Bernanke Goes for the KO and Misses

Ben Bernanke came out swinging today throwing some hard punches at those critics who say the Fed's monetary policy was too accommodative in the early-to-mid 2000s. He does so by throwing the following four-punch combination of arguments: (1) economic conditions justified the low-interest rate policy at the time; (2) a forward looking Taylor Rule actually shows the stance of monetary policy was appropriate then; (3) there is little empirical evidence linking monetary policy and the housing boom; and (4) cross country evidence indicates the global saving glut, not monetary policy was more important to the housing boom. Though Bernanke rejects the view that interest rates were too low for too long in this speech, he does acknowledge the Fed could have been more vigilant in regulatory oversight of lending standards. By far this is one of the better defenses of the Fed's low-interest rate policy of the early-to-mid 2000s that I have seen. Arnold Kling seems convinced by this rebuttal while Mark Thoma appears more agnostic about it. While Bernanke's case seems reasonable for the 2001-2002 period, I find his arguments far from convincing on all four points for the period 2003-2005 and here is why:

(1) By 2003 economic conditions did not justify the low-interest rate policy. Aggregate demand (AD) growth was robust, productivity growth was accelerating, and the ouput gap was near zero by mid 2003. The following figure shows the robust AD growth rate--measured by final sales of domestic product--and how the federal funds rate markedly diverged from it in 2003 and 2004 (marked off by the lines):


Note this rapid growth in AD indicates there was no threat of a deflationary collapse. Then what about the low inflation? That came from the robust productivity gains, not weak AD growth. The following figures shows 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:


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. It is also worth pointing out that this surge in productivity growth was both widely known and expected to persist. Productivity gains, then, were the reason for the lower actual and expected inflation. [It is also worth noting that productivity growth typically means a higher real interest rate which serves to offset the downward pull of the expected inflation component on the nominal interest rate. In other words, deflationary pressures associated with rapid productivity gains do not necessarily lead to the zero lower bond problem for the policy interest rate (Bordo and Filardo, 2004).] The big policy mistake here, then, is that the Fed saw deflationary pressures and thought weak aggregate demand when, in fact, the deflationary pressures were being driven by positive aggregate supply shocks. The output gap as measured by Laubach and Williams also shows a near zero value in 2003 that later becomes a large positive value. As Bernanke notes, though, there was a jobless recovery up through the middle of 2003. This can, however, be traced in part to the rapid productivity gains. The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.

(2) A forward looking Taylor Rule does not close the case that the stance of monetary policy during 2003-2005 was appropriate. Bernanke cleverly constructs an "improved" Taylor rule that has a forward looking inflation component to it and finds monetary policy was actually appropriate during this time. Now a forward looking rule does make sense but invoking it now appears as an exercise in ex-post data mining to justify past policy choices. Regardless of this Taylor Rule's merits, there is still reason to believe Fed policy was too accommodative during this time. As mentioned above, productivity growth accelerated and it is a key determinant of the natural or equilibrium real interest rate. Typically, higher productivity growth means a higher equilibrium real interest rate. The Fed however, was pushing real short-term interest rates down--a sure recipe for some economic imbalance to develop. Below is a figure that highlights this development. It shows the difference between the year-on-year growth rate of labor productivity and the ex-post real federal funds rate with a black line. A large positive gap--i.e. productivity growth greatly exceeds the real interest rate--emerges during the 2003-2005 period. This gap is also seen using the difference between an estimated natural real interest rate (from Fed economists John C. Williams and Thomas Laubach) and an estimated ex-ante real federal funds rate (constructed using the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters):



This figure indicates the real federal funds rate was far below the neutral interest rate level during this time. These ECB economists agree. Further evidence that Fed policy was not neutral can be found in the work of Tobias Adrian and Hyun Song Shin who show that via the "risk-taking" channel the Fed's low interest rate help caused the balance sheets of financial institutions to explode.

(3) There is evidence (not mentioned by Bernanke) that points to a link between the Fed's low interest rate policy and the housing boom. For starters, here is a figure from a paper that I am working on with George Selgin. It shows the gap discussed above between TFP growth and the real federal funds rate and the growth rate of housing starts 3 quarters later:

Also, below is a figure plotting he federal funds rate against the effective interest rates on adjustable rate mortgages, an important mortgage during the housing boom:


They track each other very closely. Bernanke, however, argues it was not so much the interest rates as it was the types of mortgages available that fueled the housing boom. My reply to this response is why then were these creative mortgages made so readily available in the first place? Could it be that investors were more willing to finance such exotic mortgages in part because of the "search for yield" created by the Fed's low interest policy?

(4) While there is some truth to saving glut view, the Fed itself is a monetary superpower and capable of influencing global monetary conditions and to some extent the global saving glut itself. As I have said before on this issue:

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).

With that background I turn to Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary (and fiscal) policy and was more the cause rather than the consequence of the funding coming from Asia.

Conclusion: Bernanke fails to make a KO of Fed critics with this speech.

Monetary Policy Quote of the Day

Scott Sumner on the efficacy of monetary policy even when the policy interest rate hit zero:

Zero rates don’t really make monetary policy more difficult, they make interest rate-oriented monetary policy more difficult... Permanent QE is just as effective as ever. Exchange rate depreciation is just as effective as ever, inflation targeting is just as effective as ever, NGDP targeting is just as effective as ever, commodity price targeting is just as effective as ever.

The strangest thing is that Ben Bernanke agrees with Sumner on this point. Just today we learn of his written reply to a Brad DeLong question on why the Fed has not adopted an explicit 3% inflation target (something that would have done wonders to prevent the great nominal spending crash of late 2008, early 2009):

...The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored. [Emphasis added]

So Bernanke agrees with Sumner in principle but is afraid of inflation expectations becoming unmoored. A look at the average 10-year inflation forecast from the Survey of Professional Forecasters says Bernanke should not be worried about inflation expectations. They have been anchored relatively well since 1997 around 2.5 percent:

Too bad Paul Krugman was not beating his influential drum with a message of inflation targeting--or in my dream world nominal income targeting--over the past year or so. Maybe others would have joined in and forced Bernanke and the Fed to think more about this option. Krugman admitted recently it would have been the first-best economic solution to the current crisis, but avoided doing so because he thought it would be a second-best political solution. (He thought expansionary fiscal policy would be more politically feasible.) Even if Krugman and other observers have been pushing the unconventional monetary policy message more forcefully over the past year, it is still not clear the Fed would have responded. David Wessel in his new book reports that Bernanke came into the Fed wanting to target inflation. He faced, however, strong opposition and (unlike his predecessor) wanted to be a consensus builder at the Fed. He did not want to force his hand on the FOMC.

Update: Scott Sumner, Brad DeLong, Free Exchange, and Will Wilkinson comment on Bernanke's response.

Lean Against the Credit Cycle Not Asset Prices

Adam Posen does not think monetary policy should respond to asset price bubbles by adjusting its policy interest rate. He likens this approach to a using a hammer to fix a leaky shower:

[I]f I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit.

Antonio Fatas weighs in and says not so fast; finding that right tool for the job can be elusive so in the meantime we should not shy from using the tools we have--imperfect as they are--in addressing asset price bubbles (hat tip Mark Thoma). All of this attention on asset prices is a distraction says William White in a recent paper. Asset bubbles are but a symptom of a deeper problem, an unleashed credit cycle:

To favor leaning against the credit cycle is not at all the same thing as advocating “targeting” asset prices. Rather, they wish to take action to restrain the whole nexus of imbalances arising from excessively easy credit conditions. The focus should be on the underlying cause rather than one symptom of accumulating problems. Thus, confronted with a combination of rapid increases in monetary and credit aggregates, increases in a wide range of asset prices, and deviations in spending patterns from traditional norms, the suggestion is that policy would tend to be tighter than otherwise.

From this broader perspective, there is no need to choose which asset price to target. It is a combination of developments that should evoke concern. Nor is there a need to calculate with accuracy the fundamental value of individual assets. Rather, it suffices to be able to say that some developments seem significantly out of line with what the fundamentals might seem to suggest. Finally, there is no need to “prick” the bubble and to do harm to the economy in the process. Rather, the intention is simply to tighten policy in a way to restrain the credit cycle on the upside, with a view to mitigating the magnitude of the subsequent downturn...

White address a number of concerns regarding this leaning against the credit cycle approach. This one in particular caught my attention:

As for the more general concerns about undershooting the inflation target, this could lead to outright deflation, but it need not. In any event, it needs to be stressed that the experience of deflation is not always and everywhere a dangerous development (Borio and Filardo, 2004) The experience of the United States in the 1930’s was certainly horrible, but almost as surely unique (Atkeson and Kehoe, 2004). There have been many other historical episodes of deflation, often associated with bursts of productivity increases, in which falling prices were in fact associated with continuing real growth and increases in living standards. As noted above, there can be little doubt that serious problems can arise from the interaction of falling prices and wages and high levels of nominal debt. But the essential point of leaning against the upswing of the credit cycle is to mitigate the buildup of such debt in order to moderate the severity of the subsequent downturn...[emphasis added]

As readers of this blog know, I made this very point in comparing the deflation threat of 2003 with the deflation threat of 2009. Had the Fed been less fearful of the benign deflationary pressures in 2003 they would not have held the federal funds rate so low for so long and, as a result, there would have been less buildup of debt and thus the potential for the harmful form of debt deflation we face today. (In case there are any doubts as to whether the deflationary pressures of 2003 were truly benign see here and here.)

Read the rest of Williams White's article Should Monetary Policy "Lean or Clean" here.

Taking the Long View

It is easy to get caught up in the issues of the day and lose sight of important long-term structural developments. That is why I appreciate Niall Ferguson's work as it provides a broad, long-term perspective on recent events. Via Joe Wisenthal, here is Ferguson's latest interview where, among other things, he discusses the long-run outlook for the United States in terms of security, finance, and influence:

US vs. Canadian Monetary Policy During the Boom

James MacGee has an interesting article that compares the post-housing boom period in Canada with that of the United States (hat tip James Hamilton). Specifically, he notes that the housing bust that took place in the United States did not occur in Canada and attempts to explain this difference by looking at the two most common reasons given for the housing boom: (1) loose monetary policy and (2) relaxed lending standards. Looking at both factors, MacGee makes the following observations:

The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.

MacGee's claim that monetary policy in the two countries were similar is based on the fact that both policy interest rates followed similar paths during the housing boom (see his central bank target rate figure). Since these indicators of monetary policy did not differ much, he concludes it must be the case that the distinguishing factor between the two countries were the lax lending standards in the United States. I certainly agree that the monetary policy was not the only factor in the housing boom. I hesitate, however, to conclude that because the policy interest rates followed similar paths the stances of monetary policy were also similar. As Nick Rowe points out its not the level of the policy interest rate but where it is relative to the natural interest rate that determines the stance of monetary policy. Consequently, to make a convincing case that monetary policy was similar in Canada and the United States during this time one needs to show the difference between the natural interest rate and the policy interest rate--called the policy rate gap hereafter--for both countries followed similar paths.

So what does the policy rate gap show? It is not easy to answer this question because it requires an estimate of the natural rate of interest for both countries. I am only aware of natural interest rate estimates for the United States covering the housing boom period. Therefore, let me approximate the idea of a natural rate of interest--and will latter corroborate this approach--by looking at the growth rate of labor productivity in both countries relative to the policy interest rate. The natural interest rate, after all, is a function of individuals' time preferences, productivity, and the population growth rate. Of these three components, the one that seems to have changed the most during the housing boom in the United States was productivity. Below is a figure showing the quarterly year-on-year growth rate of labor productivity minus the ex-post real policy interest rate for both countries. (The policy rate in Canada is the overnight rate and in the United States it is the federal funds rate. The ex-post real federal funds rate is used to make a consistent comparison since I could not find quarterly inflation forecasts for Canada.) A positive gap indicates accommodative monetary policy while a negative gaps indicates tightness. (Click on the figure to enlarge it.)



This figure reveals a large policy rate gap for the United States while for Canada it shows one hovering around zero. The figure indicates, then, that monetary policy was not the same in both countries. The Canadian monetary authorities got it about right while the Fed was too accommodating. Now in case you are not convinced that this measure is truly approximating the difference between the natural interest rate and the ex-ante real policy interest rate I have constructed the actual policy rate gap measure for the United States as a comparison. The natural interest rate data comes from this paper by Fed economists John C. Williams and Thomas Laubach while the ex-ante real federal funds rate is constructed by subtracting from the federal funds rate the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters. The figure below graphs the two U.S. policy rate gap measures:



The similarity of these two series indicates the productivity-based approximation of the policy rate gap does a decent job. The low interest rates in the United States, then, appear to have been more distortionary than those in Canada.

So what is the take away from this analysis? For starters, monetary policy was an important part of the U.S. housing boom-bust cycle. Moreover, it is possible that the relaxed lending standards themselves cannot be entirely separated from this loose monetary policy. Over at Econbrowser commentator David Pearson sums it up nicely:

Weak underwriting standards and the "Greenspan Put" were joined at the hips. What you call weak underwriting was actually just collateral-based lending (hence no-doc loans basically eliminated ability to pay as a criterion, and zero-down loans depended entirely on the creation of equity value through appreciation). Where did the confidence come from to adopt widespread collateral-based lending? I believe a great deal of it came from the Fed's asymmetric monetary policy. Remember, the underwriting standards were ultimately set by the volume of demand (from hedge funds and the like) for higher-yielding securitizations, and, in turn, that demand was generated by ultra-low interest rates at the short end...

I would also note that during the housing boom interest rates charged to non-conventional mortgages were closely tied to the federal funds rate as seen in the figure below (see this post for more on this point.)

Source: FHFA

Of course, none of this is new. John Taylor already showed us via his Taylor Rule that those countries that deviated the most from the Taylor Rule's tended to have the greatest housing booms.

Monetary Policy and the Pre-Crisis Problems in Financial Institutions

Many observers have made the case that monetary policy was too loose in the early-to-mid 2000s and, as a result, helped fuel the credit and housing boom. Some observers, however, see little role for loose monetary policy in explaining the distortions that arose in the financial system. For example, Arnold Kling's impressive paper on policies that contributed to the financial crisis finds little importance for monetary policy with regard to the bad bets and excessive leverage taken on by financial institutions during this time. While there are a number of factors that contributed to these developments in the financial system, I want to push back on the notion that monetary policy's role was relatively unimportant. There are at least two reasons why monetary policy was important here: (1) it helped create macroeconomic complacency and (2) it created distortions in the financial system via the risk-taking channel. Let's consider each one in turn.

I. Macroeconomic Complacency
The first point is related to the reduction of macroeconomic volatility beginning in the early 1980s that has become known as the Great Moderation. This development can be seen in the figure below which shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983.

Solid line = 10 year rolling average of real GDP growth rate
Dashed line = 1 standard deviation

Now there are many stories for this reduction in macroeconomic volatility and one of the more popular views is that the Federal Reserve (Fed) did a better job running countercyclical monetary policy. In fact, Fed Chairman Ben Bernanke made this very point in a famous 2004 speech. I think there is merit to this view, but not quite in the same way as does Bernanke. During this time one of the key ways through which the Fed was able to reduce macroeconomic volatility was by responding asymmetrically to swings in asset prices. Asset prices were allowed to soar to dizzying heights but cushioned on the way down with an easing of monetary policy (e.g. 1987 stock market crash, 1998 emerging market crisis, 2001 stock market crash). The Fed also used its powerful moral suasion ability to goad creditors into helping the distressed and systemically important LTCM hedge fund. All of these actions served to prevent problems in the financial system from affecting the real economy and thus, were probably a big factor behind the "Great Moderation" in macroeconomic activity. However, they also appear to have caused observers to underestimate aggregate risk and become complacent. This, in turn, likely contributed to the increased appetite for the debt during this time. This interpretation of events was recently alluded to by Fed Vice-Chairman Donald Kohn in a 2007 speech:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.

So a macroeconomic complacency created in part by the Federal Reserve set the stage for one of the biggest credit and housing booms in modern history.

II. The Risk-Taking Channel of Monetary Policy
The risk-taking channel of monetary policy is one that looks at the relationship between the Fed's interest rate policy and risk-taking by banks. Leonardo Gambacorta of the BIS summarizes how this link works:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

He goes on to empirically show a strong link between the easy monetary policy and risk-taking by banks during the early-to-mid 2000s using a database of 600 banks in the Europe and the United States. Similar work has been done by Tobias Adrian and Hyun Song Shin as I noted in this previous post. In their paper they find the following:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

I see the macroeconomic complacency idea discussed above as setting the stage for and reinforcing the risk-taking channel of monetary policy. Of course, if so then this undermines the the Sumnerian view that all was well with a 5% trend growth rate for nominal expenditures during the Great Moderation but that is another story.

A 100 Trillion Dollar Zimbabwe Bill

Previously on this blog I have looked at the extent of hyperinflation in Zimbabwe and as well as recent progress (i.e. the defacto dollarization of the economy) the country has made in overcoming this problem. I bring this up because today one of my former students gave me the following Zimbabwe bill dated 2008 (click on pictures to enlarge):


Yes, this a 100 trillion dollar note with fourteen zeros. Note that the bill apparently has several anti-counterfeiting measures like the golden bird statue on the right front. That is surprising; surely the opportunity cost of counterfeiting this bill far exceeded any benefit. Just how worthless is this currency now? Below is a picture that answers this question succinctly (click on picture to enlarge):