Revealed Preferences: Fed Inflation Target Edition

Over the past  six years the Fed's preferred measure of the price level, the core PCE deflator, has averaged 1.5 percent growth.  That is well below the Fed's explicit target of 2 percent inflation. Why this consistent shortfall?

Some Fed officials are asking themselves this very question. A recent Wall Street Journal article reporting from the Jackson Hole Fed meetings led with this opening sentence: "central bankers aren't sure they understand how inflation works anymore". The article goes on to highlight some deep soul searching being done by central bankers in the Wyoming mountains. It is good to see our monetary authorities engaged in deep introspection, but let me give them a suggestion. Dust off your revealed preference theory textbooks and see what they can tell you about the low inflation of the past six years. 

To that end, and as a public service to you our beleaguered Fed officials, let me provide some material to consider. First consider your inflation forecasts that go into making the central tendency consensus forecasts at the FOMC meetings. The figures below show the evolution of these forecasts for the current year, one-year ahead, and two-years ahead. There is an interesting pattern that emerges from these figures as you expand the forecast horizon: 2 percent becomes a upper bound.

So the first insight from revealed preferences is that you and your fellow FOMC officials have been consistently looking at an upper bound of 2% on core PCE inflation. Now if we add to this observation the fact that the FOMC has meaningful influence on inflation several years out, then these revealed preference are saying you want and expect to get an inflation upper bound of 2%. 

Your chair, Janet Yellen, conceded this point in the press conference following the December 2012 FOMC meeting:

But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13).

Now an upper bound means there can be activity below it. And we see just that that in your inflation projections. Collectively, then, all of this revealed preference evidence suggests that you and your Fed colleagues do not have a 2% inflation target, but rather an inflation corridor target. Based on your above forecasts your corridor target appears to be somewhere between 1% and 2%. 

We can get a better sense of where this inflation corridor target lies with additional revealed preference evidence. This evidence is found in the following figure which shows core PCE inflation and the timing of your QE programs. The figure suggest that you and your fellow FOMC members tend to start QE programs after core inflation had been drifting away from the 2% upper bound and you do so in a manner that prevents it from drifting below 1% for very long. (Based on this reading, you all are likely to change tack soon if core inflation does not stop drifting toward 1%. )

This reading is corroborated by looking at the changes in the Fed's share of treasury securities as a percent of all market treasuries. Ever since the zero lower bound kicked in late 2008, the FOMC has tended to allow its share of treasury holdings to adjust in manner that offsets changes in core PCE inflation. That is, when inflation was falling the Fed started increasing its share of treasury securities and vice versa.

So rest easy dear Fed official. No need for any existential angst. According to revealed preferences, you are still driving core inflation--which ignores supply shocks like changes in oil prices--it is just that you have a roughly 1%-2% core inflation target corridor rather than a 2% target. So even though you may not realize it, you are doing a bang up job keeping core inflation in your target corridor.

How to Create a Chinese Economic Crisis in Three Easy Steps

First, peg the yuan to another currency that has been rapidly appreciating over the past year...

...this will choke the tradeable sector...

 

...and really put a damper on nominal spending growth.

Second, respond to the above economic weakening by easing domestic monetary conditions. Over the past year, the People's Bank of China has done so with five cuts to its prime lending rate and several large reductions in the required reserve ratio for banks. 

Third, allow nervous investors to pull their capital out of China. Investors have come to expect a large yuan devaluation given the above developments. For the easing of domestic monetary conditions has put downward pressure on the yuan while the dollar peg has pushed it up inordinately high, creating an imbalance. The only way China can maintain this imbalance is to defend its dollar peg by burning through its foreign exchange reserves...

...a response that becomes more expensive the the tighter Fed policy becomes...

...but there is a limit to burning through these assets since China still needs some foreign reserves buffer. Ambrose-Evans Pritchard reports some observers are already wondering if China is getting close to its buffer limit. If so, China will be forced to devalue. This is what investors are now expecting and therefore are eager to get out. This puts further pressure on China's stock of foreign reserves.

Note that devaluing the yuan will be costly too. Many Chinese firms, previously expecting the dollar peg to hold, have taken out lots of dollar denominated debt. So either China burns through its reserves or it increases the private sector's real debt burdens. There are no easy choices here.

China, in short, has backed itself into a corner because it has attempted to do all three goals of the impossible trinity...

...something the emerging market crisis of 1997-1998 taught us does not end well. But China is trying anyways and the recent stock market roller coaster ride is just one of many adverse outcomes likely to come out of these efforts. Fortunately, most emerging countries are not making this mistake as noted by Greg Ip. That is good news. The bad news is that it will not be easy for China to undo the three steps it has taken toward doing the impossible trinity.

P.S. For a broader perspective that makes the same point see this post by Lars Christensen.

A Work Around for the Fed's Knowledge Problem

Ramesh Ponnuru has a new article titled Fallible Fed Needs a Few Good Rules. Here is an excerpt:

Some Republicans think that Congress should supply a framework for the Fed, making it more rule-bound. One much-discussed approach would have the Fed follow the “Taylor rule” -- named after John Taylor, a Stanford economist -- which says that the federal funds rate should be set according to a formula involving inflation, the long-run real interest rate, and the gap between the economy's actual output and its potential output. The Fed’s behavior might then be more predictable. It would raise and lower the fed funds rate according to the formula.

The Economist magazine recently criticized the idea of following a formula, arguing that the Taylor rule has drawbacks. It argued that the Fed should continue to exercise broad discretion over monetary policy.

But to say that a central bank acting on its own discretion could perform better than one following the Taylor rule doesn't mean that it is likely to do so. And the Taylor rule isn't the only possible rule. The Fed could instead act to keep the growth in nominal spending -- the total amount of dollars being spent each year on consumption and investment -- at a fixed percentage each year. That approach wouldn't require it to make confident estimates about the output gap or [equilibrium] interest rates. It would also lend itself to greater predictability, and a recent paper suggests that it might work better than either inflation-targeting or the Taylor rule, especially given uncertainty about those values.

Ponnuru alludes to an important point in the paragraph above. Monetary policy suffers from the knowledge problem. Monetary authorities simply do not know enough about the economy in real time to make informed decisions. And this is not just a problem with theoretical Taylor Rules. It is a problem for modern central banking. One area, in particular, where they have a hard time is knowing how to respond to supply shocks. They are challenging since they push output and inflation in opposite directions and have plagued central banks in advanced economies over the past decade. As I noted earlier:

Supply shocks were an issue in 2002-2004 when the much-ballyhooed productivity boom (a positive supply shock) of that time made Fed officials worry about deflation. They consequently kept interest rates low even though the housing boom was taking off. Supply shocks were also an issue in the fall of 2008 when Fed officials were concerned about rising commodity prices (a negative supply shock) and, as a result, decided to do nothing at their September FOMC meeting despite the collapsing economy. 

Across the Atltantic, the ECB has struggled even more with supply shocks. The ECB raised interest rates multiple times in 2008 and 2011 in response to the commodity price shocks (negative supply shocks). Below is a figure from a Robert Hetzel paper on this crisis that shows how misguided the rate hikes were. They occurred even though spending was already falling. It is no wonder the Eurozone has struggled so much since 2008.

One can trace this wrinkle back further. Ben Bernanke, Mark Gertler, and Mark Watson argue the reason oil supply shocks have historically been tied to subsequent weak growth is not because of the shocks themselves, but because of how monetary policy responded to those shocks. That is, central banks typically responded to the inflation created by the supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this wrinkle has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as demonstrated above, is that in practice it rarely works. Responding to supply shocks in real time requires exceptional judgement and usually some luck. In fact, as I note in this policy paper, some scholars think that the successes of inflation targeting prior to the crisis were due largely to luck. There were simply fewer supply shocks during the early years of inflation targeting.

Ironically, The Economist article Ponnuru mentions above argues discretion is preferred because of the knowledge problem! It says that "until the day the economy is fully understood, human judgment has a crucial role to play." Really? It would seem the last eight years of ad-hoc, make-it-up-as-we-go-along policy by the Fed and ECB would give pause to this type of thinking.  Especially with the weak recoveries these responses have created.

As Ponnuru notes, one of the big appeals of a nominal spending target rule is that it gets around the knowledge problem. Under this rule the Fed would simply stabilizes the path of total dollar spending.  There would be no need to worry about changes in the real economy. If for example, there were a positive supply shock—say new technology or increased oil supply—that lowered prices the Fed would do nothing other than maintain stable money spending. The composition of the spending would change—more goods and services at lower prices—but the total amount of spending would not. Likewise, total dollar spending would not change if there were a negative supply shock—such as a natural disaster or an oil shortage—though its composition would alter too.  In other words, the Fed would let relative prices and markets sort out real shocks on their own while maintaining monetary stability. This means the knowledge problem would no longer be a constraint in implementing monetary policy. This is just another reason for the Fed to adopt a nominal GDP target rule.

Austrians vs Market Monetarists on Canadian Fiscal Austerity

One of the more popular tales of 'expansionary austerity' was Canada in the mid-to-late 1990s. During this time Canada slashed government spending and brought down its debt-to-GDP ratio. Despite this fiscal stringency, the economy grew steadily and the unemployment rate fell. How was this possible?

Ramesh Ponnuru and I have argued this outcome occurred because the Bank of Canada (BoC) provided a monetary policy offset to the fiscal policy tightening. The evidence we point to in support of this view was the BoC cutting its target interest rate more than 500 basis points between 1995 and 1997. Some folks like David Henderson and Bob Murphy did not find this evidence compelling. It did not help our case that we shared the same view as Paul Krugman. Apparently, we were taking the "Keynesian view". Guilt by intellectual association?

Nonetheless, I laid out further evidence for the monetary offset view in a later post.  Bob Murphy has now replied to me in a new post and concedes that at least one of my points, the permanent increase in the monetary base, does lend some support to our view. (However, he correctly points out there are timing issues with the increase in the monetary base.) So he does concede the story is more complicated than he originally envisioned. 

In my view, however, the strongest evidence for the monetary policy offset view is not to be found in the monetary base. It is found is the divergence between the BoC's and the Fed's target interest rates. I made this point before and reiterated it in the comment sections of his new post. Below is an edited and extended version of the comment I left there. 

Bob, the monetary base data does raise some questions for both sides as you note. But let me share what I think is the most compelling evidence for the monetary offset view by making a set of observations.

First, Canada is a small open economy. During the period in question, Canada’s GDP was about 7% of US GDP on average. Canada, in other words, is very susceptible to external economic shocks, particularly ones coming from the US.

Second, Canada’s financial markets are highly integrated with US markets. This is especially true with short-term money markets which means there should be over the long run very little arbitrage opportunities between the two countries interest rates once one controls for risk and other country specific-factors.

Third, given the points above it should be the case that when the Fed (large economy) sets its short-term interest rate target in the US it also influencing short-term interest rates in Canada (small economy). This understanding would imply that the BoC generally follows what is happening to US monetary policy. That seems to be the case as seen here:

 

 But now take a closer look at the period in question:

The figure shows that Canada’s central bank interest rate differed as much as 250 basis points for a sustained period from the federal funds rate during the period in question.

How can this be possible given the observations above? Are not Canadian financial conditions tied closely to US financial conditions? The answer is yes, but they can deviate if the BoC exogenously intervenes and tinkers with interest rates. Put differently, had the BoC not intervened Canadian short-term interest rates probably would have more closely tracked the Federal Reserve’s target rate. As shown above, they typically do. But this time the BoC defied external money market pressures coming from the United States and struck its own interest rate path.

As a robustness check on this understanding I estimated the relationship between the BoC's target interest rate against the federal funds rate as well against the core inflation rate and the output gap in Canada. I estimated the model from 1980:Q1 to 1994:Q4, the period right before the BoC eases. This way we can ask the following question: given how the BoC adjusted interest rates in the past, how would one have expected it to do so going forward into the 1995-2000 period as new realizations of the federal funds, core inflation, and the output gap occurred?

If there were a deviation between the actual path and predicted path of the BoC's interest rate target during the 1995-2000 period, then this would constitute an exogenous movement or 'shock' to monetary policy. The figure below shows the results of this exercise.

The actual easing, then, was not something one could have easily predicted based on past BoC behavior. What is nice about this is that it provides a kind of a natural experiment for the monetary offset view. It provides (1) an exogenous easing of monetary policy (2) in a period of fiscal tightening and (3) results in stable aggregate demand growth. In my view the evidence provided by this natural experiment is very clear.

Nick Rowe rightly notes in the comments, though, that one should also look at the exchange rate. It depreciated during this time indicating monetary easing was at work. So it is hard for me to understand how one could view this experience as anything but strong evidence for the monetary offset view. 

China's Devaluation: Impossible Trinity, Deflationary Shocks, and Optimal Currency Blocks

So China devalued its currency peg almost 2% against the dollar. It happened just as I was wrapping up a twitter debate on this very possibility, a very surreal experience. Many more twitter discussions erupted after the announcement of this policy change and I got sucked into a few of them. My key takeaways from these discussions on the yuan devaluation are as follows. 

First, this devaluation was almost inevitable. The figure below superficially shows why: the economic outlook in China had been worsening.

The question is why? As I explained in my last post, the proximate cause is the Fed's tightening of monetary conditions. China's currency is quasi-pegged to the dollar and that means U.S. monetary policy gets imported into China. The gradual tightening of U.S. monetary conditions since the end of QE3 has therefore meant a gradual tightening of Chinese monetary conditions. Recently, it has intensified with the Fed signalling its plans to tighten monetary policy with a rate hike. U.S. markets have priced in this anticipated rate hike and caused U.S. monetary conditions to further tighten. Through the dollar peg this tightening has also been felt in China and can explain the slowdown in economic activity. Consequently, China had to loosen the dollar choke hold on its economy via a devaluation of its currency. 

There is, however, a more fundamental reason for the devaluation. China has been violating the impossible trinity. This notion says a country can only do on a sustained basis two of three potentially desired objectives: maintain a fixed exchange rate, exercise discretionary monetary policy, and allow free capital flows. If a country tries all three objectives then economic imbalances will build and eventually give way to some kind of painful adjustment. China was attempting all three objectives to varying degrees. It quasi-pegged its currency to the dollar, it manipulated domestic monetary conditions through adjustment of interest rates and banks' require reserve ratio, and it allowed some capital flows. This arrangement could not last forever, especially given the Federal Reserve's passive tightening of monetary policy.

One  manifestation of the tightening monetary conditions in the United States has been the appreciation of the dollar. Given the peg, the yuan has been appreciating too and appears to have become overvalued. China maintaining its peg against an apppreciating dollar would only have worsened this yuan overvaluation and intensified the drag it created for the Chinese economy. Already, the resulting slowdown and anticipation of Chinese authorities devaluing the yuan has lead to a $800 billion capital outflow from China. Since China desires its currency to become fully convertible in the future and because party leaders in China are unlikely to give up control of domestic monetary policy, it is almost a given that the adjustment to Chinese policy would have to come through a change to the yuan exchange rate. So this is the deeper reason for the devaluation. And it is the reason that the devaluation is probably just the first step toward an eventual floating of the yuan.

Second, those folks who are worried about the deflationary shock from this devaluation seem to forget the existing peg was creating its own deflationary shock. The idea behind the former concern is that via the devaluation Chinese goods will become cheaper to the rest of the world and given their abundance will drive down prices globally. My reply is that the tightening of U.S. monetary policy was already slowing down the Chinese economy and, as a result, creating deflationary pressures across the world. Just look at commodity prices. Moreover, the yuan devaluation need not necessarily cause a deflationary shock if the other central banks ease in turn. For example, it is likely the Fed will put off its interest rate hike this year and maybe do more easing if the yuan devaluation truly causes a large deflationary shock. 

Third, this experience highlights the importance once again of carefully choosing the currency block you join. Just like the ECB's application of a one-size-fits-all monetary policy to the very different economies of the Eurozone has proved harmful, so has the the one-size-fits-all monetary policy of the Fed to the dollar block countries proved harmful. In this case, it has proved harmful to China. Of course, the Eurozone is a currency union with a central bank that should be mindful of the entire Euro economy whereas the dollar block is number of countries that chose to peg to the dollar on their own and therefore are not the responsibility of the Fed. Still, the same principles apply: if you do not share the same business cycle or have adequate economic shock absorbers you probably should not join the currency block/union.

Update: To clarify on the impossible trinity note that prior to devaluation China had cut its benchmark interest rate four times since 2014 and cut its required reserve rate 50 basis points while maintaining the dollar peg. The domestic monetary easing has put downward pressure on the yuan and requires Chinese authorities to burn through its dollar reserves to defend the peg. As noted  above this has cost the Chinese $800 billion over the past year. Investors realize that at some point this will be too seen too costly as the dollar continues to appreciate. China will have to devalue. This anticipation only hastens the capital outflow. China, in short, has been trying to do too much: defend the peg, tinker with domestic monetary policy, and allow capital flows. China is running up against the impossible trinity.  

The Monetary Superpower Strikes Again

China's economy has been slowing down for the past few years and many observers are worried. The conventional wisdom for why this is happening is that China's demographic problems, its credit binge, and the related malinvestment have all come home to roost. While there is a certain appeal to these arguments, there is another explanation that I was recently reminded of by Michael T. Darda and JP Koning: the Fed's passive tightening of monetary policy is getting exported to China via its quasi-peg to the dollar. Or, as I would put it, the monetary superpower has struck again.

The Fed as a monetary superpower is based on the fact that it controls the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Therefore, its monetary policy is exported across the globe and makes the other two monetary powers, the ECB and Japan, mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar. As as result, the Fed's monetary policy also gets exported to some degree to Japan and the Euro. This understanding lead Chris Crowe and I to call the Fed a monetary superpower, and idea further developed by Collin Gray. Interestingly, Janet Yellen implicitly endorsed this idea in a 2010 speech:

For all practical purposes, Hong Kong delegated the determination of its monetary policy to the Federal Reserve through its unilateral decision in 1983 to peg the Hong Kong dollar to the U.S. dollar in an arrangement known as a currency board. As the economist Robert Mundell showed, this delegation arises because it is impossible for any country to simultaneously have a fixed exchange rate, completely open capital markets, and an independent monetary policy. One of these must go. In Hong Kong, the choice was to forgo an independent monetary policy.

[...]

As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies. Like Hong Kong, China pegs its currency to the U.S. dollar, but the peg is far less rigid.

[...]

Overall, we encountered concerns about U.S. monetary policy, and considerable interest in understanding the Federal Reserve's exit strategy for removing monetary stimulus. Because both the Chinese and Hong Kong economies are further along in their recovery phases than the U.S. economy, current U.S. monetary policy is likely to be excessively stimulatory for them. However, as both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.

The original context of the monetary superpower argument was that the Fed was exporting its easy monetary policy to the rest of the world in the early-to-mid 2000s. Now the argument is that its normalization of monetary policy is creating a passive tightening of monetary conditions for the rest of the world, especially the dollar peggers like China. 

So what evidence is there for this view? First, note that China's accumulation of foreign reserves begins to slowdown at the end of the pre-taper portion of the Fed's QE3 program, something that also happens with the other QE programs:

A slowdown in reserve accumulation means a slowdown in domestic money base creation and a tightening of monetary conditions more generally. A close look at the figure shows this slowdown accelerated in mid-2014. So what happen at that time?

This next figure suggests it was an increased tightening of U.S. monetary policy starting around mid-2014. This development can be seen in the rising values of the 1-year treasury rate (an average of expected short-term rates over the next year plus a small term premium) and the trade weighted value of the dollar. Both amount to a passive tightening of monetary conditions that in turn got transmitted into China. 

The trade weighted dollar is just one indicator of the stance of U.S. monetary policy. But it seems to be an important one when looking at the U.S. monetary policy-China link over the past decade. It tracks the growth of China's nominal GDP relatively closely during this period. 

So it appears the monetary superpower has struck again. Maybe it is time for dollar peggers like China to recognize that your tango partner may not have your best interests in mind.

A Closer Look at the Decline in Government Expenditures

Yesterday I shared the following on twitter:

This tweet generated a number of questions that sent me back to the data for a closer look. In the process I gained a few insights that I discuss below. These comments draw upon an excel file that compiles all the relevant BEA data and is accessible here. 

First, I want to be clear what the figure above is measuring. It is the sum of government spending, transfer payments, and interest payments across all levels of government. So it is a thorough measure. 

I learned, however, that it has one shortcoming: it subtracts out depreciation of fixed government capital which means it actually understates total dollar expenditures. Below is an updated version of this measure that corrects for this practice. As you can see this correction is not too large, it adds only a few basis points and does not change the sharp decline seen since 2010. The huge run up in total government expenditures during the crisis is largely gone. 

One observer asked how this decline breaks down among the various levels of government. I was able to create the figure below to answer this question. Most of the decline comes from reductions in federal government expenditures though there is a non-trivial reduction in state government expenditures too.

Many commentators seemed curious as to what was driving the sharp decline in expenditures. The figure below partially answers this question by decomposing total government expenditures (at all levels of government) into four categories: consumption and investment spending, transfer payments, interest on debt payments, and other. 

Because of the sequester I was not surprised to see the sharp decline in government spending. I was surprised, though, to learn transfer payments have not come down that much. I was expecting the rise in transfers to be temporary, tied to the business cycle. That seems to be the case for some transfer programs like  programs like unemployment insurance and SNAP.  Maybe the increase in transfer payments reflects the ongoing growth of social security and medicare against a denominator (NGDP) that never has returned to its pre-crisis trend. 

The big takeaway, then, is that even though the overall level of total government expenditures as percent of GDP has come back down to pre-crisis levels it composition appears to have permanently changed. 

I would also note that even though total government expenditures as a share of the economy has declined, government's reach has only grown through the increasing number of regulations. Patrick A. McLaughlin and others at the Mercatus Center have been quantifying this growth for some time now. Among other things, they have shown the growth of regulations during the time in question above has accelerated. So this post is not arguing the reach of the government into the economy has shrunk. Rather, it is only showing that government expenditures as a share of the economy have fallen to its pre-crisis levels.

Update: Some have questioned whether the striking changes in the graph are nothing more than the changes in the denominator, the sharp collapse in nominal GDP. The answer is no. There were both expenditure increases from the ARRA and decreases from the sequester and other fiscal consolidation measures. Consequently, in current dollar terms that had meant total government expenditures have flatlined since 2010 and fallen in inflation-adjusted terms. So this is far more than a simple story about changes in the denominator.