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.