Book for the Holidays

If you are looking for some holiday reading I highly recommend Scott Sumner's new book, The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression. Here is a summary:

Economic historians have made great progress in unraveling the causes of the Great Depression, but not until Scott Sumner came along has anyone explained the multitude of twists and turns the economy took. In The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, Sumner offers his magnum opus—the first book to comprehensively explain both monetary and non-monetary causes of that cataclysm.  

Drawing on financial market data and contemporaneous news stories, Sumner shows that the Great Depression is ultimately a story of incredibly bad policymaking—by central bankers, legislators, and two presidents—especially mistakes related to monetary policy and wage rates. He also shows that macroeconomic thought has long been captive to a false narrative that continues to misguide policymakers in their quixotic quest to promote robust and sustainable economic growth. 

The Midas Paradox is a landmark treatise that solves mysteries that have long perplexed economic historians, and corrects misconceptions about the true causes, consequences, and cures of macroeconomic instability. Like Milton Friedman and Anna J. Schwartz’s A Monetary History of the United States, 1867–1960, it is one of those rare books destined to shape all future research on the subject.

Order your copy here. 

Time Traveling with the Fed

Imagine we travel back in time to the second quarter of 2009. We stop by the Federal Reserve and reveal to Fed officials that the recession has now bottomed out. They are elated until we disclose that the Great Recession will be followed an anemic recovery for the next seven years. We share how ZIRP, forward guidance, and successive rounds of QE will fail to create an robust recovery and this leaves Fed officials aghast.

Reeling from shock, they ask what they should do instead of these policies. We inform them of the argument for a NGDP level target made by Scott Sumner, Christina Romer, and Michael Woodford. We also inform them that they should signal the seriousness of their intent to do so by making an arrangement with the Treasury Department to back up their actions with contingent 'helicopter drops' should the Fed fail to hit the NGDP level target.

The Fed agrees with our assessment and decides to spend its political capital on the NGDP level target proposal--instead of using it on ZIRP, forward guidance, and QE programs--and gets the backing of Congress and the Treasury Department. The great macroeconomic experiment begins.

So what would happen next in this counterfactual history? How would the economy respond to these combined efforts of monetary and fiscal policy starting in mid-2009? No one can answer these questions with certainty, but it is likely that at a minimum there would be temporarily higher inflation.

The two figures below lend support to this understanding. They come from a paper I am currently working on where I run a counterfactual forecast of inflation starting in mid-2009. The forecasts are based on three different paths of NGDP returning to its pre-crisis trend: a two-year path, a three-year path, and a four-year path. The first figure shows the three NGDP return paths and the second figure shows the inflation forecasts associated with these paths:

Although temporary, inflation is notably higher than both the actual inflation rate that occurred and the 2% target rate under each of the counterfactual NGDP return paths. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%. 

These numbers are just counterfactual forecasts, but they demonstrate a key reason why the current monetary regime could never have generated the 'catch-up' aggregate demand growth needed to offset the 2008-2009 crash in nominal spending and return it to its pre-crisis path: it would require higher than 2% inflation for a few years. And that is simply intolerable in the current environment. 

The Fed, Congress, and the body politic at large have come to view 2% or less inflation as the norm for advanced economies. Any violation of it--even if temporary and part of a systematic approach like the NGDP level target above--would be viewed as an egregious affront to civilization. Just look at some of the flack former Fed Chair Ben Bernanke got on this issue or the exchange (see last part) between him and former Senator David Vitter on the question of raising the inflation target.

This means that no matter how much QE or forward guidance the Fed engaged in, it would always be done in a way that kept inflation and, as a result, aggregate demand growth in check. This is the Fed's dirty little secret. This understanding also means that no matter how much fiscal policy was done, it too would only be effective up to the 2% inflation threshold. This is the Penske problem with modern macroeconomic policy: it relies on an engine governor rather than cruise control to regulate the speed of the economy. It is time for level targeting. 

Related
The Right Goal for Central Banks
Monetary Regime Change

Yes, the Fed (Passively) Tightened in the Fall of 2008

Fed Chair Janet Yellen went before the Joint Economic Committee of the U.S. Congress today. She gave her report on the economy and then took questions from members. Probably the most interesting question came from Senator Ted Cruz:

Thank you, Mr. Chairman. Chair Yellen, welcome. In the summer of 2008, responding to rising consumer prices, the Federal Reserve told markets that it was shifting to a tighter monetary policy. This, in turn, set off a scramble for cash, which caused the dollar to soar, asset prices to collapse, and CPI to fall below zero, which set the stage for the financial crisis.

In his recent memoir, former Fed Chairman Ben Bernanke says that, the decision not to ease monetary policy at the September 2008 FOMC meeting was, quote, "In retrospect certainly a mistake."

Do you agree with Chairman Bernanke that the Fed should have eased in September of 2008 or earlier?

This question is interesting because it presents a more subtle understanding of the Great Recession than is found in the standard narrative. In fact, it may be too subtle since it seemed to have caught Janet Yellen off guard. It also seemed to have tripped up the usually sharp Wall Street Journal reporter Sudeep Reddy in his live blogging of the hearing. Both seemed incredulous that Cruz would imply the Fed actually tightened monetary policy in the fall of 2008. But that is exactly what the Fed did, though to see it one has to understand the notion of a passive tightening of monetary policy.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a fall in the money supply or through an unchecked decrease in money velocity. Such declines are the result of firms and households expecting a worsening economic outlook and, as a result, cutting back on spending. In such settings, the The Fed could respond to and offset such expectation-driven declines in spending by adjusting the expected path of monetary policy. But the Fed chooses not do so and this leads to a passive tightening of monetary policy.

A passive tightening of monetary policy is no less harmful to the economy than an active tightening. The Fed, therefore, should be no less culpable for passive tightening than it is for active tightening. One way to see this is to imagine the Fed as a school crossing guard. If the Fed failed to prevent a child from crossing into a busy street would we be any less indignant than if it instructed the same child to cross into the busy street? Both mistakes are equally dangerous and the result of choices made by the crossing guard. It is no different with monetary policy. 

So how does this play into Cruz's comments about 2008? The answer is that the Fed began to passively tighten during the second half of 2008. It had actually done a decent job stabilizing aggregate demand for the two years leading up to this point despite a housing recession occurring during this time. But in mid-2008 it allowed a passive tightening to emerge. Arguably, this passive tightening sowed the seeds for the financial panic that erupted later in 2008 and ultimately is what turned an otherwise ordinary recession into the Great Recession. 

Okay, that is story. What evidence do we have for this understanding of the Great Recession?

First, here are two figures that demonstrate the Fed contained the housing recession for roughly two years. They show that employment and personal income outside of housing related sectors actually grew at a stable rate up until about mid-2008. Kudos to the Fed during this time.

But something clearly changes in mid-2008. My argument--echoed by Senator Cruz today--is that the Fed inadvertently allowed a passive tightening of monetary policy. This can be seen in the next few figures.

The first two figures shows the 5-year 'breakeven' or expected inflation rate. It shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. This was an unusual sharp decline and was screaming "Trouble ahead!" 

One way to interpret this decline is that the bond market was signalling it expected weaker aggregate demand growth in the future and, as a result, lower inflation. Even if part of this decline was driven by a heightened liquidity premium on TIPs the implication is still the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in both its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers' monthly nominal GDP data (i.e. NGDP = money supply x velocity) indicates this is the case:

The Fed could have cut it policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just changing the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was highly worried about inflation and that the expected policy path could tighten. 

On the financial panic side, note that the Fed kept aggregate demand stable during the early stages of the panic in 2007. Again, job well done. Only in late-2008 after the Fed had allowed passive tightening (as seen by the decline in NGDP) does the financial panic spike. This can be seen in the figure below:

So the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the 1930's Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed. 

So it is completely reasonable for Senator Ted Cruz to ask his question today about the Fed's mistake at the September 2008 FOMC meeting. I would only add that this mistake was already in play by that meeting. The September meeting served to confirm the market's worst fear that the Fed was more concerned about inflation than the collapsing economy.

This understanding of the Great Recession is not unique to Senator Ted Cruz, Scott Sumner, or myself. Robert Hetzel of the Richmond Fed has written an entire book that makes this argument (he also has an journal article). So even a Fed insider acknowledges this possibility.

Update: George Selgin shows how the Fed's sterilization in 2008 contributed to the passive tightening of monetary policy.

P.S. This post draws heavily from earlier ones that make the same point. Also see Scott Sumner's arguments for this view: here and here.

Going All Natural at the Fed

Has the market-clearing or 'natural' short-run  interest rate been negative over the past seven years? The answer to this question would go a long ways in ending much confusion about Fed policy. If the answer is yes, then the Fed has not been 'artificially' suppressing interesting rates as many have claimed. If the answer is no, then then Fed has been keeping monetary policy too loose. In other words, one cannot use interest rates to talk about the stance of monetary policy unless one compares them to their natural rate level.

There is a problem, however, in making this comparison. The natural interest rate is not directly observable, it has to be estimated. Michael Darda, chief economist of MKM Partners, provides one estimate of it and is reproduced in the figure below. Darda's estimate illustrates how knowing both the actual interest rate and the natural interest rate allows us to think more clearly about the stance of monetary policy. It shows that the Fed was a bit too easy during the boom period (the actual interest rate was less than the natural rate) and too tight during bust period (the actual interest rate was above the natural rate). Darda's estimates also shows that the gap between the actual and natural has only slowly converged since 2009, a pattern consistent with the slow recovery from the Great Recession. Other estimates tell similar stories such as the one from Robert Barsky et al (2014) published in the American Economic Review.

While these estimates are nice, it would be immensely helpful if the Federal Reserve published its own monthly estimate of the short-run natural interest rate. The Fed has a huge research staff, lots of resources, and is capable of providing this important information. It would be in the Fed's own best interest if it did so. Imagine if the Fed could point to a figure like the one above whenever someone accused it of artificially suppressing interest rates. It would make everyone's life much easier. 

Well, today we learned from the October 2015 FOMC minutes that this information is being produced by the board of governors staff (my bold):

The staff presented several briefings regarding the concept  of an equilibrium real interest rate—sometimes labeled the “neutral” or “natural” real interest rate, or “r*”—that can serve as a benchmark to help gauge the stance of monetary policy. Various concepts of r* were discussed. According to one definition, short-run r* is the level of the real short-term interest rate that, if obtained currently, would result in the economy operating at full employment or, in some simple models of the economy, at full employment and price stability. The staff summarized the behavior of estimates of the shortrun equilibrium real rate over recent business cycles as well as longer-run trends in real interest rates and key factors that influence those trends. Estimates derived using a variety of empirical models of the U.S. economy and a range of econometric techniques indicated that short-run r* fell sharply with the onset of the 2008–09 financial crisis and recession, quite likely to negative levels. Short-run r* was estimated to have recovered only partially and to be close to zero currently, still well below levels that prevailed during recent economic expansions when the unemployment rate was close to estimates of its longer-run normal level.

The Fed staffers are producing estimates of the short-run natural interest rate so why not share it with the public? Why not add it to Fed's collection of statistics that publishes on its website?  It sounds like the Fed has a range of estimates so it could report point estimates along with confidence intervals surrounding it. So how about it Janet Yellen? Why not go all natural at the Fed?

Related

A Plea to My Fellow Free Marketers

The Fed Did Not Enable the Budget Deficits

Saver's Real Problem

How to Trigger a Panic Attack at the Fed

What does it take to create a panic attack at the Fed? How about a large credit and housing boom that wreaks havoc on household balance sheets? Nope, been there, done that with no loss of sleep. What about experiencing the sharpest recession since the Great Depression? Sorry, that too is a real yawner for the FOMC. How about the national tragedy of the long-term unemployed? Boring. Okay, what about that dramatic expansion of the Fed's balance sheet and complications it makes for the normalization of monetary policy. No worries here either. Well, how about the Fed leaks that led to insider trading? Lame, nothing to see, move along. There is not much the ruffles the Fed's feathers.

But ask the Fed to set its own benchmark rule against which it and others can evaluate FOMC decisions in a non-binding manner and suddenly this happens to Fed officials:

Yes, Janet Yellen and the Fed have finally found something to freak out about, the Fed Oversight and Modernization (FORM) Act.  In various media accounts, Yellen "slammed" the bill, "warns loud against it", and has "stepped up opposition" to it. What is so freakworthy about this bill? Janet Yellen explains in a letter to congress (my bold):

I am writing regarding the House of Representative’s consideration of H.R. 3189, the Fed Oversight Reform and Modernization (FORM) Act. The FORM Act would severely impair the Federal Reserve’s ability to carry out its congressional mandate to foster maximum employment and stable prices and would undermine our ability to implement policies that are in the best interest of American businesses and consumers.This legislation would severely damage the U.S. economy were it to become law.

There are a number of harmful provisions in the FORM Act, but the provisions concerning the conduct of monetary policy are especially troubling. Section 2 of the bill would require the Federal Reserve to establish a mathematical formula or “directive policy rule” that would dictate how the Federal Open Market Committee (FOMC) adjusts the stance of monetary policy at every FOMC meeting. The Government Accountability Office (GAO) would be responsible for determining whether the rule adopted by the FOMC met all the criteria in the legislation. Any time the FOMC was judged not to be in compliance with the GAO-approved rule, the GAO would be required to conduct a full review of monetary policy and submit a report to the Congress. 

Does this really warrant a Fed panic attack? To answer this question, let's recap the highlights of section 2 in the bill, some of which are missing in Janet Yellen's letter.

• First, the bill requires the Fed to chose on its own a "directive policy rule", a reaction function that prescribes how it would respond to different economic scenarios. In other words, congress would not be forcing a specific rule on the Fed, only asking it to set up a benchmark rule based on the Fed's own preferences. The Fed could change this rule over time. 

• Second, the bill requires the Fed to explain and justify how its preferred rule is different than the "reference policy rule", which happens to be the 1993 Taylor Rule.

• Third, the GAO would report to congress whether the Fed was following its own rule and whether it changed the rule. This is the 'audit' part, since it would require the GAO to investigate why the Fed deviated from or changed the rule.

• Fourth, the Fed chair could be summoned before congress to discuss the GAO findings. 

Sorry folks, but this is definitely not freakworthy. The bill does not change the dual mandate and it does not prescribe how the Fed should conduct monetary policy. All it does is ask the Fed to set a benchmark approach for monetary policy that can be used to evaluate monetary policy in retrospect. The Fed can still deviate from it, it just has to explain why. 

I don't see how this would politicize Fed policy any more than it is already. Janet Yellen already testifies before congress and meets with political activists. If anything, having a benchmark rule would make congressional hearings on the Fed more intelligible. Both the chair and congress would be speaking from the same reference point.

This could actually help the Fed since it chooses the benchmark rule under this law. It could easily adopt a Taylor Rule where the equilibrium real rate part is not constant, but endogenous to current economic conditions. Most estimates of the Taylor Rule that take this approach show the Fed has not been easy. One of the greatest confusions over Fed policy is the belief that it has kept interest rates 'artificially' low. This bill would give the Fed a chance to show otherwise. The Fed should see this as an opportunity.

So this Fed panic attack is an overreaction. The Fed is not being constrained and, if anything, it is being given the ability to shape the conversation on monetary policy. Other countries already have quarterly reports on monetary policy that do something very similar. The Fed should get out in front of this bill and run with it. 

Fact Checking the Fact Checkers

The fourth GOP debate was last night and the economy was an important part of the conversation. Much was said last night that deserves commentary, but I want to focus on one claim that really surprised me. It surprised me because it went against the standard GOP narrative about the Fed. So what was this claim and who said it?

The claim was that the Fed tightened monetary policy in the third quarter of 2008 and this tightening contributed to the Great Recession. This view implies the Fed should have done more to avert the crisis, both in late 2008 and afterwards. It came from none other than Senator Ted Cruz. Someone has done their homework. This is a subtle, but important point that many of us have been making for the past seven years. So kudos to Senator Ted Cruz for recognizing it. 

Sadly, some observers still miss this insight and this sometimes includes the fact checkers of the debate. The latest example of this is Isaac Arnsdorf of the Politico Wrongometer, which is supposed to "truth squad the Republican debate." Here is Arnsdorf's response to Cruz:

But what did the Fed do in 2008? It wasn't tightening money. The Fed actually cut rates repeatedly in 2008. Some economists have argued policy makers didn’t cut rates fast enough given the economic conditions. But that's only "tightening" if you measure it against the demand for liquidity and market expectations. It doesn't reflect the Fed's actual policy moves.

Someone is trying too hard here. Monetary policy can tighten even if the Fed does nothing. It is called a passive tightening of monetary policy. It occurs whenever the Fed passively allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in velocity. The damage done by a passive tightening is no different than that of an overt tightening. 

But don't take my word for it, just ask Ben Bernanke.  Back in late 2010, he acknowledged the possibility of passive tightening and used it as a justification for stabilizing the size of the Fed's balance sheet (my bold):

Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred...

In short, the FOMC was concerned that a failure by the Fed to reinvest its mortgage receipts, which would amount to a reduction in the monetary base, would be contractionary. So for the FOMC, a passive tightening of policy is just as serious as an active one.

Okay, let's apply this notion of passive tightening to the fall of 2008. As I have noted before, both inflation expectations and nominal demand had been falling since mid-2008. Normally such actions would would lead to an easing of monetary policy. But the Fed decided against easing in its August and September 2008 FOMC meetings. By doing nothing at these meetings it was passively tightening.

The September decision not to ease was especially egregious given that the collapse of the financial system was happening at the very same time. Note only did the Fed not ease, but it indicated it was just as worried about inflation as it was about the real economy. In other words, the Fed was signaling it was just as likely to tighten policy going forward as it was to ease. This was probably the worst forward guidance the Fed ever gave.

So Senator Ted Cruz was absolutely right. There was a major tightening of monetary in mid-to-late 2008. And in my view, it was this tightening and the failure to correct it later that turned what would have been an ordinary recession into the Great Recession. This may be a new insight for some observers. It should not, though, be a new insight for a fact checker criticizing a candidate.  

PS. Yes, Senator Ted Cruz did go on to advocate a gold standard. He is, however, interested in a rules-based approach and I suspect would be open to a NGDP level target based rules framework. So let's be gracious and acknowledge the big insight on Fed policy that Cruz alone noted last night. 

PPS. Dr. Ben Carson said he was a long-time friend of Janet Yellen and likes her. He also said he wants to see the dollar tied to something. May I suggest a market-driven NGDP futures contract?

No, the Fed Did Not Enable Large Budget Deficits--You Did!

As a follow up to my last post, I want to repeat a point I have made before. Not only is the Fed not responsible for the low interest rates during the past seven years, but it is also not responsible for enabling the large budget deficits that occurred during this time.¹ 

But how can this be? Was not the Fed involved in massive asset purchase programs of government debt? For some it is obvious that through these programs the Fed was the 'great enabler' of the run up in government debt since 2008. Here, for example, are two former Fed officials making this claim a few years ago at a conference:

Mr Warsh and Mr Poole (who was filling in for Allan Meltzer) made a sharp distinction between the “legitimate” efforts to fight the crisis and the subsequent easing actions that were, allegedly, unjustified by the economic fundamentals. According to them, the interventions of 2007-2009 were required to ensure that “the markets could clear”, as Mr Warsh put it, while the second round of easing was done to satisfy “political masters” by monetising the debt. In fact, Mr Warsh said that the Fed was being actively unhelpful by “crowding in” Congress’s supposedly poor policy choices.

Yes, the Fed did engage in several rounds of 'quantitative easing' (QE) where it bought up a large number of treasury and agency securities. The amounts, however, were not that large relative to the total amount of securities outstanding. The Fed, therefore really was not much more than a bit player in the market for these securities.

To see this, take a look  at the absolute dollar amount of the Fed's treasury and agency assets relative to total for 2015:Q2. Of the approximately $12.67 trillion in marketable treasuries, the Fed owned $2.46 trillion. Similarly, of the roughly $8.71 trillion in mortgage-related securities the Fed ownsed $1.72 trillion. In both cases that amounts to about 19% of the total.  That is not quite the image of a 'great enabler' now is it?

This point is even more clear in the figure below. It shows the most of the run up in marketable public debt since 2008 was not due to the Fed. The black sliver in the figure represents the Fed's share of the total.

If we take the data from the figure above and put the Fed's share a percent of the total we get the following figure. Note that the Fed's current 19% is not that different from where it was in the decade prior to the crisis. Yet, we did not hear people making the 'great enabler' claims back then.

If we zoom in on this figure we see something rather remarkable. There was a sharp reduction in the Fed's share of marketable treasuries in 2007-2008. The Fed critics, however, only seem to notice the QE periods. Where were they during the 2007-2008 period?  They fail to see that the QE programs effectively reversed the 2007-2008 reduction of treasury holdings by the Fed, which itself was not all that much in the grand scheme of things. 

Finally, let me conclude with the following figure. It shows 10-year yields on government  bonds for the United States, Germany, United Kingdom, and Japan--all countries whose treasury securities are considered safe assets. Note that all of them see their yields start to drop in mid-2008 as the panic kicks and they have yet to return. Moreover, they all fell in a similar fashion. Surely, this has to be more than just the Fed at work. It has to do with a surge in risk-aversion that has yet to fully return to normal levels.

So who is ultimately responsible for the low interest rates? Like I said in my last post, market forces are responsible for the low interest rates. And who is the market? You,  me, our financial intermediaries, and foreigners. If you want to blame anyone for low interest rates start by looking in the mirror.

Update: Using SIFMA statistics, I constructed a pie chart to show who the current holders of treasury debt are as of 2015:Q2. Using this data, the Fed holdings come out a bit less than the 19% calculated above using the financial accounts data. Also, financial intermediaries include mutual funds, banking institutions, insurance companies, and pension funds.

¹Okay, if pressed I would say the Fed actually is indirectly responsible for the low rates for allowing the crisis to emerge and then not doing enough to end it promptly. This, though, is a very different argument than the one that says the Fed directly caused the low interest rates.