Obstfeld and Rogoff's New Paper

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

The Amazing Resilience of the Fed's Inflation-Fighting Credibility

I was looking at the Philadelphia Federal Reserve Bank's Survey of Professional Forecasters and found the CPI inflation forecasts tell some interesting stories. Below is a plot of the 1-year forecast and the 10-year average inflation forecast (click on figure to enlarge):

Unfortunately, the 10-year forecast data only goes back to 1991, but based on the similarities in the two forecasted series we can infer the 10-year forecast was probably elevated in the early 1980s as well. Not a terribly surprising result given the upward-trending inflation experience of the 1960s and 1970s.

What is surprising to me is that relative to where it is today, the Fed's inflation-fighting credibility was still being earned as late as 1998. I was under the impression that Paul Volker came in and with one fell swoop earned the Fed the inflation-fighting credibility that it has today. The figure above suggests it was more of journey with inflation-fighting credibility being gradually earned over the next 17 years or so.

What is even more amazing to me is that the Fed's inflation-fighting credibility has not been harmed by recent developments. The forecasters continue to predict a stable long-term trend inflation rate of 2.5%, roughly the same value that it has been since 1998. Given all the talk about the Fed blowing up its balance sheet and the potential of monetizing the debt this result is nothing less than amazing. It should also give pause to those inflation hawks who only see trouble on the horizon.

Assorted Musings

Here are some more assorted musings:

(1) Caroline Baum asks a probing question: if the Fed is not able to identity an asset bubble and prick it in a timely fashion, how then is it able to know what are appropriate spreads in the credit market as it expands it balance sheet to shore up the financial system? In the former case it claims ignorance and refuses to intervene while in the later case it claims prescience and readily intervenes. Baum notes this asymmetry is typical of Fed policy in recent times.

(2) Has the Fed's independence already been compromised? Nouriel Roubini and Ian Bremmer argue yes and its not because of congressional probbing. Rather, it is because of its bailout of large financial institutions last year. Roubini and Bremmer also explain that if the Fed is not careful it could set the stage once again for the next bubble, a point recently made by Peter Boon and Simon Johnson.

(3) Roberto M. Billi has a new article that examines whether monetary policy was optimal in past deflation scares. He looks at Japan in the period 1990 to 1995 and the United States from 2000 to 2005. Using a Taylor Rule he concludes that monetary policy was too accommodative in the case of the United States. While I concur with his conclusion and have said so before, I also would like to note several things. First, the article assumes that deflation is always economically harmful. Deflation, however, can arise for reasons other than a collapse in aggregate demand. As I have noted before, positive aggregate supply shocks can also generate benign deflationary pressures and this form has far different policy implications than deflation arising from a collapse in nominal spending. Second, when constructing the federal funds rate prescribed the Taylor Rule one needs a measure of the output gap. There are, however, different measures of the output gap and, as result, different implications for the Taylor Rule. A popular version for the United States is the CBO's output gap measure. John Williamson of the San Francisco Fed , however, argues that the CBO measure is flawed since it doesn't allow for short-run fluctuations in the growth rate of potential output. Here is his preferred measure (LW) graphed along with the CBO measure:


The CBO measures show a negative output gap during the housing boom while the LW measure shows a positive output gap. The LW makes more sense for this period. Now plug the LW measure into a Taylor Rule and there is even a stronger case that monetary policy was too loose during the housing boom period. Finally, there are other ways to learn the stance of monetary policy. Here is one measure I like.

Josh Hendrickson on Money, Monetary Disequilibrium, and Arnold Kling

Josh Hendrickson has a series of interesting posts where he examines Arnold Kling's views on money.

Measurement Before Theory

Measurement Before Theory, Part 2: A Reply to Arnold Kling

Measurement Before Theory, Part 3: A Reply to Arnold Kling

After reading these posts by Josh as well as those by Nick Rowe and Bill Woolsey, one is almost compelled to take seriously money and monetary disequilibrium.

Was it Nominal or Real?

Scott Sumner has been arguing for some time that the current recession mutated from a mild downturn in early 2008 to a sharp contraction in late 2008 and early 2009 because of a nominal shock, not a real one. Specifically, he has been making the case that monetary policy effectively tightened in late 2008 and, as a result, nominal spending collapsed and pulled down an already weakened economy. According to this view, real shocks like the one coming from the financial crisis or the spike in oil prices, which were important in starting the recession, cannot explain the severity of the downturn that began in late 2008. As readers of this blog know, I have been sympathetic to this view as can be seen here and here. Many observers, however, do not buy it or if they do find it plausible refuse to endorse it due to the lack of empirical evidence. This post is my attempt to shed some light on this debate by using some rigorous (albeit imperfect) empirical methods to tease out what shocks drove the collapse in nominal spending. This essay is in some ways an extension of what I did earlier this week, but it is motivated more by the need for empirical evidence. I won't claim it is conclusive, but it is a start.

In order to uncover the shocks that drove the collapse in nominal spending, I turned to a vector autoregression that as a base line model included expected future inflation, nominal spending, and spreads on corporates yields. The expected future inflation data comes from the Philadelphia Fed's survey of economic forecasters, nominal spending is final sales to domestic purchasers, and corporate spreads are the difference between the yield on BAA and AAA corporate bonds. The reasons for using these variables is as follows. First, Scott has been arguing that the collapse of expected future inflation in late 2008 reflected an effective tightening of monetary policy that translated into reduction of current nominal spending. In other words, the market saw deflationary pressures on the horizon and immediately cut back on spending. Second, the corporate spreads provide a convenient measure of the financial crisis and should control for any collapse in nominal spending coming from a negative financial shock. The data for these variables run from 1971:Q1 thru 2009:Q2.

The VAR was specified and estimated in a conventional manner.* With the VAR estimated I then did a historical decomposition which decomposes or attributes the forecast error for a particular series--in this case the nominal spending growth rate--into shocks or non-forecasted movements in other series. In the baseline model, the other series are expected future inflation and the financial crisis. In other words, this exercise shows how much of the non-forecasted movements in nominal spending can be explained by non-forecasted movements in expected future inflation. The figure below graphs the results of this exercise. In this figure, the other series contribution to the forecast error--the difference the actual and forecasted nominal spending growth rate--is shown by the dashed lines. The closer a dashed line is to the solid red line the more of the forecast error is explained by that shock: (Click on figure to enlarge)


In this figure we see that both the expected inflation shock and financial system shock were important in the collapse of nominal spending. At its peak, the expected inflation shock explains 50% of the decline in the nominal spending shock during the time in question. This baseline model, however, ignores the oil shock and its potential contribution to the collapse in nominal spending. The VAR was reestimated, therefore, with oil prices and generated the following results: (Click on figure to enlarge)

Here the expected inflation shock is still important, but now only explains at most 31% of the decline in nominal spending. The financial shock becomes more important and oil itself is non-trivial in explaining the decline in nominal spending.

One problem with the above analysis is that it assumes the change in expected inflation is a good measure of the stance of monetary policy. I have argued elsewhere on this blog that a better measure is the difference between the nominal spending growth rate and the federal funds rates. I redid the model with this measure of the stance of monetary policy and this is what I found: (Click on figure to enlarge)


With this measure, monetary policy explains 95% of the decline in nominal spending for 2008:Q3, 78% in 2008:Q4, and 31% in 2009:Q1. This last figure confirms Scott's story. Of course, it assumes the monetary policy measure outlined above is actually measuring the stance of monetary policy. Note everyone will agree, but I certainly believe it is. To summarize the findings from the above figures the table below list the % contribution to the decline in nominal spending growth rate coming from the different measures representing monetary policy:


*The VAR had 5 lags to remove serial correlations and the variables were all in rate form so no unit root problem.

Update: Scott Sumner responds here.

Great Survey Paper on the Predictive Ability of the Term Spread

There is new paper by David Wheelock and Mark Wohar of the St. Louis Fed that surveys the literature on the relationship between the Treasury yield curve spread and future economic activity:

Can the Term Spread Predict Output Growth and Recessions? A Survey of the Literature
This article surveys recent research on the usefulness of the term spread (i.e., the difference between the yields on long-term and short-term Treasury securities) for predicting changes in economic activity. Most studies use linear regression techniques to forecast changes in output or dichotomous choice models to forecast recessions. Others use time-varying parameter models, such as Markov-switching models and smooth transition models, to account for structural changes or other nonlinearities. Many studies find that the term spread predicts output growth and recessions up to one year in advance, but several also find its usefulness varies across countries and over time. In particular, many studies find that the ability of the term spread to forecast output growth has diminished in recent years, although it remains a reliable predictor of recessions.

What Was the Stance of Monetary Policy Late Last Year?

How does one best measure the stance of monetary policy? There are many ways to answer this question and, as a result, there are often many differing views on the stance of monetary policy. This issue came up at Cato Unbound's discussion on monetary lessons from the crisis when Scott Sumner argued that the reason the economy tanked in late 2008 and early 2009 was because tight monetary policy caused nominal spending to crash. Jeffrey Rogers Hummel disagreed; he contended that it was not tight monetary policy per se, but a collapse of velocity (i.e. increase in real money demand) that caused the fall in nominal spending. Here is Scott's reply:

[E]conomists are all over the map as to what the terms “easy money” and “tight money” really mean. In that case I am inclined to throw up my hands and ask this pragmatic question:

In a fiat money world where the central bank has almost limitless ability to pump money into the economy, and impact the expected growth of nominal aggregates, what is the most useful definition of the stance of monetary policy?

Since I believe that the Fed should target the expected growth rate of NGDP on a daily basis, I decided the most useful way to think of “easy money” was as a policy expected to lead to above-target nominal growth, and vice versa. Is this so unusual? I notice that those who favor targeting interest rates (Keynesians) define the stance of monetary policy in terms of interest rates. And I notice that many who favor targeting the money supply (monetarists) tend to define the stance of monetary policy in terms of the money supply. I prefer to target NGDP expectations. So that’s my policy indicator.

What I think Sumner is saying is that no matter what the source of volatility in nominal spending, its the Fed's job to counteract and stabilize it. In late 2008 the Fed should have been more aggressive in responding to the fall in velocity. By not doing so, Sumner is arguing monetary policy effectively was tight. I agree and have some evidence to support this view.

My evidence is based on what I consider to be a useful metric for the stance of monetary policy. This metric is difference between (1) the growth rate of nominal spending in the U.S. economy and (2) the federal funds rate. Using this metric, the federal funds rate should not deviate too far from the nominal spending growth rate otherwise monetary policy is either too loose (the federal funds rate is significantly below the nominal spending growth rate) or too tight (the federal funds rate is significantly above the nominal spending growth rate). So what does this metric look like? Using monthly nominal GDP as my measure of nominal spending I have constructed it as follows: the year-on-year percent change in nominal spending minus the federal funds rate. Here is what this series looks for the period 1993:1 - 2009:7 (Click on figure to enlarge):



Note that I have highlighted two periods in red where there was a marked spread between the nominal spending growth rate and the federal funds rate. They just so happen to be the housing boom period and the mini-great contraction period Scott Sumner has been discussing. In the former case monetary policy was too loose while in the later is was too tight.

Unfortunately the monthly GDP data only go back to 1992. However, I created the same series on a quarterly basis back to 1961. This time I used final sales to domestic purchasers as my measure of nominal spending. I took this series and plotted it against the output gap series lagged 5 quarters.*



There is surprisingly strong relationship here: almost 60% of the variation in the output gap 6 quarters ahead can be explained by current variation in this monetary stance measure. Monetary policy does matter--take note Arnold Kling--and its stance can be easily determined by this metric.

*I used the output gap measure from John Williams et al. of the San Francisco Fed. See here for why it appears to be a better measure than the CBO's output gap.