Fiscal-monetary interaction

An email correspondent sent the above graph. The title is [Federal Reserve] Liabilities and Capital: Liabilities: Earnings Remittances Due to the U.S. Treasury.

The Treasury pays the Fed interest on the Fed's asset holdings. The Fed pays interest on reserves to banks and to other financial institutions that have, effectively, deposits at the Fed. As long as Treasury interest is greater than interest the Fed pays, the Fed makes money. It spends some, and returns the interest to the Treasury. The Fed also issues cash, which pays no interest, so the Fed makes steady money on the difference between interest bearing assets and the zero return of cash. 

But when short-term rates the Fed pays rise sufficiently above the Fed's interest earnings, the Fed loses money. It stops sending interest earnings to the Treasury. The graph is in essence the amount the Fed owes the Treasury in this scheme. Usually the Fed makes some money -- the graph goes up -- then the Fed pays out to the Treasury and the graph goes back to near zero. When the Fed loses money, the Treasury doesn't send a check. Instead, the Fed accumulates its losses, $16 billion so far. The Fed then will wait to make this amount back again before it starts sending money back to the Treasury. 

CBDC in EU

I wrote an oped for Il Sole 24 Ore on central bank digital currency, as part of a series they are doing. It's here in their premium edition (gated) here on their blog, in Italian on top and English below. Thanks much to Luciano Somoza and Tammaro Terracciano for translation and inspiring the project.

THE DIGITAL EURO IS A THREAT TO BANKS AND GOVERNMENTS. AND THAT’S OK. 

A central bank digital currency (CBDC) is in principle a very good idea. It offers the possibility of very low-cost transactions to households and businesses, especially in securities and international transactions. More excitingly, CBDC offers us a foundation for an efficient and nimble financial system that is completely insulated from recurrent crises. 

But CBDC poses a puzzle, as it undercuts many of governments’ and central banks other questionable objectives. Central banks want to prop up conventional banks, who benefit from taking deposits. And governments are unlikely to want to allow the anonymity that is the great attribute of physical cash. 

One vision for CBDC basically gives everyone access to bank reserves. Reserves are interest-paying accounts that banks hold at the central bank. When bank A wishes to pay bank B, it notifies the central bank, which just changes the numbers in each account on the central bank’s computer. The transaction can be accomplished in milliseconds, and costs basically nothing. Why don’t we have that? We should.

Sumner review of Strategies for Monetary Policy

Scott Sumner posted an excellent  Review of Strategies for Monetary Policy (Book information and, yes free pdfs here). By "excellent," I don't mean he agrees with everything, especially that I wrote! He read the whole thing, including comments, and provides a concise summary along with insightful critique. I won't try to summarize his summary -- it's all good. 

The book summarizes last year's conference on monetary policy at Hoover, which focused on the Fed and ECB policy reviews. This year's analogue is unfolding via zoom,  and has had a really interesting set of papers and discussions. More coverage will follow.  

Challenges for central banks.

On October 20, I was graciously invited to give a talk at the  ECB Conference on Monetary Policy: bridging science and practice. 

I survey six challenges facing central banks: 1. Interest rates and inflation; 2. Policy reviews; 3. Financial reform post 2008 4. New challenges to finance post covid; 5. The many risks ahead; 6. Central banks and climate.  

For the whole thing, go here for a pdf. A video of my presentation is here. (The conference website will have all videso soon.) Items 1-5 are mostly interesting for monetary economists, though general readers might find my summary and distillation of the Fed policy review of some interest. 

Here, I post the section on climate change and conclusion, which are the most novel. And if you like the general approach and want to see it applied to the rest of what central banks are up to, that's another advertisement to read the whole talk pdf. 

In the section leading up to this, I describe risks to the financial system from widespread defaults, sovereign defaults, a US debt and currency crisis, another bigger pandemic, war, political chaos, cyber disaster and a few other unpleasant possibilities. But covid has taught us to prepare for the unexpected.  

....Which brings me to a great puzzle. In this context why are the ECB, BoE, BIS, IMF consumed with one and only one “risk”… climate? 

Challenge 6. Climate, Mission creep, and Politicization risk. 

I think this adventure is a dangerous mistake. 

Disclaimer: I do not argue that climate change is fake or unimportant. None of my comments reflect any argument with scientific fact. (I favor a uniform carbon tax in return for essentially no regulation.) 

The question is whether the ECB, other central banks, and international institutions such as the IMF, BIS, and OECD should appoint themselves to take on climate policy, or other important social, environmental or political causes, without a clear mandate to do so from politically accountable leaders. 

Moreover, the ECB and others are not just embarking on climate policy in general. They are embarking on the enforcement of one particular set of climate policies — policies to force banks and private companies to de-fund fossil fuel industries, even while alternatives are not available at scale, and to provide subsidized funding to an ill-defined set of “green” projects. 

To be concrete, I quote from Executive Board Member Isabel Schnabel’s recent speech. I don’t mean to pick on her, but she expresses the climate agenda very well, and her speech bears the ECB imprimatur. She recommends

"First, as prudential supervisor, we have an obligation to protect the safety and soundness of the banking sector. This includes making sure that banks properly assess the risks from carbon-intensive exposures…"

Let me speak out loud the unclothed emperor fact: Climate change does not pose any financial risk, at the 1, 5 or even 10 year horizon at which one can conceivably assess the risk to bank assets.

“Risk” means variance, unforeseen events. We know exactly where the climate is going in the next 5 to 10 years. Hurricanes and floods, though influenced by climate change, are well modeled for the next 5 to 10 years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. And political risk is a standard part of bond valuation. 

That banks are risky because of exposure to carbon-emitting companies, that carbon-emitting company debt is financially risky because of unexpected changes in climate, in ways that conventional risk measures do not capture, that banks need to be regulated away from that exposure because of risk to the financial system is nonsense. (And if it were not nonsense, regulating bank liabilities away from short term debt and towards more equity would be a more effective solution to the financial problem.) 

Strategies for Monetary Policy

Strategies for Monetary Policy is a new book from the Hoover Press based on the conference by that name John Taylor and I ran last May. (John Taylor gets most of the credit.) This year's conference is sadly postponed due to Covid-19. We'll have lots to talk about May 2021.

At that link, you can see the table of contents and read Chapter pdfs for free. You can buy the book for $14.95 or get a free ebook.

The conference program and videos are still up.

Much of the conference was about the question, what will the Fed do during the next downturn? Here we are, and I think it is a valuable snapshot. Of course I have some self interest in that view.

As long as I'm shamelessly promoting, I'll put in another plug for my related Homer Jones Lecture at the St. Louis Fed, video here and the article Strategic Review and Beyond: Rethinking Monetary Policy and Independence here. That was written and delivered in early March, about 5 minutes before the lookouts said "Iceberg ahead." John and I don't put a lot of our own work into the conference books, but it sparked a lot of thoughts.  I am grateful to Jim Bullard and the St. Louis Fed for the chance to put those together.

Monetary policy is back to "forget about moral hazard, rules, strategies and the rest, the world is ending." This is a philosophy that happens quite regularly and now has become the rule and strategy. So strategic thinking about monetary policy is more important than ever.  This is a philosophy very much due to John Taylor.

The last part of my Homer Jones paper delves into just what risks the big thinkers of central banking were worried about on the eve of the pandemic. Pandemic was not in any stress test.  BIS, BoE, FSB and IMF  wanted everyone to start stress testing ... climate change and inequality. This is a story that needs more telling.    

Kocherlakota on moral hazard

I found a kindred spirit. Narayana Kocherlakota, ex president of the Minneapolis Fed, shares my concerns over the current lending and bailout spree, in particular propping up the prices of corporate bonds.

In its last financial stability report of 2019, the Fed highlighted how many nonfinancial corporations were making use of highly risky debt. The report pointed out that “a number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors … concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds.” 

The financial stability report, of course, made no mention of pandemics or social distancing. It didn't need to — the risk to the financial system and the economy is posed by any recessionary shock. The coronavirus just happened to be the first one that come along.

Summers tweet stream on secular stagnation

Larry Summers has an interesting tweet stream (HT Marginal Revolution) on the state of monetary policy. Much I agree with and find insightful:

Can central banking as we know it be the primary tool of macroeconomic stabilization in the industrial world over the next decade?...There is little room for interest rate cuts..QE and forward guidance have been tried on a substantial scale....It is hard to believe that changing adverbs here and there or altering the timing of press conferences or the mode of presenting projections is consequential...interest rates stuck at zero with no real prospect of escape - is now the confident market expectation in Europe & Japan, with essentially zero or negative yields over a generation....The one thing that was taught as axiomatic to economics students around the world was that monetary authorities could over the long term create as much inflation as they wanted through monetary policy. This proposition is now very much in doubt.

Agreed so far, and well put. "Monetary policy" here means buying government bonds and issuing reserves in return, or lowering short-term interest rates. I am still intrigued by the possibility that a commitment to permanently higher rates might raise inflation, but that's quite speculative.

and later

Limited nominal GDP growth in the face of very low interest rates has been interpreted as evidence simply that the neutral rate has fallen substantially....We believe it is at least equally plausible that the impact of interest rates on aggregate demand has declined sharply, and that the marginal impact falls off as rates fall.  It is even plausible that in some cases interest rate cuts may reduce aggregate demand: because of target saving behavior, reversal rate effects on fin. intermediaries, option effects on irreversible investment, and the arithmetic effect of lower rates on gov’t deficits

Central banks are a lot less powerful than everyone seems to think, and potentially for deep reasons. File this as speculative but very interesting. Larry has many thoughts on why lowering interest rates may be ineffective or unwise.

The question is just how bad this is? The economy is growing, unemployment is at an all time low, inflation is nonexistent, the dollar is strong. Larry and I grew up in the 1970s, and monetary affairs can be a lot worse.

Yes, the worry is how much the Fed can "stimulate" in the next recession. But it is not obvious to me that recessions come from somewhere else and are much mitigated by lowering short term rates as "stimulus." Many postwar recessions were induced by the Fed, and the Great Depression was made much worse by the Fed. Perhaps it is enough for the Fed simply not to screw up -- do its supervisory job of enforcing capital standards in booms (please, at last!) do its lender of last resort job in financial crises, and don't make matters worse.

But how bad is it now? Here Larry and I part company. Larry is, surprisingly to me, still pushing "secular stagnation"

Call it the black hole problem, secular stagnation, or Japanification, this set of issues should be what central banks are worrying about...We have come to agree w/ the point long stressed by Post Keynesian economists & recently emphasized by Palley that the role of specific frictions in economic fluctuations should be de-emphasized relative to a more fundamental lack of aggregate demand. 

The right issue for macroeconomists to be focused on is assuring adequate aggregate demand.  

My jaw drops.

The unemployment rate is 3.9%, lower than it has ever been in a half century. It fell faster after about 2014 than in the last two recessions.

Labor force participation is trending back up.

Wages are rising faster and faster, especially for less skilled and education educated workers.

 There are 8 million job openings in the US.

Why in the world are we talking about "lack of demand?

Macro Musing Podcast

I did a podcast with David Beckworth, in his "macro musings" series, on the Fiscal Theory of the Price Level, blogging, and a few other things.



(you should see the link above, if not click here to return to the original).

You can also get the podcast at Sound Cloud, along with all the other ones he has done so far, or on itunes here.  For more information, see David's post on the podcast.

Lessons Learned I

I spent last week traveling and giving talks. I always learn a lot from this. One insight I got:  Real interest rates are really important in making sense of fiscal policy and inflation.

Harald Uhlig got me thinking again about fiscal policy and inflation, in his skeptical comments on the fiscal theory discussion, available here. At left, two of his graphs, asking pointedly one of the standard questions about the fiscal theory: Ok, then, what about Japan? (And Europe and the US, too, in similar situations. If you don't see the graphs or equations, come to the original.) This question came up several times and I had the benefit of several creative seminar participants views.

The fiscal theory says
 \[ \frac{B_{t-1}}{P_t} = E_t \sum_{j=0}^{\infty} \frac{1}{R_{t,t+j}} s_{t+j} \]
 where \(B\) is nominal debt, \(P\) is the price level, \(R_{t,t+j}\) is the discount rate or real return on government bonds between \( t\) and \(t+j\) and \(s\) are real primary (excluding interest payments) government surpluses. Nominal debt \(B_{t-1}\) is exploding. Surpluses \(s_{t+j}\) are nonexistent -- all our governments are running eternal deficits, and forecasts for long-term fiscal policy are equally dire, with aging populations, slow growth, and exploding social welfare promises. So, asks Harald, where is the huge inflation?

I've sputtered on this one before. Of course the equation holds in any model; it's an identity with \(R\) equal to the real return on government debt; fiscal theory is about the mechanism rather than the equation itself. Sure, markets seem to have faith that rather than a grand global sovereign default via inflation, bondholders seem to have faith that eventually governments will wake up and do the right thing about primary surpluses \(s\). And so forth. But that's not very convincing.

This all leaves out the remaining letter: \(R\). We live in a time of extraordinarily low real interest rates. Lower real rates raise the real value surpluses s. So in the fiscal theory, other things the same, lower real rates are a deflationary force.

Deflation Puzzle

Larry Summers writes an eloquent FT column "A world stumped by stubbornly low inflation"

Market measures of inflation expectations have been collapsing and on the Fed’s preferred inflation measure are now in the range of 1-1.25 per cent over the next decade.

Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows and the dollar has only risen as rapidly as in the past 18 months twice during the past 40 years when it has fluctuated widely

And the Fed is forecasting a return to its 2 per cent inflation target on the basis of models that are not convincing to most outside observers. 

Central bankers [at the G20 meeting] communicated a sense that there was relatively little left that they can do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates.

So why is inflation slowly declining despite our central banks' best efforts? Here is a stab at an answer. I emphasize the central logical points with bullets.

• Interest rates have two effects on inflation: a short-run "liquidity" effect, and a long-run "expected inflation" or "Fisher" effect.  

MacDonell on QE

Gerard MacDonell has a lovely noahpinion guest post "So Much for the QE Stimulus" (HT Marginal Revolution). Some good bits here, with my bold on noteworthy zingers.

The post is unusual, because practitioners tend to regard the Fed and QE as very powerful. But here he expresses nicely the skeptical view of many academics such as myself.

the Fed leadership has now abandoned its original story about how QE affects the economy and has conceded that the tool is weak

It has long been obvious that QE operated mainly through signaling and confidence channels, which wore off on their own without any adjustment in the size or composition of the Fed’s balance sheet....

Obvious to us skeptics, not to the Fed or to the many academic papers written trying to explain the supposed powers of QE

The story initially told by the Fed leadership starts with the claim that large scale asset purchases (LSAPs) [lower interest rates]... by removing default-free interest rate duration from the capital markets. ...

Translation: buying bonds to drive up bond prices

That story does not hold much water.

Swiss Deflation

The Wall Street Journal Monday Oct 19 offers a reflection on deflation in Switzerland.

"It’s as close to an economic consensus as you can get: Deflation is bad for an economy, and central bankers should avoid it at all costs."

I differ, as does Milton Friedman's "Optimum quantity of money." And my "who's afraid of a little deflation" in... The Wall Street Journal.

"Then there’s Switzerland, whose steady growth and rock-bottom unemployment is chipping away at that wisdom."

"At a time of lively global debate about low inflation and its ill effects, tiny Switzerland—with an economy 4% the size of the U.S.—offers a fascinating counterpoint, with some even pointing to what they call 'good deflation.' ”

Indeed. The 1970s had stagflation. Now we have the opposite, "good deflation."  The Phillips curve lives on in "consensus."

Switzerland also is a good case for just how powerless central banks are to do much about it.

The decline in long-term interest rates

Source: Council of Economic Advisers

Long term interest rates are trending down around the world. And it's not just since the great recession and financial crisis. The same trend has been going on for decades.

The Council of Economic Advisers just issued an excellent report surveying our understanding of this question. A blog post summary by Maury Obstfeld and Linda Tesar.

(Many other interesting CEA reports here. Occupational licensing is next on my in box.)

The report is really well done, for explaining the economic issues in clear simple terms, but without hesitating to use a model and an equation when necessary. If you're wondering how to keep your undergraduate or MBA class (heck, your PhD class) busy this week, this report will do the trick.

There is some grumbling in economics circles about the CEA and what role it should play, between Sunday morning talk show cheerleader for the Administration's policies vs. providing dispassionate  economic analysis to the Administration and country. This kind of report is the kind of CEA I cheer for.

I won't summarize the whole thing. Maury and Linda's blog post blog post does a great job of that, and you should just go read it. A few comments however.

Feldstein on inflation

Martin Feldstein has an interesting Op-Ed in the Wall Street Journal, "Why the U.S. Underestimates Growth."

The basic idea is that inflation may be overstated, because it doesn't do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn't talk about monetary policy, but that's interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?

McAndrews on negative nominal rates

Jamie McAndrews of the New York Fed has a thoughtful and clear speech on negative nominal rates and the benefits of currency. (Some previous posts on the subject here  here and here.)

A few high points:

1. Needed: anonymous electronic transactions.

Many (not all) negative interest rate proposals call for the elimination of currency. Currency is dying anyway due to the great advantages of electronic transactions. I bemoaned the loss of privacy and political freedom when the NSA, the IRS, and pretty soon Twitter and the Chinese Department of Hacking have a record of everything you've ever bought or sold. Jamie brings up another important point:

The anonymity afforded by currency transactions prevents a buyer from suffering from any actions taken after the transactions that could exploit the knowledge gained by the seller of the buyer’s identity. For example, identity theft, or theft of credit or debit card information, is avoided through the use of currency. This is an economic benefit that is distinct from valuing privacy from a civil liberties point of view. If currency cannot be used in transactions, buyers are at a disadvantage, and many otherwise beneficial transactions (not related to buyers seeking to engage in tax evasion or otherwise illicit activity) would not take place.

Anonymity has value in many transactions. Anonymity equals finality.

It's not hard to have anonymous electronic transactions. Stored value cards could work well as electronic cash. If regulators allowed it, it would be simple enough to set up a money market fund that allows anonymous investing. Regulators don't allow it.

2. Hysterisis of institutions and the lesson of the 70s

Banking at the IRS

A while ago in two blog posts here and here I suggested many ways other than currency to get a zero interest rate if the government tries to lower rates below zero. Buy gift cards, subway cards, stamps;  prepay bills, rent, mortgage and especially taxes -- the IRS will happily take your money now and you can credit it against future tax payments; have your bank make out a big certified check in your name, and sit on it, don't cash incoming checks. Start a company that takes money and invests in all these things (as well as currency).

Chris and Miles Kimball have an interesting essay exploring these ideas "However low interest rates might go, the IRS will never act like a bank." Their central point: sure that's how things work now. But with substantial negative interest rates, all of these contracts can change. It's technically possible in each case for people and businesses to charge pre-payment penalties amounting to a negative nominal rate.

Reply: Sure, in principle. Nominal claims can all be dated, and positive or negative interest charged between all dates.

But this did not happen in the US and does not happen in other countries for positive inflation and high nominal rates,  despite symmetric incentives, and at rates much higher than the contemplated 3-5% or so negative rates.  Yes,  with large nominal rates there is pressure to pay faster,  inventory cash-management to reduce people's holdings of depreciating nominal claims, but this pervasive indexation of nominal payments did not break out. The IRS did not offer interest for early payment.

More deeply, what they're describing is a tiny step away from perfect price indexing. If all nominal payments are perfectly indexed to the nominal interest rate, accrued daily, then it's a tiny change to index all prices themselves to the CPI, accrued daily. If "how much you owe me," say to rent a house, is legally, contractually, and mechanically determined as a value times e^rt, and changes day by day, then e^(pi t) is just as easy.

So, price stickiness itself would (should!) disappear under this scenario.

Price stickiness has always been a bit of a puzzle for economists. As the Kimballs speculate how easy it is to index payments to negative interest rates, so economists speculate how easy it is to index payments to inflation. Yet it seems not to happen.

So this point of view strikes me as a bit of a catch-22 for its advocates, who generally are of the frame of mind that prices and nominal contracts are sticky and that’s why negative nominal rates are a good idea to "stimulate demand" in the first place.  If we can have negative nominal rates and change all these legal and contractual zero-rate promises to allow it, then prices won't be sticky any more!   Conversely, I should be cheering, as it amounts to a broad push to unstick prices. That has long seemed to me the natural policy response to the view that sticky prices are the root of all our troubles. It would allow negative rates, but eliminate their need as well.

Alas, the world seems remarkably resistant to time-indexing all payments.