual mandate, specified by Congress, to be maximum employment and a symmetric 2% inflation target. The Committee currently attempts to achieve this goal, in part, through adjustments in the target range for the federal funds rate. Changes in the fed funds rate target range are made in response to all available information. The Committee is currently normalizing policy, which implies that further increases in the target federal funds rate range are expected, but such changes will probably occur gradually. That was actually harder than I thought it would be, and the end result is still not as simple as we might like. What's a "symmetric 2% inflation target," anyway?

But what's wrong with the original paragraph in the FOMC statement? It both says too much, and too little. Do people need to be told the Fed is looking at everything? Don't they understand that? The Fed is going to monitor actual and expected inflation developments, but so what? What's it going to do in response to what it sees? What exactly are the levels of the fed funds rate that are expected to prevail in the long run? An informed person would know that some of that information is in the Summary of Economic Projections, but why isn't there a reference to that in the statement?

People have agonized and argued at great length over the wording of FOMC statements. Sometimes a single word can get considerable attention. But, if the goal is communicating with the informed public, all the effort in crafting the statement has perhaps been wasted if people can't understand it, or if they feel it leaves them no better informed. But perhaps the FOMC statement serves as a vehicle for obtaining consensus among the Committee's members and achieving continuity in its decisions. Maybe it's not about communication with the outside world at all - possibly we should just think of the statement as a small window through which we can view some of the intricacies of FOMC decisionmaking.

But, I think the Fed is actually pretty effective at communicating with the public, and communication is a two-way street. If there are people complaining that the Fed isn't keeping them up to speed, they should first spend some time on the receiving end of Fed communications, and see if their attitude changes. What's the Fed doing, with respect to communications? I'll give you a sample, based on what I know about the activities of the St. Louis Fed:

1) The St. Louis Fed President, Jim Bullard, has a very active schedule of speeches and interviews. Jim is a great communicator (though whether he's at Elvis level I'm not sure) and does a first rate job of getting ideas into the public forum.

2) There are many people at the St. Louis Fed who give public presentations and interviews. For example, Research department economists are trained in media relations, and some of the community outreach we do is through our branches - in Memphis, Louisville, and Little Rock. Economists do presentations for Boards of directors, and for members of the general public at these institutions.

3) The St. Louis Fed has been a world leader in consolidating economic data, and making it accessible to the public. That's what FRED, Geofred, and Fraser are about. These products help promote financial literacy, and allow people to engage with economic ideas.

4) You probably didn't know this, but the St. Louis Fed is an educator, through its econlowdown program. The group responsible for these programs was awarded the 2017 Excellence in Financial Literacy Education (EIFLE) Award for Education Program of the Year: Children, General.

5) An annual event at the St. Louis Fed is Dialogue with the Fed, where an economist gives a prepared talk to the public, and a panel then answers questions from the audience.

6) The St. Louis Fed has an array of publications. On the higher end is the St. Louis Fed Review, for which some knowledge of economics is required; the Regional Economist is a more widely-accessible economics publication, and there are shorter pieces in Economic Synopses, and the On the Economy Blog.

So, I think the state of central bank communication - at least the part of it I know something about - is very healthy. That said, the issues are technical, and sometimes complicated, and a lot more can be done by central banks and educators to make those issues better-understood.

Wednesday, March 29, 2017

Low Real Interest Rates and Monetary Policy

That real rates of return on government debt are at historical lows is well-established. Of course, the anticipated real rate of return on government debt - which is what matters for economic behavior - is unobservable, and that's problematic. Typically, macroeconomists resort to proxy measures as a starting point for addressing issues related to low real interest rates. For example, we could use the current twelve-month measured inflation rate as a proxy for anticipated inflation, and subtract that from some observed nominal interest rate to get a crude measure of the real interest rate. Like this, for example:
The chart shows the three-month US T-bill rate, minus the 12-month pce inflation rate. As you can see, it's not like we have never seen real rates of interest (by this measure) as low, but short-term real interest rates have never been as persistently low, at least in the post-1960 sample.

Typically, though, when low real interest rates are discussed in policy circles, the discussion does not revolve so much around actual real rates of interest, but some other real interest rate concept. And there are several such concepts, which is bound to make things confusing, if not totally impenetrable. Let's try to sort this out.

(1) The natural real rate of interest: For the average macroeconomist, this measure is well-defined, though not necessarily useful. The natural real rate of interest, or Wicksellian natural rate is the real interest rate in a New Keynesian (NK) macroeconomic model, if we remove all wage and price stickiness. For simplicity, early NK models were built so as to leave out all sources of inefficiency, except for wage stickiness (sometimes) and price stickiness (usually). These models may have efficiency loss due to monopolistic competition, but that's a by-product of the approach to price stickiness. So, essentially, the natural real rate of interest is the real rate of interest in the underlying real business cycle model with flexible wages and prices. Why am I saying this concept is "not necessarily useful?" First, while there is some complacency among NK practitioners that NK is all we need to think about in understanding monetary policy, that's a dangerous idea. The basic model has many faults, not least of which is that it neglects the essential details of monetary policy - assets actually play no role in the model, in that there is no central bank balance sheet, no open market operations, no banks, no role for credit, for money, etc. Second, the baseline NK model cannot explain why the natural real rate of interest might be low. For example, low-real-interest-rate NK macroeconomics, such as Eggertsson and Woodford's work or Werning's, typically assumes the real interest rate is low because the subjective discount factor is high. That is, the low natural rate results from a contagious attack of patience. As is well-known, preference shock "explanations" for economic phenomena aren't helpful. If you like explaining the financial crisis as a contagious attack of laziness accompanied by an increased dislike for some assets and an infatuation with some other assets, most people aren't going to listen to you - and those that do listen shouldn't. I think some NK practitioners think of the high discount factor as a stand-in for something else. If so, it would be more useful to develop explicitly what that something else is.

(2) The equilibrium real interest rate: I'll let Ben Bernanke explain this one: helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
This is where the confusion starts. Bernanke tells us this is a synonym for the "Wicksellian interest rate," suggesting that the "equilibrium rate" is the same as the "natural rate." And he says that the equilibrium real interest rate is the "rate consistent with full employment of labor and capital resources," which would tend to steer the reader in the direction of thinking this is an NK natural rate of interest. But, the remainder of the paragraph appears to describe what happens in an IS-LM model, so Bernanke is mixing theories - never a recipe for clarity. Further, "equilibrium real interest rate" is bad language for describing the natural rate of interest in the NK model, as the sticky-prices-and-wages real interest rate is in fact an equilibrium real interest rate - but it's a non-standard equilibrium concept.

(3) The neutral real interest rate: Janet Yellen covered this one in a recent speech:
Gauging the current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance at a given time. A useful concept in this regard is the neutral "real" federal funds rate, defined as the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a "neutral" policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator. Although the concept of the neutral real federal funds rate is exceptionally useful in assessing policy, it is difficult in practical terms to know with precision where that rate stands. As a result, and as I described in a recent speech, my colleagues and I consider a wide range of information when assessing that rate. As I will discuss, our assessments of the neutral rate have significantly shifted down over the past few years.
To clarify, here's what I think she means. It's common to think of monetary policy in terms of a Taylor rule, which we can write as:

R = r* + a(i-i*) + b(y-y*) + i*,

where R is the fed funds rate, r* is a constant, i is the actual inflation rate, y is the actual level of output, i* is the inflation target, and y* is full-employment output. It's typical for people to assume that a > 1 and b > 0. Then, if there is full employment and the central bank is hitting its inflation target, we have R = r* + i*. So, in the Taylor rule, r* is the neutral real interest rate, and r* + i* is the neutral nominal fed funds rate before we have "adjusted for inflation," as Janet Yellen says.

So, given that r* is low, what implications does this have for monetary policy? Of course, the answer to that question should depend on why it is low. Economists have discussed several reasons for low real interest rates:

1. Low productivity growth: In standard models, the real interest rate falls when consumption growth falls. Lower growth in total factor productivity growth implies lower growth in consumption in the long run, which implies a lower real interest rate.

2. Demographics: Demographic structure matters for savings behavior, which in turn matters for the real interest rate. In particular population growth and longevity are important. For example, lower population growth tends to increase capital per worker and lower the real interest rate, and people save more if they expect to live longer, which also will tend to increase capital per worker and reduce the real interest rate. A paper by Carvahlo et al. is an attempt to disentangle some of those effects.

3. Higher demand and lower supply of safe, liquid assets: The low real interest rates we observe are interest rates on government debt, and such assets have functions that go well beyond providing a safe vehicle for savings. Government debt is widely traded in financial markets, and is the principle form of collateral in the market for repurchase agreements, which is a key part of the "financial plumbing" that helps financial markets run efficiently. Much like money, government debt bears a liquidity premium - market participants are willing to hold government debt at lower rates of return than if they were holding it purely for its associated payoffs. Then, the higher the demand for government debt relative to its supply, the higher the liquidity premium, and the lower the real interest rate on government debt. The supply of safe collateral fell as a result of the financial crisis - some types of private collateral and sovereign debt were no longer considered safe. As well, the crisis engendered an increase in demand for safe collateral due to an increase in perceived crisis risk, and because of new financial regulations, associated with Dodd-Frank and Basel III, for example.

I tend to think that (3) is most important, but that's based on working through some models, like this one and this one, and my own informal views on what is going on in the data. On that note, I should add a fourth factor:

4. Monetary policy: Indeed, the real rate of interest on government debt may in part be low because of monetary policy. First, conventional monetary policy can make the real interest rate permanently low. For example, in this paper, if safe collateral is scarce, a reduction in the nominal interest rate also reduces the real interest rate - permanently. That's because the open market operation that reduces the nominal interest rate is a purchase of good collateral (same effect under a floor system with reserves outstanding). Second, an expansion in the central bank's balance sheet can reduce the real interest rate, as I show in this paper. Basically, swapping reserves for government debt reduces the effective stock of safe collateral, as reserves are an inferior asset to government debt (why else would the interest rate on reserves exceed the T-bill rate?). Thus a central bank balance sheet expansion exacerbates the problem of collateral scarcity - quantitative easing may be a bad idea.

What we need to evaluate what is going on is a model that can incorporate these factors, and can be used both to evaluate quantitatively how (1)-(4) matter, and the implications for optimal monetary policy. So what are economists in central banks up to in this respect? At the most recent Brookings paper conference, there are a couple of papers that deal with the problem, one by Kiley and Roberts, at the Federal Reserve Board, and the other by Del Negro et al. at the New York Fed.

Let's look first at the Kiley and Roberts (KR) paper. The key monetary policy problem KW perceive with low r* - and this, not surprisingly, is consistent with mainstream policy views - is that this will cause the effective lower bound (ELB) on the nominal interest rate to bind more frequently. As they say,
ELB episodes may be more frequent and costly in the future, as nominal interest rates may remain substantially below the norms of the last fifty years.
Why would this happen? Going back to our Taylor rule, a lower r* implies that, when the central bank is hitting its targets, then the nominal interest rate has to be lower. So, if the economy is being hit by shocks which cause the central bank to move the nominal interest rate up and down, and if the average nominal interest rate is lower, then the central bank will find itself more frequently constrained by the ELB. Then, periods at the ELB will be periods when the central bank departs from its goals, and there is nothing (other than unconventional policy) that the central bank can do about it. Faced with this perceived problem, some policymakers contemplate increases in the central bank's inflation target - inflation would on average be higher, which may imply a welfare loss but, as the argument goes, there are benefits from being constrained by the ELB less frequently.

This is basically Fisherian logic. Over the long run, a higher nominal interest rate will be associated with higher inflation. Perhaps curiously, KR studiously avoid mention of Irving Fisher, though Jonas Fisher gets several mentions. The one callout to I. Fisher is this:
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
By the "Fisher equation" they mean the long-run Fisher effect, I think. Supposing that the long run real interest rate is a constant, r*, the long run relationship between the nominal interest rate and inflation is R = r* + i. But, of course, in the quote they have the causality going the wrong way. In their models, it's the central bank that controls inflation by controlling the nominal interest rate, so it's the nominal interest rate that's causing the inflation rate to be what it is, not the other way around. That's basic neo-Fisherism.

So what do KR do? They simulate a couple of models to determine what the potential losses are from retaining a 2% inflation target in a low-r* environment. The first model (and this won't surprise you if you know anything about quantitative policy analysis at the Board) is the FRB/US model. For the uninitiated, the FRB/US model is basically a relic of the 1960s - the type of large-scale econometric model that Lucas convinced us in 1976 should not be used for policy analysis. And, 41 years later, here's FRB/US - being used for policy analysis. As KR say:
As emphasized in Brayton, Laubach, and Reifschneider (2014) and Laforte and Roberts (2014), the FRB/US model is extensively used in monetary-policy analysis at the Federal Reserve and captures features of the economy that reflect consensus views across macroeconomists, but is not strictly “micro-founded” in the manner used in many academic analyses.
So, apparently, economists at the Board choose to ignore academic standards (no reputable academic journal would - or should - publish an article about the policy predictions of FRB/US), and go about "extensively" using FRB/US to think about policy.

And you can see where it goes wrong. Here's what FRB/US tells us about what happens in a low-r* world:
... the ELB binds often and inflation falls systematically short of the 2 percent objective; in addition, output is, on average, below its potential level.
Basically, FRB/US is an extended IS/LM/Phillips curve model. In it, long-run inflation is exogenous (2% basically), and inflation will deviate in the short run from its long run value due to Phillips curve effects. So, not surprisingly, in this type of framework, when the ELB binds, output is below "potential" and this causes inflation to fall short of its target. But, by neo-Fisherian logic, if on average the nominal interest rate is too high, because it keeps bumping up against the ELB, inflation should, on average, be exceeding its target. For example, in recent history in the US, some people think that the inflation rate was persistently below target because the nominal interest rate was effectively at the ELB, and we could have done better (have had higher inflation) if the nominal interest rate were permitted to go below zero. Not so. The fact that inflation was persistently below target indicates that the ELB was not a binding constraint. The nominal interest rate was too low.

What else are KR up to? They also use an off-the-shelf DSGE model, developed by Linde, Smets, and Wouters, to address the same policy question. Is this model an better-equipped to answer the question than the FRB/US model? No. Such models, though smaller and more manageable than old-fashioned large-scale macroeconometric models like FRB/US, certainly can't lay any claim to structural purity - there are plenty of ad-hoc features (adjustment costs, habit persistence) thrown in to fit the data, and the model certainly was not set up to capture the phenomenon at hand. Though this DSGE model can certainly capture a decline in productivity (feature (1)) there's nothing much in there with regard to (2)-(4), and the monetary policy detail is shockingly weak. So, I don't think we should take the results seriously.

The second paper, by Del Negro et al. (DGGT) is more of a straightforward time series exercise - but there's some DSGE in this one too. This paper confronts the data in a useful way, focusing on the "convenience yield" on government debt (which I called a "liquidity premium" above), and showing, for example, that corporate debt does not share this convenience yield, which is important. The analysis documents a fall in the real rate of interest beginning in the 1990s, and the estimate of the current real interest rate is 1.0-1.5%. The econometrics in DGGT is sophisticated, but ultimately I'm not sure if I trust it more than what I see in the chart at the beginning of this post. Currently, the 3-month T-bill rate rate is about 0.80%, and the last reading for the twelve-month pce inflation rate is 1.9%. So, by my crude measure, the current real interest rate is -1.1%. If someone is giving me an estimate of 1.0-1.5%, I'm going to think that's way too high. If, given current policy settings, inflation is roughly at target, as is labor market tightness, then the nominal interest rate must be about right, if we follow our Taylor-rule logic.