Tag: Liquidity Trap

Tim Duy’s Five Questions for Janet Yellen

Posted on by Brad DeLong
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A very nice piece here from the very-sharp Tim Duy:

Tim Duy: Five Questions for Janet Yellen

Next week’s meeting of the Federal Open Market Committee (FOMC) includes a press conference with Chair Janet Yellen. These are five questions I would ask if I had the opportunity to do so in light of recent events.

(1) 1. What’s the deal with labor market conditions? You advocated for the creation of the Federal Reserve’s Labor Market Conditions Index (LMCI) to serve as a broader measure of the labor market and as an alternative to a narrow measure such as the unemployment rate. The LMCI declined for five consecutive months through May, the most recent release…. On June 6, however, you said that:

the job market has strengthened substantially, and I believe we are now close to eliminating the slack that has weighed on the labor market since the recession.

The LCMI signals that although the economy may be operating near full employment, it is now moving further away from that goal. Is it appropriate for the Fed to still be considering interest rate hikes when your measure is moving away from the goal of full employment? Or have you determined the LMCI is not a useful measure of labor market conditions?

(2) Has the effect of QE been underestimated? Since the Fed began and completed the process of ending quantitative easing (QE), the dollar has risen in value, the stock market rally has stalled, the yield curve has flattened, broader economic activity has slowed, and now we are experiencing a slowing in labor market activity. These are all traditionally signs of tighter monetary policy, but you have insisted that tapering is not tightening and that policy remains accommodative. Given these signs, is it possible or even likely that you have underestimated the effectiveness of QE and hence are now overestimating the level of financial accommodation?

(3) Optimal control or no? The Fed appears determined to hit its inflation target from below. In other words, the central bank is positioning policy to tighten despite inflation currently running below the 2 percent target in order to avoid an overshoot at a later date. In the past, however, you argued for an ‘optimal control’ approach that anticipated an explicit overshooting of the inflation target in order to more rapidly meet the Fed’s mandate of full employment. Under optimal control, it seems that given stalled progress on reducing underemployment, coupled with deteriorating labor market conditions, the Fed should now be explicitly aiming to overshoot the inflation target by keeping policy loose. Do you believe the optimal control approach you previously advocated is wrong? If so, what caused you to change your mind?

(4) An Evans Rule for all? Chicago Federal Reserve President Charles Evans remains concerned about asymmetric policy risks. Persistently below target inflation risks undermining the public’s belief that the Fed is committed to reaching its target. Such a loss of credibility hampers the ability to subsequently meet the central bank’s target. In contrast, the well-known effectiveness of traditional policy tools means there is less upside risk to inflation. Consequently, he argues for an updated version of the Evans Rule (or an earlier commitment to not hike rates as long as unemployment exceeded 6.5 percent and inflation was below 2.5 percent).
Specifically, Evans said:

In order to ensure confidence that the U.S. will get to 2 percent inflation, it may be best to hold off raising interest rates until core inflation is actually at 2 percent. The downside inflation risks seem big — losing credibility on the downside would make it all that more difficult to ever reach our inflation target. The upside risks on inflation seem smaller.

Recall that in your most recent speech you indicated unease with inflation expectations and — at least implicitly — recognized the asymmetry of policy risks:

It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

This — especially when combined with your past support for an optimal control approach to policy — suggests that you should be amenable to adopting Evans’ position. Do you support Evans’ proposal that the Fed should stand down from rate hikes until the inflation target is reached? Why or why not?

(5) Just how much do you care about the rest of the world? Earlier this year, Federal Reserve Governor Lael Brainard suggested that the many developed economies operating at or below zero percent interest rates reduces the central bank’s capacity for raising rates:

‘Financial tightening associated with cross-border spillovers may be limiting the extent to which U.S. policy diverges from major economies…

At last September’s FOMC press conference, you said that you thought the global forces were insufficient to restrain the path of U.S. monetary policy. In response to a question about ‘global interconnectedness’ preventing the U.S. from ever moving away from zero percent interest rates, you said:

I would be very surprised if that’s the case. That is not the way I see the outlook or the way the Committee sees the outlook. Can I completely rule it out? I can’t completely rule it out. But, really, that’s an extreme downside risk that in no way is near the center of my outlook.

Given the events of the past six months — especially the refusal of longer-term U.S. Treasury yields to rise despite repeated hints of monetary tightening — have you reassessed your opinion? Do you view the risks of such an outcome as greater or lower than your assessment made last September?

Bottom Line: Most of these questions try to push Yellen to explain her past positions in light of the current data and actions. I think understanding how and why her positions change is critical to understanding how the Fed reacts to the conditions facing it. Making the so-called ‘reaction function’ clear remains the most important piece of the Fed’s communication strategy.

These five questions–“What’s the deal with labor market conditions?… Has the effect of QE been underestimated?… Optimal control or no?… An Evans Rule for all?… Just how much do you care about the rest of the world?”–are the right questions to ask. And Tim’s bottom line–“Push Yellen to explain her past positions in light of the current data and actions. I think understanding how and why her positions change is critical…. Making the so-called ‘reaction function’ clear remains the most important piece of the Fed’s communication strategy”–is the right bottom line.

After all, does this look like an economy crossing the line of potential output in an upward direction with growing and substantial gathering inflationary pressures to you?

Change in Labor Market Conditions Index FRED St Louis FedNewImage
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The Federal Reserve is simply not doing a good job of communicating its reaction function. It is not doing a good job of linking its model of the economy to current data and past events. Inflation, production, and employment (but not the unemployment rate) have been disappointingly low relative to Federal Reserve expectations for each of the past nine years. These events should have led to substantial rethinking by the Federal Reserve of its model of the economy. And yet the model set forward by Yellen and Fischer (but not Evans and Brainard) appears to be very much the model they held to in the late 1990s, which was the model they believed in in the early 1980s: very strong gearing between recent-past inflation and expected inflation, and a Phillips Curve with a pronounced slope, even with inflation very low.

Unless my Visualization of the Cosmic All is grossly wrong along the relevant dimensions, this is not the right model of the current economy. There was never good reason to think that the bulk of the runup in inflation in the 1970s was due to excessive demand pressure and unemployment below the natural rate–it was, more probably, mostly due to supply shocks plus the lack of anchored expectations. Only if you highball the estimate of the Phillips Curve’s slope for the 1970s can you understand the fall in inflation in the early 1980s as due overwhelmingly to slack, rather than ascribing a component to the reanchoring of inflation expectations. Thus the way to bet is that the economy on its current trajectory will produce less upward pressure on current inflation and also on inflation expectations than the Federal Reserve currently projects.

But how will it react when the data once again disappoints Federal Reserve expectations–as it has? In June 2013, the Fed was predicting that annual GDP growth during the 2013-2015 period would average 2.9%, with longer-run growth of real potential GDP averaging 2.4%. Instead, annual growth has averaged 2.3% (or 2.2%, if estimates for the first half of 2016 are correct). Nor did it perform better on other measures. The Fed predicted an annual inflation rate, based on the personal consumption expenditures index, of 1.9% for 2015. The true number was 1.5%. Similarly, its average projection of the federal funds rate for 2015 was 1.5%. The figure is currently 0.25%. This three-year period, starting in 2013, in which the economy undershot the Fed’s expectations, follows a three-year period in which the economy likewise fell short of the Fed’s forecast. And that period followed a three-year period, starting in 2007, in which the Fed massively understated downside deflationary risks.

Yet the prevailing model does appear to be the model of the early 1980s. It continues to gear inflation expectations at unrealistically high levels based on past inflation. And it continues to rely on the unemployment rate as a stand-in for the state of the labor market, at the expense of other indicators. So the big questions are: Will that commitment break? What would make them revise their models of the economy? And how will those model revisions affect their policy reaction function map from data to interest rates?

In an environment of economic volatility like the one in which we find ourselves today, a prudent central bank should do everything it can to raise expected and actual inflation, in order to gain the ability to stabilize the economy in any direction. If interest rates were well above zero, the Fed would have scope to raise them further in case of overheating or to lower them in response to adverse demand shocks.
But the Fed continues to neglect asymmetry, considering it only a second- or third-order phenomenon. It is not pushing for inflation at or above its target, even as optimal-control doctrines that themselves neglect asymmetry call for such a trajectory. Instead, by tightening policy by an amount that it cannot reliably gauge, it is narrowing its room for maneuver.

Looking at the current composition of the FOMC does not add to confidence:

  • On the left, Lael Brainard and Charles Evans certainly understand the situation–and have been right about almost everything they have opined on over the past eight years. Dan Tarullo shares their orientation, but these are not his issues.

  • On the right, Robert Kaplan and Patrick Harker replace hawks who were always certain, often wrong, and never open-minded–and are the products of failed searches: a job search is not supposed to choose a director of the search-consultant firm or the head of the search committee. Jeffrey Lacker and James Bullard and their staffs have been more wrong on monetary policy than the average FOMC member over the past eight years, but do not appear to have taken wrongness as a sign that their views of the economy might need a rethink. Esther George and Loretta Mester and their staffs feel the pain of a commercial banking sector in the current interest-rate environment, but I have never been convinced they understand how disastrous for commercial banks the medium- and long-term consequences of premature tightening and interest-rate liftoff would be.

  • In the neutral center, Jerome Powell does not appear to have views that differ from those of the committee as a whole. These are not Neel Kashkari’s issues: he is too good a bureaucrat to want to dissent from any consensus or near consensus on issues that are not his. And I simply do not have a read on Dennis Lockhart and his staff.

  • The active center is thus composed of Janet Yellen, Stanley Fischer, Bill Dudley, Eric Rosengren, and John Williams. Market risk and confusion is generated by uncertainty about their models of the economy, uncertainty about how they will revise their models as the data comes in, and uncertainty as to how they will react in committee, with six voices to their right calling for rapid interest-rate normalization and only three voices to their left worrying about asymmetric risks and policy traction.

When I listen to this center, one vibe I get is that the asymmetries are really not that great. Janet Yellen this March:

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. 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…

Another vibe I get is more-or-less what Bernanke said back in 2009:

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…. A monetary policy strategy aimed at pushing up longer-run inflation expectations in theory… 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…

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.

And I cannot help but be struck by the inconsistency between the two vibes. The claim that we need not worry about asymmetry because we are willing to undertake radical policy experimentation fits very badly with the claim that we dare not rock the boat because the anchoring of inflation expectations on the upside is very fragile. Combine these with excessive confidence in the current model–with a tendency to make policy based on the center of the fan of projected outcomes with little consideration of how wide that fan actually is–and I find myself with much less confidence in today’s Fed than I, four years ago, thought I would have today.

Must-Read: Steve Goldstein: Fed’s Lael Brainard Calls for ‘Waiting’ as Labor Market Has Slowed

Posted on by Brad DeLong
Https www federalreserve gov monetarypolicy files fomcprojtabl20151216 pdf

Must-Read: If people on the FOMC had known late last November that the first half of 2016 would be as bad as it is shaping up to be–a GDP growth rate that looks to be 1.7%/year rather than 2.4%/year, and a PCE-chain inflation rate of not 1.6%/year but 0.8%/year–how many of them would have pulled the trigger and gone for an interest rate increase last December?

I confess I do not know why Lael Brainard is saying “there is uncertainty that future data will resolve in the near-term and so we should wait” rather than “if we knew then what we know now we wouldn’t have raised rates in December, and so we should cut”:

Steve Goldstein: Fed’s Lael Brainard Calls for ‘Waiting’ as Labor Market Has Slowed: “Brainard, who’s the first Fed official to speak since the Labor Department…

…reported just 38,000 jobs were added in May, said the central bank should wait for more data on how the economy is performing in the second quarter, as well as a key vote by Britain on whether to leave the European Union. ‘Recognizing the data we have on hand for the second quarter is quite mixed and still limited, and there is important near-term uncertainty, there would appear to be an advantage to waiting until developments provide greater confidence,’ Brainard said at the Council on Foreign Relations. She said she wanted to have a greater confidence in domestic activity, and specifically mentioned the uncertainty around the Brexit vote, as reasons to pause at the next Federal Open Market Committee meeting, which is due to end June 15…

Must-Read: Timothy B. Lee: The Economy Just Got Its Worst Job Report in Years

Posted on by Brad DeLong

Must-Read: The way to bet is that two-thirds of the surprising component of this month’s employment report will be reversed over the next quarter or so.

Nevertheless: does anybody want to say that the Federal Reserve’s increase in interest rates last December and its subsequent champing-at-the-bit chatter about raising interest rates was prudent in retrospect? Anyone? Anyone? Bueller?

And does anybody want to say–given that the downside risks we are now seeing were in the fan of possibilities as of last December, and given that the Federal Reserve could have quickly reacted to neutralize any inflationary pressures generated by the upside possibilities in the fan last December–that the Federal Reserve’s increase in interest rates last December and its subsequent champing-at-the-bit chatter about raising interest rates was sensible as any form of an optimal-control exercise?

And we haven’t even gotten to the impact of the withdrawal of risk-bearing capacity from the rest of the world that happens in a Federal Reserve tightening cycle…

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Timothy B. Lee: The Economy Just Got Its Worst Job Report in Years: “The US economy created 38,000 jobs in May, the slowest pace of job growth in five years…

…Not only did job growth fall well short of economists’ expectations in May, the Labor Department also revised its estimates for March and April job growth downward by a total of 59,000…. One factor is the strike among Verizon workers, which cost the economy about 34,000 jobs. Those jobs should reappear in future reports…. There’s other bad news…. Over the last six months, the economy had started to reverse a years-long decline in the labor force participation rate…. But the latest report shows the economy has given most of those gains back, with the labor force participation rate falling from 63 percent in March to 62.6 percent in May…

Must-Read: Olivier Blanchard: How to Teach Intermediate Macroeconomics after the Crisis?

Posted on by Brad DeLong

Must-Read: Am I allowed to say that nearly all of this is in Paul Krugman’s 1998 The Return of Depression Economics?

Olivier Blanchard: How to Teach Intermediate Macroeconomics after the Crisis?: “The IS relation remains the key to understanding short-run movements in output…

…In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation. I was struck by how many times during the crisis I had to explain the ‘paradox of saving’ and fight the Hoover-German line, ‘Reduce your budget deficit, keep your house in order, and don’t worry, the economy will be in good shape.’ Anybody who argues along these lines must explain how it is consistent with the IS relation. The demand for goods, in turn, depends on the rate at which people and firms can borrow (not the policy rate set by the central bank, more on this below) and on expectations… animal spirits… largely self-fulfilling. Worries about future prospects feed back to decisions today….

The LM relation… is the relic of a time when central banks focused on the money supply…. The LM equation must be replaced, quite simply, by the choice of the policy rate by the central bank, subject to the zero lower bound. How the central bank achieves it… can stay in the background…. Traditionally, the financial system was given short shrift in undergraduate macro texts. The same interest rate appeared in the IS and LM equations…. This is not the case and that things go very wrong. The teaching solution, in my view, is to… discuss how the financial system determines the spread between the two….

Turning to the supply side, the contraption known as the aggregate demand–aggregate supply model should be eliminated…. One simply uses a Phillips Curve…. Output above potential, or unemployment below the natural rate, puts upward pressure on inflation. The nature of the pressure depends on the formation of expectations…. If people expect inflation to be the same as in the recent past, pressure takes the form of an increase in the inflation rate. If people expect inflation to be roughly constant… pressure takes the form of higher—rather than increasing—inflation. What happens to the economy, whether it returns to its historical trend, then depends on how the central bank adjusts the policy rate in response to this inflation pressure…. This… is already standard in more advanced presentations and the new Keynesian model (although the Calvo specification used in that model, as elegant as it is, is arbitrarily constraining and does not do justice to the facts). It is time to integrate it into the undergraduate model…. These modified IS, LM, and PC relations can do a good job….

I consider two extensions… expectations… openness. Here, also, there are important lessons from the crisis…. The long interest rate… as the average of future expected short rates, with a fixed term premium. Quantitative easing… can affect this premium…. Deriv[ing]… exchange rates from the uncovered interest rate parity condition… assumes infinitely elastic capital flows. The crisis has shown… capital flows have finite elasticity and are subject to large shocks beyond movements in domestic and foreign interest rates. Periods of ‘risk on-risk off’ and large movements in capital flows have been an essential characteristic of the crisis and its aftermath…

Must-Read: Narayana Kocherlakota: There Goes the Fed’s Credibility

Posted on by Brad DeLong

Must-Read: By now we can no longer understand the Federal Reserve Chair as needing to maintain harmony on a committee that has on it many regional reserve bank presidents who have failed to process the lessons of 2005-2015. By now all the regional bank presidents are people whom the Federal Reserve Board has had an opportunity to veto:

There Goes the Fed s Credibility Bloomberg View

Narayana Kocherlakota: There Goes the Fed’s Credibility: “The Federal Reserve promised to keep its preferred measure of inflation…

…close to 2 percent over the longer run…. Some would say that central banks are out of ammunition…. Actually, though, the Fed has been deliberately tightening monetary policy over the past three years. Just last week, Chair Janet Yellen made a point of saying that the Fed intends to keep raising interest rates in the coming months….

Would it have started pulling back on stimulus in May 2013 if its short-term interest-rate target had been at 5 percent instead of near zero, and if it hadn’t been holding trillions of dollars in bonds? I strongly suspect that the Fed would instead have added stimulus by lowering interest rates…. The Fed’s current course is driven not by the state of the economy, but by a desire to get interest rates and its balance sheet back to what is considered ‘normal.’ Savers, bankers and many politicians agree with this objective…. The Fed, however, promised to focus on actual economic outcomes….

Investors’ doubts [about the Fed] aren’t surprising, given the Fed’s focus on ‘normalizing’ interest rates rather than on hitting its inflation target. Such concerns will create an extra drag on the economy if and when bad times do come. In other words, the Fed’s willingness to renege on its promises seems likely to make the next recession worse than it otherwise would be.

Must-Read: Michael Woodford: Quantitative Easing and Financial Stability

Posted on by Brad DeLong

Must-Read: The extremely sharp Michael Woodford makes the obvious point about quantitative easing and financial stability: by increasing the supply and thus reducing the premium on safe liquid assets, it should–if demand and supply curves slope the normal way–not increase but reduce the risks of the banking sector.

It is very, very nice indeed to see Mike doing the work to demonstrate that I was not stupid when I made this argument in partial equilibrium:

J. Bradford DeLong (January 17, 2014): “Beer Goggles”, Forward Guidance, Quantitative Easing, and the Risks from Expansionary Monetary Policy: When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector’s risk-bearing capacity:

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And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity…

It is reassuring that I was not stupid–that there is nothing important in general equilibrium that I had missed:

Michael Woodford: Quantitative Easing and Financial Stability: “Conventional interest-rate policy, increases in the central bank’s supply of safe (monetary) liabilities, and macroprudential policy…

…are logically independent dimensions of variation in policy… [that] jointly determine financial conditions, aggregate demand, and the severity of the risks associated with a funding crisis in the banking sector…. If one thinks that the [risk] premia that exist when market pricing is not “distorted” by the central bank’s intervention provide an important signal of the degree of risk that exists in the marketplace, one might fear that central-bank actions that suppress this signal–not by actually reducing the underlying risks, but only by preventing them from being reflected so fully in market prices–run the danger of distorting perceptions of risk in a way that will encourage excessive risk-taking. The present paper… argues… that the concerns just raised are of little merit….

Quantitative easing policies can indeed effectively relax financial conditions…. Risks to financial stability are an appropriate concern of monetary policy deliberations…. Nonetheless… quantitative easing policies should not increase risks to financial stability, and should instead tend to reduce them…. Investors are attracted to the short-term safe liabilities created by banks or other financial intermediaries because assets with a value that is completely certain are more widely accepted as a means of payment. If an insufficient quantity of such safe assets are supplied by the government (through means that we discuss further below), investors will pay a “money premium” for privately-issued short-term safe instruments with this feature, as documented by Greenwood et al. (2010), Krishnamurthy and Vissing-Jorgensen (2012), and Carlson et al. (2014). This provides banks with an incentive to obtain a larger fraction of their financing in this way… choose an excessive amount of this kind of financing… because each individual bank fails to internalize the effects of their collective financing decisions on the degree to which asset prices will be depressed in the event of a “fire sale.” This gives rise to a pecuniary externality, as a result of which excessive risk is taken in equilibrium (Lorenzoni, 2008; Jeanne and Korinek, 2010; Stein, 2012)….

Cut[ting] short-term nominal interest rates in response to an aggregate demand shortfall can arguably exacerbate this problem, as low market yields on short-term safe instruments will further increase the incentive for private issuance of liabilities of this kind (Adrian and Shin, 2010; Giavazzi and Giovannini, 2012)…. Quantitative easing policies lower the equilibrium real yield on longer-term and risky government liabilities, just as a cut in the central bank’s target for the short-term riskless rate will, and this relaxation of financial conditions has a similar expansionary effect on aggregate demand in both cases. Nonetheless, the consequences for financial stability are not the same…. Conventional monetary policy[‘s] reduction in the riskless rate lowers the equilibrium yield on risky assets… [by] provid[ing] an increased incentive for maturity and liquidity transformation on the part of banks…. In the case of quantitative easing, instead, the equilibrium return on risky assets is reduced… through a reduction rather than an increase in the spread…. The idea that quantitative easing policies, when pursued as an additional means of stimulus when the risk-free rate is at the zero lower bound, should increase risks to financial stability because they are analogous to an expansionary policy that relaxes reserve requirements on private issuers of money-like liabilities is also based on a flawed analogy…. In the model presented here, quantitative easing is effective at the zero lower bound… because an increase in the supply of safe assets… reduces the equilibrium “money premium”… [which reduces] banks’ issuance of short-term safe liabilities… so that financial stability risk should if anything be reduced….

[This] paper develops these points in the context of an explicit intertemporal monetary equilibrium model, in which it is possible to clearly trace the general-equilibrium determinants of risk premia, the way in which they are affected by both interest-rate policy and the central bank’s balance sheet, and the consequences for the endogenous capital structure decisions of banks…

Helicopter Money!: No Longer So Live at Project Syndicate

Posted on by Brad DeLong

For economies at the the zero lower bound on safe nominal short-term interest rates, in the presence of a Keynesian fiscal multiplier of magnitude μ–now thought, for large industrial economies or for coordinated expansions to be roughly 2 and certainly greater than one–an extra dollar or pound or euro of fiscal expansion will boost real GDP by μ dollars or pounds or euros. And as long as the interest rates at which the governments borrow are less than the sum of the inflation plus the labor-force growth plus the labor-productivity growth rate–which they are–the properly-measured amortization cost of the extra government liabilities is negative: because of the creation of the extra debt, long-term budget balance allows more rather than less spending on government programs, even with constant tax revenue.

Production and employment benefits, no debt-amortization costs as long as economies stay near the zero lower-bound on interest rates. Fiscal stimulus is thus a no-brainer, right?

Perhaps you point to a political-economy risk that should economies, for some reason, move rapidly away from the zero lower bound their governments will not dare make the optimal fiscal-policy adjustments then appropriate. But future governments that wish to pursue bad policies no matter what we do today. And offsetting this vague and shadowy political-economy risks is the very tangible benefit that fiscal expansion’s production of a higher-pressure economy generates substantial positive spillovers in labor-force skills and attachment, in business investment and business-model development, and in useful infrastructure put in place.

Truly a no-brainer. The only issue is “how much?” And that is a technocratic benefit-cost calculation. Rare indeed these days is the competent economist who has thought through the benefit-cost calculation and failed to conclude that the governments of the United States, Germany, and Britain have large enough multipliers, strong enough spillovers of infrastructure investment and other demand-boosting programs, and sufficient fiscal space to make substantially more expansionary fiscal policies optimal.

This is the backdrop against which we today find aversion to fiscal expansion being driven not by pragmatic technocratic benefit-cost calculations but by raw ideology. And so we find my one-time teacher and long-time colleague Barry Eichengreen https://www.project-syndicate.org/commentary/monetary-policy-limits-fiscal-expansion-by-barry-eichengreen-2016-03 being… positively shrill: While “the world economy is visibly sinking”, he writes:

the policymakers… are tying themselves in knots… the G-20 summit… an anodyne statement…. It is disturbing to see… particularly… the US and Germany [refusing] to even contemplate such action, despite available fiscal space…. In Germany, ideological aversion to budget deficits… rooted in the post-World War II doctrine of ‘ordoliberalism’… [that] rendered Germans allergic to macroeconomics…. [In] the US… citizens have been suspicious of federal government power, including the power to run deficits… suspicion… strongest in the American South…. During the civil rights movement, it was again the Southern political elite… antagonistic to… federal power…. Welcome to ordoliberalism, Dixie-style. Wolfgang Schäuble, meet Ted Cruz.

Barry, faced with the triumph of sterile austerian ideology over practical technocratic economic stewardship, concludes with a plea:

Ideological and political prejudices deeply rooted in history will have to be overcome…. If an extended period of depressed growth following a crisis isn’t the right moment to challenge them, then when is?

Barry will continue to teach the history. He will continue to teach that expansionary fiscal and monetary policies in deep depressions have worked very well, and that eschewing them out of fears of interfering with “structural adjustment” has been a disaster. But this is no longer, if it ever was, an intellectual discussion or debate.

So perhaps there is a flanking move possible. “Monetary policy” and “fiscal policy” are economic-theoretic concepts. There is no requirement that they neatly divide into and correspond to the actions of institutional actors.

German, American, and British austerians have a fear and suspicion of central banks that is rooted in the same Ordoliberal and Ordovolkist ideological fever swamps as their objections to deficit-spending legislatures. But it is much weaker. It is much weaker because, as David Glasner points out, fundamentalist cries for an automatic monetary system–whether based on a gold standard, on Milton Friedman’s k%/year percent growth rule, or John Taylor’s mandatory fixed-coefficients interest-rate rule–have all crashed and burned so spectacularly. History has refuted Henry Simons’s call for rules rather than authorities in monetary policy. The institution-design task in monetary policy is not to construct rules but, instead, to construct authorities with sensible objectives and values and technocratic competence.

And central banks can do more than they have done. They have immense regulatory powers to require that the banks under their supervision to hold capital, lend to previously discriminated-against classes of borrowers, and serve the communities in which they are embedded as well as returning dividends to their shareholders and making the options of their executives valuable. And they have clever lawyers.

Their policy interventions have always been “fiscal policy” in a very real sense. They collect the tax on the economy we call “seigniorage”. There is no necessity that they turn their seigniorage revenue over to their finance ministries. Their interventions have always altered the present value of future government principal and interest payments.

Mid nineteenth-century British Whig Prime Minister Robert Peel was criticized by many for putting too-tight restrictions on crisis action in the Bank of England’s recharter. His response was that the new charter was written to cover eventualities that people could foresee. But that should eventualities occur that had not been foreseen, the only hope was for there then to be statesmen who were willing to assume the grave responsibility of dealing with the situation. And that he was confident there would be such statesmen.

Yes, it is time for central bankers to assume responsibility and undertake what we call “helicopter money”.

It could take many forms. It depends on the exact legal structure and powers of the central banks. It also depends on the extent to which central banks are willing, as the Bank of England did in the nineteenth century, to undertake actions that are not intra but ultra vires with the implicit or explicit promise that the rest of the government will turn a blind eye. The key is getting extra cash into the hands of those constrained in their spending by low incomes and a lack of collateral assets. The key is doing so in a way that does not lead them to even a smidgeon of fear that repayment obligations have even a smidgeon of a possibility of becoming in any way onerous.

The Intellectual Industry of Manufacturing Objections to Helicopter Money/Social Credit Is a Peculiar One…

Posted on by Brad DeLong

The very sharp Nick Rowe is distressed and depressed:

Nick Rowe: “This article on helicopter money is such a mare’s nest…”

I agree with Rowe: Borio, Disyatat, and Zabal seem to me to be confused. They seem to be saying that in the long-run a permanent increase in the nominal non-interest-bearing monetary base must be “financed” by one of:

  1. raising reserve requirements–thus imposing financial repression and levying an implicit tax on the banking sector.
  2. transforming the monetary base at the margin into interest-bearing debt.
  3. keeping the policy interest rate at zero permanently so that there is perfect substitutability between interest-bearing government debt and the non-interest-bearing monetary base.

My first reaction is that they have missed:

(4) a higher future price level so that the nominal non-interest-bearing monetary base is not an increase in the real non-interest-bearing monetary base.

And my second reaction is that their conclusion is simply not right. Their conclusion is that helicopter money

is equivalent to either debt or to tax-financed government deficits, in which case it would not yield the desired additional expansionary effects…

And thus, at least in a world of Ricardian equivalence where interest rates will not permanently remain at the zero lower bound, helicopter money is completely impotent.

But Bernanke covered this long ago:

If the price level were truly independent of money issuance, then the monetary authority could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we shall see it is quite corrosive of claims of monetary impotence…

The ECB’s problem right now is that it simply cannot meet its inflation target using its standard policy tools. Helicopter money would enable the ECB to meet its inflation target–and in that lies its additional power to stimulate production and employment.

Claudio Borio, Piti Disyatat, and Anna Zaba: Helicopter money: The illusion of a free lunch: “Beware of central banks bearing gifts…

…Helicopter money, as typically envisioned, comes with a heavy price: it means giving up on monetary policy forever. Once the models are complemented with a realistic interest-rate setting mechanism, a money-financed fiscal programme becomes more expansionary than a debt-financed programme only if the central banks credibly commits to setting policy at zero once and for all. Short of this, these models would suggest a rather limited additional expansionary impact of monetary financing. If something looks too good to be true, it is. There is no such thing as a free lunch.

Monetary Policy 201

Posted on by Brad DeLong

This from Paul Volcker strikes me as substantially wrong:

Paul Volcker and Cardiff Garcia: AlphaChatterbox Long Chat:

[My] first economics course… at Harvard… Arthur Smithies…. Session after session he would drill into our head that a little inflation was a good thing. And I could never figure out why. But I know he kept saying it, so already at the time I for some reason had an allergy to what he was saying. But it’s interesting, his lectures, it’s the same thing that central banks are saying today….

I would never interpret it as you have to have [inflation] exactly zero. Prices tend to go up or down a little bit depending upon whether the economy’s booming or not booming. And I can’t understand making a fetish of a particular number, frankly. What you do want to create is a situation where people don’t worry about prices going up and they don’t make judgments based upon fears of inflation instead of straightforward analysis of what the real economy is doing.

And I must confess, I think it’s something of a moral issue…. You shouldn’t be kind of fooling people all the time by having inflation they didn’t expect. Now, they answer, well, if they expect it, it’s okay. But if they expect it, it’s not doing you any good anyway. Those arguments you set forward don’t hold water if you’re expecting it…

There are three major considerations:

  1. In any economy with debt contracts that fix principal in nominal terms, it is easier to fall into a destructive Fisherian debt-deflation chain of bankruptcies when you have a zero rate of inflation than when you have positive inflation and so some normal-time upward drift in the price level.
  2. Sometimes the Wicksellian “neutral” or “natural” short-term safe real interest rate will be less than zero. That’s the rate consistent with full employment and no price-level surprises. That’s the rate at which the economy wants to be, and the rate that a central bank properly performing its stabilization policy mission will aim for. But whenever the Wicksellian “neutral” rate is, say, -x%, no central bank can get the economy there unless the inflation rate is +x%.
  3. People really, really hate having their nominal wages cut. Firms would thus rather reduce costs by firing people than reduce costs by cutting nominal wages: in the first case, at least the people who hate you are no longer around to cause trouble and disrupt operations. Getting your nominal wages cut is a psychological diss with substantial sociological consequences. In an environment of moderate inflation firms thus have an extra degree of effective freedom at their disposal in reacting to changing circumstances: they can raise their prices by the amount of ongoing inflation, but not give the the corresponding inflation-compensating nominal wage increases. That extra degree of freedom is worth a considerable amount to employers. And it is worth a considerable amount to workers as well–for workers hate getting fired, especially in a slack economy, much, much more than they hate having their real wages eroded by inflation.

Paul Volcker, although he would not put it this way, seems to be working with a Lucas aggregate supply curve: that the unemployment rate is equal to the natural rate of unemployment minus or plus a slope parameter times how much people have been positively or negatively surprised by inflation, and that workers’ utility is highest when unemployment is at its natural rate, and lower when unemployment is either more or less than the natural rate.

Volcker, however, would not call it a Lucas aggregate supply curve. He would call it a Smithies aggregate supply curve, or a Viner (1936) aggregate supply curve:

In a world organized in accordance with Keynes’ specifications, there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead…

It has never been clear to me why this Viner aggregate supply function has such a hold on the economics profession as a benchmark model from which you start–and, in this case, stop–thinking.

I do not think it is clear to Cardiff Garcia either. In his conversation with Volcker, he raised these points:

Cardiff Garcia: If you have zero percent inflation, then you’re closer to having a [destructive] deflationary spiral…. If you have a little bit of positive inflation, then interest rates will be correspondingly a bit higher, so if there’s a downturn, you have room to lower them. And… if you have a little bit of inflation, then it’s easier for companies to give real wage cuts to their employees without laying them off, if they just freeze their wages and then they go down because of inflation…

But Volcker does not pick up on any of these–sea-room to avoid deflationary spirals, more freedom to move the Wicksellian “neutral” rate to where it wants to be, more labor-market flexibility. He simply takes immediate refuge in the Viner aggregate supply function, according to which it’s only unexpected inflation that ever matters for anything…

Social Credit and “Neutral” Monetary Policies: A Rant on “Helicopter Money” and “Monetary Neutrality”

Posted on by Brad DeLong

Must-Read: Badly-intentioned or incompetent policymakers can mess up any system of macroeconomic regulation. And we now have two centuries of history of demand-driven business cycles in industrial and post-industrial economies to teach us that there is no perfect, automatic self-regulating way to organize the economy at the macroeconomic level.

Over and over again, the grifters, charlatans, and cranks ask: “Why doesn’t the central bank simply adopt the rule of setting a “neutral” monetary policy? In fact, why not replace the central bank completely with an automatic system that would do the job?”

Over the decades many have promised easy definitions of “neutrality”, along with rules-of-thumb for maintaining it. All had their day:

  • advocates of the gold standard,
  • believers in a stable monetary base,
  • devotees of a constant growth rate for the (narrowly defined) supply of money;
  • believers in a constant growth rate for broad money and credit aggregates;
  • various “Taylor rules”.

And the answer, of course, is that by now centuries of painful experience have taught central bankers one thing: All advocates, wittingly or unwittingly, were simply selling snake oil. All such “automatic” rules and systems have been tried and found wanting.

It is a fact that all such rule-based central bank policies and all such so-called automatic systems have fallen down on the job. They have failed to properly manage “the” interest rate to set aggregate demand equal to potential output and balance the supply of whatever at that moment counts as “money”, in whatever the operative sense of “money” is at that moment, to the demand for it.

Nudging interest rates to the level at which investment equals savings at full employment is what a properly “neutral” monetary policy really is.

Things are complicated, most importantly, by the fact that the business-cycle patterns of one generation are never likely to apply to the next. Consider: At any moment in the past century, the macroeconomic rules-of-thumb and models of economies’ business-cycle behavior that had dominated forty, thirty, even twenty years before–the ones taught then to undergraduates, assumed as the background for op-eds, and including in the talking points of politicians whose aides wanted them to sound intelligent in answer to the first question and fuzz the answer to the follow-up before ducking away. We can now see that, for fifteen years now, central banks have been well behind the curve in their failure to recognize that the business-cycle pattern of the first post-World War II generations has definitely come to an end. The models and approaches developed to understand the small size of the post-WWII generation’s cycle and its bias toward moderate inflation are wrong today–and are worse than useless because they propagate error.

And this should not come as a surprise. Before World War I there were the truths of the gold standard and its positive effect on “confidence”–the ability of that monetary system to, as Alfred and Mary Marshall put it back in 1885, induce:

confidence [to] return, touch all industries with her magic wand, and make them continue their production and their demand for the wares of others…

and so restore prosperity.

Yet those doctrines proved unhelpful and destructive to economies trying to deal with the environment of the 1920s and 1930s.

Those scarred by the 1970s have, ever since, been always certain that another outbreak of inflation was on the way. They have been certain that central bankers need to be, first of all, hard-nosed men. And so those scarred missed the great tech and stock booms of the end of the first millennium. Their advice was bad then. It is bad now.

More recently, there were those who drew the lesson from the twenty years starting in the mid-1980s that central bankers had finally learned enough to be able to manage an economy to keep the business cycle small–the so-called “Great Moderation”. They were completely unready for 2007-9. And they have had little or nothing useful to say since. Their advice was bad then. It is bad now.

And looking back at this history, right now the odds must be heavy indeed that people are barking up the wrong tree when they, today, fixate on the need for higher interest rates to fight the growth of bubbles. Or when they, today, talk about the danger that central bankers will be unable to resist pressure from elected governments to finance substantial government expenditures via the inflation tax.

The cross-era successes of macroeconomic theory as relevant to policy have been very limited. The principles that have managed to remain true enough to be useful across eras take the form of principles of modesty:

  1. There is the Mill-Fisher insight: We should look closely at the demand for and supply of liquid cash money, because a large excess demand for cash is likely to trigger a large demand shortfall of currently-produced goods and services. But Milton Friedman and others’ attempts to turn this into a rigid mechanical forecasting rule and a rigid mechanical k%/year money-growth policy recommendation blew up in their face.

  2. There is the Wicksell-Keynes insight: We should look closely at the supply of savings and the demand for finance to fund investment. But, again, Walter Heller’s and others’ attempts to turn this into a model that could then be used to guide fine tunings of policy blew up in their face.

  3. There are the Bagehot-Minsky insights: The insights about leverage, debt, and the macro economic consequences of sudden psychological phase transitions of assets from from rock-solid to highly-risky. But so far nobody in the Bagehot-Minsky tradition has even tried to construct a counterpart to the mechanical Keynesianism of the 1960s or the mechanical monetarism of the 1980s.

And by now this has become far too long to be a mere introduction to one of today’s must-reads: the very sharp Adair Turner:

Adair Turner: The Helicopter Money Drop Demands Balance: “Eight years after the 2008 financial crisis…

…the global economy is still stuck…. Money-financed fiscal deficits — more popularly labelled ‘helicopter money’ — seems one of the few policy options left…. The important question is political: can we design rules and responsibilities that ensure monetary finance is only used in appropriate circumstances and quantities?… In the real world… most money is… created… by the banking system… initial stimulus… can be multiplied later by commercial bank credit and money creation… [or] offset by imposing reserve requirements….

The crucial political issue is the danger that once the taboo against monetary finance is broken, governments will print money to support favoured political constituencies, or to overstimulate the economy ahead of elections. But as Ben Bernanke, former chairman of the US Federal Reserve, argued recently, this risk could be controlled by giving independent central banks the authority to determine the maximum quantity of monetary finance….

Can we design a regime that will guard against future excess, and that households, companies and financial markets believe will do so? The answer may turn out to be no: and if so we may be stuck for many more years facing low growth, inflation below target, and rising debt levels. But we should at least debate…

Adair Turner is very sharp. But this is, I think, more-or-less completely wrong: There is no set of institutions that can leap the hurdle that he has set–there never was, and there never will be. But it is madness to say: “Since we cannot find institutions that will guarantee that we follow the right policies, we must keep our particular institutions and policies that force us to adopt the wrong ones.” Sufficient unto the day is the evil thereof. Fix that evil now–with an eye on the future, yes. But don’t tolerate evils today out of fear of the shadows of future evils that are unlikely to come to pass.