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Monday, September 18, 2017

Is Larry Summers a Fan of Nominal GDP Level Targeting?



You are going to have listen to my podcast with him to find out the answer. Here is a hint: we spent a portion of the show talking about NGDP level targeting (NGDPLT) and what it would take to actually get it implemented it at the Federal Reserve. So listen to the show to find out Larry's thoughts on NGDPLT as well as his views on secular stagnation, Fed policy since the crisis, and macroeconomic policymaking in real time. It was a fun interview. 

P.S. You can also read the transcript of our interview.
P.P.S. For those interested in NGDPLT here is my latest policy brief on it and here is a longer research paper on it.

Will Shrinking the Fed's Balance Sheet Matter?

This week the Fed is expected to announce it will begin shrinking its balance sheet. Will it matter? 

To answer that question it is useful to first recall how and why the Fed's balance sheet was expanded. Between December 2008 and October 2014 the Fed conducted a series of large scale asset purchases (LSAPs) that expanded its balance sheet from about $900 billion to $4.5 trillion. That is an expansion of about 500 percent. 

The Fed turned to LSAPs for additional stimulus when its target for the federal funds rate—the traditional tool of U.S. monetary policy—hit the zero lower bound in late 2008. The main theory the Fed used to justify the LSAPs was the portfolio balance channel. It says that because of market segmentation the Fed's purchase of safe assets would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower long-term interest rates, and push up asset prices. This would help the recovery. 

LSAPs were supposed to trigger the portfolio balance channel by reducing the relative supply of safe assets to the public. This reduction in safe asset supply to the public can be seen by looking at the growing share of safe assets held by the Fed under the various QE programs. The Figure below shows this development for marketable U.S. treasury securities:


This figure also shows another development that has taken place since late 2014: the Fed's share of treasuries has been shrinking. I call this the Fed's "reverse QE" program. Per the portfolio channel, this should be a passive tightening of monetary policy as the Fed's share of safe assets has fallen. Put differently, this should be portfolio rebalancing in reverse that causes long-term treasury yields to rise. 

The figure below, however, shows the opposite has happened under "reverse QE". Other than the Trump bump, 10-year treasury yields have been heading down. Even if we focus just on the ZLB period of "reverse QE"--October 2014 through December 2015--we still see this pattern:



So what does this all mean? It suggests that outside of the 2008-2009 crisis period the portfolio balance channel never really mattered. There are good theoretical reasons for this conclusion as noted by Michael Woodford, John Cochrane, and Stephen Williamson.1 It is not clear, then, that QE2 and QE3 made much difference to the recovery. To be clear, there is some empirical evidence that shows some small-to-modest results for these programs. Even if these results are taken as given, however, most evidence points to this success coming from the signaling channel rather the portfolio balance channel.2

This implies the Fed's shrinking of its balance sheet should not be a big deal. The Fed has been signaling for some time it would start shrinking its balance sheet this year. It even released a detailed plan in June of how it will happen. So there should be no surprises--the Fed is carefully using the signaling channel to keep markets calm. Given this signaling and the lack of a binding portfolio balance channel,  the concerns about the shrinking of the Fed balance sheet causing monetary policy to tighten are mostly noise.

I say mostly noise because there is one potential concern. It is the financial pressure caused by the new regulatory demands of the liquidity coverage ratio running up against the spread between IOER and treasury bills. I wrote about this issue awhile back in an OpEd:
The second reason the scaling back of the Fed's balance sheet may be challenging is that post-2008 regulation now requires banks to hold more liquid assets. Specifically, banks now have to hold enough high-quality liquid assets to withstand 30 days of cash outflow. This liquidity coverage ratio has increased demand for such assets of which bank reserves and treasury securities are considered the safest. So, in theory, as the Fed shrank its balance sheet, the banks could simply swap their excess reserves (that the Fed was pulling out of circulation) for treasury bills (that the Fed was putting into circulation). The challenge, as observed by George Selgin, is that the Fed's interest on excess reserves has been higher than the interest rate on treasury bills. This creates relatively higher demand for bank reserves.  
Banks would not want to give up the higher-earning bank reserves at the very moment the Fed was trying to pull them out of circulation. This tension could create an effective shortage of bank reserves and be disruptive to financial markets. The solution here would be for the Fed to lower the interest on excess reserves to the level of treasury bill interest rates.
The figure below illustrates this potential problem. It shows the Fed's upper and lower bounds on the federal funds rate and the 1-month treasury bill interest rate. These upper bound is the IOER and the lower bound is the reverse repo rate. The reverse repo rate has (sort of) anchored the 1-month treasury bill yield, but the issue is the spread between it and the IOER. Why would  banks want to give up bank reserves for treasury bills when reserves earn at least 25 basis points more than treasury bills? The Fed will be pushing against this demand when it tries to pull the excess reserves out of the banking system. Good luck wth that. 


To summarize, we need not worry about the portfolio balance channel kicking into reverse as the Fed begins shrinking its balance sheet. We should, however, worry about the distortions created by the positive IOER-treasury bill yield spread as Fed unwinds its asset holdings. The Fed can fix this problem by equalizing IOER and short-term market interest rates.

Update: Cardiff Garcia reviews a research note by Nomura's Lew Alexander on shrinking the Fed's balance sheet. Also, Nick Timiraos has a nice long piece on the Fed's LSAPs in the WSJ.
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1Theoretical Problems with the Portfolio Balance Channel. The portfolio balance channel as envisioned by the FOMC relied on controversial assumptions about segmented markets and the Fed being a more efficient financial intermediary than other financial firms. On the first assumption, if the Fed can truly affect long-term treasury interest rates because the long-term treasury market is segmented from other markets, then by definition actions in the treasury market should not spill over into other markets. Put differently, portfolio rebalancing cannot take place in truly segmented markets. On the second assumption, if the Fed takes duration risk off of private-sector balance sheets via LSAPs, the risk really has not gone away since those long-term assets are now on the Fed’s balance sheet which, in turn, is backed-up by the tax payer. The private sector is still bearing the risk. The Fed, in other words, is not some special financial intermediary that can transform and diversify away the riskiness of the assets it purchases. This is the Modigliani-Miller theorem critique applied to central bank asset purchases as shown by Wallace (1981). Ben Bernanke acknowledged this theoretical tension by famously quipping that the “problem with QE is it works in practice not in theory.”

During the financial crisis the above assumptions were probably reasonable when markets froze up and the Fed become the lender of last resort. So QE1 probably made a meaningful difference. But after the crisis it is hard to make a convincing case for the assumptions holding. That is why QE2 and QE3 probably did not pack much punch. See Stephen Williamson, John Cochrane, or Michael Woodford (p. 61-65) for more on the theoretical problems with the Fed's understanding of the portfolio balance channel.

2The signaling channel is based on the idea that the LSAPs indicate a firm commitment by the Fed to keep interest rates low for a long period that would not be evident in the absence of the LSAPs.

Friday, September 15, 2017

Monetary Regime Change: Mission Accomplished

Christina Romer, former CEA chair, called for a monetary regime change several times between 2011 and 2013. It is now several years later and it appears we did finally get a monetary regime change. Unfortunately, it is not the kind of regime change Christina advocated and actually goes in the opposite direction. 

Christina called for the Fed to adopt a nominal GDP level target that would restore aggregate demand to its pre-crisis growth path. Instead, we got a regime change that has effectively lowered the growth rate and the growth path of aggregate demand. This regime change, in my view, is behind the apparent drop in trend inflation that Greg Ip recently reported on in the Wall Street Journal. 

It is not easy to change trend inflation--just ask Paul Volker--but the Fed and other forces seemingly accomplished just that over the past decade. Since the end of the crisis, the average inflation rate on the Fed's preferred measure of inflation, the core PCE deflator, has fallen to 1.5 percent The headline PCE deflator average has fallen to 1.4 percent over the same period. Both are well below the Fed's target of 2 percent. 

This persistent shortfall of inflation has received a lot of attention from critics, including me. Lately, some Fed officials are also beginning to see the inflation shortfall as more than a series of one-off events. Governor Lael Brainard's recent speech is a good example of this change in thinking with her acknowledgement that trend inflation may be falling.

Still, there is something bigger going on here that is being missed in these conversations about the inflation rate. A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.



The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  

Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path. 

Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. So this is a joint monetary-fiscal problem that has effectively created a monetary regime change.

So yes, we got a monetary regime change, but no it is not the one Christina Romer and most of us wanted. 

Tuesday, August 22, 2017

The IOER Debate Redux

Back in the glory days of macroeconomics blogging there was a lot of electronic ink spilled over interest on excess reserves (IOER). Commentators, including myself, debated whether IOER mattered to the recovery or if it was just another innocuous tool for the Fed to control interest rates. 

I generally argued that the IOER did matter for the economy--it was more than just a new tool. It began with a call I  made in October 2008 that the introduction of IOER that month was likely to be contractionary. In later conversations, I acknowledged that, yes, the Fed does sets the aggregate level of reserves. Even so, I retorted, banks could still influence the composition of all those reserves based on their investing decisions. These decisions, in turn, could be influenced by the level of IOER. That is, if IOER were set high relative to other safe asset yields then banks might decide to invest in excess reserves rather than in other safe assets like treasury bills. This could stall the 'hot potato' process and affect the recovery. For example, imagine the economy starts heating up and, as a result, the demand for loans picks up. Banks facing this increased pressure for money creation might opt to invest in excess reserves instead of loans if the risk-adjusted return on excess reserves were high enough. That could happen by raising IOER sufficiently high. Consequently, IOER mattered to macroeconomic policy and needed to be set appropriately.

The above paragraph roughly summarizes my position during the many IOER debates that took place over the past decade. Needless to say, I got plenty of pushback and there were many spirited debates. These exchanges sharpened my thinking on the topic. Here, for example, is a long write up from Cardiff Garcia at FT Alphaville on one such debate in 2012. Those were fun times, but folks generally moved on to other conversations.  

One person, though, who kept the IOER conversation going is George Selgin. He has written extensively on IOER, most recently in a 60-page testimony to the House Committee on Financial Services. In it, Selgin argues that the Fed has, in fact, set the IOER too high and this has been a drag on the recovery. Along these lines, he presented a chart on page 20 that shows what appears to be a systematic relationship between (1) an IOER and comparable market interest spread and (2) the relative demand for excess reserves. 

The chart was intriguing, but its sample period did not span the whole IOER period. So I wanted to see if the relationship was robust across the period. Also, I thought it would be useful to look at the actual holders of the excess reserves. The figure below shows the combined cash assets of "large domestically-charted banks" and "foreign-related" banks as reported in the Fed's H8 report. These combined cash assets track excess reserves fairly closely. These two types of banks, then, are the main holders of excess reserves.


Following Selgin's example, I plotted the (1) spread between the IOER and the overnight LIBOR and (2) cash assets as percent of total assets. I did so for both the foreign-related and large domestic banks. If the IOER spread does in fact cause banks to hold more excess reserves relative to other assets, then we would expect the banks share of excess reserves in the portfolios to go up with the spread. 

The figure below confirms that this is the case for the foreign-related banks for the period December 2008 - July 2017. The relative yield on excess reserves does seem to influence the real demand for excess reserves. 


The next figure puts these two series together in a scatterplot. The IOER - excess reserve relationship is strong with a R2of 73%.



Next, I looked at domestically-chartered banks. There is still a positive relationship here, but it is weaker as seen in the next two figures.




The last figure shows the relationship is not trivial--it has an R2of 41%--but it is nowhere near the strength of the foreign banks. So for some reason the IOER-Libor spread  creates a stronger incentive for foreign banks to hold comparatively more excess reserves.  That is an interesting observation worthy of future exploration.

The main takeaway, though, from the above figures is that it appears Selgin's claim is correct. A rise in the IOER spread does seem to influence the relative demand for excess reserves, with the effect being  strongest for foreign banks in the United States.This implies the IOER is more than just a new interest rate tool for the Federal Reserve. George Selgin may have just rekindled the IOER debate. 

Friday, July 21, 2017

Assorted Musings

Some Assorted Musings:

1.  I have a new policy brief at the Mercatus Center that makes the case for a Nominal GDP level target from the knowledge problem perspective. It is a non-technical paper meant to be accessible by policy makers and lay people. It echoes some of the  more technical arguments made in this paper by Josh Hendrickson and myself. 

 2. George Selgin testified this week before the House Financial Services Committee as part of the hearing Monetary Policy v. Fiscal Policy: Risks to Price Stability and the Economy. His testimony is a tour de force through the issue of interest on excess reserves

3.  Scott Sumner pushes back against all the macro moralists waving their finger at Germany for running current account surpluses. He argues it is mistaken to blame Germany's current account surplus for dragging down global demand growth. 

4. Is any part of potential GDP endogenous to the level of aggregate nominal demand? This is a question we have looked at before on this blog. A new paper reexamines this issue and concludes the answer is yes. Below are the key figures from the paper. The first one shows the standard CBO potential GDP estimates over time against a new estimate. Matthew Klein reports on the paper. 



Wednesday, July 5, 2017

An Alternative to Raising the Inflation Target

Ramesh Ponnuru and I have a new article in the National Review where we make the case that a better alternative to a higher inflation target is a NGDP level target:
Does the U.S. economy need more inflation? A group of 22 progressive economists has written a letter to the Federal Reserve urging it to appoint a blue-ribbon commission to study whether the central bank should raise its target for inflation above its current 2 percent. Fed chairman Janet Yellen, in her press conference following the latest interest-rate increase, called it “one of the most important questions” facing the organization. The economists’ advice shouldn’t be rejected out of hand, but it should be rejected. They make some valid points in their diagnosis of the ills of the current monetary regime. But the Fed can and should address these problems without raising inflation...  
These arguments for a higher inflation target are reasonably strong if you accept the premise that keeping inflation stable should be the Fed’s principal task in the first place. There is, however, a superior alternative. That alternative would stabilize the growth of nominal spending: the total amount of dollars spent throughout the economy...  
This policy would capture the benefits of inflation targeting...A key difference between the two policies is that a nominal-spending target would allow inflation to fluctuate over the short term in response to movements in productivity. 
In general, a nominal GDP level target allows for more inflation flexibility than is currently seen in practice while keeping the growth path of nominal demand stable. This rule would also improve over  current approaches by better risk-sharing in the financial system, better aligning of the Fed's interest interest rate with the natural interest rate, and better maintenance of money neutrality. Finally, its an target that invokes the imagery of Chuch Norris and Jean-Claude Van Damme.

Friday, June 16, 2017

Monetary Disequilibrium



This week on the podcast I had a great time talking the monetary disequilibrium view of business cycles with Steve Horwitz. This perspective sees the deviation between desired and actual money holdings as the cause of business cycles.  Since money is the one asset on every market, all one needs to do is disrupt monetary equilibrium and you have disrupted every other market. This is not true for any other asset. The monetary disequilibrium view, in short, takes money seriously.

This understanding is different than the dominant view today that sees business cycles being the result of deviations between the expected paths of the natural and actual real interest rate. After the show I asked Steve if there was mapping between these these two views and he said yes. The views should be complementary. Nonetheless, the monetary disequilibrium view rarely get a hearing so I was really glad to do this interview with Steve. 

I have also posted below a presentation I used to give my undergraduates on monetary disequilibrium. It provides some of the graphs Steve mentioned in the interview. Finally, I highly recommend Leland Yeager's book The Fluttering Veil: Essays on Monetary Disequilibrium. Yeager was a leading advocate of this view and his book provides an accessible introduction to the topic. [Update: for those wanting a formal treatment see this Josh Hendrickson paper (ungated version)]