What Moves the Interest Rate Term Structure?, by Michael Bauer, Economic Letter, FRBSF: To understand the effects of news on bond markets, it is instructive to look beyond individual maturities and consider the entire term structure of interest rates. For example, unexpected changes in monthly nonfarm payroll employment numbers cause large movements at short and medium maturities, but do not affect long-term interest rates. Inflation news affects the long end of the term structure. Monetary policy actions vary in their effects on interest rates, but cause volatility at all maturities, including distant forward rates.
Daily changes in various interest rates are a staple of the financial news. But what causes these constant up-and-down movements? The underlying determinants are factors such as prospects for economic growth, expectations regarding inflation and monetary policy, and compensation for risk. Interest rates change as market participants receive new information about these factors. Often, various interest rates move together in the same direction.
However, there is more to interest rate changes than direction and magnitude. Bonds that mature at different time horizons do not move in lockstep. Much can be learned by looking at changes in the term structure of interest rates, that is, the entire range of rates from short maturities to long. Sometimes short-term interest rates move strongly and the long end of the term structure barely shifts. At other times, the short end remains anchored and the action is only in medium- and long-term rates. Identifying changes in interest rates across the maturity spectrum can be useful when assessing the impact of news on market expectations about the macroeconomy and future monetary policy. This Economic Letter looks at how different types of news affect interest rates across maturities.
Shifts in the term structure of interest rates
Yields on U.S. Treasury securities typically receive the most attention in reporting on the fixed income markets. Treasury security maturities range from less than a month to about 30 years. Gürkaynak, Sack, and Wright (2007) have constructed a useful data set of Treasury security yields and forward rates based on the prices of these securities. The data set is updated every day and publicly available at http://www.federalreserve.gov/econresdata/researchdata.htm.
To get a better picture of the effects of news on interest rates at different time horizons, I look at forward interest rates. Forward rates are rates contracted today for a loan made or security issued at a specified future date. A forward rate with, say, two years maturity is the interest rate that would be contracted for today on an overnight loan to be extended in two years. Conceptually, the forward interest rate is determined by expectations about the real short-term interest rate and the rate of inflation two years in the future. The rate also includes compensation for the interest rate risk of a two-year commitment. Changes in forward rates with different maturities reflect expectations of inflation and monetary policy at specific time horizons.
Figure 1 Interest rate changes on July 8, 2011
For example, consider the employment report released on July 8, 2011, in which the U.S. Bureau of Labor Statistics (BLS) reported that total nonfarm payroll employment increased by 18,000 in June. This fell well short of the consensus forecast for a 105,000 increase in payroll positions and was interpreted as bad news regarding the pace of economic recovery. Figure 1 shows the daily changes between July 7 and July 8, 2011, in hundredths of a percentage point for one- to ten-year Treasury yields and forward rates one to ten years ahead. All yields decreased, but by different magnitudes.
To get a better idea of the interest rate movements across horizons, I consider forward rates instead of yields. A forward rate is about one specific future point in time whereas yields are averages of forward rates. Thus forward rates offer clearer information about different horizons. On July 8, following the BLS employment report, the largest movements occurred in forward rates two to four years ahead. Changes at the longer end of the term structure eight to ten years out were much smaller. To the extent that these yield changes reflect shifting expectations for future short-term interest rates, the June employment report caused market participants to lower their anticipated path for the Federal Reserve’s policy rate, the federal funds rate, most dramatically at the two- to four-year horizon.
Macro surprises and the response of the term structure
Figure 2 Responses of forward rates to surprises
A. Payroll News
B. Core CPI News
The employment report example demonstrates a typical pattern. Interest rates respond to macroeconomic surprises in a pro-cyclical fashion. That is, yields fall in response to weaker-than-expected data and rise in response to stronger-than-expected data. Several empirical studies have documented this pattern. Balduzzi, Elton, and Green (2001) studied the response of some specific Treasury yields to macroeconomic announcements using a now standard event study methodology. The authors constructed a measure of surprise based on the difference between actual data and the median forecast in surveys prior to the data release, standardized to be comparable across different releases. They then performed a statistical exercise to measure the responses of Treasury yields to the macroeconomic surprises. Studies of this sort typically find that short-term yields respond little, but long-term yields react strongly to macroeconomic data surprises.
To go beyond individual yields, I estimate the responses across the entire term structure, and capture changes in all interest rates. Most of the variation in interest rates is captured by just a few underlying statistical factors. Based on this idea, it is possible to build a model that calculates the responses to economic data releases of Treasury security yields and forward rates across the entire term structure (see Bauer 2011).
Figure 2 shows the response of the forward rate curve to surprises in payroll employment and to the core consumer price index (CPI), which excludes food and energy. The dashed lines indicate the model’s predictions with 95% confidence. Forward rates at short and medium horizons show large and significant responses to surprises in nonfarm payrolls. The strongest response, around 0.07 percentage point, occurs at a maturity of about two years. Notably, far-ahead forward rates at horizons longer than six years do not significantly respond to the employment news. On the other hand, responses to core CPI inflation surprises are smaller in magnitude, but extend to the long end of the maturity spectrum. Distant forward rates show a small but statistically significant increase of about 0.015 percentage point to a higher-than-expected core CPI.
Thus, this model suggests an important difference between the effects of employment news and inflation news on interest rates. While employment news causes large responses, only inflation news affects the long end of the term structure (see Bauer 2011). This result contrasts with the findings of other studies regarding the long forward rate response to economic news (see Gürkaynak, Sack, and Swanson 2005).
Monetary policy actions
Monetary policy actions, such as changes in the federal funds target, releases of Federal Open Market Committee (FOMC) statements, or speeches by committee participants, often contain new information relevant to financial markets. Importantly, while the Fed has direct control only over the federal funds rate, it can also affect interest rates at other maturities by changing expectations of future monetary policy. How does monetary policy affect the term structure? In what way does it affect longer-term interest rates, which are crucial in determining lending costs and mortgage rates, and strongly influence economic behavior? Looking at the entire term structure of forward rates reveals how much news about monetary policy changes perceptions of economic fundamentals and affects rates at different horizons. Specifically, changes in the term structure show whether policy actions directly affect distant forward rates or whether the effects die after medium horizons.
An important difference exists between macroeconomic news and monetary policy news. We can quantify economic surprises, but we do not have a measure that satisfactorily captures all aspects of policy surprises. The language of FOMC statements and speeches cannot easily be quantified. To capture the surprise component, researchers have focused on how policy actions affect financial markets (see Kuttner 2001). Thus, to assess the effects of policy actions, I employ the same model-based methodology I used with employment and inflation news, examining changes across the entire term structure of interest rates as policy surprises were made public.
Figure 3 Effects of monetary policy actions on forward rates
Figure 3 shows the effects on forward rates of three Fed moves in 2007 to lower the federal funds target: a half percentage point cut on September 18, a quarter percentage point cut on October 31, and another quarter percentage point cut on December 11. These three easing actions had very different effects on the term structure. In September, the size of the cut surprised market participants. Short-term rates fell, but longer forward rates actually increased, which may have reflected an upward revision in expectations about economic growth. In October, forward rates at short and medium horizons increased on the day of the meeting, probably because markets had expected a larger federal funds rate move or a change in the language of the Fed’s policy statement. Thus, monetary policy was viewed as tighter than previously anticipated. Markets had anticipated the Fed’s December cut, so the short end of the term structure did not move much. But medium and longer-term forward rates fell significantly. Changing statement language apparently led market participants to expect much easier monetary policy over the medium and long horizons.
This variability of term structure shifts is typical of the effects of monetary policy on interest rates. This reflects the fact that policy actions are inherently multidimensional. Markets must consider both a federal funds rate decision or other policy action and an FOMC statement whose language may have changed from previous statements. The effects of policy actions and statements vary based on market expectations. The strongest effects occur when market participants are surprised. This makes monetary policy actions complex objects that affect the term structure of interest rates in highly variable ways. The complexity of monetary policy would also be apparent from the movements of inflation-adjusted interest rates, inflation expectations, and other asset prices.
Figure 4 Forward rate variability
Are there systematic effects of monetary policy on the term structure? Considering policy-driven interest volatility is helpful in answering this question. Figure 4 compares the forward rate volatilities on days of FOMC statements with the volatilities on days without such statements. Days on which the Fed released statements about monetary policy show higher volatilities than other days. Evidently, monetary policy is a key driver of interest rate movements. While most action is in rates at medium maturities of two to three years, policy actions also cause significant volatility in distant forward rates. Of course, this does not tell us whether long rates move in the same direction as shorter-term rates. It does however show that the effects of monetary policy on expectations extend to long horizons and do not die after horizons of a few years.
Conclusion
To understand the effects of macroeconomic data surprises and monetary policy actions on financial markets, it is important to consider how these affect the entire cross section of interest rates. Such an analysis shows where on the time horizon market expectations of economic fundamentals have changed. Similar analysis of the term structures of real interest rates, inflation expectations, and risk premiums has the potential to reveal even more about how changes in economic fundamentals drive the term structure of interest rates.
Gürkaynak, Refet S., Brian Sack, and Jonathan H. Wright. 2007. “The U.S. Treasury Yield Curve: 1961 to the Present.” Journal of Monetary Economics 54(8), pp. 2291–2304.
Kuttner, Kenneth N. 2001. “Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures Market.” Journal of Monetary Economics 47, pp. 523–544
This is the Press Release from Wednesday's FOMC meeting:
Press Release, Release Date: November 2, 2011, For immediate release: Information received since the Federal Open Market Committee met in September indicates that economic growth strengthened somewhat in the third quarter, reflecting in part a reversal of the temporary factors that had weighed on growth earlier in the year. Nonetheless, recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has increased at a somewhat faster pace in recent months. Business investment in equipment and software has continued to expand, but investment in nonresidential structures is still weak, and the housing sector remains depressed. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September. The Committee is maintaining its existing policies of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Charles L. Evans, who supported additional policy accommodation at this time.
Aftershocks, by Tim Duy: The reality of the worsening European situation came home to roost on Wall Street this week. Last week's "summit to end all summits" offered up only broad brush strokes to begin with, and even those were rapidly erased by plans for a Greek referendum on the deal. A rumor circulated earlier today that the referendum was dead, but that has since been refuted by the Greek government. It appears that either the Greek government collapses or the referendum will occur - and neither outcome is good for market participants looking for certainty in these uncertain times.
Let me suggest this as well - that even if Greece comes back on board with the existing agreement, the damage is already done. Three thoughts today:
A deepening Eurozone recession is inevitable. Even if full-blown financial crisis is avoided, the cost will be continued austerity programs that will sink the Eurozone economy ever deeper into recession. This will only exacerbate the problems facing European banks as nonperforming loans rise, which will be on top of the credit contraction to follow plans to have banks recapitalizing themselves with private money by next summer.
The unintended consequences of the EFSF. The EFSF was already a farce to begin with, underfunded and relying on leverage to cover up a lack of money. The farce continued as European leaders sought handouts from China to fund a project they themselves were not committed to. Then the lack of details within the latest plan is hampering the ability of the EFSF to issue debt. From the FT (hat tip to Zero Hedge):
The bond from the European financial stability facility will seek to raise €3bn ($4bn) and will be in 10-year bonds rather than a 15-year maturity because of worries over demand, say bankers. A 10-year bond is more likely to attract interest from Asian central banks than a longer maturity.
Bankers familiar with the issue said the EFSF had been considering a €5bn issue. However, the EFSF has denied this, saying it had always sought a €3bn issue...
...EFSF officials decided to price this week because market conditions might deteriorate if they hold off any longer, according to bankers.
The bond is expected to price at yields of about 3.30 per cent, about 130 basis points over Germany, the European market benchmark. This represents a big mark-up since the middle of September, when existing 10-year EFSF bonds were trading at about 2.60 per cent, only 70bp over Germany.
Now the insurance component of the EFSF is blowing back in their faces. From the FT:
“It is kind of ironic: it is Draghi’s first day. His first decision is ‘yes, buy Italian bonds’,” said Gary Jenkins, head of fixed income at Evolution Securities. He added that the move to make Europe’s rescue fund, the European financial stability facility, issue insurance on new Italian and Spanish debt was deterring buyers: “They have created a situation where the only people buying Italian debt are themselves.”
A trader of Italian government bonds said: “It was meltdown at one point before the ECB came in. There were no prices in Italian government bonds. That is almost unheard of in a big market like Italy. There were just no buyers and therefore no prices.”
By not creating a backstop for previously issued bonds, the Europeans have clearly identified those bonds at risk of default. If the Europeans are not willing to buy or insure the bonds, why should investors? Answer: They shouldn't. Consequently, the ECB was forced to do what it hates, buy Italian debt, and even then yields climbed above 6%, nearing levels that many believe is the point of no return for Italy.
Moreover, one should question the what is the meaning of "insurance" for Europe. I can't imagine the ESFS actually making good on any promises to insure bondholders, as the Europeans appear adept at defining defaults as "voluntary" and therefore not credit events covered by insurance.
Will the ECB be Europe's white knight? I think we all agree that lacking a lender of last resort, Europe has something of a credibility problem. As in, no credibility. And it has been pointed out repeatedly that the ECB could step into this role. After all, we are talking about the future of the Euro, which should be something of a concern for central bankers. And, as noted by Kash Mansori at The Street Light, by guaranteeing a price for Italian debt, the ECB would like have to buy far less than they think. But here is the problem - why should the Italians get an ECB backstop at 6%, while the Irish pay 8% and the Portuguese 12%? Politically, the ECB needs to backstop either everybody equally or nobody. Setting a ceiling on Italian debt alone risks setting off a firestorm of public anger within those nations already struggling under the weight of austerity programs. And note that even if the ECB does come into the fight, the will only do so in return for additional austerity. In other words, they might stave off financial collapse, but not recession.
Bottom Line: No matter how many summits they have, there is no easy out for the Europeans at this point.
The U.S. Federal Reserve announced new figures Wednesday used to calculate next year’s reserve requirements for depository institutions.
For net transaction accounts–mostly checking accounts–the first $11.5 million in deposits will be exempt from reserve requirements in 2012, up from $10.7 million in this year.
The Fed will assess a 3% reserve ratio on net transaction accounts from $11.5 million up to $71.0 million, compared with a ceiling of $58.8 million this year.
And the Fed will assess a 10% reserve ratio on net transaction accounts in excess of $71.0 million. The Fed didn’t change the reserve ratios in its annual indexing announcement.
Banks must hold a percentage of net transaction accounts as reserves in the form of vault cash, as a deposit in a Federal Reserve Bank or as a deposit in a pass-through account at a correspondent institution, the Fed said.
“The actions we have taken recently will be helpful in supporting growth and jobs,” Federal Reserve Bank of New York President William Dudley said. “The Fed is doing — and will continue to do — everything in its power to promote jobs and price stability.”
But Dudley said, “I do not think that monetary policy is all powerful,” explaining that “to get the strongest possible recovery, we need reinforcing action in areas such as housing and fiscal policy.” The decision last month to sell $400 billion in its short-dated holdings and buy a like amount of longer-dated bonds “should provide some additional support for growth,” Dudley said. ...
While the Fed has only just embarked on the program markets call Operation Twist, speculation is growing that more stimulus in the form of expanded Fed purchases of mortgage assets could be around the corner. Dudley is widely viewed as being in sympathy with Fed Chairman Ben Bernanke and the other Fed officials who believe the central bank still can provide stimulus to the economy.
Dudley left open the possibility he’d support the Fed buying mortgage securities beyond what it is doing now. ...
The Fed has a considerable dissident faction that contend at a time when families and companies are cutting debt, making credit more affordable won’t do much to boost growth and bring down the unemployment rate. ...
This topic came up in class the other day (see here and here too):
Did Speculation Drive Oil Prices? Market Fundamentals Suggest Otherwise, by Michael D. Plante and Mine K. Yücel, Economic Letter, FRB Dallas: Oil market speculation became an especially popular topic when the price of crude tripled over 18 months to a record high $145 per barrel in July 2008. Of particular interest to many is whether speculators drove oil prices beyond what fundamentals would have otherwise justified. We explore this issue over two Economic Letters. In this article, we look at evidence from the physical market for oil and conclude that fundamentals, and not speculation, were behind the dramatic rise and fall in oil prices. In our companion Economic Letter, we examine the futures market.
Oil prices began their climb in 2002, reaching a record high in mid-2008, and then collapsed at the end of ’08 amid the global recession. As world economic growth picked up, so did oil prices. Overall, the year-over-year change in oil prices has fairly closely tracked world gross domestic product (GDP) growth (Chart 1).
Energy consumption increases as GDP rises; but energy consumption in developing countries increases almost twice as fast as in developed countries. GDP expansion in emerging economies was particularly strong between 2005 and 2007, averaging 8 percent per year. Real GDP in China, for example, grew by an average 12.7 percent annually between 2005 and 2007, while the nation’s oil consumption increased 5.1 percent annually during the period.
From the beginning of 2007 to mid-2008, weekly prices for West Texas Intermediate (WTI) crude oil jumped 152 percent, from $57 to $143 per barrel. It’s possible that growing demand for crude oil might not be the reason for the rise. However, if the increase was due to other factors, oil consumption should have begun falling in response to the higher prices. Instead, there was almost no consumption decline during the period, implying that oil prices were driven by growing world income and demand.
Insensitivity to Price Change Consumers of oil and oil products are not very sensitive to price changes, especially in the short run. In economic jargon, the price elasticity of demand is very low. This is mainly because oil’s use for transportation purposes accounts for two-thirds of consumption, especially in developed countries, where there are no close substitutes in the short term. When consumers are insensitive to price changes, a shock in the oil market, whether from increased demand or reduced supply, will heighten price volatility.
To see whether rising oil prices from 2007 through mid-2008 are compatible with the elasticities for oil estimated in the energy economics literature, we performed a simple calculation. Taking the developed-world and emerging market GDP growth rates from the International Monetary Fund, and making some assumptions about income elasticities of demand, we can calculate the higher oil demand implied by these growth rates. Then, by comparing actual growth in consumption and the calculated consumption numbers, we can determine the oil price elasticities they imply. We found that these elasticities would have to range from 0.01 to 0.08 for prices to surge as they did in 2007 and 2008—well within the estimated elasticity ranges in the energy economics literature.[1]
OPEC Market Power Firmed Prices The oil market is not perfectly competitive. The Organization of the Petroleum Exporting Countries (OPEC), since its formation in 1970, has been an oligopolistic producer, trying to boost prices by controlling members’ output (with more success at times of higher demand growth). The remaining non-OPEC producers form a price-taking, competitive fringe. OPEC’s market share has dwindled from 52 percent in the early 1970s to a still hefty 42 percent today. In the 1990s, as the market grew, so did both OPEC and non-OPEC production. However, non-OPEC oil output growth flattened around 2003, while OPEC output continued expanding from 37 percent in 2003 to the current 42 percent level. Increased market power, coupled with rising demand, was a significant factor keeping oil prices high.
Low OPEC Excess Capacity OPEC’s crude oil production capacity has changed little since the 1970s, rising from 34 million barrels per day in 1973 to 35.5 million barrels per day in 2008. However, increased world consumption greatly diminished the cartel’s excess capacity. OPEC has added capacity slowly, using its restrained output to keep prices high.
It is easier to keep cartel members disciplined and conforming to production quotas when capacity is tight. Moreover, shocks in a tight oil market can increase price volatility because OPEC lacks the ability to offset these shocks, even if it desires to. Chart 2 shows the inverse relationship of oil prices and the cartel’s excess capacity. In mid-2008, when oil prices reached record highs, OPEC excess capacity was down to 1 million barrels per day.[2]
Inventories Did Not Increase A speculator wanting to drive up the current price of oil would have to buy in the spot market. Since the price is determined in a cash marketplace where transactions are settled with physical oil changing hands, speculative buyers would have to store their purchases, and inventories would rise. Instead, during the oil price run-up in 2007 and 2008, inventories in the U.S. were being depleted. Chart 3 shows WTI prices and U.S. oil inventories and illustrates the workings of an efficient market—as supplies diminish, prices rise and the market tightens.
Another possibility might be speculators using floating storage, keeping oil in tankers at sea and off the market. Floating storage appears to increase in 2008, rising from 68.4 million barrels at the end of October to 97 million barrels in May (Chart 4). However, floating storage declined in June and continued falling throughout the summer.
We would have expected to see floating storage rise significantly during the summer if speculators were in the market; instead, the opposite occurred. Floating storage did rise much later in the year, but that was concurrent with the global recession.
There is one additional type of storage—producers maintaining the oil as reserves and not producing. However, if we look at OPEC output, it clearly rose as oil prices went up, until July 2008. OPEC increased production by 2.4 million barrels per day from the beginning of 2007 to July 2008. Non-OPEC production remained relatively constant and did not rise, though this is largely a function of non-OPEC producers’ zero excess capacity rather than an attempt to restrict output.
Other Commodities Surged Those believing speculation pushed up prices point to the coincident increase in the number of noncommercial traders in the futures market—for example, speculators—and the rise in oil prices.[3] However, Chart 5 shows that this may not necessarily be the case. It depicts the prices of WTI, Illinois Basin coal, tallow and cobalt. Of these commodities, there is a futures market only for WTI. Yet, prices for Illinois Basin coal, tallow and cobalt increased as fast as oil, if not faster, in 2008 and fell just as quickly when the economy crumbled. Such integrated movement in the prices of these commodities is consistent with a pure demand story, rather than a speculation one.
Fundamentals, Not Speculation Activity in the futures market increased appreciably in the past decade, as did the number of noncommercial traders. This rise was coincident with the rise in oil prices, leading some to hypothesize that speculation—rather than market fundamentals—drove the price of oil.
The tripling of oil prices from early 2007 to mid-2008 is consistent with several market fundamentals, including increased demand from emerging markets, low elasticities of demand and reduced OPEC excess capacity. The behavior of inventories was also consistent with the reality of a tight market, not with a story of speculation-driven hoarding, whether we look at inventories above ground, below ground or floating at sea. Hence, evidence from the physical market for oil, similar to that from the futures market, is consistent with oil-market fundamentals leading to increasing oil prices before the global recession.
Notes
An elasticity of 0.01 implies that for every 10 percent change in oil prices, consumption falls by 0.1 percent. Estimated short-run price elasticities for oil range from 0.0 to –0.11. See “A Literature Review of Demand Studies in World Oil Markets,” by Frank J. Atkins and S.M. Tayyebi Jazayeri, University of Calgary, Department of Economics Discussion Paper 2004-07, April 2004.
OPEC excess capacity has ranged from a high of 9.8 million barrels per day in 1985 to a low of 700,000 barrels per day in 2004.
Christopher Sims and Tests for Causality: To tell the full story of Christopher Sims' contributions to causality, we need to go back to the state of the art in policy evaluation in the 1960s, in particular, to something known as the St. Louis equation:
Yt = c + a0Mt + a1Mt-1 + a3Mt-2 + b0Gt + b1Gt-1 + b2 Gt-2 + et
In this equation, output (Y) is regressed on current and lagged values of money (M) and government spending (G). The idea was to see how output responded historically to changes in money and government spending, and then use these estimates to guide policy. If we know how Y responds to M, then we can use that knowledge to set monetary policy optimally.
Now, there is a fundamental problem with this approach highlighted by the Lucas critique (the negative reaction to the other common approach, using large-scale structural models to evaluate policy, was discussed yesterday). If you change monetary policy you also change the values of the a and b coefficients so that the estimates are no longer reliable, and hence no longer a guide, but that criticism came later. At the time there was another worry.
The worry was something known as simultaneity bias. Consider the Mt term in the equation above. If Mt is "econometrically exogenous," i.e. if it doesn't depend upon Yt, then the estimated value of a0 will be unbiased. But if Mt depends upon Yt , perhaps through and equation such as Mt = h0 + h1Yt + ut, then the estimate of will be biased and hence a poor guide to policy decisions.
The first use of causality tests was to test to see if h1 in the "policy equation" was equal to zero, and Sims was a key player in the development of these tests. Thus, Sims starts his 1972 AER paper with:
This study has two purposes. One is to examine the substantive question: Is there statistical evidence that money is "exogenous" in some sense in the money-income relationship? The other is to display in a simple example some time-series methodology not now in wide use. The main methodological novelty is the use of a direct test for the existence of unidirectional causality.
If there was unidirectional causality from M to Y, then the estimate would be unbiased. But if there was two-way causality, i.e. if Y causes M (h1 is not zero), then the estimate would be problematic.
Sims contributed greatly to this literature, and once this work was largely complete, it quickly became clear that these tests could be used to assess causality more generally, the method was not limited to checking for econometric exogeneity.
But there was also a problem. The basic technique (an F-test on a set of coefficients) to test for causality worked well on 2-variable systems, but it didn't work reliably for systems with three or more equations (the problem was that X can cause Y, and Y can then cause Z so that there is a causal path from X to Z, but the F-test approach will miss this).
Sims Second major paper on causality addresses this problem by providing two new tools to assess causality, impulse response functions and variance decompositions (along the way it was also shown that Sims and Granger causality are equivalent). Impulse response functions, which have since become a key analytical device in macroeconomics, trace out the response of the variables in the model to a shock to another variable in the system (identification restrictions are needed to ensure that the shock is actually a policy shock, see here). If the variable, say output, responds robustly to a shock to, say, the federal funds rate, then we say that the federal funds rate causes output. But if we shock the federal funds rate and output essentially flat-lines in response, then causality is absent.
However, even when there is causality according to the impulse responses, impulse response functions do not tell us how important one variable is in explaining the variation in another variable (the impulse response function could look impressive, but it may be that we are only explaining 1% of the total variation in the other variable so that the response we are seeing is not very important in explaining why the other variable fluctuates over time). Variance decompositions solve this problem. They don't tell you the sign/pattern of the response like impulse response functions do, but the do give an indication of how important one variable is in explaining the variation in another variable (e.g. if M explains 75% of the variance in output, that's impressive and notable, but if it's only 1% then money isn't very important in explaining why output changes over time).
Sims second paper also made another important point. In his first paper, he found that money causes output (so it could not be treated as econometrically exogenous as in the St. Louis equation). But that was in a two-variable system including only M and Y. In his second paper he adds interest rates (i) and prices (P) to get a four variable system, and he finds that this overturns the results in his first paper. Once i is added to the model, M no longer causes Y. Thus, the lesson is that if you leave important variables out of a VAR system, it can produce misleading results.
But Sims' main contributions were, initially, the F-tests for testing causality in bivariate systems, and the addition of IRFs and VDCs to assess causality in higher order systems. In addition, he also provided many of the common "pitfalls of causality testing," -- causality testing can be misleading in a number of ways. One is above, leaving a variable out of a system. If A causes B to change tomorrow, and C to change the next day, a system containing only B and C will look as though B causes C when in fact there is no causality at all, a third variable causes both. Other pitfalls can occur, for example, when there is optimal control or when expectations of future variables are in the model. Identifying the pitfalls of the methods he (and others) developed was also an important contribution to the literature.
Sims' work on causality was highlighted in the Nobel announcement, and I hope this provided some background on this topic. But there's a lot more to be said about Sims' work over and above his work on causality testing discussed above and his work on structural VARs I discussed yesterday, e.g. his recent papers on rational inattention, and I hope to write more about both Sims and Sargent when I can find the time.
The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire.
Consistent with this prediction, the September employment report painted a picture of an economy still wading through knee-deep mud, but not in economic collapse. That said, prior to the report, Barry Ritholtz offered some wisdom regarding individual data points versus trends:
What does matter is the overall vector of a given economic sector. Vectors include the rate of acceleration or deceleration, persistency, direction etc. Think overall “trend” and changes thereto. For employment, this means: Are we seeing an increase in the factors that lead to hiring? What is the ratio between hires at big firms vs small firms? Are Wages increasing, staying flat, or decreasing; Temp workers getting hired, total hours worked etc. What are the likely data and modeling errors? Collectively, those factors all add up to an issue of the employment situation roughly improving, maintaining a stability, or getting worse.
Hence, each data point should be looked at in terms of whether it is continuing the overall trend, or suggesting a reversal in trend. Everything else is noise.
With trends in mind, the data did little to dispel my concern that private sector hiring rolled-over earlier this year, especially when combined with last week's read on employment via the ISM nonmanufacturing report:
A string of stronger-than-projected statistics -- capped by the news on Oct. 7 of a 103,000 rise in payrolls last month --has prompted economists at Goldman Sachs Group Inc. and Macroeconomic Advisers LLC to raise their growth forecasts for third quarter growth to 2.5 percent from about 2 percent. That’s nearly double the second quarter’s 1.3 percent rate and would be the fastest growth in a year.
“The U.S. economy doesn’t look like it’s double-dipping at all,” said Allen Sinai, president of Decision Economics Inc. in New York. “But it is a crummy recovery.”
The article offers up the usual caution on Europe and increasingly tight fiscal policy when the New Year begins. But the bottom line is correct - on the basis of existing data, the recession call looks like a long-shot.
Getting to the recession call requires generally ignoring the incoming data on the real economy and instead focusing on financial markets. Then recognize that in recent experience, financial distress leads to broader economic distress. Moreover, at the moment, the slowdown in US economic growth coupled with the possibility of sovereign default in Europe are combining in such a way as to expose the inherent vulnerabilities in a still-under-capitalised global financial system. See Edward Harrison here.
And although there is optimism the European situation can be resolved in three weeks, they seem to be walking a very fine line between attempting to recapitalize the banking system without undermining sovereign debt ratings while maintaining what effectively amounts to a pegged exchange rate system that is fundamentally inconsistent with the economic needs of more than one nation. In addition, they have an odd situation where every nation needs to issue Euro-denominated debt, but no nation can actually print Euros as a backstop. It's as if each nation issues only foreign-denominated debt, with ultimately no lender of last resort on a national level. Of course, the European Central Bank could fill this role, but will they?
My experience is that when a financial landscape is as ugly as we see here, there is no rescue plan. Things tend to get much worse before they get better. That seems to be what financial market are telling us.
With that cheery thought in mind, I offer another distressing correlation. While I generally find monetary aggregates difficult indicators in the best of time, this caught my attention:
Since the end of the 1990's, there has been a negative correlation between M2 growth and industrial production growth. It appears that financial market disruptions of the current magnitude are sufficient to drive substantial changes in spending. If this correlation continues to hold, then I need to rethink my belief that any recession in the near term will be relatively mild considering the lack of rebound from the last recession. Perhaps underneath today's seemingly comforting data something very ugly is brewing. Which means enjoy these big rallies on Wall Street while you can.
If you squint your eyes near the end of the sample, you'll see that Operation Twist appeared, on impact, to move short and long inflation expectations in opposite directions. The effect did not last long, however. The march downward continues--for now, at least.
Expected inflation over the next five years has fallen to less than 1.5% based on measures in the market for Treasury Inflation Protected Securities, or TIPS. That is down from nearly 2.5% in April.
“That is making me a little bit worried,” Mr. Bullard said, because it could be a sign that inflation could drop well below the Fed’s informal 2% objective and that there is a greater risk of deflation, or falling consumer prices. If economic activity continued to weaken or if the economy were to be hit by another shock, then inflation expectations could decline substantially below the Fed’s objectives, he said.
The Fed last year pointed to the risk of deflation as a reason to launch a bond-buying program known as quantitative easing. Mr. Bullard said that while the market now is suggesting a growing risk of deflation, he does not see deflation as likely, but rather something to keep an eye on. The bar to another round of quantitative easing was still high “at this point,” he said. ...
Fed Chairman Ben Bernanke also said Wednesday the Fed is watching price trends very closely given the decline in market-based measures of inflation expectations. ... The chairman had been asked about the moves in the TIPS market. He said that in surveys, respondents expect that price increases will average around 2% over the coming years, which is where the central bank wants them. ...
“The transmission mechanism for monetary policy remains somewhat impaired, and for this reason I am not expecting large gains from the Fed’s most recent action,” Federal Reserve Bank of Atlanta President Dennis Lockhart said.
Lockhart was referring to the decision of the Fed last week to implement what many in financial markets are calling Operation Twist. The central bank announced it would sell some $400 billion of its shorter dated holdings and buy longer dated bonds, in a bid to lower borrowing costs and improve a moribund state of economic activity.
The effort is “a measured, incremental attempt to add more support to the recovery. It’s not a fix for everything that ails the economy, but it should help,” Lockhart said. ...
Lockhart, in his speech Tuesday, sought to condition how Operation Twist is seen, and he also signaled it’s possible the Fed could take additional action to help the economy. ...
“I don’t see a recurrence of economic contraction. That said, we are in a period of greater risk and uncertainty,” the official warned. “I expect the pace of the recovery to build, albeit modestly, and this will bring a gradual reduction in unemployment,” Lockhart said. He expects the U.S. gross domestic product to rise 1% to 2% this year and 2% to 3% next year.
“The European debt crisis looms as the biggest threat at the moment, in my opinion,” he said. ...
The directors of the Kansas City and Dallas banks dissented, as they had at a previous meeting on the interest rate charged on emergency loans to U.S. lenders. The dissenting bank directors called for an increase in the discount rate, to 1.0%.
The discount rate meetings were held prior to the Fed’s latest policy-setting meeting Nov. 2-3. ... The Fed has kept the discount rate unchanged at 0.75% since February, when it was raised by a quarter percentage point as the economy worked to recover from deep recession and financial markets tried healing from crisis. The rate had been reduced early in the financial crisis to relieve U.S. banks. ...
A new report released Monday by the nonpartisan Congressional Budget Office found that the cost of the program, known as TARP, has plummeted since its passage in October 2008, when policymakers thought that the world stood on the brink of an economic meltdown.
"Clearly, it was not apparent when the TARP was created two years ago that the cost would turn out to be this low," the CBO report says. ...
The TARP was conceived in the final days of the Bush administration and pushed through a reluctant Congress in less than three weeks. It is widely thought to have helped stabilize a financial sector on the verge of collapse, though it remains hugely unpopular with the public. ...
All told, $389 billion has been distributed through the TARP, which expired in October. The CBO estimates that an additional $44 billion is still waiting to go out the door, primarily to troubled insurance giant American International Group and federal mortgage programs. That would bring total TARP outlays to $433 billion, of which about half - $216 billion - has been repaid.
The rest of the TARP investments, meanwhile, have become markedly less risky, according to the CBO, and in many cases even profitable. ...
While the cost of the TARP is coming in far below expectations, it is just one of several massive government programs aimed at propping up the financial industry. The Federal Reserve and the FDIC have together guaranteed billions of dollars in bank debt.
Interest on Reserves and Inflation: There's been a lot of talk lately about the Fed's policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn't paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.
First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it's the demand. Increasing the supply of loans won't have much of an impact if firms aren't interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren't using the accumulated funds to make new investments and it's not clear how making more cash available will change that.
Second, I doubt very much that a quarter of a percentage interest -- the amount the Fed pays on reserves -- is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).
Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn't have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem.
But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks. The incentive to loan money is the difference between what the bank can earn by loaning the money or purchasing a financial asset and what it can make by holding the money as reserves. Suppose, for example, that the Fed raises the interest rate on reserves to the market rate of interest. In that case, banks would have no incentive at all to make loans and would instead just hold the reserves.
The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool -- interest on reserves -- to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation. They can raise the interest rate on reserves freezing them within the banking system, and then remove the reserves over time through open market operations as desired.
To say this another way, traditionally the only way the Fed could raise the federal funds rate is through open market operations that remove reserves from the system. However, since interest on reserves is a floor for the federal funds rate (it's a floor because nobody would lend reserves at a rate less than they can earn by holding them), an increase in the rate the Fed pays on reserves will increase the federal funds rate even though the reserves are still in the system. The economy can be slowed through increases in the federal funds rate without having to remove substantial quantities of reserves all at once as would be the case if open market operations were the only tool available.
Thus, though I don't think paying interest on reserves has much of an effect on loan activity right now, even if you believe it has, this is the price that must be paid for the ability to do QEI and QEII. If the Fed did not have this tool available, it would be much more fearful about its ability to control inflation, and much less likely to try to use unconventional policy to spur the economy.
Update: In comments, Andy Harless correctly points out that the Fed could cut the rate it pays on reserves to zero now, but still have the authority to raise rates later as necessary to help to fight inflation. As I noted in a reply to Andy, I agree, but the Fed does not -- I meant to, but forgot to include Bernanke's worries that cutting the rate to zero would cause problems in the federal funds market. Bernanke's argument is:
“The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,” he said.
“Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it’ll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”
The argument itself is a bit hard to swallow and I don't buy it, prior to the recession the rate was zero and the markets functioned fine. But from the Fed's perspective that doesn't matter -- they seem to believe that it is necessary to pay something on reserves to prevent problems in the overnight market for reserves. Thus, in the Fed's view, paying a quarter of a percent right now is a necessary part of this policy, a policy that gives them the comfort they need to employ quantitative easing. The Fed may or may not be correct about the impact on the overnight federal funds market, but it holds all the cards and as a practical matter, if you want QEII, then this is part of the bargain.
What is QEII, by Mark Thoma, CBS MoneyWatch: What is QEII? Quantitative easing, which the Fed has done once already (known as QEI) and is about to do again (QEII), can be understood through a device called the yield curve. The yield curve shows how the expected return on financial assets changes with differences in the maturity of the assets:
The horizontal axis shows the time to maturity, with overnight financial assets such as the federal funds market on the left and 30 year assets such as mortgages on the right. Other maturities, e.g. 3 month, 6 month, one year, 5 years, 10 years, 20 years, etc., lie between these values. The vertical axis shows the expected return on the assets. The curve generally slopes upward due to the extra return that is required to induce people to tie their money up for longer and longer periods of time.
Prior to the housing bubble, the Fed was able to shift the entire yield curve up and down by buying and selling short-term Treasury bills. Thus, the Fed had control of both long-term and short-term interest rates:
However, during the housing bubble but prior to its collapse, the Fed seemed to lose control over the long end of the yield curve. Buying and selling short-term T-Bills no longer seemed to have much impact on long-term interest rates:
Since it is predominantly long-term rates that determine business investment, the purchase of new homes, and the purchase of consumer durables such as cars and refrigerators, this was of concern within the Fed. But the reason for this was never fully understood, and the crisis diverted attention away from this issue. However, one way the Fed can potentially overcome this problem is to buy and sell longer term Treasury bonds, i.e. those that exist on the long end of the yield curve, to bring long term rates up or down as desired.
This is, essentially, all that QEII is. It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets.
However, the need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates as it seemed to prior to the crisis -- that control returned once the bubble popped. It's because the Fed can no longer move rates at the short-end.
Presently, the Fed cannot operate at the short end of the yield curve because the short-term rate the Fed generally targets –- the overnight federal funds rate -- is at or very near zero. Operating at the short-end of the yield curve doesn’t do much good since those rates can’t come down any further. However, the Fed can still bring down rates at the long-end:
The hope is that the fall in rates at the long end will spur new investment and consumption (along with other effects such as an increase in net exports due to a fall in the exchange rate, though see here for a denial that the Fed is intending to change the value of the dollar with QEII).
So that’s QEII. It’s nothing more than conventional monetary policy moved out along the yield curve.
Myths about the Fed, by Greg Ip, Washington Post: ...By printing money, the Fed will create runaway inflation. The Nobel Prize-winning economist Milton Friedman issued a famous dictum nearly 50 years ago: "Inflation is always and everywhere a monetary phenomenon." His belief has become widespread over the years, to the point that even many non-economists assume that when the Fed prints money, higher prices inevitably result. But the link between money and inflation is weaker than people think.
The Fed's current policy of "quantitative easing"essentially means it is printing money ($600 billion) to buy assets such as government bonds. The Fed isn't literally printing the $20 bills that end up in your wallet - it's doing the electronic equivalent. When it buys a $100 bond from a bank, it deposits $100 into the bank's account at the Fed. This electronic money is called reserves, and the Fed conjures it up out of thin air.
However, this money can lead to inflation only if banks lend it and consumers and businesses spend it. Banks lend when they have strong balance sheets and when credit-worthy customers demand loans. People and businesses spend when their incomes are growing and they're confident about the future. None of this has been true lately.
The Fed is trying to stimulate spending, but not by showering people with newly minted dollars. Rather, when the Fed buys bonds, it pushes their prices up and their yields down. Lower long-term interest rates will tempt some people to borrow. They will also make stocks more attractive. Higher stock prices will make consumers feel wealthier and spend more. If that spending outstrips the economy's productive capacity, inflation could result. But that's years away: The economy today is awash in idle factories and unemployed workers. ...
The ability of countries to use monetary policy to address domestic problems depends upon whether they have a fixed or floating exchange rate.
Under floating exchange rate systems, each country has the ability to set domestic monetary policy independently. However, in fixed exchange rate regimes -- as when the value of the domestic currency is fixed to the value of gold -- countries lose the ability to pursue domestic monetary policy. This is because any attempt to change the money supply to ease domestic economic problems would cause the value of the currency to change relative to gold.
Since the money supply cannot be manipulated at will, an advantage of a gold standard is that it insulates countries from inflation due to excessive money growth – a helpful constraint for countries with a history of inflation problems. The disadvantage is that monetary policy would no longer be available as a stabilization tool. Countries are forced to increase their reliance on fiscal policy, which can create its own problems.
The experience of the Great Depression shows that the loss of the use of monetary policy as a stabilization tool can be quite costly. In the 1930s, the countries that abandoned their commitment to the gold standard had much better outcomes than countries that kept the value of their currency fixed in terms of gold. In addition, historical experience with the gold standard shows that both inflation and deflation will still occur because variations in the supply and demand for gold will alter the price of gold relative to other commodities.
So the cost of giving up monetary policy is high while the benefits from price stability are not very large. So why does Robert Zoellick suggest “employing gold as an international reference point of market expectations about inflation, deflation and future currency values”? Since the gold standard is a proven bad idea, I am going to give him the benefit of doubt and assume he has something else in mind – perhaps Jeffrey Frankel’s interpretation is correct. But whatever he is suggesting, returning to the gold standard is not a policy we should pursue.
There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.
First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.
Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]
Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.
Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three, it is the inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment).
In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined, but generally a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices).
However, in the Taylor rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here). That is, volatile prices such as food and energy are essentially tossed out of the index.
Another feature is that the indexes often include both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better.
The core inflation rate you see in the news, the one that strips out food and energy, should be though of as a short-hand, quick measure of all three of these concepts. But in each case the Fed uses measures (formally or informally) designed to best satisfy these three functions. For example, when it forecasts future inflation, it uses a different concept of core inflation than it uses in setting policy.
The Fed paper linked above is one example of how the Fed searches for the optimal way to predict future inflation. All that matters for policy is finding the most accurate way to predict inflation, and they will use whatever definition of inflation is best suite for this job. There is evidence that core inflation is best and that's why it is used, but it is a statistical question and didn't have to come out that way (and the best measure of core inflation may not be simply stripping out food and energy - also, there are different measures of prices to choose from, e.g. the CPI and the PCE).
When it comes to setting policy, the Fed doesn't formally use a Taylor rule, though they certainly have Taylor rule estimates in the information they use when considering policy moves, instead they look at a variety of measures of inflation (both core and total), and they look at the rate of change in input prices such as wages and commodities (e.g. oil) as well. They then weight each of those pieces of information in some way (and hence construct an implicit index of all of this information), and then set the federal funds rate accordingly. While I have no way of knowing if the weights they use are optimal, this is exactly what the theoretical models say they should do. But the point is that it is some implicit combination of all of this information that matters for policy, and hence this core measure is very different from the core measure that is best at predicting future inflation alone.
The core inflation rate you see in the news, the CPI less food and energy, does do a fairly good job of representing the information the Fed uses to forecast future inflation, i.e. it is a measure of the trend rate of inflation (but not the best one), and it also does well at approximating the information the Fed will use to set policy, but the actual process it uses is more complicated than this and the Fed employs measures that are specialized for the job at hand.
Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same.
What the Fed did and why: supporting the recovery and sustaining price stability, by Ben S. Bernanke, Commentary, Washington Post: ...The Federal Reserve's objectives - its dual mandate, set by Congress - are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. ...
The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. ...
While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Our earlier use of this policy approach had little effect on ... broad measures of the money supply... Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.
The Fed must adopt an inflation target, by Frederic Mishkin, Commentary, Financial Times: Ben Bernanke, the Federal Reserve chairman, discussed his institution’s inflation mandate in a recent speech, leading to speculation a numerical inflation target is under consideration inside America’s central bank. And if there ever was a time to establish such a transparent and credible commitment to a specific target, it is now.
The Fed has a dual mandate, to achieve price stability and maximum sustainable employment. But at the moment it is missing both objectives. ... This combination of economic slack and low inflation raises the possibility that inflation expectations will drift downwards.
Meanwhile, to stimulate the economy, the Fed has signaled that it is likely to restart its policy of quantitative easing... This signal has already led to concerns ... that the Fed may be too soft on inflation in the future, which could see inflation expectations rise.
By establishing an inflation objective ... the Fed can guard against both of these problems. Providing a firm anchor for long-run inflation expectations would make the threat of deflation less likely. But a firm anchor would also ... help ensure that any new moves to quantitative easing would not be misinterpreted as signaling a shift in the central bank’s long-run inflation goal, making an upward surge in inflation expectations less likely too.
The Fed can establish a strong nominal anchor through two straightforward steps. First, the federal open market committee could come to a consensus on the specific numerical value that Mr Bernanke referred to as the “mandate-consistent inflation rate” in his recent speech..., about 2 per cent, or a bit below. Second, the FOMC should announce that this rate would only be modified for sound economic reasons...
Some commentators have worried that establishing an inflation objective will soon lead to an overemphasis on controlling inflation, and not enough concern about stabilizing real economic activity. Agreeing on a mandate-consistent rate is, however, consistent with the Fed’s dual mandate. Indeed the use of the term “mandate consistent” indicates that it should not be misinterpreted as a commitment to control inflation within too tight a range over too short a time horizon. Also, by allowing the rate to be adjusted if sound economic reasoning supports it, the Fed would not be locked in to an inappropriate goal.
A final concern is that these two steps would not provide a sufficient degree of commitment to the target itself. But by stating its intention not to modify the rate without a clear technical rationale, the FOMC would provide a firm nominal anchor ... for long-run inflation expectations.
By adopting an explicit numerical inflation objective at this juncture along the lines I have suggested, the Fed would improve economic outcomes by anchoring inflation expectations more firmly while allowing sufficient flexibility to ensure ... the goal of maximum sustainable employment as well. The Fed and its chairman should move quickly to introduce one.
Why QE Needs to Involve non Government Securities - Brad DeLong: ...The point--from one point of view, the neo-Wicksellian point of view--behind quantitative easing is to reduce the interest rate that matters for private business investment: the long-term, default-risky, systemic-risky, beta-risky, real interest rates at which private businesses finance their capital expenditures. You can reduce this flow-of-funds equilibrium interest rate and raise the level of economic activity in any neo-Wicksellian framework in two ways:
Reduce the "safe" real interest rate on short-term, safe government bonds.
Reduce the various premia--duration, default, systemic risk, and beta risk--between the rates the Treasury pays to borrow in T-bills and the rates businesses pay to borrow.
Conventional open-market operations that lower the nominal interest rate on T-bills accomplish the first. Once the nominal interest rate on T-bills has been pushed to zero, quantitative easing policies that create expectations of higher future inflation continue to lower the real interest rate on T-bills and thus help the situation.
Suppose, however, that the nominal interest rate on T-bills is zero and that you cannot alter inflation expectations--cannot commit to keeping your quantitative easing permanent, cannot commit to an exchange rate path, whatever, you cannot do it and inflation expectations are immovable. Then what?
Then, as Paul Krugman says, quantitative easing is working be altering the spread between the short-term safe T-bill rate and the long-term, systemic-risky, beta-risky, default-risky rate. How does it do that? Lloyd Metzler and James Tobin would say that it does so by altering relative asset supplies--by taking duration risk, systemic risk, beta risk, and default premia off of private savers' books and placing them on the government's books (and thus on the taxpayers, who are a very different group of people than are private savers). To the extent that quantitative easing thus involves assets whose risk characteristics are very similar--federal funds and two-year T-notes, say--we would not expect even a lot of quantitative easing to have much of an effect on anything.
Thus a quantitative easing program that is going to have bite should involve Federal Reserve purchases of long-term risky private assets rather than merely long-term U.S. Treasuries. ...
Today is the second day of a two-day Federal Open Market Committee meeting. The rate decision along with the accompanying verbiage will be released at 2:15 p.m. If I were still there, I’d go in with a tentative idea of how I would vote, but would try to keep an open mind during the presentations and discussions. ...
“Come With Me to the F.O.M.C.” was the title of a Richmond Fed pamphlet written long ago and updated by others. Its lasting popularity suggests an interest in what goes on behind the closed doors. While I’ve been retired from the Fed almost four years, it changes so slowly that I expect my memories aren’t far off.
Some F.O.M.C. Color
My almost 14 years as an F.O.M.C. member came with the presidency of the Federal Reserve Bank of Dallas from Feb. 1, 1991, to Nov. 4, 2004. Alan Greenspan was chairman during that time and then-Governor Bernanke sat next to me for almost three years. Reserve Bank presidents inherit their place around the table from their predecessors, and Dallas used to sit between St. Louis and Boston. For the first several years of my tenure, Alan Greenspan sat at the head of the long board table, but he announced one day that he was switching to the middle spot. That was a landmark event. We all rotated to keep our relative position, and I got the chairman’s former seat.
Since Chairman Greenspan didn’t normally conduct policy by the seat of his pants, as his successor has been accused of doing, his seat never made me feel smarter. The president of the Boston Fed decided about that time to move to the other end of the table — I don’t know what I did — so I ended up between Bill Poole of the St. Louis Fed and Governor Bernanke, the only two principals around the table with beards. Ben’s was trimmed pretty short, but Bill’s was kind of shaggy. It made my nose itch when I looked his way.
Two-day meetings like the one concluding today used to occur only twice a year — in February and July. Chairman Bernanke added more two-day meetings to the schedule. The July meeting was close to the Fourth, and the British ambassador always had us as dinner guests on the evening between meetings. Those dinners were nice, but they ran on too long. The vice chairman, Alice Rivlin, was the all-time champion at extricating us before midnight. The dialogue during the dinner between the chairman and the ambassador was an education for me — actually for us all — but I’m probably the only one to admit it.
Congress centralized power in Washington in the 1930s, and gave the coveted (in central bank world) title of governor to the seven-member Washington contingent and “demoted” the twelve former regional governors to “president.” It also reduced the number of “presidents” voting from 12 to 5 so Washington would have a 7 to 5 advantage if votes ever split along those lines. The New York Fed president, as vice chairman of the F.O.M.C., always has a vote; 4 of the other 11 regional bank presidents also have a vote, based on an annual rotation.
I mention the voting arrangement because it is often misunderstood. All the presidents participate fully in all the discussions, and an observer would be unable to tell the voters from the nonvoters until the vote at the end of the meeting. A persuasive nonvoting president would probably have more influence on the outcome than a non-persuasive voter.
F.O.M.C. members traditionally don’t discuss their votes or policy before the meeting. If the presidents got together for dinner the night before, they limited their discussion to Reserve Bank business and gossip. Usually they went their separate ways for dinner. Being the introvert that I am, I frequently had take-out Chinese food in my hotel room.
Everyone arrives for the meetings after having done tons of homework. The Reserve Banks have excellent research departments, but they are smaller and less specialized than the board’s research staff. The presidents are expected to say something about their regions, as well as the national and international economy. It’s a lot like cramming for finals. The board staff’s material, mostly contained in the “green book,” included all recent data in context, forecasts made under alternative assumptions, and special topics of current interest. It was always comprehensive and outstanding in quality.
The board staff also prepared a “blue book” with alternative policy choices and commentary. Forecasts based on the board’s econometric models were treated respectfully by everyone...
See also Come with Me to the FOMC, Remarks by Governor Laurence H. Meyer, Willamette University, Salem, Oregon April 2, 1998.
It is folly to place all our trust in the Fed, by Joseph Stiglitz, Commentary, Financial Times: In certain circles, it has become fashionable to argue that monetary policy is a superior instrument to fiscal policy – more predictable, faster, without the adverse long-term consequences brought on by greater indebtedness. Indeed, some advocates wax so enthusiastic that they support recent drives for austerity in many European countries, arguing that if there are untoward effects they can be undone by monetary policy. Whatever the merits of this position in general, it is nonsense in current economic circumstances. ...
It should be obvious that monetary policy has not worked to get the economy out of its current doldrums. The best that can be said is that it prevented matters from getting worse. So monetary authorities have turned to quantitative easing. Even most advocates of monetary policy agree the impact of this is uncertain. ...
By contrast, if we extend unemployment benefits we know, not perfectly but with some degree of precision, how much of that money will be spent. Doubters of the effectiveness of fiscal policy worry that such spending will simply crowd out other spending, as government borrowing forces interest rates up. There may be times when such crowding out occurs – but this is not one. ... (There are other, even less convincing arguments: that taxpayers offset future liabilities by reducing consumption. It would have been nice if this had happened when the Bush tax cuts of 2001 and 2003 were enacted; instead, the savings rate fell ever lower until it reached zero.)
A final argument invoked by critics of fiscal policy is that it is unfair to future generations. But monetary policy can have intergenerational effects every bit as bad. There are many countries where loose monetary policy has stimulated the economy through debt-financed consumption. This is, of course, how monetary policy “worked” in the past decade in the US. By contrast, fiscal policy can be targeted on investments in education, technology and infrastructure. Even if government debt is increased, the assets on the other side of the balance sheet are increased commensurately. Indeed, the historical record makes clear that returns on these investments far, far exceed the government’s cost of capital. ...
Given the complexity of the economic system, the difficulties in predicting how expectations will be altered, and the pervasive irrationalities in the market, there is no way the impact of any economic policy could be ascertained with certainty. ...
To pursue austerity in the hope that monetary policy can reliably be used to undo any untoward effects, is, in short, sheer folly.
The Final End of Bretton Woods 2?, by Tim Duy: The inability of global leaders to address global current account imbalances now truly threatens global financial stability. Perhaps this was inevitable - the dollar has not depreciated to a degree commensurate with the financial crisis. Moreover, as the global economy stabilized the old imbalances made a comeback, sucking stimulus from the US economy and leaving US labor markets crippled. The latter prompts the US Federal Reserve to initiate a policy stance that will undoubtedly resonate throughout the globe. As a result we could now be standing witness to the final end of Bretton Woods 2. And a bloody end it may be.
I increasingly suspect that the combination of falling oil prices and falling demand for imported goods will produce significant fall in the US trade and current account deficit in the fourth quarter, with a corresponding fall in the emerging world’s combined surplus. The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much….
And rather than ending with a whimper, Bretton Woods 2 may end with a bang….
….If Bretton Woods 2 ends in 2009 – if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down – it won’t have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for US debt would dry up – pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy... it didn’t quite play out that way. The US and European banking system collapsed before the balance of financial terror collapsed.
But Bretton Woods 2 was soon reborn, as the steady improvement to the US current account deficit was soon reversed:
Bretton Woods 2 simply morphed forms. Rather than a reliance on US financial institutions to intermediate the channel between foreign savers and US households, a modified Bretton Woods 2 - Bretton Woods 2.1 - relied on the US government to step into the void created by the financial mess and become the intermediary, either by propping up mortgage markets via the takeover of Freddie and Fannie, or the fiscal stimulus, or a dozen of other programs initiated during the financial crisis.
In essence, a nasty surprise awaited US policymakers - after two years of scrambling to find the right mix of policies, including an all out effort to prevent a devastating collapse of financial markets and a what Administration officials believed to be a substantial fiscal stimulus, the US economy remains mired at a suboptimal level as stimulus flows out beyond US borders. The opportunity for a smooth transition out of Bretton Woods 2 was lost.
How has it come to this? To understand the challenge ahead, we need to begin with two points of general agreement. The first is that the US has a significant and persistent current account deficit, which implies that domestic absorption of goods and services, by all sectors, exceeds potential output. In other words, we rely on a steady inflow of goods and services to satisfy our excess demand, a situation we typically find acceptable during a high growth phase when domestic investment exceeds domestic saving. The second point of agreement is that high unemployment implies that actual output is far below potential output. We clearly have unused capacity.
Points one and two appear that they should be mutually exclusive, but they are not. The fact that they are not begs an explanation. Paul Krugman sends us to Paul Samuelson to provide that explanation:
Here’s what he [Samuelson] wrote in his 1964 paper “Theoretical notes on trade problems”: “With employment less than full and Net National Product suboptimal, all the debunked mercantilist arguments turn out to be valid.” And he went on to mention the appendix to the latest edition of his Economics, “pointing out the genuine problems for free-trade apologetics raised by overvaluation”.
I think Samuelson is correct; an excessively high dollar is the explanation for the simultaneous existence of a sizable current account deficit and excessive unemployment. Indeed, there appears to be a externally determined downward limit to real value of the Dollar, and we are close to pushing against it:
The US appears to have little control over that minimum level. Foreign central have repeatedly acted to limit Dollar depreciation. Over the years, US policymakers have happily accepted this state of affairs (the steady financial inflow certainly helped support structural fiscal deficits), all the while ignoring the very real structural outcomes of blind adherence to the idea of a strong Dollar. spencer at Angry Bear succinctly lays out the structural impact:
The first chart is of imports market share, or imports as a share of what we purchase in the US. In the second quarter of this year imports market share rebounded to about where it was at the pre-recession peak, or about 16% of consumption. Since the early 1980's when the US started borrowing abroad to finance its two structural deficits -- federal and foreign--trades share of consumption has risen from about 6% to some 16%. Normally this has a small negative impact on the US economy, but sometimes you get quarters like the last quarter. Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $). That mean that the increase in imports was 87.5% of the increase in domestic demand.
To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%. It does not take some great new "freshwater" theory to explain why the stimulus is not working as expected, simple old fashioned Keynesian models explain it adequately.
Years of current account deficits - deficits induced not by the decisions of private savers looking to maximize returns but by foreign public sector entities seeking to maintain export growth - has literally resulted in a US economy that, on net, is unable to produce the goods its citizens want to consume. Hence a blast of stimulus flows overseas , the rising trade deficit heralded as a sign of strong US demand despite the inconvenient truth of little net job creation.
Which brings us to this observation by Simon Johnson:
The main reason the U.S. isn’t bouncing back so fast is because of exports and the dollar. South Korea, Russia, and other emerging markets that go through severe crises usually undergo a sharp depreciation in the inflation-adjusted value of the currency, making them hypercompetitive, at least for a while. This makes it easier to replace imports with domestic goods and services and much more attractive to export.
In contrast, the global financial crisis actually strengthened the U.S. dollar as it was seen as a haven, although the dollar has fallen somewhat from its recent peak against major trading partners.
Currency depreciation - of substantial magnitude - is a mechanism by which economies recover from financial crisis. But we shouldn't underestimate that challenges that accompany such an adjustment. If it happens to quickly - a sudden stop of capital - the most likely short run outcome is that the current account deficit will be resolved with import compression via a sharp drop in demand. This would be painful, to say the least. It is not the optimal path.
Neither, though, is the current path - a painstakingly slow Dollar depreciation. The result so far is persistently high US unemployment, with no relief in sight. In frustration, policymakers lash out against the wrong target, free trade. Krugman's frustration rises to the level that he supports the Levin bill as the only remaining option:
Finally, the idea that what we need is a mature discussion of global rebalancing strikes me as reasonable — if you have been living in a cave the past three or four years. We’ve been reasoning, and reasoning, and reasoning, and nothing changes. Clearly, China does not want to act — not out of national interest, but because of the political influence of its export industries. It won’t change its behavior unless it faces an additional incentive — like the prospect of countervailing duties.
But I don't want to make this piece about China. It is more than China at this point. It became more than China the instant US Federal Reserve policymakers woke up one morning and decided they needed to take the dual mandate seriously. And seriously means quantitative easing. Brad DeLong suggests that when the Fed actually acts on November 3, it will be too little too late. But if it is too little, more will be forthcoming.
Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2. November 3, 2010. Mark it on your calendars.
So perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve. A side effect of the next round of quantitative easing is an attack on the strong dollar policy.
The rest of the world is howling. The Chinese are not alone; no one wants it to end. From Bloomberg:
Leaders of the world economy failed to narrow differences over currencies as they turned to the International Monetary Fund to calm frictions that are already sparking protectionism….
….Days after Brazilian Finance Minister Guido Mantega set the tone for the gathering by declaring a “currency war” was underway, officials held their traditional battle lines. U.S. Treasury Secretary Timothy F. Geithner and European Central Bank President Jean-Claude Trichet were among those to signal irritation that China is restraining the yuan to aid exports even as its economy outpaces those of other G-20 members.
“Global rebalancing is not progressing as well as needed to avoid threats to the global economic recovery,” Geithner said. “Our initial achievements are at risk of being undermined by the limited extent of progress toward more domestic demand- led growth in countries running external surpluses and by the extent of foreign-exchange intervention as countries with undervalued currencies lean against appreciation.”
At the same time, officials from emerging economies including China complained that low interest rates in the U.S. and its developed-world counterparts mean investors are pouring capital into their markets, threatening growth by forcing up currencies and inflating asset bubbles. The MSCI Emerging Markets Index of stocks has soared 13 percent since the start of September...
...“Near-zero interest rates and rapid monetary expansion are geared at stimulating domestic demand but also tend to produce a weakening of their currencies,” Mantega said Oct. 9. As a result, developing countries will continue to build up reserves in foreign currency to avoid “volatility and appreciation.”
Consider the enormity of the situation at hand. The Federal Reserve is poised to crank up the printing press for the sake of satisfying their domestic mandate. One mechanism, perhaps the only mechanism, by which we can expect meaningful, sustained reversal from the current set of imbalances is via a significant depreciation of the dollar. The rest of the world appears prepared to fight the Fed because they know no other path.
Bad things happen when you fight the Fed. You find yourself on the wrong side of a whole bunch of trades. In this case, I suspect it means that Bretton Woods 2 finally collapses in a disorderly mess. There may really be no other way for it to end, because its end yields clear winners and losers. And the losers, in this case largely emerging markets, and not prepared to accept their fate.
Moreover, there is no agreement on what should be the post-Bretton Woods 2 rules of the game for international finance. Is there even a meaningful policy discussion? Perhaps a little hope via Bloomberg:
Suggestions for how to resolve currency differences were vague in Washington, with French Finance Minister Christine Lagarde proposing better coordination and more diversification, while Canada’s Jim Flaherty suggested that new “rules of the road” be outlined.
Of course, in the next sentence hope is dashed:
European Central Bank Executive Board member Lorenzo-Bini Smaghi suggested the G- 20 may be too big to find a compromise.
Unless checked in South Korea, the discord may snap the G- 20’s united front formed to fight the financial crisis and recession.
And don’t expect that the International Monetary Fund is prepared to deal with this crisis:
Unable to find common ground themselves, governments agreed the IMF should serve as currency cop by preparing reports which show how the policies of one economy affect others. The studies will focus on the U.S., China, the U.K. and the euro area.
“The need to have this kind of spillover report has been discussed for months and now it’s part of our toolbox,” IMF Managing Director Dominique Strauss-Kahn said.
Well, thank the Heavens above, the IMF stands ready to produce a report. Now I can sleep easy.
Bottom Line: The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.
The two rebalancing acts, by Olivier Blanchard, Vox EU: A “strong, balanced, and sustained world recovery” as demanded by the G20 is a daunting challenge for policymakers. This column argues that two rebalancing acts are required: internal rebalancing – replacing government spending with private-sector demand, and external rebalancing – addressing the global imbalances between exporting and importing countries. These two rebalancing acts, it adds, are taking too long.
Achieving a “strong, balanced, and sustained world recovery” – to quote from the goal set in Pittsburgh by the G20 – was never going to be easy. It requires much more than just going back to business as usual. It requires two fundamental and complex economic rebalancing acts (IMF 2010a).
Internal rebalancing: When private demand collapsed, fiscal stimulus helped reduce the fall in output. This helped avoid the worst. But private demand must now become strong enough to take the lead and sustain growth, while fiscal stimulus gives way to fiscal consolidation.
External rebalancing: Many advanced countries, most notably the US, relied excessively on domestic demand before the crisis, and they must now rely more on net exports. Many emerging market countries, most notably China, had relied excessively on net exports, but must now look to domestic demand.
Too slow
These two rebalancing acts are taking place too slowly.
Private domestic demand remains weak in advanced countries. This reflects both a correction of pre-crisis excesses and the scars of the crisis. US consumers who had over-borrowed before the crisis are now saving more and consuming less. While this is good for the long run, it is a drag on demand in the short run. Housing booms have given way to housing slumps, housing investment will remain depressed for some time to come, and financial system weaknesses are still constraining credit.
External rebalancing remains limited. Net exports are not contributing to growth in advanced countries – the US trade deficit remains large. Many emerging markets continue to run large current-account surpluses, and to respond to capital inflows primarily through reserve accumulation rather than exchange-rate appreciation. International reserves are higher than they have ever been and continue to increase.
The result is a recovery which is neither strong, nor balanced, and runs the risk of not being sustained (IMF 2010b). For the last year or so, inventory accumulation and fiscal stimulus were driving the recovery. The first is coming to a natural end. The second is slowly being phased out. Consumption and investment now have to take the lead. But, in most advanced economies, weak consumption and investment, together with little improvement in net exports, are leading to low growth. Unemployment is high, and barely decreasing.
By contrast, in many emerging market countries, where excesses were limited and the scars of the crisis are few, consumption, investment, and net exports are all contributing to strong growth, and output is back close to potential.
Does banking sector instability damage the real economy? Or the other way round? This column presents data from 18 OECD countries between 1980 and 2008. It finds that banking sector stability appears to be an important driver of GDP growth in subsequent quarters. It argues that monetary policy should therefore pay more attention to banking sector soundness.
At the November 2008 meeting of the G20, just two months after the collapse of Lehman Brothers, the need for regulatory reform had already been clearly established.
“The IMF, the expanded Financial Stability Forum, and other regulators and bodies should develop recommendations to mitigate pro-cyclicality, including the review of how valuation and leverage, bank capital, executive compensation, and provisioning practices may exacerbate cyclical trends.”(G20 2008)
Yet while there may be consensus over the need for a stable banking system, there is far less certainty about whether the banking instability itself is a cause or an effect of economic crises and subsequent slowdowns (Kaminsky and Reinhart 1999, Demirgüç-Kunt and Maksimovic 1998, Rajan and Zingales 1986). In a recent study (Monnin and Jokipii 2010), we made an attempt to disentangle the links between real economy and banking sector.
How to measure banking sector stability?
Our first step is to find a good measure for banking sector stability. Much of the literature to date has focused on binary indicators, comparing crisis versus non crisis periods. It remains unclear, however, whether “normal” reductions in banking sector stability – i.e. a level of instability that can regularly be observed but that does not translate into a banking crisis – have a significant impact on growth. For example, consider a banking sector which suffers credit losses in a business cycle downturn but which is still able to function without external help. The stability of such a banking sector has clearly decreased after credit losses, but since it is still functioning, it is not in a fully fledged crisis either. To take into account such “normal” variations, we develop a continuous index to measure banking sector’s probability of default. We define instability as the probability of the banking sector becoming insolvent within the next quarter. This measure is based on Merton (1974) and we compute it for a sample of 18 OECD countries, over the 1980-2008 period.
Fed Official Defends Effectiveness of More Action, by Michael S. Derby, WSJ: Expanding the Federal Reserve balance sheet would have a real and positive impact on the U.S. economy, should officials decide to follow that path, the man responsible for implementing central bank monetary policy goals said Monday.
“The evidence suggests that the expansion of the securities portfolio to date has helped to foster more accommodative financial conditions, and further expansion would likely provide additional accommodation,” said Federal Reserve Bank of New York Executive Vice President Brian Sack. ... But the official stopped short of saying any decision to act had been made. ...
Sack was optimistic about the impact the action can have on the economy. “The sluggish outlook for the economy and the risks that surround that outlook have raised the possibility of further monetary policy accommodation,” Sack said. “In the current circumstances, there would seem to be room for the Federal Reserve to expand its holdings of Treasury securities without creating difficulties for market functioning,” he added.
While asset buying is an “imperfect policy tool,” Sack said “balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” He countered those ... who doubt the further effectiveness of asset purchases, by saying “it seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions.”
Sack warned there are limits to the policy. He noted that asset buying has to be done in fairly large size to move the needle. There’s also reason to believe that as yields fall to “extremely low levels,” such a policy’s effectiveness “would diminish at some point.” ...
Chapter 1 Why Study Money, Banking, and Financial Markets? [continued]
Why Study Banking and Financial Institutions?
What Defines Banks and Financial Institutions? What is Financial Intermediation? Direct versus Indirect Finance Why is Financial Intermediation Important?
Chapter 3 What is Money?
Meaning of Money Functions of Money
Medium of Exchange Unit of Account Store of Value
Evolution of the Payments System
Commodity Money Partially backed paper money Full backed paper money Fiat Money
Since Fed officials met last week and signaled they are open to new steps to try to strengthen the economy, chatter has flown around financial markets about the possibility of a major new infusion of cash, on the order of $1 trillion.
Some of this talk is a little premature: It is not a given that the Fed will take action at all at its the Nov. 2-3 meeting. ... More:
How much quantitative easing? Shock-and-awe or dribs-and-drabs? Treasuries or mortgage-backed securities? Cut the interest rate on excess reserves?
How much quantitative easing? This is the biggest question of them all. The strategy that Fed Chairman Ben Bernanke and company are most likely to pursue to try to strengthen economic growth and get inflation up closer to their 2 percent target is to buy vast quantities of bonds on the open market, essentially increasing the money supply.
That is called quantitative easing; Fed watchers refer to a new round of such easing "QE2," since it would follow earlier bond purchases announced during the financial crisis.
But how many hundreds of billions of dollars? In its previous efforts to prop up the economy, the Fed expanded the size of its balance sheet from $800 billion to about $2.3 trillion. That may have been a significant factor in ending the recession in June 2009. Still, the government was taking so many audacious steps to try to arrest the economy's free-fall that it's hard to know exactly how much of a role QE1 played.
The first round of quantitative easing probably had a greater impact on the economy than would any steps taken now, in part because the financial markets were dysfunctional at the time. ...
Fed leaders will have to decide... Does that mean they should go even bigger, undertaking $1 trillion or more in bond purchases because smaller numbers won't have enough impact? Or should they move more cautiously, given that the benefits are likely to be small?
Bernanke addressed this question in a speech last month, but had no definitive answers. "The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool," Bernanke said. "However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses."
Shock-and-awe or dribs-and-drabs? A closely related question is how the Fed would announce new easing measures. In the earlier rounds of asset purchases, the Fed announced vast quantities of planned asset purchases all in a few, dramatic steps (such as a March 17, 2009, announcement that it would buy up to $1.25 trillion in mortgage backed securities, among other steps).
The shock-and-awe strategy has some clear benefits. Interest rates respond rapidly to the initial announcement, and then the Fed can take its time actually undertaking the purchases. It is a clear sign of commitment from the central bank that it is acting boldly, and by creating a boost in financial markets, the benefits for the economy can begin flowing the moment the announcement is made.
But St. Louis Fed President James Bullard has advocated having smaller purchases announced at each policy meeting, an approach that is gaining favor within the central bank. ...
With this strategy, the Fed would lose the immediate benefits of shocking financial markets with an announced wall of money. But they would gain the flexibility to respond to economic conditions as they evolve. That, in turn, may make it easier for some members of the Fed policymaking committee who are resistant to more easing to get on board...
Treasuries or mortgage-backed securities? Further Fed easing would consist of buying assets. But what assets?
The two major options -- the assets that the Fed can purchase using its standard legal authority, as opposed to invoking emergency lending provisions -- are to buy U.S. Treasury bonds or housing-related debt issued by Fannie Mae and Freddie Mac. During the try-anything crisis response in 2009, the Fed did both. Here are the pros and cons of each.
Buying Treasury bonds is, in a sense, a purer exercise of the Fed's money-creation power. The purchases would lower the long-term rate on Treasury bonds, which are widely viewed as the "risk-free" rate across the economy. Other forms of debt, such as corporate lending, occur at some premium to the risk-free rate, so the Treasury bond purchases should pull down rates across the economy. Also, the Treasury bond market is enormous, so the Fed would have leeway to intervene without crowding out private buyers.
One major downside: If it buys Treasuries, the Fed could (and, if the past is a guide, would) be accused of "monetizing the debt," or printing money to fund large U.S. budget deficits. ...
The second major option would be to buy mortgage-backed securities from Fannie and Freddie (and perhaps the companies' debt). One upside of this tack is that it would stimulate the troubled housing market by targeting mortgage rates directly. That said, mortgage rates have fallen dramatically over the last few months, with little apparent benefit to the housing market overall, so further declines might not make much difference for housing.
There are two major downsides to this strategy. First, it would put the Fed in the position of distorting capital allocation, favoring housing over other sectors. Treasuries would be more of a neutral step. Second, the market for mortgage securities has been slow to return to normal after the earlier Fed purchases -- $1.25 trillion ending in March -- crowded out private buyers. If the Fed gets back in, it may delay the return of private funding even further and thus be counterproductive.
Cut the interest rate on excess reserves? Since summer, Fed officials have discussed cutting the rate they pay banks on reserves parked at the Fed as a tool to boost the economy. It works like this: For money they keep at the Fed beyond their regulatory minimums, banks are currently paid 0.25 percent interest. The Fed could cut that rate to close to zero, and then banks would have a bit more incentive to do something useful with that cash, such as lending it to clients.
But it would be no panacea. Banks are parking that money at the Fed because they want it to be very safe and readily available should they need it. So money that they no longer keep at the Fed banks would most likely pour into other ultra-safe, short-term investments, such as Treasury bills. That would not create much of an economic bounce, though at the margins it would reduce interest rates across the economy and have some mild benefit on growth.
That economic benefit, however, could prompt technical problems in the money markets caused by the decline of rates closer to zero. Still, the central bank would likely consider cutting the interest rate on excess reserves in conjunction with bond purchases.
Chapter 1 Why Study Money, Banking, and Financial Markets?
Why Study Money and Monetary Policy?
Money and Business Cycles Money and Inflation Money and Interest Rates Conduct of Monetary Policy Fiscal Policy and Monetary Policy
Why Study Banking and Financial Institutions?
What Defines Banks and Financial Institutions? What is Financial Intermediation? Direct versus Indirect Finance Why is Financial Intermediation Important?
Why Study Financial Markets?
Bond Market Stock Market Foreign Exchange Market
Chapter 2 An Overview of the Financial System (pgs 25-27, 39-42)
Application: This is something the Oregonian asked me to do awhile back:
Mark Thoma, Guest opinion, Oregonian, Sept. 19, 2008: Many people associate the onset of the Great Depression with the stock market crash in October 1929. But a more important cause was a series of banking panics in the years prior to the Great Depression, and the particularly severe banking collapse from 1930-1933.
The response to this crisis and the devastating economic disruption that came along with it was the Banking Acts of 1933 and 1935, also known as the Glass-Steagall Acts. The goal was to stabilize the banking system by enhancing the power of the Federal Reserve to regulate financial markets and to intervene when problems emerged.
And it worked. The changes resulted in a very long period, over 50 years, where financial markets remained calm.
That calm is now over, and we are experiencing our worst financial crisis since the Great Depression. What happened? What ended the tranquility? Very simply, financial innovation got ahead of regulation.
The problems we are having did not arise in the traditional banking sector; the problems come from what is called the shadow banking sector. This is comprised of firms such as hedge funds that do just what banks do -- they take deposits, they use the funds to purchase financial assets such as housing loans, and they only keep a fraction of those deposits on hand as cash reserves. But these firms are essentially unregulated and hence subject to the same problems that traditional banks faced prior to the 1930s.
What is the solution to our problems? First and foremost, We need to clean up the mess we are in and do all we can to stop things from getting any worse. Recreating the Resolution Trust Co., as we did in the aftermath of the savings and loan crisis, would be a useful step to take to remove the bad financial paper that is poisoning financial markets.
Over the longer run, it is essential that regulation be modernized. The most important task is to bring the shadow banking sector out into the sunlight, and to put it under the same regulatory structure and safeguards faced by traditional banks.
The last time we restructured our financial system from the ground up, the result was more than 50 years of stability. With a determined effort we can repeat that success and modernize our financial system so that it is substantially less likely to suffer a massive meltdown, but still innovative enough to meet our financial needs.
This is from the Wall Street Journal:
The financial crisis—and ensuing recession—has helped turn economics bloggers like (clockwise from top left) Greg Mankiw, Paul Krugman, Alex Tabarrok and Mark Thoma into Internet celebrities (WSJ)
Bubbles and Policy, by Tim Duy: The Wall Street Journal
carried a front page article today detailing changing views at the Federal
Reserve regarding the policy treatment of emerging bubbles of speculative
activity. Much of the ground has been well tread. Is monetary policy
or regulatory policy the best mechanism to address bubbles? I tend to
favor the latter category, should we have a regulatory environment that is not
essentially captured by those policymakers are supposed to regulate.
Interest rate policy is a rather blunt weapon that kills indiscriminately.
For instance, I am sympathetic with the view that interest rates were not
necessarily too low during the build up of the housing bubble. Indeed,
relatively low rates of investment (equipment and software) growth suggests that
real rates were actually too high. But capital flowed to housing instead
of more productive investment activities because that was the path of least
resistance. Policymakers could have chosen to put some grit on that path
by, for example, aggressively evaluating lending standards with regards to
products such as "Liar's Loans," etc., but chose to follow a hands off approach.
What caught my attention in the article was this passage:
Yet the question of whether and how to tackle bubbles before they burst is
becoming a growing concern amid fears of new bubbles developing in commodities
markets and in emerging economies. Gold prices are up more than 50% in a year's
time. China's Shanghai Composite stock index is up more than 75% this year.
Stocks in Brazil are up even more. Oil prices have rebounded. They remain far
below last year's peaks but a return to those highs could fuel inflation in
goods and services more directly than tech stocks or housing did.
I think it is important to recognize what bubbles should be the focus of
Federal Reserve concerns. After all, the Fed is charged with maintaining
price stability and maximum sustainable employment in the United States.
Why should the Fed be concerned with housing prices in Hong Kong or stock prices
in Brazil and China? Don't those bubbles fall under the responsible of
foreign central banks? It seems clear that in such cases, the extent of
the Fed's concerns should be limited to the regulatory arena. Are US based
banks lending into those bubbles, thereby setting the stage for negative
feedback loops? If so, raise capital requirements on that lending, tighten
underwriting standards, etc. Just don't derail the US recovery by raising
rates to pop a bubble in Brazil.
I will admit that oil prices can be a bit more tricky. The gains in oil
prices seem silly given ongoing evidence that the world is awash in oil.
From the WSJ:
Café owner Ken Kennard sees the glut in the global oil market as a potential
environmental threat to this sleepy seaside tourist hub.
Mr. Kennard is worried about a fleet of oil tankers -- almost 40 in all, each
packing hundreds of thousands of barrels of crude and oil-derived products --
that have anchored several miles off the coast of southeast England in recent
months.
The heavy traffic stems from a near-record excess oil supply, a byproduct of
the recession, that is prompting producers to stash oil offshore until they can
find customers. The excess supply hasn't stopped oil prices from surging almost
80% this year and padding the pockets of big oil producers like Royal Dutch
Shell PLC and the Organization of Petroleum Exporting Countries.
To be sure, some of the rise in the price of oil is attributable to the
decline in the Dollar, a natural consequence of low US interest rates and an
important channel for the transmission of monetary policy. But it is not
clear that higher oil prices necessarily yield additional core inflationary
pressure given the current institutional arrangements between labor and
management. The recent experience has been that individuals were not able
to convert high inflation expectations in 2008 into higher wages. Instead,
the opposite occurred as consumption sunk and unemployment skyrocketed.
All which means the Fed would need to think long and hard about leaning against
the oil price increase if that entailed contractionary monetary policies; the
costs are potentially high relative to the benefits. Here again, though,
regulators need to be carefully evaluating the nature of lending into the oil
space.
My views on this topic have shifted somewhat over the past two years.
In early 2008, I was concerned that the Fed's rush to lower rates was
contributing to destructive oil price bubble. But, in retrospect, nations
that pegged to the Dollar and thus imported the Fed's easy policy were just as
much, if not more, to blame, as those central banks failed to maintain policies
appropriate for domestic conditions.
In short, the Fed does need to be aware of the full set of consequences of
their policy stance. But bubbles abroad should not prevent the
Fed from adopting the right policy stance for the US economy. Indeed, many
of the bubbles discussed now clearly should not be the responsibility of the
Fed.
Policy lags and other problems in pursuing activist policies
Chapter 25 Rational Expectations and Implications for Policy
RE and the Lucas critique
Materials from class:
none this time
Video:
Application:
The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly
countless number of undergraduates that Fed's hold on monetary independence was
tenuous at best. Independence is not guaranteed by the Constitution. Congress
made the Fed, and Congress can unmake the Fed. The Fed could only maintain the
privilege of independence if policymakers pursued policy paths that fostered
maximum, sustainable growth. Deviating from such paths would have consequences.
The Fed is quickly learning the extent of those consequences, as Congress
launches an assault on the Fed's independence.
Some find the loss of support for the Fed puzzling.
Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what
they should have done:
First of all, from the day after the collapse of Lehman Brothers, the policies
followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S.
administrations have been very helpful. They have been good ones. The
alternative--standing back and watching the markets deal with the
situation--would have gotten us a much higher unemployment rate than we have
now. Credit easing by the Fed and support of the banking system by the Fed and
the Treasury have significantly helped the economy: have kept things from
getting much worse.
The Fed earns accolades from academics for its handling of the crisis, in
particular since the Lehman failure. Fair enough; I have few quibbles with
policy since last fall. But what about the years before Lehman, when the
crisis was building? Where was the Fed then? Did they abdicate
regulatory responsibility? How did banks develop such incredible exposure
to off-balance sheet SIV's? How could the Fed ignore increasingly
predatory lending in the mortgage market? What exactly was Timothy
Geithner, then president of the all important New York Fed, regulating and
supervising? Clearly not Citibank.
To be sure, there were plenty of other regulatory failures along the way, but
the Fed - an independent Fed - should have been in a much better position to
raise regulatory and supervisory roadblocks during the debt build-up compared to
other, more politically susceptible agencies. The Fed's independence
should have allowed it to be a leader, not a follower. Ideological
objections to regulation, apparently,
prevented the Fed from looking for problems in their own backyard.
Rapid debt creation was justified as a response to asset appreciation, with
little concern that the connection might just be a bit more self-reinforcing.
The resulting crisis left the Fed struggling to keep the ship afloat - and in
that struggle the Fed stepped too deep into the realm of fiscal policy in an
effort to keep the trains running on time. But that mission creep was
simply incompatible with the Fed's desire for secrecy. This was all to
predictable: Like it or not, you cannot commit literally billions of
dollars of taxpayer money and in the process secretly funnel money through AIG
to the investment banking community without expecting just a little blowback.
The last I checked, this was still a democracy.
Worse now for the Fed is the impression that monetary authorities work first and
foremost for Wall Street. Of course, Fed officials see this a bit
differently - they see supporting Wall Street as their mechanism for supporting
Main Street. Ultimately, without the former, the latter is locked out of
capital markets, and economic chaos follows. The purpose of Wall Street is
supposed to be to channel investment funds into Main Street. But most
Americans no longer view Wall Street as ultimately working in their best
interests - maybe correctly. This is the same Wall Street that
aggressively pushed garbage loans onto the American people as policymakers
praised the wonders of financial innovation. When did the purpose of
finance evolve into simply a mechanism to enrich the relative few at the expense
of many? And when did policymakers embrace this view? As Paul
Krugman has noted, the
Fed
cannot envision a world not dominated by the magic of structured finance.
Yet this is a world tht failed us to completely.
Ultimately, can you really blame Americans if they have lost their faith in the
supposedly omnipotent Federal Reserve?
An independent central bank is crucial. Political control of monetary policy
must inevitably lead to accelerating inflation and long-run economic
instability. But at the moment, the American economy could use an increase in
expected inflation. And a real threat to Fed independence would almost certainly
deliver it, either because markets would anticipate increased political
influence on monetary policy ever after, or because the Fed would seek to fend
off pressure from Congress by easing further, which amounts to the same thing.
But we don't actually want there to be a real threat to Fed independence,
because that way uncontrolled inflation lies.
The Fed has made it clear that unemployment is expected to remain unacceptable
high in the medium run while disinflationary pressures persist. Yet
policymakers have also made it clear that they believe they have done all they
can, or are willing, to do to combat unemployment. They equate credibility
with maintaining a 1.7-2% inflation target. Couldn't credibility be
consistent with a 4% inflation target? And wouldn't such a target be more
appropriate in a zero interest rate world? But alas, challenging the Fed
now with their independence at stake will only convince policymakers to dig in
their heels more aggressively.
What if the only way to get the Fed to do the right thing is to strip them of
their independence? It is a real possibility, although disastrous in the
long-run. Yet look at the dithering from the Bank of Japan,
still faced with a deflationary environment years and years after they
pushed to zero rates:
It was no coincidence that the new government of Yukio Hatoyama chose the day
when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of
noise on the issue. Both the deputy prime minister and finance minister made
concerned comments. Their unspoken message to the BoJ was clear: remove
monetary-stimulus measures at your peril. At the end of its two-day meeting, the
BoJ left its policy rate unchanged at 0.1%, and continued to use other measures,
such as buying government bonds, that it believes make monetary policy
“extremely accommodative.”
But the BoJ does not give the impression it is particularly concerned about
prices. It believes there are not yet clear signals of a deflationary mindset in
corporations or the public at large, and that a recovery in private demand will
eventually pull the economy out of its slump.
Good Lord, we have been talking about pulling Japan out of its slump for TWO
DECADES! Fear of inflation combined with a perception that acquiescing to
a higher inflation target would be akin to losing monetary independence has kept
BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain.
Is the Fed headed to the same place? Maybe.
I don't think the Fed can regain the trust of the public while at the same time
protecting the secrecy of their actions to save Wall Street (moreover, it is not
clear that such secrecy is now needed in any event). The relationship
between policymakers and financiers is now seen as far too cozy from the
perspective of the public. I think the Fed needs to make clear that they
work for the people, not for Wall Street. A strong statement by Federal
Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too
big - that we should no longer tolerate the expansion of financial firms to the
point that they pose systemic risk - would be a good start. Simply put,
Bernanke's choice set is dwindling - either risk losing independence, or step up
to the regulatory and policy plate like you intend to hit one out of the park.
If Wall Street is no longer working for Main Street, it is time to side with
Main Street.
There is, however, one important source of information on the effectiveness
of monetary and fiscal stimulus in an environment of near-zero interest rates,
dysfunctional banking systems and heightened risk aversion that has not been
fully exploited: the 1930s. This column – based on a paper presented at the 50th
Economic Policy Panel Meeting held in Tilburg on 23-24 October 2009 – draws out
some of the lessons for today’s crisis (Almunia et al. 2009).
Parallels: the Great Depression and the Great Recession
In previous columns,
two of us documented the strong parallels between the early stages of the Great
Depression and the early stages of our Great Recession. The causes of the two
episodes were quite similar. In the earlier episode they included an
unsustainable real estate boom (centred in Florida), lax supervision and
regulation, and global imbalances (known then as “the transfer problem”).
Similar circumstances suggest similar effects of policy, whether positive,
negative or none.
The problem is that the policy response then was limited. The Keynesian
argument for expansionary fiscal policy – whether right or wrong – was not known
in this pre-Keynesian era. Hence there was relatively little variation in fiscal
stance, with conservative policies being the default option. The aggressive use
of discretionary monetary policy was also relatively unusual, as central banks
were wedded to gold-standard ideology.
But there were exceptions. Japan’s aggressive use of monetary policy under
Takahashi was one, Italy’s large budget deficits under Mussolini another. And
there were good – exogenous – reasons for this variation. Fiscal impulses were
generally governed by forces other than immediate economic conditions; Italy’s
war in present-day Ethiopia, Hitler’s rearmament, the approach of World War II.
Who responded to the crisis with monetary stimulus depended heavily on prior
monetary experience; counties that had suffered high inflation in the 1920s
tended to be reluctant to abandon the gold standard in the 1930s.
New research
Cross-country comparisons can thus help us untie the Gordian Knot and move
the debate from the realm of ideology to that of evidence. Our project therefore
focuses on assembling annual data on growth, budgets and central bank policy
rates, mainly from League of Nations sources, for 27 countries covering the
period 1925-39.
This leaves the question of what model or empirical technique to apply.
Rather than prejudging the answer, we employ a battery of empirical methods. ...
The details of the results differ, but the overall conclusions do not. They
show that where fiscal policy was tried, it was effective.
Our estimates of its short-run effects are at the upper end of those
estimated recently with modern data; the multiplier is as large as 2 in the
first year, before declining significantly in subsequent years.... This is, in
fact, what one should expect if one believes that the effectiveness of fiscal
policy is greatest when interest rates are at the zero bound, leading to little
crowding out of private spending. It is what one should expect when households
are credit constrained by a dysfunctional banking system. Given similar
circumstances in 2008, this underscores the advantages of using 1930s data as a
source of evidence on the effects of current policy. ...
Monetary policy in the 1930s was not powerless
The results for monetary policy are less robust but point in the same
direction. A positive shock to the central bank discount rate leads to a fall in
GDP...
This result is notable, given the presumption, widespread in the literature,
that monetary policy is ineffective in near-zero-interest-rate (liquidity trap)
conditions. On the contrary, in the 1930s it appears that accommodating monetary
policy helped, by transforming deflationary expectations (Temin and Wigmore
1990) and by helping to mend broken banking systems (Bernanke and James 1991).
Given the prevalence of both problems circa 2008, we suspect that the results
carry over.
For others with different priors, these results may sit less easily. But the
time for priors is over. Policy should rest on an evidentiary basis. The
evidence we have marshalled so far speaks clearly. ...
Ben Bernanke’s Outlook for the Economy, by Mark Thoma, MoneyWatch: A few quick reactions to Ben Bernanke’s speech
today where he talks about something of concern recently–namely, how
the Fed will view changes in the value of the dollar. If the dollar
begins to fall, that will increase the price of imported goods and
materials used in production and that, in turn, adds to domestic
inflationary pressure. To support the dollar and lower the inflation
pressure, the Fed would have to raise interest rates, but that would
endanger the recovery of domestic output and employment by raising
borrowing costs, and it would also make U.S. exports more expensive to
foreign buyers.
So, if the dollar starts falling, will the Fed raise interest rates
to head off the inflationary pressure, or will it maintain low interest
rates in an attempt to stimulate the economy? Bernanke says they will
certainly keep an eye on the dollar, but it’s only one part of a larger
picture:
We are attentive to the implications of
changes in the value of the dollar and will continue to formulate
policy to guard against risks to our dual mandate to foster both
maximum employment and price stability. Our commitment to our dual
objectives, together with the underlying strengths of the U.S. economy,
will help ensure that the dollar is strong and a source of global
financial stability.
So what will the Fed do? Bernanke made it clear that while he sees
some improvement, we are very far from the “all clear” sign for the
economy:
On the one hand, those who see further
weakness or even a relapse into recession next year point out that some
of the sources of the recent pickup–including a reduced pace of
inventory liquidation and limited-time policies such as the “cash for
clunkers” program–are likely to provide only temporary support to the
economy. On the other hand, those who are more optimistic point to
indications of more fundamental improvements, including strengthening
consumer spending outside of autos, a nascent recovery in home
construction, continued stabilization in financial conditions, and
stronger growth abroad.
My own view is that the recent pickup
reflects more than purely temporary factors and that continued growth
next year is likely. However, some important headwinds–in particular,
constrained bank lending and a weak job market–likely will prevent the
expansion from being as robust as we would hope.
He also made it clear that inflation is not much of a worry right now:
The outlook for inflation is also subject
to a number of crosscurrents. Many factors affect inflation, including
slack in resource utilization, inflation expectations, exchange rates,
and the prices of oil and other commodities. Although resource slack
cannot be measured precisely, it certainly is high, and it is showing
through to underlying wage and price trends. Longer-run inflation
expectations are stable, having responded relatively little either to
downward or upward pressures on inflation; expectations can be early
warnings of actual inflation, however, and must be monitored carefully.
Commodities prices have risen lately, likely reflecting the pickup in
global economic activity, especially in resource-intensive emerging
market economies, and the recent depreciation of the dollar. On net,
notwithstanding significant crosscurrents, inflation seems likely to
remain subdued for some time.
Putting those two things together, fear that the economy will not
recover as robustly as we’d like, plus the belief that inflation
pressures are not a worry right now, leads to the following policy:
The Federal Open Market Committee
continues to anticipate that economic conditions, including low rates
of resource utilization, subdued inflation trends, and stable inflation
expectations, are likely to warrant exceptionally low levels of the
federal funds rate for an extended period.
I agree (very much) that inflation is not a worry right now, and
that the Fed should be primarily concerned with output and employment
at this point. Today’s remarks were intended to reassure markets (and
foreigners holding our debt) that the dollar is on the Fed’s radar, and
that it won’t allow the dollar to go into free fall. But practically,
today’s remarks tell us that the Fed expects to maintain low interest
rates for the foreseeable future.
Depression multipliers, by Paul Krugman: Barry
Eichengreen and Kevin O’Rourke have lately been scoring a series of
research coups, based on the combination of historical perspective and
a global view. Most famously, they showed that on a global basis the
first year of the current crisis was every bit as severe as the first year of the Great Depression.
The background here is that there are two problems with estimating
multipliers relevant to our current situation. First, you need to look
at what happens under liquidity-trap conditions — and except in
Japan,these haven’t prevailed anywhere since the 1930s. The second is
that in the United States, fiscal policy was never forceful enough to
provide a useful natural experiment. We didn’t have a really big fiscal
expansion until World War II; and WWII isn’t a good experiment because
the surge in defense spending was accompanied by government policies
that suppressed private demand, such as rationing and restrictions on
investment.*
What E&R do here is use a broad international cross-section to
overcome this problem. This works because a number of countries had
major military buildups during the 1930s — fiscal expansions that can
be regarded as exogenous to the economic situation, since they were
driven above all by Hitler’s rearmament programmes and
other nations’ efforts to match the Nazis in this sphere, and by
one-off events like Italy’s war in Abyssinia.
What do E&R find? Initial fiscal multipliers of 2 or more,
although they shrink over time. Yes, fiscal expansion is expansionary.
* I really, really don’t understand why this point has been so hard to get across.
The Fed Is Already Transparent, by Anil K. Kashyap and Frederic S. Mishkin,
Commentary, WSJ: Under the banner of increasing Federal Reserve
transparency, Congressman Ron Paul has sponsored a bill that would subject the
Fed's monetary policies to an audit by the Government Accountability Office
(GAO). The bill is a veiled attempt to undermine the Fed's independence. If it
passes, it will cripple policy making—particularly when it comes to inflation.
It is completely appropriate to hold the Fed accountable for its decisions. But
the Paul bill, H.R. 1207, will only produce redundancies: Congress already has
multiple ways of finding out what the Fed is doing and why.
The Fed produces a report and testifies twice a year before Congress about its
monetary policy actions. During this testimony, the Fed is forced to explain
what it has done, and elected officials question the Fed about its choices. In
addition, the Fed makes the minutes from its monetary policy meetings available
to the public, and Fed officials routinely give speeches explaining their
approach.
What's more, it is highly doubtful that the GAO has the technical competence to
evaluate monetary policy. If it did try to conduct these audits, at best it
would merely rehash known information. At worst, the GAO would generate
confusion by offering its own analysis.
Economic theory and massive amounts of empirical evidence make a strong case for
maintaining the Fed's independence. When central banks are subjected to
political pressure, authorities often pursue excessively expansionary monetary
policy in order to lower unemployment in the short run. This produces higher
inflation and higher interest rates without lowering unemployment in the long
term. This has happened over and over again in the past, not only in the United
States but in many other countries throughout the world.
The Fed's independence is critical to its credibility. During the financial
crisis, this credibility allowed the Fed to take extraordinary action to prevent
a possible depression without triggering inflation. But eventually the Fed will
have to scale back its unprecedented monetary accommodation. When it does move
to tighten monetary conditions, it must be allowed to do so without political
interference.
Weakening the Fed's independence now might raise the risk of inflation, which
would cause borrowing costs to rise and would lower prospects for a strong
economic recovery. For these reasons, we joined over 400 prominent economists in
July when we signed a petition opposing the type of incursion on the Federal
Reserve that Mr. Paul is proposing.
Fortunately, Congress is considering an amendment to the bill that would prevent
the negative consequences of the original Paul legislation. This amendment, put
forward by Rep. Mel Watt (D., N.C.) would change the focus of the bill by
instructing the GAO to audit the new lending facilities at the Federal Reserve
that were authorized under the 13(3) "unusual and exigent circumstances" clause
of the Federal Reserve Act. The 13(3) lending authority, which had not been used
by the Fed since the Great Depression, was the basis for many of the most
controversial decisions made during the crisis, including the rescue of AIG and
the establishment of new lending facilities.
This audit would involve oversight of the operational integrity of these
facilities' accounting, internal controls, and protection against losses. It
would also disclose the borrowers from these facilities one year after the
facilities are closed. The audit would produce new, important information that
is not otherwise available and would play to the strengths of the GAO. And the
amendment would exempt the Fed's normal monetary policy actions from the audit.
We strongly support an amendment of this type because it will increase the Fed's
accountability without compromising its monetary independence. We also believe
that the lag in disclosing the names of borrowers would enable Congress to have
appropriate oversight over these facilities without compromising their
effectiveness. Earlier disclosure would diminish the efficacy of these
facilities because of the so-called stigma problem: If borrowing from emergency
lending facilities is immediately made public, the markets would know that the
borrowers might have financial difficulties, which would make it harder for the
borrowers to operate.
No one can be fully comfortable with all the unprecedented actions that the Fed
has taken to limit the damage from the financial crisis. We appreciate the
frustration of the public and members of Congress who want a better
understanding of what has happened. Forming a committee of experts to write a
report on the crisis might help reassure the public and provide some lessons for
crisis management in the future. But the Paul bill, as originally written, won't
help with these goals and will only stifle the recovery.
There's a chance, as always, that I'll talk about something else, but this is still worth reading:
Why do central banks have assets?, by Nick Rowe: If you look at the balance sheet of a central bank, you will see it has liabilities (mostly currency) and assets (normally mostly government bonds/bills). Why do central banks have assets? Do they need them?
The wrong answer is that central banks need assets to "back" the value of the currency, and that paper currency would be worthless otherwise. The right answer is: since the government gets all the profits from a central bank anyway, there's no point in giving the government the assets; that owning assets lets the bank reverse course and reduce the money supply if it ever needs to; and it stops the accountants freaking out.
Today is the second day of a two-day Federal Open Market Committee
meeting. The rate decision along with the accompanying verbiage will be
released at 2:15 p.m. If I were still there, I’d go in with a tentative
idea of how I would vote, but would try to keep an open mind during the
presentations and discussions. ...
“Come With Me to the F.O.M.C.” was the title of a Richmond Fed
pamphlet written long ago and updated by others. Its lasting popularity
suggests an interest in what goes on behind the closed doors. While
I’ve been retired from the Fed almost four years, it changes so slowly
that I expect my memories aren’t far off.
Some F.O.M.C. Color
My almost 14 years as an F.O.M.C. member came with the presidency of
the Federal Reserve Bank of Dallas from Feb. 1, 1991, to Nov. 4, 2004.
Alan Greenspan was chairman during that time and then-Governor Bernanke
sat next to me for almost three years. Reserve Bank presidents inherit
their place around the table from their predecessors, and Dallas used
to sit between St. Louis and Boston. For the first several years of my
tenure, Alan Greenspan sat at the head of the long board table, but he
announced one day that he was switching to the middle spot. That was a
landmark event. We all rotated to keep our relative position, and I got
the chairman’s former seat.
Since Chairman Greenspan didn’t normally conduct policy by the seat
of his pants, as his successor has been accused of doing, his seat
never made me feel smarter. The president of the Boston Fed decided
about that time to move to the other end of the table — I don’t know
what I did — so I ended up between Bill Poole of the St. Louis Fed and
Governor Bernanke, the only two principals around the table with
beards. Ben’s was trimmed pretty short, but Bill’s was kind of shaggy.
It made my nose itch when I looked his way.
Two-day meetings like the one concluding today used to occur only
twice a year — in February and July. Chairman Bernanke added more
two-day meetings to the schedule. The July meeting was close to the
Fourth, and the British ambassador always had us as dinner guests on
the evening between meetings. Those dinners were nice, but they ran on
too long. The vice chairman, Alice Rivlin, was the all-time champion at
extricating us before midnight. The dialogue during the dinner between
the chairman and the ambassador was an education for me — actually for
us all — but I’m probably the only one to admit it.
Congress centralized power in Washington in the 1930s, and gave the
coveted (in central bank world) title of governor to the seven-member
Washington contingent and “demoted” the twelve former regional
governors to “president.” It also reduced the number of “presidents”
voting from 12 to 5 so Washington would have a 7 to 5 advantage if
votes ever split along those lines. The New York Fed president, as vice
chairman of the F.O.M.C., always has a vote; 4 of the other 11 regional
bank presidents also have a vote, based on an annual rotation.
I mention the voting arrangement because it is often misunderstood.
All the presidents participate fully in all the discussions, and an
observer would be unable to tell the voters from the nonvoters until
the vote at the end of the meeting. A persuasive nonvoting president
would probably have more influence on the outcome than a non-persuasive
voter.
F.O.M.C. members traditionally don’t discuss their votes or policy
before the meeting. If the presidents got together for dinner the night
before, they limited their discussion to Reserve Bank business and
gossip. Usually they went their separate ways for dinner. Being the
introvert that I am, I frequently had take-out Chinese food in my hotel
room.
Everyone arrives for the meetings after having done tons of
homework. The Reserve Banks have excellent research departments, but
they are smaller and less specialized than the board’s research staff.
The presidents are expected to say something about their regions, as
well as the national and international economy. It’s a lot like
cramming for finals. The board staff’s material, mostly contained in
the “green book,” included all recent data in context, forecasts made
under alternative assumptions, and special topics of current interest.
It was always comprehensive and outstanding in quality.
The board staff also prepared a “blue book” with alternative policy
choices and commentary. Forecasts based on the board’s econometric
models were treated respectfully by everyone...
See also Come with Me to the FOMC, Remarks by Governor Laurence H. Meyer, Willamette
University, Salem, Oregon April 2, 1998.
Fed Chief Cites Trade Imbalances’ Role in Crisis, by Edmund Andrews, NY Times:
Ben S. Bernanke, the chairman of the Federal Reserve, said on Monday that global
trade imbalances played a central role in the global economic crisis and warned
that the both the United States and fast-growing Asian nations needed to do more
to prevent them from recurring.
“We were smug,” Mr. Bernanke said of the United States, saying the American
financial regulatory system was “inadequate” at managing the immense inflows of
cheap money from China and other countries that had huge trade surpluses.
Though the Fed chairman acknowledged that trade imbalances have declined sharply
as a result of the crisis, mainly because trade itself plunged, he warned that
American foreign indebtedness will aggravate the imbalances once again unless
the United States reduces its soaring federal budget deficit.
“The United States must increase its national saving rate,” he said. “The most
effective way to accomplish this goal is by establishing a sustainable fiscal
trajectory, anchored by a clear commitment to substantially reduce federal
deficits over time.” ...
By the same token, he said, Asian countries needed to rely less on exports and
more on their consumption at home for their economic growth. One way to increase
Asian household consumption, he said, would be for countries like China to
increase social insurance programs and reduced the uncertainty that currently
hangs over many consumers. ...
With the Asian economy expanding at an annualized rate of 9 percent in the
second quarter of this year, and China’s economy expanding at rates of more than
10 percent, Mr. Bernanke said, “Asia appears to be leading the global recovery.”
But the Fed chairman warned that the United States-led crisis was fueled in
large part by huge inflows of cheap money to the United States from countries
like China that were trying to recycle dollars from their huge trade surpluses.
The Fed chairman noted that global trade and financial imbalances have narrowed
considerably since the crisis began... But he cautioned that the imbalances
could widen out again as economic growth revives. While the United States has to
tighten its belt by saving more and consuming less, China and other Asian
countries need to increase their consumer spending in order to promote faster
domestic economic growth.
Mr. Bernanke avoided what was in many ways the elephant in the room: the value
of the United States dollar. The dollar has dropped sharply in recent weeks
against the euro and the Japanese yen, which has helped increase American
exports by making them cheaper in some foreign markets. But the dollar has not
budged in more than a year against China’s renmimbi...
Some Federal Open Market Committee members argued that expanding their purchases above $1.25 trillion might help to “reduce economic slack more quickly,” according to minutes of the Federal Open Market Committee’s Sept. 22-23 meeting released yesterday in Washington.
Policy makers considered a relapse into recession a bigger risk than a near-term rise in prices, the minutes show. They predicted “cautious” consumer spending, business investment and hiring. If those conditions persist into 2010, the Fed may extend the housing-debt purchase program beyond its current March 31 end-date, economists said. ...
In the September meeting, Chairman Ben S. Bernanke and his fellow policy makers decided to slow purchases of mortgage securities to avoid disrupting the housing market while extending the duration of the program by three months. The Fed is also buying $200 billion of housing agency debt.
At the same time, policy makers repeated their pledge to keep interest rates low for “an extended period.” The Fed has made the purchase of securities a leading monetary policy tool.
Central bankers in last month’s meeting raised their economic projections based on improved housing markets, stabilizing consumer spending and a recovery in growth outside the U.S., the minutes said.
Even so, “many participants noted that the economic recovery was likely to be quite restrained,” the minutes said. “Credit from banks remained difficult to obtain and costly for many borrowers; these conditions were expected to improve only gradually.” ...
The U.S. central bank is the largest buyer of securitized mortgages issued by Fannie Mae and Freddie Mac, purchasing 79.5 percent of new issuance in August, according to the Mortgage Bankers Association.
Fed purchases of mortgage securities have helped push down interest rates on mortgages, making it cheaper for Americans to buy a home. ... Economists’ estimates of how much the Fed’s retreat from the mortgage-bond purchase program will raise borrowing costs vary from a quarter-point to more than a percentage point, said Julia Coronado, senior economist at BNP Paribas in New York.
“The big question here is, where are mortgage rates going to go if and when the Fed walks away?” said Coronado. “There are people on the committee that are unsure. They are worried about the sustainability of the recovery.”
FOMC members “discussed the importance of maintaining flexibility to expand the asset purchase programs should the economic outlook deteriorate or to scale back the programs should economic and financial conditions improve more than anticipated,” the minutes said.
Policy makers in recent speeches have been debating the timing and conditions for an exit from the central bank’s unprecedented intervention into the economy. ...
The Misplaced Tough-Mindedness of National-Debt Hawks, by Simon Johnson and James Kwak, Commentary, Washington Post: The editorial page of this newspaper on Sunday came out against using additional fiscal stimulus to boost national output and reduce the growth rate of unemployment. The basic argument, made in qualitative terms, was that the costs of the incremental national debt would outweigh the benefits in additional output and well-being for the people benefited. ...
Ever since the early Clinton administration, the sophisticated, hard-headed thing has been to say that deficits matter. Bill Clinton and Robert Rubin made the case that if you care about national prosperity and social welfare, you have to balance the budget, which has the effect of reducing interest rates. ...
Today, we face the largest federal government deficits since World War II and our fiscal position is likely to only get worse as the population ages, Social Security and Medicare expenditures increase, and our creaky pension system springs more leaks. The government also took on massive potential liabilities bailing out the financial system over the past year, which could increase the risk of inflation in the long term. The recession, which was severely deepened by the financial crisis, has also caused a steep drop in tax revenue, further increasing the national debt.
This means that we need to fix our health-care system, and that we cannot afford another financial crisis on the scale of the last one. But it has little to do with the policy question on the table: whether to spend more money to cushion the impact of the recession on the national economy and on the people suffering from it.
The textbook argument for fiscal stimulus still applies. We face a large output gap -- the difference between the amount the economy could produce and the amount it is producing -- because demand from households (for consumption) and companies (for investment) is low. The government should therefore increase spending in order to increase demand and help close the output gap. This should be balanced by lower spending or higher taxes when the economy has recovered. The fact that our baseline amount of debt has changed does not affect the validity of this principle.
The cost of additional stimulus, according to The Post's editorial, is "a higher national debt burden, which future Americans must pay off by working harder and saving more than they otherwise would have." But the idea that we are borrowing from our grandchildren is a common fallacy. As Mark Thoma pointed out in an example that is worth reading, issuing debt today is a transfer of cash from someone with savings to all the people who benefit from whatever the government spends the proceeds on; when the debt comes due -- in, say, 30 years -- there will be a transfer of cash from taxpayers to whoever is holding the bond at that point. (For example, the heirs of the person who bought the bond.) The money doesn't move from one generation to another.
But what about China? Aren't we borrowing money from China? Yes, but at the margin, we as a country (combining households, businesses and the government) are getting the money at a very low interest rate that we don't have to pay back for a long time. Now, this probably cannot go on forever -- that interest rate could start to rise -- but as Dean Baker points out, the underlying problem is that we export less than we import, which is what causes foreigners to accumulate financial claims on us.
The proper questions to ask, as with all borrowing, are whether the money is being used ... effectively..., especially when Congress is involved. But just as in the original stimulus debate early this year, there are some obvious places to start, such as extending unemployment benefits and providing direct aid to states. ...
We are not saying that we should simply ignore the national debt. But the best way to address the debt is to make a binding commitment now to raise taxes in the future when the economy recovers. The second-best way is to pass health-care reform that has a reasonable chance at reducing the growth rate of health costs. And the third-best way is to reform the financial system to minimize the chances of and the potential damage caused by another financial crisis. Using the national-debt bogeyman to avoid taking obvious steps to combat the recession and helping its victims is misplaced tough-mindedness.
3 Questions: Robert Solow on the struggle ahead, MIT News: Economist Robert Solow's seminal work in the 1950s and 1960s showed how new technologies create a large portion of economic growth, an achievement for which he was awarded the 1987 Nobel Prize in Economics. With the economy seemingly in need of a technological boost again, the emeritus Institute Professor sat down with MIT News for a talk in his office this week.
Q. What is your assessment of the economy now, and where is it going? A. Forecasting is hard and dangerous, and I don't do it. But it appears that the worst of the recession is over. However, the economy will be getting better slowly. And saying the economy is getting better is not the same thing as saying the economy is doing well. Real GDP fell by about 3.5 percent during the recession. But capacity increased 2.5 percent. We were producing 6 percent less than we knew how to produce. That gap has to narrow to reduce unemployment. If we rely only on the normal self-curing powers of a market economy, it may take until late in 2010 or early 2011 before we reduce that gap. So for that reason we should not rule out further stimulus in the next six to nine months. It's not easy because we have this enormous deficit. But we should recognize that even if the economy improves on its own, it won't do very much.
I had hoped that President Obama at the beginning of his term, while his popularity was at its highest, would have taken a very strong line. I don't think he could have asked for $1.4 trillion in stimulus, but he could have had a slightly bigger and better package, had he bullied a little bit more. If Obama or [David] Axelrod were to reply, "Boy, are you naïve," about the politics, I don't think I could have answered that. I'm just saying what I think God would have done if God were making these decisions. Congress falls well short of God.
Q. Your research made clear how much technology can contribute to economic growth. To what extent might we see technology driving growth now? A. I actually think the situation of the economy calls for a surge in technologically oriented investment. We have to expect consumer spending to be weak in our economy, not just for six months, but for the next few years. It will not be as strong a driving force as it has been the past several years. Something has to take its place. Government spending can't, since government will have a hard time financing the inevitable deficits and is not in a position to aggressively increase its deficit spending.
That leaves two sources of expenditure to replace the pullback of consumers. One of those is net exports. That's a long story. The other is business investment. We need business investment to support the economy. We have every reason to want to divert our resources toward secure and renewable sources of energy, new materials and environmental improvement. It's our job, a place like MIT, to produce those new technologies, then it's the job of private industry to grab them, but I also think it's the job of the federal government to shift incentives, from incentives to consume more to incentives to invest more. Obama ran on this kind of platform, and if he can put some money behind that fundamentally correct view, he might generate something. It's going to take more than that to replace 5 percent of GDP, but that would be a neat place to start.
Q. In 2005 you wrote that you were "disaffected" by the "assumptions and methods" of macroeconomics. There has been a lot of debate about this subject in the last month. What is your assessment of the state of macroeconomics now? A. The disaffection I expressed is still my assessment. The beast [the economic crisis] expressed the same disaffection in 2007 and 2008, and the currently fashionable way of doing macroeconomics in the profession literally had nothing to offer in response. The problem as I have thought about it is that currently fashionable macroeconomics likes to formulate things in a way that inevitably endows the economy with more coherence and purpose than we have any right to assume. I certainly hope this is obvious enough to the younger people in the profession, the graduate students and even junior faculty. I expect there will be a revival of doing macroeconomics that does not push that kind of coherence on aggregate economic behavior. Which is not to say that some individuals don't behave in a coherent way, but the system does not translate that behavior into something like a super-individual.
What happens to innovation, technology and growth during recessions? Are recessions temporary, or do they have a permanent impact on the trend rate of output? Antonio Fatás says "one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy," but these questions deserve "more attention in terms of academic research":
More on the medium-term outlook for the recovery, by Antonio Fatás: The magazine The Economist has an article this week on the persistence of the current recession and whether output will return to its trend. The arguments that the article present are similar to those made in the Chapter 4 of the recent World Economic Outlook by the IMF (see our previous post on this matter): it is likely that the current recovery is not strong enough to bring output back to trend. In a recent NBER working paper, Cechetti, Kohler and Upper also provide empirical evidence suggesting that financial crisis leave long-lasting (negative) effects on output.
The question on the connection between recessions (or business cycles in general) and potential output ("the trend") is one that has not been studied much in economics. Most of the models we use tend to think about the trend as being independent of business cycles - so recoveries always bring output back to the pre-crisis trend. Policy makers tend to use the concept of the output gap, the deviation of output from its potential, to think about the strength of the recovery under the assumption that in a "normal" year the output gap should be back to zero.
The strongest evidence one can find in favor of this hypothesis (that recessions are temporary) comes from the US economy. The US economy has displayed a surprising tendency to return to trend even after some major events such as the great depression, World War II or the recessions of the 70s. Below you can see a chart that shows the evolution of GDP per capita in the US during the period 1870-2008. The red line represents a (log-)linear trend using data up to 1928. It is remarkable how close the blue line is to the red line and how the economy recovers to return to trend.
In fact, using 1870-1928 data, a prediction using that (log-)linear trend leads to an error of only 1% for the level of GDP per capita in 2008. Of course, the picture is misleading in the sense that in some cases it took a long time for the economy to come back to this trend, but it is still interesting that it returned to the same trend. It could have returned to the same growth rate but at a different level but that's not what we see, we see that the output loss is always recovered after a number of years. This suggests that the supply side of the economy (innovation, technology) is unaffected by output fluctuations.
If one looks more carefully at the data, the evidence becomes much weaker. In contradiction to what we see in the picture above, empirical economists know that output fluctuations are very persistent. In fact, one cannot reject the hypothesis that all output fluctuations leave a permanent scar in the economy. If we suffer a recession, output never goes back to trend, it remains at a lower level forever (this is what is known in the academic literature as the existence of a "unit root" in output).
From a theoretical point of view, there are two ways to justify the fact that recessions always leave permanent effects:
1. Technological changes are the cause of business cycles. Recessions are period where we are not good at innovating and this causes both a recession and a permanent loss in output. This is what we know as "real business cycle theory".
2. Innovation is affected by recessions. During recessions firms invest less and this lead to a temporary slowdown of technological progress, so the economy never returns to the same trend. It will go back to its normal growth rate but the temporary effects on growth will leave a permanent scar on the economy. This is the argument that we hear these days to support the fear that the current recovery will not be strong enough. A few years ago I wrote a couple of academic papers that presented this theory and some international evidence in favor of this hypothesis (the papers can be found here and here). This is an area of macroeconomics that I believe deserves more attention in terms of academic research (but I am biased, given that I have written on the subject). And it is not just about financial crisis but, more generally, about what happens to innovation, technology and growth during recessions.
Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the
available — albeit thin — evidence is that it takes a
huge expansion of the Fed’s balance sheet to accomplish as much as would be
achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing
to expand its balance sheet to the $10 trillion or so it would take to be as
expansionary as it “should” be given, say, a Taylor rule.
Which means that the zero bound is still binding, which means that right now
we’re very much still in liquidity trap territory.
