Sunday, November 16, 2014

Another Look at Neo-Fisherism

Below the fold is a recent Twitter discussion I had with David Andolfatto and Noah Smith on Neo-Fisherism. The big takeaway from this conversation is that we all view the expected path of the consolidated government balance sheet as being a key determinant for current aggregate demand growth. This understanding has been implicit in Market Monetarist's calls for level targeting and explicit in our calls for a permanent expansion of the monetary base in a depressed economy. The fact that we have not seen rapid aggregate demand growth is strong evidence that the Fed's QE programs are not expected to permanently alter the consolidated government balance sheet.

The key difference between us that I see is that Neo-Fisherites question our assumption that fiscal policy would not offset a central bank attempting to permanently expand the monetary base. My reply is that if in a depressed economy monetary policy did go to some kind of level targeting (or a higher inflation target for folks like Paul Krugman) it would be a big regime change that would require political consensus and have Treasury's backing. Nick Rowe goes further and argues that even in a normal economy fiscal policy typically responds in a supportive role to monetary policy, not the other way around:
I am of the view that the Bank of Canada targets 2% inflation (or NGDP or whatever), and it adjusts the nominal interest rate (or base money or whatever) to hit that target, and its actions affect its profits, and those profits affect the government's spending and taxation decisions. In the long run, the government adjusts its budget to be consistent with the Bank of Canada's actions. Not vice versa. We saw that adjustment in 1995.
The point is that absent a troubled-state environment where fiscal policy does dominate and shape monetary policy actions (e.g. Zimbabwe 2008-2009) it is reasonable to assume the actions of fiscal policy will support and be consistent the objectives of monetary policy.

Along these lines, it is interesting to look back at my NGDP growth path target proposal that would have the U.S.Treasury Department take over and do helicopter drops when the Fed failed to hit some NGDP level target. My original motivation for this proposal was to insure against central bank incompetence in stabilizing aggregate demand. (The threat of the Treasury temporarily taking over monetary policy would also provide a strong incentives for Fed officials to do their job.) In doing so, however, this proposal would also serve to manage the expected path of the consolidated government balance sheet in a manner that would stabilize aggregate nominal expenditures. The proposal, then, is very Neo-Fisherian in spirit. So in some ways we are not all that different.

Monday, September 22, 2014

The Love Affair Conservatives Should Be Having

Paul Krugman and Josh Barro are going after conservatives for their "new love affair with Canada". They claim conservatives are incorrect to view Canada's successful fiscal consolidation in the 1990s as evidence of  "expansionary austerity." Here is Krugman:
Canadian austerity in the 1990s was offset by a huge positive movement in the trade balance, due to a falling Canadian dollar and raw material exports...Since we can’t all devalue and move into trade surplus, this meant that the Canadian story in the 1990s had no relevance at all to the austerity debate of 2010.
Actually, the Canadian story is very relevant to the austerity debate of 2010, but not in the way portrayed by most conservatives. For the Canadian story is largely about expansionary monetary policy offsetting contractionary fiscal policy. The Canadian dollar's fall was not some random event, but the result of concerted efforts by the Bank of Canada to counter the drag of fiscal austerity. This is an important story and it is not the first time it has transpired. About fifteen years earlier the Bank of England also used monetary policy to offset fiscal policy. Ramesh Ponnuru and I wrote about it these experiences back in 2012 in The Atlantic:
The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.
Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.
The U.S. economy over the past two years has exhibited the same pattern. Since mid-2010, total federal expenditures, measured in dollars, have trended down. The budget deficit as a share of the economy has fallen more than 2 percent over this time. This fiscal tightening has taken place in the midst of a barrage of economic shocks including the Eurozone crisis, the 2011 debt ceiling talks, and concerns about an Asian economic slowdown that have kept economic uncertainty elevated. Yet nominal spending has been incredibly stable, growing at about 4.5 percent a year. The recovery has been sluggish, but the Fed appears to have kept fiscal contraction and other economic shocks from ending it.
So yes, the Canadian experience was very relevant in 2010. And it became even more relevant in 2013 when budget sequestering further tightened fiscal policy. In fact, the context of the above article was the "fiscal cliff" crisis of 2012 that led up to the sequester. We were arguing back then the Fed, like the Bank of England and the Bank of Canada, had the ability to offset the looming fiscal austerity of 2013. Paul Krugman, on the other hand, was worried the spending cuts would further depress the economy. Here, for example, was an October, 2012 comment by Krugman:
[T]he only reason to worry about the fiscal cliff is if you’re a Keynesian, who thinks that bringing down the budget deficit when the economy is already depressed makes the depression deeper.
Fortunately, the Fed started QE3 and the Evans Rule about that time. We believed that though these programs were far from perfect--they were not properly designed to restore full employment--they had the potential to at least offset the fiscal austerity of 2013 even with a binding zero lower bound (ZLB). As Mike Konczal noted our views would be put to the test in 2013. The year 2013, therefore, would provide a natural experiment of sorts that would test whether monetary policy could offset contractionary fiscal policy at the ZLB. Even Paul Krugman recognized this point: 
On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
And let's be clear: fiscal policy was tightening. The IMF's cyclically-adjusted government budget balance as a percent of potential GDP showed fiscal policy had been tightening since 2010. It just tightened more so in 2013. This natural experiment would put all the Keynesians, Post-Keynesians, and sectoral-balance theories to the test. Many of these folks made dire predictions about the sequester. There are many I could list, but one predicted it would cost 700,000 jobs over 2013-2014.

So how did this natural experiment at the ZLB turn out? The economy did not collapse and 700,000 jobs were not lost. Real GDP maintained stable growth and over 4 million new jobs have been created so far in 2013-2014 period. More importantly, the one variable both fiscal policy and monetary policy directly affect, aggregate nominal spending, did not collapse in 2013-2014.This experiment indicates, then, that monetary policy can offset fiscal policy at the ZLB.

Conservatives should be having a love affair with this outcome. It shows that government spending can be curtailed without adverse consequences for the economy if monetary policy provides an offset. It is the same story that unfolded in Canada in the mid-1990s and the United Kingdom in the early 1980s. Conservatives need to embrace this view and run with it. It implies a reduced role for fiscal policy in stabilizing the economy.1 Some conservatives have embraced it, but most have not and continue to draw the wrong lessons from these experiences. If they want to make a convincing argument against an activist fiscal policy this is it.

P.S. Unfortunately, the many voices who were predicting doom and gloom because of the sequester have gone silent. No mea culpas from them. Their silence speaks volumes. Others, instead, point to the continued absence of full employment, but this is simply a moving of the goal posts. The original argument made by Market Monetarist was only that an offset was possible. We did not claim QE3 and the Evans Rule would restore full employment. We argued that would require something bolder like a NGDP level target.

Update: I was asked for evidence showing the Bank of Canada (BoC) explicitly eased policy in the mid-to-late 1990s. Below is a figure of their target policy interest rate corridor from a BoC report in 1998. It shows a sustained path of lowered policy interest rates--roughly 500 basis points!-- through early 1998. Here is a link to how the BoC manages its target.

1Okay, I have endorsed a NGDP-level target-based helicopter drop which is technically fiscal policy. The proposal is outlined here. The main reasons for my endorsement is to incentivize the Fed to act properly and provide insurance against central bank incompetence. This is a pragmatic proposal.

Monday, September 1, 2014

Another Bond Market Conundrum?

Is the U.S. economy in the midst of another bond  market "conundrum"? The last time we had one was in 2005 when former Fed chairman Alan Greenspan became perplexed over long-term interest rates failing to rise with the tightening of monetary policy. Some observers see something similar happening today. They note that the Fed has been tightening monetary policy with its tapering of QE3 and yet the benchmark 10-year treasury interest rate has been falling since the beginning of 2014. This conundrum gets even more interesting when one looks at the five-year treasury interest rate. It has hardly budged since the beginning of the year even as the 10-year interest rate has steadily declined. Jim Hamilton calls these developments the 'bond market condrum redux.

So what could be driving these developments? Robin Harding and Michael Mackenzie suggest it is the worsening economic conditions in the Eurozone and its implications for ECB monetary policy. Here is Harding-Mackenzie:
The link between US monetary policy and US bond yields has fallen apart this year, showing how fears of deflation in Europe are driving global financial markets. According to analysis by the Financial Times, the correlation between five- and ten-year Treasury yields has fallen to its lowest level on record, with US bonds appearing to track European monetary policy instead.


Five-year bond yields closely reflect the path of interest rates that markets expect from central banks. Ten-year yields normally move in tandem. But so far in 2014, the US ten-year has fallen from 3 per cent to 2.4 per cent – even as news on the economy has got stronger – while the US five-year yield has barely changed.

That is unprecedented: no other global shock going back to the 1960s has ever caused US five and 10-year yields to diverge like this. In recent months, the US 10-year yield has been more correlated with falling five-year yields in Europe.
I think Harding-Mackenzie may be on to something with the Euro zone-U.S. treasury yield connection. It is worth taking a closer look. To do so, we first need to recall that long-term interest rates can be broken down into the following components:

(1) long-term interest rate = average short-term interest rate expected over same horizon + term  

The term premium is the added compensation investors require for holding long-term treasuries over short-term ones. For example, if a financial panic causes a "rush to safety" by investors and they are more willing to hold long-term treasuries, then they will demand less compensation and the term premium will decline. The other component, the average short-term interest rate, is a nominal interest rate and via the Fisher relationship can be further decomposed into real interest rate and expected inflation terms:

(2) long-term interest rate = (average expected real short-term interest rate + average expected 
     inflation) +  term premium 

The average expected real short-term interest rate is typically tied to the expected growth of the economy.1 If the U.S. economic outlook is improving, it should increase and vice versa. Over the short-run it should track the business cycle while over the longer run it should track trend economic growth. It is also called the real risk-free interest rate and approximates what many macroeconomists call the natural interest rate.

Okay, with all that said we can now take a look at these components and assess the Harding-Mackenzie explanation for recent interest rate movements. The figure below shows these series since 2013 (It is constructed using the Adrian, Crump, and Moench (2013) term premium estimates and implied inflation forecasts from TIPs.)

This figure shows two interesting developments since the beginning of 2014. First, the term premium has been steadily falling. This decline could be explained by increasing worries over the Eurozone driving investors on the margin to treasury securities. This is not exactly the Harding-Mackenzie story, but it does provide a potential link between what is happening in Europe and long-term U.S. yields. 

Second, the real risk-free rate has been steadily climbing since the beginning of the year. This is consistent with the gradually improving U.S. economic outlook. As I have shown before, short-term swings in this real risk-free interest rate track the business cycle fairly closely. Consequently, this second development should not be surprising.

So on one hand the term premium is arguably falling because of Eurozone woes, while on the other hand the real risk-free rate is rising because of the improved U.S. economic outlook. The term premium decline, however, is larger and on net is dragging down the 10-year treasury yield (given stable inflation expectations).

But what about the 5-year treasury yield? The figure below provides the same decomposition as above and shows similar developments:

The big difference here is that changes in the term premium and real risk-free rate are much closer in size and therefore closer to offsetting each other. The graph below summarizes these differences. It shows similar increases in the real risk-free yield for both treasury securities, but much larger declines in risk premiums for the 10 year security.

In my view, then, the real bond market conundrum is why has the term premium falling more for the 10-year treasury? Has the flight to safety associated with the Euro crisis been weighted more toward long-term treasury securities? Or is it something else?

Update: See this Bruegel review of blogs for more the bond market conundrum.

 1It is technically tied to the expected growth of productivity, the expected growth of the labor force, and household's discount rates. See here for more on these points.

Sunday, August 24, 2014

About the Fed Not Trying Hard Enough To Hit Its Inflation Target

It is hard not to be cynical when you see charts like this one. It shows what appears to be a systematic relationship over the past 6 years between changes in the Fed share of marketable treasuries and PCE core inflation:

The figure indicates the Fed allows its share of marketable treasuries to change--by either engaging in LSAPs or refraining from doing so as the total share grows--so that core PCE inflation stays in the 1% to 2% corridor. Here is the scatterplot of this data:

Now this is just a reduced-form relationship, but it is highly suggestive and consistent with my claim from an earlier post that there really is no 2% target. Rather, there is a 2% ceiling to an inflation target corridor. As I showed in that post, the timings of the QE programs tend to line up with this view. The above chart provides further evidence.

P.S. For those observers who are so focused on endogenous money that they fail to see how a central bank can shape the medium-to-long run path of inflation recall what we discussed here and here. A brief excerpt:
Now to be clear, most money is inside money--money endogenously created by banks and other financial firms--and the Fed only indirectly influences its creation. However, it does so in an important way by shaping the macroeconomic environment in which money gets created. Consequently, it can have a large influence on inside money creation. For the same reason it can also influence how stable is the velocity of money. By successfully stabilizing the expected growth path of total dollar spending, the Fed will be causing this seesaw process [offsetting changes in the money supply and money velocity] to work properly.

Friday, August 22, 2014

Talking About the Past Five Years

I recently gave a talk to the Financial Planning Association of Kentucky. The slides from the presentation are below and readers of this blog with be familiar with many of them. In case you are not familiar, below is the slide outline and where to go for more information. The audience asked many questions that led the discussion beyond what was presented on the slides, including the Triffin Dilemma for US treasuries, why the Fed likes core PCE, and what is holding back the recovery. It was a lively and fun discussion.

Slide Outline
(1)  Monetary Policy Tightened During the Recession. See here, here,and here.
(2) The Fed Allowed the Money Supply to Collapse. See here, here, and chart to the right.
(3) The Fed Did Not Gobble Up the National Debt. See here and here.
(4) The Fed Did Not Artificially Lower Treasury Interest Rates. See here, here, and here.
(5) The Fed Actually Wants Inflation Between 1% and 2%. See here.

Friday, August 15, 2014

The Secular Stagnation Bug is Spreading at the Fed

Speaking of secular stagnation, it appears to be catching on at the Fed. Here is CNBC's Alex Rosenberg:
Is there something seriously wrong with the economy?
It's a scary prospect, and a concern that's gotten louder and louder over the past year. In economic circles, it goes by the alliterative name of "secular stagnation." And it's a phrase that Fed watchers are likely to hear more and more in the months ahead.
Recent comments by the vice chairman of the Federal Reserve, Stanley Fischer, indicate questions within the central bank about whether the slow growth that has followed the recent recession could reflect, or at least could potentially morph into, longer-term issues within the economy. And while Fischer avoided the phrase "secular stagnation" in his Monday speech, Minneapolis Fed President Narayana Kocherlakota is planning to host a November symposium that directly addresses the issue of secular stagnation by name, CNBC has learned.
Actually, it is worse than Rosenberg reports. The FOMC projections that are available show a pronounced downward trend in the "longer run" forecast of the federal funds rate. This projection is the expected average value of the federal funds rate over the long run. In short, its the expected long-run netural federal funds rate. Its declining trend can be seen in the figure below which shows the average of each member's FOMC "longer-run"forecast for each meeting where projections are available:

I have a hard time believing the fundamentals warrant this downward revision in the long-run neutral interest rate. Where is the optimism? Clearly, the FOMC members need to drink an elixir of readings by Joel Mokyr, Erik Brynjfolsson and Andrea McAfee, and Marc Andreessen to beef up their technology optimism. And then they could follow it up with a Bill McBride treat of demographic optimism. And to wash it all down, they should finish with a John Cochrane cocktail of secular stagnation skepticism.

Update: I stand corrected. Stanley Fischer in his speech actually leaves open the possibility of strong productivity growth going forward. Good for him! Here is an excerpt and related footnote:
Possibly we are moving into a period of slower productivity growth--but I for one continue to be amazed at the potential for improving the quality of the lives of most people in the world that the IT explosion has already revealed. Possibly, productivity could continue to rise in line with its long-term historical average10 
And here is footnote 10
For a fuller discussion, see, for example, Erik Brynjolfsson and Andrew McAfee (2011), Race Against the Machine: How the Digital Revolution Is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy (Lexington, Mass.: Digital Frontier Press); Erik Brynjolfsson and Andrew McAfee (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: W. W. Norton & Company); and Martin Neil Baily, James Manyika, and Shalabh Gupta (2013), "U.S. Productivity Growth: An Optimistic Perspective," International Productivity Monitor, no. 25 (Spring), pp. 3-12. See also Ben Bernanke (2013), "Economic Prospects for the Long Run," speech delivered at Bard College at Simon's Rock, Great Barrington, Mass., May 18. 

Secular Stagnation: Missing the Forest for the Trees

There is a new VoxEU ebook on secular stagnation. The book is a collection of essays by many prominent economists, most of whom are proponents of secular stagnation. As readers know, I am not convinced that this problem lingers over the U.S. economy and have explained why at the Washington Post and on this blog. This latest book does nothing to ease my skepticism. Many of the authors continue to mismeasure the real interest rate and ignore what I see as important technology and demographic developments that undermine the case for secular stagnation. Let's review these key issues.

First, real interest rates adjusted for the risk premium have not been in a secular decline. Everyone from Larry Summers to Paul Krugman to Olivier Blanchard ignore this point in the book. They all claim that real interest rates have been trending down for decades. The editors of the book, Coen Teulings and Richard Baldwin, even claim that this development is the 'prima facie' evidence for secular stagnation. What they are doing wrong is only subtracting expected inflation from the observed nominal interest rate. They also need to subtract the risk premium to get the natural interest rate, the interest rate at the heart of the story. For it is the natural interest rate that is affected by expected growth of technology and the labor force.

This point can illustrated by looking at the 10-year treasury yield for the United States (these graphs were first used in my Washington Post piece). The figure below shows the 10-year nominal treasury yield along with its expected inflation and term premium. The former is the annual average inflation rate expected over the next ten years, while the latter is the risk premium on treasuries that increases with the holding period of the security. The expected inflation series is constructed using data from the Survey of Professional Forecasters and the Livingston Survey.  The term premium is the average of the Kim-Wright and Adrian, Crump, and Moench estimates of the term premium. 

Note that both the expected inflation and the term premium begin to grow in the mid-1960s and peak in the early 1980s. From there, they both experience a secular decline. These developments track the increased uncertainty over the nominal anchor, inflation expectations, and economic policy that occurred during this time. Many stories are given for why this happened--LBJ trying to do Vietnam and the Great Society, beginning of  the Bretton Woods System breakdown, Fed using bad economic theory, etc.--but the big point is there was a big policy break from the past of relative price stability and this shock affected both the risk premium and inflation expectations.

Proponents of secular stagnation only account for the expected inflation term. They subtract it from the observed nominal treasury yield and behold a declining trend in real interest rates is found starting around early 1980, as seen below. 

But this is not the risk-free real interest rate, the one that best approximates the natural interest rate idea. To get that, the secular stagnationists need to also subtract the estimated risk premium. This measure, shown below, shows no clear declining trend but does show a stationary-like process that revolves around a mean just about 2%.

Now one could claim a new trend has set in over the last decade, but proving its a trend in this short of time is impossible. Moreover, there is a simpler answer: the deviations around the 2% mean are driven by the business cycle and we just happen to have gone through one of the worst in a long time. The figure below supports this view as it plots the CBO's output gap measure against the 10-year risk-free real interest rate:

To be clear, the 10-year real risk-free rate should be equal to the average of the expected path of the short-term real risk-free rates over the same time horizon. The first few years of this interest rate path are determined by the business cycle, which explains the risk-free rate's correlation with the output gap as noted above. The remaining years are shaped by expected growth of productivity and labor force and that explain the roughly 2% trend. Proponents of secular stagnation are effectively claiming the long-term 2% trend is no more. I don't buy it because one, I think they are confusing the trend for the cycle, and two, technology and demographic developments are far better than commonly portrayed. That leads us to our next point.

Second, technology growth appears to be rapidly growing but getting harder to measure. This point has been made recently by Joel Mokyr  in the Wall Street Journal and Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. Their basic point is that the economy is being radically transformed via smart machines and this will spur a period of great productivity growth, high returns to capital, and more investment. For example, imagine all the new infrastructure spending that will have to be done to support the increased use of driverless cars and trucks. Even over the past few decades there have been meaningful gains as illustrated by this hilarious spoof the show 24 being made in 1994. Noah Smith makes the case for big productivity gain even more recently. The secular stagnationists should take these developments more seriously. 

Probably one reason these developments get overlooked is that they are hard to measure. As I noted in my Washington Post piece, a good example can be found in your smartphone. It contains many items you had to formerly purchase separately--books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, dictionaries, etc.--and were counted part of GDP. Now most are free and not a part of GDP. My sense is this is not a recent phenomenon, but has been going on for sometime as the economy has become more service orientated. Measuring productivity in the service sector is notoriously hard. And it is only going to get harder.

Here is a great illustration of this measurement problem. Tyler Cowen has made the case that there has been a Great Stagnation in innovation that explains the observed slowdown in productivity data. I looked at the John Fernald TFP data and found this troubling chart. It seemed to confirm the Great Stagnation theory. It showed a sharp break in trend TFP growth starting around 1973:

Tyler Cowen approved of the chart, but Noah Smith raised some good questions about it. He observed that the Fernald TFP data can be decomposed into TFP in investment production and TFP in consumption production. TFP in investment looks better than the overall TFP:

While that is interesting, what is really striking is the TFP in consumption. It has basically flatlined since the early 1970s and is what is driving the Great Stagnation. In the spirit of Tyler Cowen, let's call this segment "The Great Flattening."

The Great Flattening does not seem reasonable. Has productivity growth in consumption really been flat since the early 1970s? No meaningful gains at all? This does not pass the smell test, yet this is one of the best TFP measures. This suggest there are big measurement problems in consumption production. And I suspect they can be traced to the service sector. I suspect if these measurement problems were fixed there would be less support for secular stagnation (and maybe for the Great Stagnation view too).

Third, the demographic outlook is not as dire as the secular stagnationists make it out to be. Bill McBride has been noting for some time that the U.S. demographic outlook is improving as the largest cohort is now found in the Millenial age group. Matt Busigin also makes this point. Globally, the United Nations also forecasts that working-age populations in many parts of the world will grow through 2050. More labor growth implies a higher return to capital and more investment demand.

These are the reason I remain skeptical about secular stagnation and optimistic about future U.S. economic growth. Maybe the secular stagnation story makes sense for the Eurozone, but at a minimum the authors of this VoxEU book should be more cautious in their endorsement of it for the United States. My sense is that they are missing the forest for the trees. They see a five-year slump, the zero lower bound, and a gloomy outlook. From these few bad 'trees' they conclude the entire forest has succumbed to the secular stagnation disease. The evidence above suggests they are wrong. They need to start looking closer at the forest.