Eeyore and Tigger Show the Failings of U.S. Monetary Policy

Betsey Stephenson and Justin Wolfers take us on a journey to Hundred Acre Wood:

Eeyore and Tigger have become central bankers. The wood's economy is suffering the repercussions of a recent honey binge. Both Eeyore and Tigger want to help the recovery along, a goal they hope to achieve by holding interest rates low for a long time. But each communicates this differently.

Chairman Eeyore is a true dismal scientist, who sees bad news everywhere. He's sure the economy will be in the doldrums for years. Indeed, he's so worried that folks who don't understand his pessimistic outlook will make bad decisions that he gives a speech warning them about it. He says the economy is so weak that he'll need to keep rates low for several years. Eeyore's message is so sobering that it mutes the desired stimulus effect of the low interest rates. After all, why would you buy anything, or invest in producing it, if you have just learned that some of the smartest forecasters in the country think the economic outlook is so awful that they dare not raise rates until 2014? 

Chairman Tigger has a totally different approach. He figures that the prospect of a terrific party will revive everyone's animal spirits. He also knows what folks are thinking: Every time the economy gets going, the Fed spoils the party by taking away the punch bowl -- that is, by raising interest rates to keep inflation in check. So Tigger gives a speech promising to keep interest rates low for several years -- even when the economy recovers.The prospect of low interest rates sustaining a long and robust recovery leads everyone to start spending. After all, good times are just around the corner. 

Eeyore and Tigger both did essentially the same thing. They announced that interest rates would be low for several years. But their messages are importantly different, and so yield very different effects.

Their point is that Ben Bernanke has been acting too much like Chairman Eeyore.  I agree, but would add that it is nearly impossible for Bernanke to act differently given the format of the new long-term interest rate forecasts.  The format shows where FOMC officials expect the federal funds rate to be over the next few years.  What is missing and essential for knowing the stance of monetary policy is the expected natural (or equilibrium) federal funds rate.  A  federal funds rate is only stimulative if it is below its natural rate level.  It is not enough for the federal funds rate to be low, for the natural interest rate could be low too.

If the FOMC would show the forecasts of the actual and the natural federal funds rates over the various forecast horizons, then the public could know with much more clarity the Fed's intentions. Until then, the Fed's new communication strategy is at  at best white noise to the market and at worst worst a quagmire of confusion. 

Greg Ip on Safe Assets as Money

Greg Ip has a new article in The Economist where he discusses how U.S. treasuries and other safe assets can serve as medium of exchange:

[D]emand for American government debt is driven by much more than a hunger for returns. Financial-market participants use Treasury bonds and bills as collateral to secure lending, for instance. And for risk-averse investors such as foreign central banks, money-market funds and retirees, America’s debt is uniquely suited to storing savings without much due diligence. In short, its government debt is a lot like money.

I agree with the central premise of the article, but would add a few points. 

First, I would frame the discussion in this way: there are retail money assets and institutional money assets.  Retail money assets are the traditional money assets measured by the M2 money supply and are used by households and small businesses.  Institutional money assets go beyond M2 and includes treasuries, commercial paper, repos, GSEs, and other safe assets used to facilitate exchange in the shadow banking system.  Since most of the creditors to the shadow banking system are institutional investors, these assets should be called institutional money assets. 

Second, institutional money assets include both privately-produced and publicly-produced safe assets.  If the Fed is doing its job and and providing sufficient aggregate demand to keep the economy at full employment, then there should be plenty of privately-produced safe assets.  Only if the Fed allows nominal spending to crash, which would reduce privately-produced safe assets, is there a need for the government to step in and create safe assets.  To put it differently, if the Fed were to announce today that it was adopting a nominal GDP level target and planned to restore it to its pre-crisis trend, then there would most likely be a recovery and an increase in the private supply of safe assets.  As a result, the institutional money asset supply  would increase and there would be less need to produce treasuries. 

Third, the broader context for this discussion is that there is currently a shortage of safe assets for the global economy.  And, as I noted before, there is both a long-term, structural dimension to this problem as well as a short-term, cyclical one:  

The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero.  The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton.  I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths.  In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them. 

This failure of the world's major central banks means U.S. treasuries will remain in hot demand.  This seemingly insatiable demand is evidenced by the low yields on treasuries.

Fourth, there is a Triffin dilemma for U.S. debt.  The global financial system in its current setup needs increasing amounts of U.S. treasuries.  This means the U.S. government must continue to run large budget deficits.  Over time, however, these large budget deficits may jeopardize the safe-asset status of U.S. treasuries, the very thing driving the insatiable demand for them. So a tension exists between providing enough treasuries to keep the global economy going and maintaining the safe-asset status of treasuries. 

Finally, the New Monetarists like David Andolfatto have been making some of these points for awhile. Greg Ip should spend some time talking to them as well. 

The "What Would Milton Friedman Say?" Whack-A-Mole Game

Over the past few years, many writers have made the claim that Milton Friedman would roll over in his grave if he knew what Ben Bernanke was doing at the Fed.  These observers claim that both the ad-hoc nature and scale of monetary policy intervention would never be sanctioned by Milton Friedman.  I and others have responded many times that except for the former point, this critique is wrong.  Just look at Milton Friedman's own words to see why.  Nevertheless, this "What would Milton Friedman Say?" critique  against Bernanke's Fed keeps reappearing in prominent media outlets like a never-ending whack-a-mole game.

Chart of the Day

From Marcus Nunes we get this figure which helps shed some light on the recent upswing in the stock market.   It shows that as inflationary expectations improve so does the stock market.  

The easiest way to interpret this relationship is that when inflationary expectations rise, the market is effectively saying it expects higher aggregate demand in the future.  Given nominal rigidities, the higher expected aggregate demand in turn means higher expected real growth. Ergo, higher stock prices.  (For a more technical discussion on this relationship see David Glasner who first spotted this relationship.)

Note that Marcus Nunes shows in the figure how the Fed's various monetary easing programs have been tied to trend changes in inflation expectations and the stock market.  Thus, the most recent developments might also be attributed to the Fed's new long-run interest rate forecasts which is not on the figure.

For me the big take away from this picture is that all this time the Fed has been playing with us.  If the Fed's timid, piecemeal programs listed on the figure above can systematically affect the stock market, then just imagine what would happen if the Fed had gone nuclear and adopted a nominal GDP level target.  The stock market would be way up, balance sheets would be stronger, the economic outlook would be vastly improved, and the economy would be back on path to full employment.

Update: Given my claims above, I was curious to see how close the TIPS-created expected inflation series tracked the nominal GDP forecasts provided in the quarterly Survey of Professional Forecasters. To do this, I transformed the 5-year expected inflation series into a quarterly average and plotted them against the forecasted growth of nominal GDP over the next four quarters.  Here is what I got:

This indicates that my interpretation of the expected inflation series as an implicit forecast of expected future aggregate demand is appropriate, at least for now.

This is What Ails Europe

Paul Krugman argues that the primary problem facing Europe is a monetary one (my bold):

So what does ail Europe? The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects of the gold standard — defects that played a major role in causing and perpetuating the Great Depression. 

[...] 

If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.

I agree that the Eurozone was a flawed currency union from the start.  So yes, what ails Europe is a structural monetary problem. But the monetary problem goes deeper than that.  There is also a cyclical monetary problem that is alluded to in the bold passage above.  This cyclical dimension can be seen in the figure below:

This figure shows that ECB's failure to stabilize and restore nominal spending to expected levels--as proxied by the  1995-2006 trend--during the crisis as the real culprit behind the Eurozone crisis.  This failure to act has been devastating because it means nominal incomes are far lower than were expected when borrowers took out loans fixed in nominal terms.  European borrowers, both public and private, are therefore not able to pay back their debt and the result is a fiscal crisis.

The reduced ability for Europeans to payback debt also means that risk premiums on countries with lots of debt or ones perceived to have debt problems increases, further raising these country's debt burden with higher financing costs.  The fiscal crisis gets bigger, and being easy to observe, gets wrongly credited as the cause of the Eurozone's problems.  Consequently, the Eurozone crisis is prescribed with the fiscal solution of austerity. The real solution, then, requires the ECB to restore nominal incomes to their originally expected values. This is what ails Europe.

What is Money?

Nick Rowe says we should not think of money as a store of wealth:

Money is what money does. There are two functions of money that define what is and what is not used as money: medium of exchange; and medium of account. That's it... We need to start worrying a lot more about how money works as a medium of exchange. We need to understand a lot better than we do how money works as a coordinating device in a decentralised economy. And we need to understand a lot better than we do how money can sometimes fail as a coordinating device. Because, outside a very simple economy, people can't barter their way back to full employment if the monetary exchange system fails. 

We need to stop thinking of money as a store of wealth, just like all the others. And let's start by changing the textbook definition of money, by deleting that bit about money being a store of wealth. 

I agree, but would add that we also need to start thinking about money at all levels of transactions. Most textbooks and many economists think of money assets at only the retail level (i.e. the M2 money supply).  This crisis has taught us that institutional money assets--those assets like treasuries, commercial paper, and repos that facilitate transactions in the financial system--matter too.  The bank run on the shadow banking system was a bank run using institutional money assets.  If we really want to understand money and its implications for the economy we need to be thinking about these money assets too.  Thanks to Gary Gorton, David Aldonfatto, and Stephen Williamson I have come to better appreciate this point.  And thanks to this perspective I have come to see the demand for safe assets and budget deficits in a different light. 

NGDP Targeting News Roundup

Just when you thought interest in nominal GDP (NGDP) might be waning there is more, including some discussions of it from central bank officials.  

First, Mark Carney, Governor of the Bank of Canada delivered a speech where he discussed what would be a monetary policy for all seasons. He had some nice things to say about NGDP targeting, but ultimately comes out in favor of flexible inflation targeting as the top choice.  The thing is, flexible inflation targeting is effectively like a NGDP target if conducted properly.  Sweden is a good illustration of it.  There are other examples, but the point is this: why not just be explicit about it?  Doing so would not just formalize what is being done implicitly, but it would better anchor nominal expectations--especially if it were an level target--and thus reduce the chances of  large collapses in aggregate nominal spending.  Why not add more clarity?  And why focus on a symptom (i.e. inflation) when one can focus on the cause directly (i.e. changes in aggregate demand)? 

Now the above assume the flexible inflation target is executed flawlessly and ends up stabilizing aggregate demand. In practice, the discretion afforded a central bank under flexible inflation targeting makes it vulnerable to poor leadership and bad decisions.  And it is likely bad decisions will arise under flexible inflation targeting because of supply shocks.  In principle, such shocks should not be a problem for flexible inflation targeting, but in practice with political pressure and with real time data limitations they do create problems.  Imagine, for example, there is a great productivity boom.  All else equal, the natural interest rate would rise and disinflationary pressures would emerge.  The central bank should ignore the disinflationary pressures and let the policy rate rise to the level of the natural interest rate to keep the economy at full employment.  However, it might be tempting to leave the policy rate below the natural interest rate since the economy is humming from the productivity gains and inflation is low.  It certainly would not be a popular move to raise interest rates.  With a NGDP target such problems are ignored altogether. Simply focus on stabilizing the path of aggregate demand.  Keep it simple.  

Second, Renee Holtom of the Richmond Fed has a nice article examining the implications of the Fed tolerating higher inflation as a way to kick start a robust recovery.  She discusses all the reasons for doing so, including a NGDP target..  The one thing missing is that she fails to mentions that the proper response to folks like Raghuram Rajan, who argues the Fed would do more harm to savers if it allowed higher inflation, is that the point of the temporarily higher inflation is to spark a recovery that would ultimately lead to higher real returns for savers.  Interest rates are low because the economy is weak. Spark a robust recovery and watch real interest rates take off.  This is a point that is missed by many, especially Bill Gross.  (Also see Scott Sumner's response to Holton.)

Third, in what appears to be the latest convert to Market Monetarism, Jason Rave does a good review of NGDP targeting.