Tag: Monetary Policy

The Bond Market and Expectations: A Parthian Shot

Posted on by Brad DeLong
Parthian shot Google Search

In my The Need for Expansionary Fiscal Policy I quote Greg Ip:

policy makers are rightfully wary about acting in the face of so many contradictory signals. In the U.S., unemployment is moving lower and stocks are hitting new highs. Bonds could be pricing in secular stagnation, or merely a greater bias toward hyper-stimulative monetary policy by central banks…

If bond markets were pricing in a a greater bias toward hyper-stimulative monetary policy by central banks, the yield curve would be very steeply sloped indeed. Just saying.

Must-Read: Jon Faust: Why Has Transparency Been so Damn Confusing?

Posted on by Brad DeLong

Must-Read: I believe that the extremely sharp Jon Faust is completely correct when he says that over the past three years Fed policy has been driven by: (1) as long as employment gains persist, gradually reducing accomodation; and (2) as long as inflation remains below target, pause in the removal of accommodation if it looks as though employment gains might falter. The problem is that there has been an awful lot of information hitting the Fed over the past three years about the economy. For one thing, we have learned that the unemployment rates typically thought of as reflecting full employment now come with prime-age employment-to-population ratios of not 81% or 80% but 78%:

Employment Population Ratio 25 54 years FRED St Louis Fed

And we have learned that financial markets are not looking forward to any maturity of Treasury bonds yielding more than inflation for, well, forever:

30 Year Treasury Constant Maturity Rate FRED St Louis Fed

Both of those pieces of information should have led to a reevaluation of the policy rule. They have not. Both of those pieces of information are not consistent with the economy evolving as the Fed expected it three years ago.

So the great question is: What–if anything–will trigger the Fed’s reevaluation of its policy rule? And what will it change its policy rule to if that reevaluation is triggered? That–rather than people getting distracted by shiny pronouncements from individual FOMC participants–is why transparency has been so damn confusing:

Jon Faust: Why Has Transparency Been so Damn Confusing?: “[Fed] consensus has behaved consistently as if driven by two principles…

…[1] So long as steady job market gains persist, continue a gradual, pre-announced removal of accommodation. [2] So long as inflation remains below target, take a tactical pause if credible evidence arises that the job gains might soon falter…. Over the last three years, we’ve gotten normalization at a preannounced pace as in to the first principle, punctuated only by brief (so far) tactical pauses as under the second…. My story directly contradicts the popular narrative of a skittish, market-obsessed Fed flip-flopping at every opportunity. This is where the well-disguised part comes in….

The 19 policymakers on the FOMC have, since the crisis held widely divergent views…. Under the leadership of the Chair, these views somehow blend in a reasonably coherent compromise policy… fully embraced by no one…. The chosen policy often appears to be an orphan, at best, and can become a whipping boy. But the consensus policy is generally much simpler to understand than those 19 component views…. There is a strong pull toward that ‘skittish, market-obsessed Fed’ narrative…. The FOMC statement and press conference… are the principal places where the communication is unambiguously directed at explaining the consensus…. Communications other than these systematically obscure and confuse much more than they clarify…

Brexit: I Think Paul Krugman Is Confused Here…

Posted on by Brad DeLong
Interest Rates Government Securities Treasury Bills for United Kingdom© FRED St Louis Fed

Bearing in mind what has happened to me almost every single time since 1997 when I have concluded that Paul Krugman is wrong…

The key, I think, is something hidden in Paul’s column. It is the fact that the effect of pretty much any shock depends on what the private financial market and the public monetary and fiscal policy response to it is:

Paul Krugman: Still Confused About Brexit Macroeconomics: “OK, I am still finding it hard to understand the near-consensus among my colleagues…

…about the short- and medium-term effects of Brexit…. [While] Brexit will make Britain somewhat poorer in the long run, it’s not completely obvious why this should lead to a recession in the short run…. So let me give an example of the kind of analysis that I think should raise eyebrows: BlackRock…. “‘Our base case is we will have a recession’, Richard Turnill, chief investment strategist at the world’s largest asset manager, told reporters…. ‘There’s likely to be a significant reduction of investment in the UK,’ he said, adding that Brexit will ensure political and economic uncertainty remains high…

When we say ‘uncertainty’, what do we mean? The best answer I’ve gotten is that for a while, until things have shaken out, firms won’t be sure where the good investment opportunities in Britain are, so there will be an option value to waiting… Brexit might have seriously adverse effects on service exports from the City of London. This would mean that investment in, say, London office buildings would become a bad idea. On the other hand, it would also mean a weaker pound, making investment in industrial properties in the north of England more attractive. But you don’t know how big either effect might be. So both kinds of investment are put on hold, pending clarification.

OK, that’s a coherent story, and it could lead to a recession next year. At some point, however, this situation clarifies. Either we see financial business exiting London, and it becomes clear that a weak pound is here to stay, or the charms of Paris and Frankfurt turn out to be overstated, and London goes back to what it was. Either way, the pent-up investment spending that was put on hold should come back. This doesn’t just mean that the hit to growth is temporary: there should also be a bounce-back…. But that’s not what BlackRock, or almost anyone else, seems to be saying; they’re projecting lower growth as far as the eye can see. They could be right. But I still don’t see the logic. It seems to me that ‘uncertainty’ is being used as a catchall for ‘bad stuff’.

When asset managers–indeed, when anyone anywhere in the world who is not a trained economist–uses the phrase “more uncertainty”, they do not mean what me trained (or mistrained) economists mean: they do not mean that the future distribution of the random variable has a larger variance but the same mean. What they mean, instead, is that the distribution has a larger and longer lower tail. The variance is up and the mean is lower. The principal thing they see as pushing down investment in the near future is the fear of this lower tail–not capitalizing on the option value of waiting until more knowledge comes in.

Back in 1992 Britain exited the ERM. ERMexit had two effects: (1) a small reduction in the desirability of locating in Britain to serve the continental European market because one now faced exchange rate risk, and (2) a large easing of conventional monetary policy and thus lower interest rates and a lower value of the pound because the Bank of England no longer had to maintain the pound at an overvalued parity. The result: boom.

Today Brexit looks to have two effects: (1) a large reduction in the desirability of locating in Britain to serve the continental European market, and (2) ???? (we are not going to get a large easing of conventional monetary policy):

Interest Rates Government Securities Treasury Bills for United Kingdom© FRED St Louis Fed

In a proper neoclassical flex-price zero-debt world that was, somehow, at the zero lower bound on nominal interest rates, the response to Brexit would be to bounce the real value of the pound down and to bounce the internal price level down and follow that bounce with higher inflation. The much more strongly negative real interest rate produced by the price level bounce-down-followed-by-inflation would cushion the decline in investment. And the boost to exports from the bounced-down real value of the pound would soak up workers exiting investment-goods industries and maintain full employment.

Of course, the proper neoclassical flex-price zero-debt world is one in which the full operation of Say’s Law is a metaphysical necessity, and so full employment is always attained. We, however, do not live in a proper neoclassical flex-price zero-debt world. It is the job of fiscal and monetary authorities to follow policies that push real prices–real exchange rates, real interest rates, real wage levels–to the values that would obtain in such a world, and so preserve full employment. We can imagine:

*1. Expansion of government purchases: preserve full employment by replacing I with G. Not going to happen in any Britain ruled by anything like this generation of Tories.
2. A helicopter drop: the Bank of England buys bonds for cash, cancels the bonds, and the government cuts taxes by the amount of cancelled bonds. Might happen even with this generation of Tories if they were less thick. But they seem to be very thick indeed.
3. Continued whimpers from Mark Carney that he would not chase away the Inflation-Expectations Imp were she to somehow appear. Not likely to be effective.
4. Everybody becomes so terrified about the safety of their assets in Britain that the real value of the pound bounces low enough that expanding exports soak up all of labor exiting from investment-goods industries.

Paul seem to be betting that (4) is a real live high-probability possibility: the short-term safe real interest rate is pinned at -2%/year for the foreseeable future, but the pound will bounce low enough for expanded exports to preserve full employment. It could happen–the world is a surprising place. But that possibility seems to me to be a tail possibility, not something that should be at the core of one’s forecast.

Must-Read: Paul De Grauwe and Yuemei Ji: Animal Spirits and the Optimal Inflation Target

Posted on by Brad DeLong

Must-Read: Paul De Grauwe and Yuemei Ji: Animal Spirits and the Optimal Inflation Target: “Low inflation targets can cause economies to hit the zero lower bound during deflationary periods caused by even mild shocks…

…In such circumstances, central banks lose their ability to stimulate the economy. This column assesses the risk of this happening using a model that endogenises self-perpetuating optimism and pessimism in the economy. Given agents’ intrinsic chronic pessimism during times of recession, central banks should raise their inflation targets to 3 or 4% to preserve their ability to stimulate the economy when needed.

Must-Read: Narayana Kocherlakota: Three Antidotes to the Brexit Crisis

Posted on by Brad DeLong

Must-Read: Correct, IMHO, from the very sharp Narayana Kocherlakota. Now perhaps his successor Neel Kashkari and the other Reserve Bank presidents not named Charlie Evans might give him some back up?

The one thing I do not like is Narayana’s “Granted, there is a risk that such steps will spook markets by signaling that the Fed is concerned about the state of the U.S. financial system.” That sentence seems to me to misread market psychology completely. As I see it–and as the people in markets I talk to say–right now markets are fairly completely spooked by their belief that the Federal Reserve is unconcerned, and takes that lack of concern as a sign of Federal Reserve detachment from reality. Narayana’s following sentences seems to me to be highly likely to be the right take: “I’d say the markets are already pretty spooked” and “By demonstrating that it is paying attention to these obvious signals, the Fed can help to bolster confidence in its economic management”.

Let me stress that, at least from where I sit, that confidence in Federal Reserve economic management is, right now, lacking.

The people I talk to in financial markets tend to say that they believe markets took Stan Fischer on January 5 to be something of a wake-up call with respect to Fed groupthink:

Liesman: When I looked at where the market is priced, the market is priced below where the Fed median forecast is. Quite a bit. Two rate hikes really, if you count them in quarter points. Does that concern you that the market needs to catch up with where the Fed is or is it a matter of you think the Fed needs to recalibrate to where the market is?

Fischer: Well, we watch what the market thinks, but we can’t be led by what the market thinks. We’ve got to make our own analysis. We make our own analysis and our analysis says that the market is underestimating where we are going to be. You know, you can’t rule out that there is some probability they are right because there’s uncertainty. But we think that they are too low.

For eight straight years now the Federal Reserve has been more optimistic than the markets. And for eight straight years now the markets have been closer to being correct. And yet the Federal Reserve still believes that it “can’t be led by what the market thinks” and has “got to make our own analysis”? Why?

Narayana Kocherlakota: Three Antidotes to the Brexit Crisis: “The Fed should ensure that banks have enough loss-absorbing equity capital…

…not allow them to return equity to shareholders…. The measure should apply to all banks, so markets won’t read it as a signal about individual institutions’ relative strength. Second, there’s a risk that investors’ flight to safe assets could develop into a broader credit freeze. To mitigate this, the Fed should lower its short-term interest-rate target…. Finally, the Fed should consider reviving the Term Auction Facility, which allows banks to borrow funds from the central bank with less of the stigma…. Granted, there is a risk that such steps will spook markets by signaling that the Fed is concerned about the state of the U.S. financial system. That said, as an outsider who gets much of his information from Twitter, I’d say the markets are already pretty spooked. By demonstrating that it is paying attention to these obvious signals, the Fed can help to bolster confidence in its economic management. One important lesson of the last financial crisis is that the guarantors of stability must be proactive if they want to be effective. It’s time for the Fed to put that lesson into practice.

Must-Read: John Authers: Yield on 10-Yr U.S. Treasury…

Posted on by Brad DeLong

Must-Read: That the Brexit vote would deliver a substantial leftward IS shock to the global economy was not very foreseeable. But that something could deliver such a shock was very foreseeable indeed.

S P 500© FRED St Louis Fed 30 Year Treasury Constant Maturity Rate FRED St Louis Fed 30 Year Treasury Constant Maturity Rate FRED St Louis Fed

Do not be reassured by the recovery of the stock market: P = D/(r-g). That the stock market has not gone up as a result of Brexit indicates that the lower interest rates expected in the long run (r) have been offset by the lower growth rate of profit due to additional expected economic weakness (g).

By now Yellen and Bernanke before her have had three full Reserve Bank president-appointment cycles–2006, 2011, and 2016–to get the non-Governor members of the FOMC on the page. It is no longer credible to claim that technocratic imperatives of ideal monetary policy have to bow to the requirements of maintaining committee consensus to promote banking-sector confidence with the Fed.

If financial markets were going to scream any louder that a régime shift to a less deflationary monetary policy régime is called for, how would they do that?

John Authers : On Twitter:

Must-Read: Jamie Chisholm: Treasury Yields Hit Record Lows

Posted on by Brad DeLong

Must-Read: May I please have a theory from the Federal Reserve–I am not asking for much: just a theory–as to why they continue to be confident that their models are a better guide to likely futures than financial markets, and as to why they continue to regard the lower tail of outcomes as something that can be handled if and when it happens rather than something they need to be desperately clawing away from as fast as they can?

Jamie Chisholm: Treasury Yields Hit Record Lows: “The 10-year Treasury yield is down 7 basis points to 1.39 per cent…

…earlier touching 1.377 per cent, its most meagre offering on record. The 30-year Treasury yield also hit an all-time low of 2.14 per cent. Equivalent maturity German Bunds and UK gilts are down 3bp to minus 0.17 per cent and off 4bp to 0.80 per cent, respectively — also flirting with record lows. The Bank of England has already said it is likely to loosen policy further in coming months, and governor Mark Carney on Tuesday said banks could stop building up rainy-day funds in an attempt to support lending. Shares in real estate companies, life insurers and housebuilders are leading declines in London, following the Standard Life news. Miners are under pressure too, as the ‘risk off’ mood batters commodities, with base metals lower and Brent crude down 3.6 per cent to $48.31 a barrel.

What I Saw and Did Not See About the Macroeconomic Situation Eight Years Ago: Hoisted from the Archives

Posted on by Brad DeLong

Hoisted from the Archives from June 2008J. Bradford DeLong (June 2008): The Macroeconomic Situation, with added commentary:

Looking back, what did I get right or wrong back eight years ago when I was talking about the economy? I said:

  • That the best way to think about things was that we were in a 19th-century financial crisis, and so we should look way back to understand things (RIGHT)
  • That a recession had started (RIGHT), which would probably be only a short and shallow recession (WRONG!!!!)
  • That the Federal Reserve understood (MAYBE) that it has screwed the pooch by failing to prudentially regulate shadow banks, especially in the housing sector (RIGHT), but that it would shortly fix things (MAYBE).
  • That the Federal Reserve was still trying to raise interest rates (RIGHT).
  • That the Federal Reserve should not be trying to raise interest rates (RIGHT), because the tight coupling between headline inflation today and core inflation tomorrow that it feared and expected had not been seen for 25 years (RIGHT).
  • That central bank charters are always drawn up to make financial markets confident that they are tightly bound not to give in to pressure and validate inflation (RIGHT).
  • That, nevertheless, when the rubber hit the road and financial crisis came there was ample historical precedent that central banks were not strictly bound by the terms of their charters–that they were guidelines and not rules (RIGHT).
  • That the Federal Reserve understood these historical precedents (WRONG) and would, with little hesitation, take actions ultra vires to avoid a major financial and economic collapse (WRONG).
  • That there was a long-standing tradition opposed to central banks’ taking action to stem financial crisis and depression–a Marx-Hayek-Mellon-Hoover axis, if yo will (RIGHT).
  • That this axis thought that business cycle downturns were always generated by real-side imbalances that had to be faced via pain and liquidation–could not be papered over by financial prestidigitation (RIGHT).
  • But that this axis was wrong: business cycle downturns, even those to a large degree generated by real-side imbalances, could be papered over by financial prestidigitation (RIGHT).
  • That even though the Fed and the Treasury believed that interest rates should still go up a little bit, they were also engaged in unleashing a huge tsunami of financial liquidity upon the economy (RIGHT).
  • That this liquidity tsunami was appropriate as an attempt to maintain full employment response to the collapse in construction and to the great increase in financial risk (RIGHT).
  • That this liquidity tsunami would do the job, and the recession would be short and shallow (WRONG!!!!!!!!)
  • That the runup in oil prices was not a speculative bubble that would be rapidly unwound (RIGHT).
  • That the runup in oil prices was a headwind for real growth (RIGHT).
  • That the dollar was headed for substantial depreciation (WRONG).
  • That the housing price and housing construction shocks to the economy were still ongoing (RIGHT).
  • That for those with a long time horizon equities were fairly valued, offering higher returns than other asset classes, if risky returns (RIGHT).
  • That asset prices would fluctuate (RIGHT).

But I did not, even in June 2008, understand (a) how bad the derivatives books of the major money-center banks were, and (b) how weak the commitment of central banks to doing whatever was necessary to stabilize the growth path of nominal GDP was.

PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation PowerPoint Presentation

Must-Read: Tim Duy: Fed Once Again Overtaken by Events

Posted on by Brad DeLong

Must-Read: That the Brexit crisis would happen was unforeseeable. That the odds were strongly that some negative shock would hit the global economy was very foreseeable indeed. And yet the Fed since 2014 has been actively making sure that it is unprepared.

10 Year Treasury Constant Maturity Rate FRED St Louis Fed

Starting with Bernanke’s abandonment in 2013 of a policy bias toward further expansion and acceptance of a need for interest rate normalization and the resulting Taper Tantrum, there has been a dispute between the markets and the Fed. The markets have expected the Federal Reserve to try to normalize interest rates and fail, as the economy turns out to be too weak to sustain higher rates. The Federal Reserve has always expected to be able in less than a year or so to successfully liftoff from zero and embark on a tightening cycle, raising interest rates by about one percentage point per year.

The markets have been right. Always:

Tim Duy: Fed Once Again Overtaken By Events: “A July hike was already out of the question before Brexit, while September was never more than tenuous…

…Now September has moved from tenuous to ‘what are you thinking?’… as market participants weigh the possibility of a rate cut…. Internally they are probably increasingly regretting the unforced error of their own–last December’s rate hike…. Uncertainty looks to dominate in the near term. And market participants hate uncertainty. The subsequent rush to safe assets… is evident…. Direct action depends on the length and depth of the financial turmoil currently underway. I think the Fed is far more primed to deliver such action than they were a year ago. And that… will minimize the domestic damage from Brexit.

The Fed began 2015 under the direction of a fairly hawkish contingent that viewed rate hikes as necessary to be ahead of the curve on inflation. Better to raise preemptively than risk a sharper pace of rate hikes in the future…. [But] asset markets were telling exactly the opposite, that there was far less accommodation than the Fed believed. Fed hawks were slow to realize this, and, despite the financial turmoil of last summer, forced through a rate hike in December. I think this rate hike had more to do with a perceived need to be seen as ‘credible’ rather than based in economic necessity. I suspect doves followed through in a show of unity for Chair Janet Yellen. They should have dissented.

Markets stumbled again in the early months of 2016, and, surprisingly, Fed hawks remained undeterred. Federal Reserve Vice Governor Stanley Fischer scolded financial market participants for what he thought was an overly dovish expected rate path. And even as recently as prior to the June meeting, Fed speakers were highlighting the possibility of a June rate hike, evidently with the only goal being to force the market odds of a rate hike higher. But I think that as of the June FOMC meeting, the hawkish contingent has been rendered effectively impotent…. I suspect the Fed will be much more responsive to the signal told by the substantial drop in long-term yields that began last Friday (as I write the 10 year is hovering about 1.46%) then they may have been a year ago….

I expect some or all of…. Forward guidance I. Fed speakers will concur with financial market participants that policy is on hold until the dust begins to settle…. Forward guidance II…. Watch for the balance of risks to reappear – it seems reasonable to believe they have shifted decidedly to the downside. Forward guidance III. This would be an opportune time for Chicago Federal Reserve President Charles Evans to push through Evans Rule 2.0. No rate hike until core inflation hits 2% year-over-year…. Forward guidance IV. A lower path of dots in the next Summary of Economic projections to validate market expectations…. Rate cut. Former Minneapolis Federal Reserve President Narayana Kocherlakota argues that the Fed should just move forward with a rate cut in July. I concur…. If all else fails. If some combination of 1 through 5 were to fail, the Fed will turn to more QE and/or negative rates…

I am thinking of Stan Fischer on January 5, 2016 on interest rates:

Well, we watch what the market thinks, but we can’t be led by what the market thinks. We’ve got to make our own analysis. We make our own analysis, and our analysis says that the market is underestimating where we are going to be. You know, you can’t rule out that there is some probability they are right because there’s uncertainty. But we think that they are too low…

Even though the markets had been right and the Fed wrong for the previous three years, as of January 2016 Fischer was claiming that market expectations were irrationally pessimistic and that the Fed understood the state of the economy.

I would very much like to hear Stan Fischer give a speech early next month laying out how he has over the past six months marked to market his beliefs about the state of the economy and the correct economic model.

Must-Read: Steve Cecchetti and Kermit Schoenholtz: A Primer on Helicopter Money

Posted on by Brad DeLong

Must-Read: Ummm… But aren’t the objections to expansionary fiscal policy today all that they involve governments taking on interest rate risk–that that is not a risk governments today ought to bear? And so isn’t the fact that helicopter money extinguishes that risk and is a more stable fiscal policy than bond-financed spending the entire point?

So I don’t understand…

Steve Cecchetti and Kermit Schoenholtz: A Primer on Helicopter Money: “Helicopter money is not monetary policy…

…It is a fiscal policy carried out with the cooperation of the central bank…. If the yield curve still has any upward slope, issuing reserves rather than long-term bonds to finance fiscal expenditure will appear cheaper in terms of current debt service. However, this apparent saving is an illusion because it ignores interest rate risk…. Helicopter money may strain the relationship between the fiscal and monetary authority… creating a situation commonly known as ‘fiscal dominance.’… A central bank does not face rollover risk, so a fiscal expansion financed by central bank money is more stable than one financed by bond issuance…. But is rollover risk really a concern for the government of most advanced economies? We doubt it….

Helicopter money today is… expansionary fiscal policy financed by central bank money. And, if interest rates have fallen to the ELB, it is neither more nor less powerful than any bond-financed cut in taxes or increase in government spending in combination with QE.