Must-read: Narayana Kocherlakota: “Information in Inflation Breakevens about Fed Credibility”

Posted on by Brad DeLong

Must-Read: Whenever I look at a graph like this, I think: “Doesn’t this graph tell me that the last two years were the wrong time to give up sniffing glue the zero interest-rate policy”? Anyone? Anyone? Bueller?

Graph 3 Month Treasury Bill Secondary Market Rate FRED St Louis Fed

And Narayana Kocherlakota agrees, and makes the case:

Narayana Kocherlakota: Information in Inflation Breakevens about Fed Credibility: “The Federal Open Market Committee has been gradually tightening monetary policy since mid-2013…

…Concurrent with the Fed’s actions, five year-five year forward  inflation breakevens have declined by almost a full percentage point since mid-2014.  I’ve been concerned about this decline for some time (as an FOMC member, I dissented from Committee actions in October and December 2014 exactly because of this concern).  In this post, I explain why I see a decline in inflation breakevens as being a very worrisome signal about the FOMC’s credibility (which I define to be investor/public confidence in the Fed’s ability and/or willingness to achieve its mandated objectives over an extended period of time).

First, terminology.   The ten-year breakeven refers to the difference in yields between a standard (nominal) 10-year Treasury and an inflation-protected 10-year Treasury (called TIPS).  Intuitively, this difference in yields is shaped by investors’ beliefs about inflation over the next ten years.  The five-year breakeven is the same thing, except that it’s over five years, rather than 10.  

Then, the five-year five-year forward breakeven is defined to be the difference between the 10-year breakeven and the five-year breakeven.   Intuitively, this difference in yields is shaped by beliefs about inflation over a five year horizon that starts five years from now.   In particular, there is no reason for beliefs about inflation over, say, the next couple years to affect the five-year five-year forward breakeven. 

Conceptually, the five-year five-year forward breakeven can be thought of as the sum of two components:
 
1. investors’ best forecast about what inflation will average 5 to 10 years from now

  1. the inflation risk premium over a horizon five to ten years from now – that is, the extra yield over that horizon that investors demand for bearing the inflation risk embedded in standard Treasuries.
     
    (There’s also a liquidity-premium component, but movements in this component have not been all that important in the past two years.) 

There is often a lot of discussion about how to divide a given change in breakevens in these two components.  My own assessment is that both components have declined.  But my main point will be a decline in either component is a troubling signal about FOMC credibility.  

It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility.  The FOMC has pledged to deliver 2% inflation over the long run.  If investors see this pledge as credible, their best forecast of inflation over five to ten year horizon should also be 2%.   A decline in the first component of breakevens signals a decline in this form of credibility.  

Let me turn then to the inflation-risk premium (which is generally thought to move around a lot more than inflation forecasts). A decline in the inflation risk premium means that investors are demanding less compensation (in terms of yield) for bearing inflation risk. In other words, they increasingly see standard Treasuries as being a better hedge against macroeconomic risks than TIPs.  

But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low.  This observation is why a decline in the inflation risk premium has information about FOMC credibility.  The decline reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low – that is, increasing probability to a scenario in which both employment and prices are too low relative to the FOMC’s goals. 

Should we see such a change in investor beliefs since mid-2014 as being ‘crazy’ or ‘irrational’? The FOMC is continuing to tighten monetary policy in the face of marked disinflationary pressures, including those from commodity price declines.  Through these actions, the Committee is communicating an aversion to the use of its primary monetary policy tools: extraordinarily low interest rates and large assetholdings. Isn’t it natural, given this communication, that investors would increasingly put weight on the possibility of an extended period in which prices and employment are too low relative to the FOMC’s goals?

To sum up: we’ve seen a marked decline in the five year-five year forward inflation breakevens since mid-2014.  This decline is likely attributable to a simultaneous fall in investors’ forecasts of future inflation and to a fall in the inflation risk premium.   My main point is that both of these changes suggest that there has been a decline in the FOMC’s credibility.   

To be clear: as I well know, in the world of policymaking, no signal comes without noise.  But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable.   Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.

Must-read: Bill Black: “Announcing the Bank Whistleblowers United Initial Initiatives”

Posted on by Brad DeLong

Must-Read: Bill Black: Announcing the Bank Whistleblowers United Initial Initiatives: “I am writing to announce the formation of a new pro bono group and a policy initiative that we hope many of our readers will support and help publicize…

…Gary Aguirre, Bill Black, Richard Bowen, and Michael Winston are the founding members of the Bank Whistleblowers United.  We are all from the general field of finance and we are all whistleblowers who are unemployable in finance and financial regulation because we spoke truth to power and committed the one unforgivable sin in finance and in Washington, D.C. – being repeatedly proved correct when the powerful are repeatedly proved wrong….

Our group publicly released four documents on January 29, 2016.  The first outlines our proposals, all but one of which could be implemented within 60 days by any newly-elected President (or President Obama) without any new legislation or rulemaking.  Most of our proposals consist of the practical steps a President could implement to restore the rule of law to Wall Street.  As such, we expect that candidates of every party and philosophy will find most of our proposals to be matters that they strongly support and will pledge to implement. The second document fleshes out and explains the proposals.  We ask each candidate to pledge in writing to implement the portions of our plan that they specify to be provisions they support.  Again, we invite President Obama to do the same. The third document asks each candidate to pledge not to take campaign contributions from financial felons.  That group, according to the federal agencies that have investigated them, includes virtually all the largest banks. The fourth document explains why we formed our group is and contains our bios….

The most recent U.S. bubble and resultant financial crisis and Great Recession were driven by three epidemics of fraud led by elite bankers. The three epidemics that drove the crisis are appraisal fraud, ‘liar’s’ loans (collectively, these were the loan origination frauds), and the resale of those fraudulently originated mortgages through fraudulent ‘reps and warranties’ to the secondary market and the public. Banks, like fish, rot from the head – the ‘C Suite.’ Liar’s loans is an industry term that shouts the industry’s knowledge that it was originating overwhelmingly fraudulent loans.  In a liar’s loan the lender agrees not to verify data that is essential to prudent underwriting.  This would be an insane practice for an honest lender – and it was practice that was always discouraged by the federal regulators – but it optimizes ‘accounting control fraud.’… Not a single one of those elite bankers who led the fraud epidemics has been prosecuted and only one, a woman who was only moderately senior, has been held personally accountable in any meaningful way through a civil suit (made possible by a whistleblower). This is the greatest strategic failure of the DOJ in recent history. The SEC has also proven ineffective in holding the elite Wall Street bankers who led these fraud epidemics personally accountable. As with DOJ, one of the fundamental problems that has gotten worse is the ‘revolving door.’  We propose a practical means of reducing that problem….

We unanimously support the 60-Day Plan, but our Plan is not a ‘take it or leave it’ demand.  The candidates will choose which provisions of our Plan they support and will pledge to implement. In this first document we outline the substance of the Plan.  We are simultaneously releasing a longer document that explains the rationale for our Plan provisions and exactly how they can be implemented without new legislation or rules…

African American workers are hurt more by the decline in union and manufacturing jobs

Posted on by Bridget Ansel

The sources of income growth and mobility in the U.S. labor market have changed dramatically over the past several decades. Good-paying union jobs and manufacturing employment were once a prominent foundation for the country’s middle class, but these jobs have been eviscerated in recent history—with a disproportionate effect on African Americans.

Since the 1980s, union membership has plummeted for all demographic groups across the United States. For black workers, however, union jobs have disappeared significantly faster than they have for white workers. (See Figure 1.)

Figure 1

In 1983—the earliest year for which we have comparable data—31.7 percent of black workers were union members or covered by a union contract, compared to 22.2 percent of white workers. By 2015, however, union representation rates for black and white workers had fallen to 14.2 percent and 12.5 percent, respectively. While this was a steep decline for white workers (a drop of 43.6 percent), the fall for black workers was substantially sharper (a drop of 55.2 percent).

Research shows that the decline of unions is a significant cause of rising wage inequality among male workers. Recent work also demonstrates a strong correlation between union membership and intergenerational earnings mobility. African Americans may be disproportionately losing these positive benefits of unionization.

A major reason for the fall in unionization has been the large decrease in manufacturing employment, due primarily to long-term downward trends among rich countries but also to a large trade deficit. Yet the overall decline in the role of manufacturing has actually been more acute for African Americans than it has been for white workers. (See Figure 2.)

Figure 2

Prior to the 1990s, both black and white workers were equally likely to be employed in manufacturing. In 1979, the share of African Americans working in manufacturing was 23.9 percent, essentially the same rate for white workers of 23.5 percent. In 1990, both of these rates had fallen but remained the same for black (18.4 percent) and white (18.3 percent) workers.

After the early 1990s, however, black and white representation in manufacturing industries began to diverge. As of last year, the share of African Americans in manufacturing was only 8.6 percent, compared to 11.2 percent of white workers. In other words, a black worker was 23.2 percent less likely to have a manufacturing job than a white worker—a substantial blow considering that manufacturing jobs typically pay higher wages than other industries.

Manufacturing employers aren’t hiring African American workers like they did in prior years. Even though the black share of the overall U.S. workforce grew between 1979 and 2015, the black share of the manufacturing workforce did not increase commensurately during that time and actually declined from 9.5 percent in 1979 to 9.2 percent in 2015.

The combination of the downturn in manufacturing jobs and the decline in unionization has disproportionately affected African American workers. As we pursue policies to improve the quality of work, we should prioritize those which benefit the groups who have lost more of the good jobs that the labor market used to provide.

Project Syndicate: Debunking America’s Populist Narrative

Posted on by Brad DeLong

Debunking America’s Populist Narrative: BERKELEY – One does not need to be particularly good at hearing to decipher the dog whistles being used during this year’s election campaign in the United States. Listen even briefly, and you will understand that Mexicans and Chinese are working with Wall Street to forge lousy trade deals that rob American workers of their rightful jobs, and that Muslims want to blow everyone up.

All of this fear mongering is scarier than the usual election-year fare. It is frightening to people in foreign countries, who can conclude only that voters in the world’s only superpower have become dangerously unbalanced. And it is frightening to Americans, who until recently believed – or perhaps hoped – that they were living in a republic based on the traditions established by George Washington, Abraham Lincoln, and Teddy and Franklin Roosevelt. READ MOAR

Must-reads: March 31, 2016

Posted on by Brad DeLong

Must-read: Daniel Gross: “The Ties that Bind: Railroad Gauge Standards and Internal Trade in the 19th Century U.S.”

Posted on by Brad DeLong

Must-Read: Really neat piece on technology standards and antitrust: On June 1, 1886, U.S. railroads converted the U.S. South to the national gauge… and increased their own profits enormously, but because they effectively colluded on freight rates there were no increases in railroad-sector consumer surplus generated by this advance in efficiency in the short run. The takeaways: standards matter a lot, and for the health of the overall market and for equitable growth market competition and antitrust policy matter even more:

Daniel P. Gross: The Ties that Bind: Railroad Gauge Standards and Internal Trade in the 19th Century U.S.: “Technology standards are pervasive in the modern economy…

…and a target for public and private investments, yet evidence on their economic importance is scarce. I study the conversion of 13,000 miles of railroad track in the U.S. South to standard gauge between May 31 and June 1, 1886 as a large-scale natural experiment in technology-standards adoption that instantly integrated the South into the national transportation network…. I find a large redistribution of traffic from steamships to railroads serving the same route that declines with route distance, with no change in prices and no evidence of effects on aggregate shipments, likely due to collusion by Southern carriers. Counterfactuals… suggest that if the cartel were broken, railroads would have passed through nearly 70 percent of their cost savings from standardization, generating a 20 percent increase in trade on the sampled routes. The results demonstrate the economic value of technology standards and the potential benefits of compatibility in recent international treaties to establish transcontinental railway networks, while highlighting the mediating influence of product market competition on the public gains to standardization.

Must-reads: March 30, 2016

Posted on by Brad DeLong

Must-read: Jonathan Chait: “Oh, Good, It’s 2016 and We’re Arguing Whether Marxism Works”

Posted on by Brad DeLong

Must-Read: Jonathan Chait: Oh, Good, It’s 2016 and We’re Arguing Whether Marxism Works: “[Tyler] Zimmer is articulating the standard left-wing critique of political liberalism…

…illiberal left-wing ideologies, Marxist and otherwise, follow the same basic structure… reject… free speech as a positive good enjoyed by all… conclu[de] that political advocacy on behalf of the oppressed enhances freedom, and political advocacy on behalf of the oppressor diminishes it.

It does not take much imagination to draw a link between this idea and the Gulag. The gap between Marxist political theory and the observed behavior of Marxist regimes is tissue-thin…. [The] party… [that is] the authentic representative of the oppressed… [can] shut down all opposition…. [And] Marxists reserve for themselves the right to decide ‘which forms of expression deserve protection and which don’t,’ [so] the result of the deliberation is perfectly obvious…

Watching as the Federal Reserve juggles priceless eggs in variable gravity…

Posted on by Brad DeLong

Is it necessary to say that we hold Ben Bernanke, Mervyn King, Mark Carney, Janet Yellen, Stan Fischer, Lael Brainard, and company to the highest of high standards–demand from them constant triple aerial somersaults on the trapeze–because we have the greatest respect for and confidence in them? It probably is…

Back in 1992 Larry Summers and I wrote that pushing the target inflation rate from 5% down to 2% was a very dubious and hazardous enterprise because the zero-lower bound was potentially a big deal: “The relaxation of monetary policy seen over the past three years in the United States would have been arithmetically impossible had inflation and nominal interest rates both been three percentage points lower in 1989. Thus a more vigorous policy of reducing inflation to zero in the mid-1980s might have led to a recent recession much more severe than we have in fact seen…”

This does seem, in retrospect, to have been quite possibly the smartest and most foresightful thing I have ever written. Future historians will, I think, have a very difficult time explaining how the cult of 2%/year inflation targeting got itself established in the 1990s. And they will, I think, have an even harder time explaining why the first monetary policymaker reaction to 2008-2012 was not to endorse Olivier Blanchard et al.’s call for a higher, 4%/year, inflation target in the coded terms of IMF speak:

The great moderation (Gali and Gambetti 2009) lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment….

The crisis has shown that large adverse shocks do happen. Should policymakers aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? Are the net costs of inflation much higher at, say, 4% than at 2%, the current target range? Is it more difficult to anchor expectations at 4% than at 2%? Achieving low inflation through central bank independence has been a historic accomplishment. Thus, answering these questions implies carefully revisiting the benefits and costs of inflation.

A related question is whether, when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimize the likelihood of deflation, even if this means incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, which was on the mind of the Fed in the early 2000s, is one we must return to…

But instead we got a very different reaction. Sudeep Reddy reported on it back in 2009:

Sudeep Reddy (2009): Sen. Vitter Presents End-of-Term Exam For Bernanke: “Earlier this month, Real Time Economics presented questions from several economists…

…for the confirmation hearing of Federal Reserve Chairman Ben Bernanke…. Sen. David Vitter (R., La.) submitted them in writing and received the responses from Bernanke….

D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?

[Bernanke:] The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations.

In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.

The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

This sounds like nothing so much as the explanations offered in the 1920s and 1930s for returning to and sticking with the gold standard at pre-WWI parities, and the explanations offered at the start of the 1990s by British Tories for sticking to the fixed parities of the then-Exchange Rate Mechanism. The short answer is that real useful positive credibility is not built by attempts to stick to policies that are in the long run destructive–and hence both incredible and stupid. As we learn more about the economy and as the structure of the economy changes, the optimal long-run policy strategy changes as well. Credibility arising from a commitment that the Federal Reserve will seek to follow an optimal long-run policy framework and to accurately convey its intentions but will revise that framework in light of knowledge and events is worth gaining and maintaining. Credibility arising from a commitment to stick, come hell or high water, to a number that Alan Greenspan essentially pulled out of the air with next to no substantive analytical backing in terms of optimal-control analysis is not.

Now, however, we have another answer from Janet Yellen: that the zero lower bound is not, in fact, such a big deal:

Janet Yellen: The Outlook, Uncertainty, and Monetary Policy: “One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment…

…Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.10 While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Over on the Twitter Machine, the very-sharp Tim Duy–I take it from his picture that there is ample snowpack for the ski resorts in the Cascade Range–is impressed by how different the tone of this speech is with the get-ready-for-liftoff speeches of last fall:

And Dario Perkins and Mark Grady have chimed in in support: “suddenly she’s realised the rest of the world matters!…” and “lots of common messages, but emphasis v[ery] diff[erent] on the risks. And no mention of lags or falling behind the curve at all…”

I, by contrast, am still struck by the gap that remains between where she seems to be and where I am.

For there is a natural next set of questions to ask anyone who says that the zero lower bound and the liquidity trap are not big deals. That set is:

  • Then why isn’t nominal GDP on its pre-2008 trend growth path?

  • Why is the five-year ahead five-year market inflation outlook so pessimistic?

  • Why hasn’t the Federal Reserve pushed interest rates low enough so that investment as a whole counterbalances the collapse in government purchases we have seen since 2010?

Gross Domestic Product FRED St Louis Fed Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed FRED Graph FRED St Louis Fed

I cannot help but be struck by the difference between what I see as the attitude of the current Federal Reserve, anxious not to do anything to endanger its “credibility”, and the Greenspan Fed of the late 1990s, which assumed that it had credibility and that because it had credibility it was free to experiment with policies that seemed likely to be optimal in the moment precisely because markets understood its long-term objective function and trusted it, and hence would not take short-run policy moves as indicative of long-run policy instability. There is a sense in which credibility is like a gold reserve: It is there to be drawn on and used in emergencies. The gold standard collapsed into the Great Depression in the 1930s in large part because both the Bank of France and the Federal Reserve believed that their gold reserves should never decline, but always either stay stable of increase.

It was Mark Twain who said that although history does not repeat itself, it does rhyme. The extent to which this is true was brought home to me recently by Barry Eichengreen’s excellent Hall of Mirrors…

I tell you, I have a brand new set of lectures to write for a large monetary-policy module in American Economic History…