The Great Liquidity Demand Shock

I  have been arguing here for some time that the Great Recession of 2007-2009 was nothing more than a pronounced money demand shock that the Federal Reserve failed to fully offset.  As a consequence, nominal spending collapsed and given sticky prices the real economy crashed too.  This seems self evident to me and other so called quasi-monetarists (a term coined by Paul Krugman) like Scott Sumner, Bill Woolsey, Nick Rowe, and Josh Hendrickson. Some folks, however, do not buy it.   They disagree that the fundamental problem was a money demand shock and by implication they disagree that the Fed could have done anything to offset it.  This thinking can be vividly seen in the responses to my National Review article where I make the case for QE2 with a money demand shock story. 

A more thoughtful response to my argument comes from Brad DeLong who says rather than a narrow money demand shock being the underlying cause of the Great Recession, it was a broader liquidity demand shock.  Thus, the demand for all highly liquid assets increased and derailed nominal spending.  Though some of the quasi-monetarists may disagree with him on the details, I think they would agree with DeLong in general and might even call him a closet quasi-monetarist. 

So what is the evidence for DeLong's theory of a great liquidity demand shock?  I went to the flow of funds data and looked up the share of highly liquid assets as a percent of total assets for the (1) household and nonprofit sector, (2) the nonfarm nonfinancial corporate business sector, and (3) the nonfarm noncorporate business sector.  For highly liquid assets I sum up for each sector  currency and checkable deposits, time saving deposits, money market funds, and treasury securities.  Presumably, the share of highly liquid assets as a percent of all assets for each sector spiked during the crisis if in fact there was a great liquidity demand shock. 

Here is the figure for the households and nonprofit sector:

Source

This figure shows that the share of total assets for households and nonprofits allocated to highly liquid assets was declining since the 1980s.  This downward trend was dramatically reversed beginning around 2007 and is still elevated.

Next is the figure for the nonfarm nonfinancial corporate business sector:

Source

Corporations also saw a spike in their share of highly liquid assets after several decades of very little change. Here too the highly liquid share remains elevated.

Finally, here is the nonfarm noncorporate business sector:

Source

Here too, there is a spike in the share of highly liquid assets. Though the share has gone done slightly, it is still elevated relative to the pre-crisis period.  

My takeaway from these figures is that (1) there was a great liquidity demand shock and (2) the Fed failed to sufficiently offset it.  Presumably, one objective of QE2 is to bring theses shares back into line with pre-crisis values.  The figures indicate, though, there is a long way to go before that happens.

Update: If the treasury securities are eliminated from the numerator in the above figures then one gets something  that more closely measures the share of assets allocated to traditional money assets. The figures for the three sectors are here, here, and here.  These figures are very similar to the ones above.  Thus, money demand appears elevated too.

Why the Surge in Commodity Prices?

Paul Krugman explains the main reason for the rising commodity prices:

 [T]oday, as in 2007-2008, the primary driving force behind rising commodity prices isn’t demand from the United States. It’s demand from China and other emerging economies. As more and more people in formerly poor nations are entering the global middle class, they’re beginning to drive cars and eat meat, placing growing pressure on world oil and food supplies. 

There are many observers who disagree with this interpretation.  They argue it is loose U.S. monetary policy and speculation that is driving the surge in commodity prices.  Krugman notes there is a way to test this alternative theory:

The last time the prices of oil and other commodities were this high, two and a half years ago, many commentators dismissed the price spike as an aberration driven by speculators. And they claimed vindication when commodity prices plunged in the second half of 2008.

But that price collapse coincided with a severe global recession, which led to a sharp fall in demand for raw materials. The big test would come when the world economy recovered. Would raw materials once again become expensive? 

If so, then  Krugman's theory is more plausible.  So what does the data show? Is there is a close relationship between the growth in emerging economies and commodity prices?  Here is a figure that shows the year-on-year growth rates of industrial production in emerging economies and the CRB Commodity Spot Index: (Click on figure to enlarge.)

Sources: NBEPA , Moody's FreeLunch.com

I'd say Krugman has a solid case.  One could argue, though, that because the Fed's monetary policy gets exported to much of the emerging economy its monetary policy is providing stimulus to these countries and through them is indirectly putting upward pressure on commodity prices.  Even so, this still does not mean U.S. monetary policy has been too loose. It could be that the Fed's global monetary stimulus is simply putting the emerging economies back on their trend growth path.  After all, the emerging economies were growing in the double digits before the Great Recession and are only now returning to trend growth.  This can be seen in the figure below: (Click on figure to enlarge.)

Sources: NBEPA

At a minimum, Krugman's argument should give pause to those observers who point to rising commodity prices as a harbinger of runaway inflation.  There are many factors driving global commodity prices.  U.S. monetary policy is only one of them and probably is not the most important.

P.S. See Scott Sumner for more on what commodity prices tell us about monetary policy.

Update: Menzie Chinn looks at petroleum prices and comes to a similar conclusion.  Here is an interesting excerpt from his post:

One last observation regarding the monetary/real debate over the oil price resurgence. If indeed oil prices were rising over the past month primarily because of monetary policies in the US, one would expect the oil price change in the US to diverge from that in other economies not undertaking another round of quantitative expansion. Figure 4 shows the price of oil expressed in dollars, and in euros.

For the jump in prices during December, I don't see a pronounced divergence.

Salvaging the Equation of Exchange

Jim Hamilton is not a big fan of this equation:

MV = PY,

This is the famous equation of exchange where M is the money supply, V is velocity, P is the price level, and Y is real GDP.  Back in 2009 he questioned Scott Sumner's use of it in thinking about the economic crisis.  I replied that though it was just an accounting identity, it still shed some light on the economic crisis in its expanded form.  Now he is questioning its use as a way to measure velocity.  He correctly notes that  velocity is nothing more than a residual from this accounting identity, whose value can change based on what measure of the money supply one uses (i.e. V =[PY]/M). He further questions its usefulness by noting in several figures that M1's growth rates seem to be almost perfectly offset by changes in velocity's growth rate.  Here is a figure that reproduces Hamilton's M1 graphs for the 1980-2010 period.  (Click on figure to enlarge.)

Yes, it is rather striking in this figure that the growth rate of M1 and M1 velocity tend to move in almost perfectly opposite directions.  But why should the growth rates of M1 and M1 velocity necessarily move in opposite directions?  Hamilton's critique, as I understand it, is that they should move inversely because velocity is simply a residual in the equation of exchange.  But this understanding hinges on the assumption that nominal GDP growth is relatively stable.  But nominal GDP growth has not always been stable.  It just so happens, however, that most of the time in Hamiltion's 1980-2010 figures cover the "Great Moderation", the period when the Fed did a relatively good job of stabilizing nominal spending.  One would therefore expect the changes in the money supply to largely offset changes in velocity during this time. The Fed was doing its job. The near symmetry in the figure is a testament to its success.

Now if one looks outside the 1980-2010 period this symmetry is harder to find. Here is the 1960-1979 period with the same series: (Click on figure to enlarge.)

The lack of symmetry here is not particularly surprising.  The Fed's performance in stabilizing the growth of nominal spending was abysmal during this time, as shown by Josh Hendrickson.  Along these same lines, there are points in the 1980-2010 figure where the symmetry is missing. They all occur during recessions.  These are cases where the Fed failed to adequately stabilize NGDP.

I find these figures, motivated by the equation of exchange, insightful.  They show there is merit in using the equation of exchange.  Moreover, if one looks to the expanded equation of exchange form as done here there is much insight this identity can brig to bear on the economic crisis. 

Update:  Nick Rowe explains these pictures using Milton Friedman's thermostat. Meanwhile, Arnold Kling provides an alternative interpretation of the data.

The Case for Nominal GDP Targeting

I am late getting to this, but Mark Thoma wants to hear the case for nominal GDP targeting.  This approach to monetary policy requires the Fed stabilize the growth path for total current dollar spending.  As an advocate of  nominal GDP level targeting, I am more than happy to respond to Mark's request.  I will  focus my response on what I see as its  three most appealing aspects: (1) it provides a simple and intuitive approach to monetary policy, (2) it focuses monetary policy on that over which it has meaningful influence, and (3) its simplicity makes it  easier to implement  than other  popular alternatives. Let's consider each point in turn.

(1) It provides a simple and intuitive approach to monetary policy.   This first point can be  illustrated by considering the following scenario. Imagine the U.S. economy is humming along at its full potential.  Suddenly a large negative shock, say a housing bust, hits the economy.  This development leads to a decline in expectations of  current and future economic activity.  As a result, asset prices decline,  financial conditions deteriorate, and there is a rush for liquidity.  The rise in demand for liquidity means less spending by households and firms and thus, less total current dollar spending in the U.S. economy.  Because prices do not adjust instantly, this drop in nominal spending causes a decline in real economic activity too.  Thus, even though the primal cause of the decline in the real economy was the housing bust, the proximate cause  was the drop in total current dollar spending.  The Fed cannot undo the housing bust, but it can prevent the drop in total current dollar spending by providing enough liquidity to offset  the spike in liquidity demand.  If nominal spending has not been stabilized then the Fed has failed to do this.  A nominal GDP target, then, is simply a mandate for the Fed to stabilize total current dollar spending.

Though a simple objective, stabilizing nominal spending is key to macroeconomic stability. The figure below shows that changes in the growth rate of total current dollar spending (i.e. nominal GDP)  got transmitted mostly to changes in the growth rate of real economic activity (i.e. real GDP) rather than inflation (i.e. GDP Deflator).  This implies that had monetary policy done a better  job stabilizing nominal spending then there would have been fewer recessions during this time. (Click on figure to enlarge.)

(2) It focuses monetary policy on that over which it has meaningful influence. There are two types of shocks that buffet the economy: aggregate supply (AS) shocks and aggregate demand (AD) shocks.  A nominal GDP targeting rule only responds to AD shocks.  It ignores AS shocks while keeping total current dollar spending growing at a stable rate.  This is the way it should be.  For if monetary policy attempts to offset AS shocks it will tend to increase macroeconomic volatility rather than reduce it.  For example, let's say Y2K actually turned out to be hugely disruptive for a prolonged period. This negative AS shock would reduce  output and increase prices.  A true inflation targeting central bank would have to respond to this negative AS shock by tightening monetary policy, further constricting the economy. A nominal GDP targeting central bank would not face this dilemma. It would simply keep nominal spending stable.

In general, any kind of price stability objective for a central bank is bound to be problematic because price level  changes can come from either AD or AS shocks and are hard to discern.  For example, was the low U.S. inflation in 2003 the result of  a weakened economy (a negative AD shock) or robust productivity gains (a positive AS shock)? It makes much more sense to focus on the underlying economic shocks themselves rather than a symptom of them (i.e. price level changes).  Nominal GDP targeting does that by focusing just on AD shocks. This point is graphically illustrated here using the AD-AS model. More discussion on this point can be found here.

(3) Its simplicity makes it easier to implement  than other  popular alternatives. This is true on many front.  First, a nominal GDP target requires only a measure of the current dollar value of the economy.  It does not require knowledge of the proper inflation measure, inflation target, output gap measure, the neutral  federal fund rate, coefficient weights, and other elusive information that are required for inflation targeting and the Taylor Rule.  There will always be debate on which form of the above measures is appropriate.  For example, should the Fed go with the CPI or PCE, the headline inflation measure or the core, the CBO's output gap or their own internal estimate, the original Taylor Rule or the Glenn Rudebush version, etc.? A nominal GDP target avoids all of these debates.  

Second, nominal GDP targeting would also be easier to implement because it is easy to understand.  The public can comprehend the notion of stabilizing total current dollar spending. It is less clear they understand  output gaps, core inflation, the neutral federal funds rate, and other esoteric elements now used in monetary policy.  The Fed would have a far easier time explaining itself to congress and the public if it followed a nominal GDP target. On the flip side, this increased understanding by the public would make the Fed more accountable for its failures. 

Third, a nominal GDP target would take the focus off of inflation and what its appropriate value should be. Thus, if there needed to be some catch-up inflation and nominal spending to get nominal GDP back to its targeted growth path the Fed could do it with less political pressure. 

Some folks argue that the nominal GDP targeting is nothing more than just a special case of a Taylor Rule. Maybe so, but they miss the bigger point that nominal GDP targeting is a far easier approach to implement for the reasons laid out above.  Moreover, in practice the Fed has deviated from the Taylor Rule and during these times it appears to be more of a pure inflation targeter.  Thus, adopting an explicit nominal GDP target would force the Fed to stick to stabilizing nominal spending at all times. 

Ultimately, I would like to see the Fed adopt not only a nominal GDP level target, but a forward-looking one that targeted nominal GDP futures market.  This is an idea that Scott Sumner and Bill Woolsey have been promoting for some time. See here and here for more on this proposal.

Monetary Policy Can Save the Eurozone, For Now

The Weekly Standard has an article by Christopher Caldwell on the challenges facing the Eurozone.  It is an interesting article that has as its main thesis the following:

Europe’s countries now face the choice of giving up either their newfangled money or their ancient national sovereignties. It is unclear which they will choose.

This is a conventional view, but is it correct? Are the choices really limited to saving the Euro or preserving national sovereignties?  For the long-run the answer is probably yes. It is difficult to make a monetary union work without a political union.  For many of the economic shock absorbers needed to make a monetary union work--common treasury, fiscal transfers, labor mobility, price flexibility--either require a political union or would be more effective with one.

In the short-run, though, there is another option: more monetary easing by the ECB.  As Ryan Avent explains, further easing by the ECB would cause a real depreciation for the Eurozone periphery vis-a-vis the Eurozone core:

[T]he key to a relatively painless internal revaluation is inflation in tighter markets. And it's here that the European Central Bank could play a particularly useful role. Were the ECB to adopt a looser monetary policy, we would expect inflation to pick up first in the markets with the least excess capacity, and that would obviously mean rising prices for Germany.

Prices, therefore, would increase more in Germany than in the troubled periphery.  Good and services from the periphery would then be relatively cheaper.  Thus, even though the exchange rate among them would not change, there would be a relative change in their price levels.  This  would make the Eurozone periphery more externally competitive.  The relative price level change would not be a permanent fix to structural problems facing the Eurozone, but it would provide more time to address the problems.  Unfortunately, this is not likely to happen. The one thing Germans hate more than Eurozone bailouts is Eurozone inflation.

Hoity-Toity Fed People

It has been frustrating to watch Fed officials explain QE2.  The standard Fed story centers around the QE2 driving down long-term interest rates and stimulating more borrowing.  As I have repeatedly noted, this narrow focus on the interest rate channel leaves out many other channels through which monetary stimulus can work.  Moreover, it creates the wrong impression that QE2 will only be successful if long-term interest rates are held low.  Thus the rising long-term yields are seen by many observers as indicating QE2 is a failure when the opposite is probably true.  An anonymous commentator from my previous post eloquently summarizes this  confusion coming from the Fed's marketing of QE2:

I agree that rising yields actually indicate that QE2 is working.

But I also have sympathy for all the people who get "confused," because, of course, you have had hoity-toity Fed people themselves saying that one mechanism through which QE will stimulate things is by lowering long-term rates, supporting housing prices, and so on and so forth.

Bottomline, it would sure help if the Fed would clearly and succinctly communicate (a) the mechanisms by which its policies are supposed to work and (b) the sign-posts and markers (e.g., asset price movements) for people to look at to ascertain whether things are going as intended.

Right now we have the utter IRONY of QE2 working exactly as it was intended (thank the lord) and the "experts/pundits" getting downright angry because what they're seeing is not what they expected to see, and, of course, what they expected to see is simply no more and no less than what they were told to expect by the very people who are implementing QE2.

Well said.

Jeremy Siegel Gets It

Jeremy Siegel is making the case the case that rising yields indicate the Fed's policy is actually working:

The recent surge in long-term Treasury yields has led many to say that the Fed's second round of quantitative easing is a failure. The critics predict that QE2 may end up hurting rather than helping the economic recovery, as higher rates nip in the bud any rebound in the housing market and dampen capital spending. But the rise in long-term Treasury rates does not signal that the Fed's policy has backfired. It is a sign that the Fed's policy is succeeding.

Long-term Treasury rates are influenced positively by economic growth—which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity—and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields. 

The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up. It has also lowered risk aversion, which implies rising long-term rates. The evidence for a decline in risk aversion among investors is the shrinkage in the spreads between Treasury and other fixed-income securities, the strong performance of the stock market, and the decline in VIX, the indicator of future stock-market volatility. This means that expectations of accelerating economic growth—and a reduction in the fear of a double-dip recession—are the driving forces behind the rise in rates. 

More and more observers are picking up on this notion that rising yields may be reflecting an improving economic outlook. As I have noted before, this is a welcome reprieve from the common but wrong view that QE2's success is dependent on the Fed maintaining low long-term interest rates.  The correct story goes something like this: higher expected inflation from QE2 should increase expected nominal spending and in turn raise expected real economic growth (given sticky prices and excess capacity).

Here is the latest figure on the 10-year expected inflation (red line) and the 10-year real yield (blue line) from the TIPs market. It continues to show an upward march for real yields. 

Update: Underscoring the view that rising yields indicate an improved economic outlook, Catherine Rampell notes three good economic reports came out today (retail sales, small business optimism index, and ppi) and that economic forecasts are being revised up.