Interview, talk, and slides - Barokong

August 14, 2020    Comment   

Interview, talk, and slides - Barokong

I did an interview with Cloud Yip at Econreporter, Part I and Part II, on various things macro, money, and fiscal theory of the price level. It's part of an interestingseries on macroeconomics. Being a transcript of an interview, it's not as clean as a written essay, but not as incoherent as I usually am when talking.

On the same topics, I will be giving a talk at the European Financial Association, on Friday, titled  "Michelson-Morley, Occam and Fisher: The radical implications of stable inflation at the zero bound,"slides here. (Yes, it's an evolution of earlier talks, and hopefully it will be a paper in the fall.)

And, also on the same topic, you might find useful a set of slides for a 1.5 hour MBA class covering all of monetary economics from Friedman to Sargent-Wallace to Taylor to Woodford to FTPL.  That too should get written down at some point.

The talk incorporates something I just figured out last week, namely how Sims' "stepping on a rake" model produces a temporary decline in inflation after an interest rate rise. Details here. The key is simple fiscal theory of the price level, long-term debt, and a Treasury that stubbornly keeps real surpluses in place even when the Fed devalues long-term debt via inflation.

Here is really simple example.

Contrast a perpetuity with one period debt, and a frictionless model. Frictionless means constant real rates and inflation moves one for one with interest rates

$$ \frac{1}{1+i_t} = \beta E_t \frac{P_t}{P_{t+1}} $$

The fiscal theory equation, real value of government debt = present value of surpluses,  says

$$\frac{Q_t B_{t-1}}{P_t} = E_t \sum \beta^j s_{t+j}$$

where Q is the bond price, B is the number of bonds outstanding, and s are real primary surpluses. For one period debt Q=1 always. (If you don't see equations above or picture below, come back to the original here.)

Now, suppose the Fed raises interest rates, unexpectedly,  from \(i\) to \(i^\ast\), and (really important) there is no change to fiscal policy \(s\). Inflation \(P_{t+1}/P_t\) must jump immediately up following the Fisher relation. But the price level \(P_t\)might jump too.

With one period debt, that can't happen -- B is predetermined, the right side doesn't change, so \(P_t\) can't change. We just ramp up to more inflation.

But with long-term debt, any change in the bond price Q must be reflected in a jump in the price level P. In the example, the price of the perpetuity falls to

$$ Q_t = \sum_{j=1}^\infty \frac{1}{(1+i^\ast)^j} = \frac{1+i\ast}{i^\ast}$$

so if we were expecting P under the original interest rate i, we now have

$$\frac{P_t}{P} = \frac{1+i^\ast}{1+i} \frac{i}{i^\ast}$$

If the interest rate rises permanently from 5% to 6%, a 20% rise, the price level jumps down 20%. The sticky price version smooths this out and gives us a temporary disinflation, but then a long run Fisher rise in inflation.

Do we believe it? It relies crucially on the Treasury pigheadedly raising unchanged surpluses when the Fed inflates away coupons the Treasury must pay on its debt, so all the Fed can do is rearrange the price level over time.

But it tells us this is the important question -- the dynamics of inflation following an interest rate rise depend crucially on how we think fiscal policy adjusts. That's a vastly different focus than most of monetary economics. That we're looking under the wrong couch is big news by itself.

Even if the short-run sign is negative, that is not necessarily an invitation to activist monetary policy which exploits the negative correlation. Sims model, and this one, is Fisherian in the long run -- higher interest rates eventually mean higher inflation. Like Friedman's example of adjusting the temperature in the shower, rather than fiddle with the knobs it might be better to just set it where you want it and wait.

Yellen Questions - Barokong

August 08, 2020    Comment   

Yellen Questions - Barokong

Fed chair Janet Yellen gave a remarkable speech at a Fed conference in Boston. I have long wanted to ask her, "what are the questions most on your mind that you would like academics to answer?" That's pretty much the speech.

Some commenters characterized this speech as searching for reasons to keep interest rates low forever. One can see the logic of this charge. However, the arguments are thoughtful and honest. If she's right, she's right.

The last, and I think most important and revealing point, first:

1. Inflation

"My fourth question goes to the heart of monetary policy: What determines inflation?"

"Inflation is characterized by an underlying trend that has been essentially constant since the mid-1990s; .... Theory and evidence suggest that this trend is strongly influenced by inflation expectations that, in turn, depend on monetary policy....The anchoring of inflation expectations...does not, however, prevent actual inflation from fluctuating from year to year in response to the temporary influence of movements in energy prices and other disturbances. In addition, inflation will tend to run above or below its underlying trend to the extent that resource utilization--which may serve as an indicator of firms' marginal costs--is persistently high or low."

I think this paragraph nicely and clearly summarizes the current Fed view of inflation. Inflation comes from expectations of inflation. Those expectations are "anchored" somehow, so small bursts of or disinflation will melt away. On top of that the Phillips cure -- the correlation between inflation and unemployment or output -- is causal, from output to inflation, and pushes inflation up or down, but again only temporarily.

What a remarkable view this is. There is no nominal anchor. Compare it, say, to Milton Friedman's MV=PY, the fiscal theory's view that inflation depends on the balance of government debt to taxes that soak up the debt, the gold standard, or John Taylor's rule. In the Yellen-Fed view, "expectations" are the only nominal anchor.

Even Fisher’s interest rates have vanished from the economics of inflation. Nominal interest rate = real interest rate plus expected inflation suggests something linking nominal interest rates and inflation, but that's gone too.

You can see also the implication: don’t worry about energy prices and other “disturbances” to inflation. Don’t even worry about "overheated" real economies, temporary Phillips-curve induced bouts of inflation. With "anchored" expectations, the inflation will melt away.

To be sure, “inflation expectations..in turn, depend on monetary policy.” But just how?

“…we need to know more about the manner in which inflation expectations are formed and how monetary policy influences them. Ultimately, both actual and expected inflation are tied to the central bank's inflation target, whether that target is explicit or implicit. But how does this anchoring process occur? Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform? Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future?”

The two paragraphs together are an interesting melange of old and new Keynesian economics. In full-on new-Keynesian economics, the answer to my question is straightforward. The Fed announces an inflation target, and a rule following the Taylor principle: for each 1% that inflation exceeds or undershoots the target, the interest rate will rise more than 1%. In new-Keynesian models, this leads to inflation or deflation that spirals away from the target. So, this threat of hyperinflation or deflation “coordinates expectations” around the Fed’s target. It’s a Dr. Strangelove sort of target — do what we want or we blow up the world.

What if inflation is so low that interest rates hit zero, as they have for the past 8 years? Don’t worry, sooner or later a shock will come and inflation will rise all on its own, the Fed can start manipulating inflation again. So, expectations that the Fed will in the future go about this Dr. Strangelove business can still anchor expectations of future inflation around the Fed’s target, and, working back, inflation today.

You can tell that this is a step too far for Mrs. Yellen, and most policy people trained in the 1970s (and me too, but for other reasons). Though “marginal costs” enter her Phillips curve, and though expectations of future inflation clearly anchor that Phillips curve, she clearly does not buy the idea that monetary policy affects those expectations by threatening explosive interest rates. Here she clearly has in mind the old-Keynesian view that higher interest rates lower and stabilize subsequent inflation, not the other way around.

Half her heart goes with adaptive expectations — “Does a central bank have to keep actual inflation near the target rate for many years before inflation expectations completely conform?” Anchored expectations come from the Fed’s painful success in the 1980s, and belief that it will do that again. But half her heart goes with the promise of new-Keynesian models: “Can policymakers instead materially influence inflation expectations directly and quickly by simply announcing their intention to pursue a particular inflation goal in the future?”

You see here some of the debate between the traditional ISLM Keynesians and monetarists at the Fed, on one side, and the promise of these new-Keynesian elements on the other. Both sets of traditional models took their adaptive expectations seriously, and worried that any increase in inflation would raise expectations of inflation and off to 1970s we go. Now both sets of traditionalists are the doves.

How much easier it could be to simply announce an inflation target, everyone believes it, and inflation or lack of inflation follows! It’s the ultimate in speak loudly enough and you don’t even need a stick.

I' skeptical. I think people have heard a lot of promises from public officials, and believe nearly none of them. Every year for the last about half-century the secretary of the Treasury has issued a forecast that the deficit will be eliminated one year after the President’s term ends. How many people in the US know the difference between Janet Yellen and Judge Judy? You have to spend a lot of time inside the walls of the Fed to think that Fed announcements of what their inflation target will be 10 years from now makes a difference to anyone but about 100 bond traders.

Our thesis topic for the week: Is it possible to write down this melange of new and old Keynesian models? You are looking for some model in which higher interest rates lower future inflation, which usually takes adaptive expectations, yet an announcement of a target can anchor expectations, which usually takes rational, forward-looking ones. I guess it’s possible to write down any model, so I should qualify, in a simple and vaguely believable way?

(I should put my horse in the race. I think the “anchor” is fiscal policy. Expected inflation is stable so long as people think fiscal policy is in control. That makes Mrs. Yellen right in a lot of ways. However, higher interest rates might make people quickly realize fiscal policy is not under control, which makes her critics’ nervousness also right. But today is not about my answer or the right answer, it's about Mrs. Yellen's and the Fed's views. I say this mostly so that I don’t get counted as one or the other side of the current hawk v dove debate.)

2. The Phillips curve

"While this general framework for thinking about the inflation process remains useful, questions about some of its quantitative features have arisen in the wake of the Great Recession and the subsequent slow recovery. For example, the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis..."

Translation. Inflation just sat there and did nothing in the face of the hugest unemployment we've seen since the great depression. The Phillips curve, relating inflation to unemployment or output, has completely fallen apart.  This being the central piece of economics in Fed story for how it affects inflation — higher rates lead to less output and employment, lower marginal costs, lower prices — we’re a bit befuddled.

The implications of a vanishing Phillips curve are fun to debate. At a recent meeting at the Fed, I opined it was falling apart because huge variation in unemployment correlated with tiny changes in inflation. No, my counterpart said with a wry smile! It means that we can cure unemployment with only half a percentage point more inflation!

Putting the last two observations together, I think we see where the Fed is going. If inflation is just a trend, battered around by commodity prices, anchored by speeches, and immune to anything the Fed actually does; then that frees the Fed from what used to be its main job -- worrying about inflation -- to just worry about real stimulus with no worry about inflation. Moreover, if unemployment can skyrocket with no huge deflation, as it did, then the Fed can push unemployment way down without worry about more inflation, even in the short run. Instead of the Fed mainly determining inflation, with recessions an unfortunate byproduct, we now have a vision of the Fed mainly worrying about real stimulus, and not needing to worry about inflation. The fact that my first point, inflation, was Mrs. Yellen's last, encourages this reading.

3. Hysteresis. Does demand create its own supply? And vice versa.  (Yes, the Say's law echo is intentional.)

."..one study estimates that the level of potential output is now 7 percent below what would have been expected based on its pre-crisis trajectory, and it argues that much of this supply-side damage is attributable to... the deep recession and slow recovery..... a marked slowdown in the estimated trend growth rate of labor productivity. The latter likely reflects an unusually slow pace of business capital accumulation since the crisis and, more conjecturally, the sharp decline in spending on research and development and the very slow pace of new firm formation in recent years."

It is easy to read this as the latest excuse for dovishness, a new instance of the answer in search of a question. But take the argument seriously. Surely "demand" and "supply" -- poor concepts in the first place -- do leak to each other. If "demand" causes a long depression of investment in human or physical capital, then "supply" will be lower.

"...the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market. ...More research is needed, however,.."

I hope the Fed will do that more research before jumping on this theory. Casual investigation of past episodes are not promising. The late 1970s are the textbook case of a "high pressure economy" stimulated by monetary policy and "demand." They did not produce wonders of "supply," either of greater capital or more economic efficiency.

"More generally, the benefits and potential costs of pursuing such a strategy remain hard to quantify, and other policies might be better suited to address damage to the supply side of the economy."

I have noticed a tendency for Fed economists to work hard on issues that have an ear at the top. I  wish Mrs. Yellen had mentioned one or two such "other policies" to reduce the chance that this is interpreted as a throw-away line, not an invitation to write papers proving hysteresis.

4. Heterogeneity.

For nearly a century, the main simplification of macroeconomics has been to gloss over differences between people. "Consumption" and "employment" may be too high or low, but the fact that gains and losses are not spread evenly does not matter, to first order, when understanding the movements of the same aggregates. Note, I do not say they don't matter -- they matter a lot. If one in 10 loses their job, it matters a lot to the person losing the job. The issue is, if you want to know how monetary policy affects average employment or consumption, does it matter that 1 in 10 loses a job and the rest keep their jobs, vs. each of us working 10 percent fewer hours?

Of course it matters, the layman says. But simplification is the key to progress in any science. Chemistry did not get going by working out quantum mechanics. Furthermore, you can see quickly that heterogeneity matters only if economic decisions are nonlinear -- and we know how to model that nonlinearity. Linear decisions add up and behave just like a single household with the average response. Again, the layperson says of course economics is nonlinear. But unless you know just how it's nonlinear, that complication doesn't help. Wrong nonlinearity and state dependence is worse than none at all.

There is a huge new literature on heterogeneity. When a shock hits, some people don't have any savings and have to stop spending, now. Others can dip in to savings. People who lose their jobs are different from people who lose some hours, in big ways.

Watching from afar, I, like Mrs. Yellen, am impressed by this effort, but still scratching my head to understand what it all means for the economy as a whole.

" the various linkages between heterogeneity and aggregate demand [and supply! and equilibrium! Please, Mrs. Yellen, there is more to life than "demand"] are not yet well understood, either empirically or theoretically."

She continues

"More broadly, even though the tools of monetary policy are generally not well suited to achieve distributional objectives, it is important for policymakers to understand and monitor the effects of macroeconomic developments on different groups within society."

That's another sentence that deserves careful study. It is easy to cross the line from "understand and monitor" to target. It's not just easy, it's inevitable. So, the mandate of monetary policy has stretched from price stability to add low interest rates and maximum employment (by statute), to "financial stability," which now means understanding and monitoring, and inevitably trying to control, asset prices, housing prices, debt levels, bank profits (not yet at the Fed, but clearly on the minds of ECB and BOJ policy), and now will be targeting inequality too. I wish for another throwaway line on "other policies." Yes, Fed policy does affect some people more than others. But if the Fed tries to counter the ill effects of other policies -- bad public schools, say -- by monetary policy, it will first do a terrible job of its main objective, and second it can no longer stay independent and a-political.

5. Finance

In light of the housing bubble and subsequent events, policymakers clearly need to better understand what kinds of developments contribute to financial crises. ...

Research on this topic has, of course, been ongoing for some time, and it has expanded greatly in the wake of the financial crisis. But I believe we have a lot more to learn about the ways in which changes in underwriting standards and other determinants of credit availability interact with interest rates to affect such things as consumer spending, housing demand and home prices, business investment (especially for small firms), and the formation of new firms.

I can hardly object to the idea that we need to better understand how finance links to macroeconomics. Since 2008, about 3/4 of the papers at every conference or job market talk are about putting various financial constraints into economic models. I'm interested that Mrs. Yellen is also still looking for something solid to come out of all this.

Again though, one can be quite uncomfortable with the implicit message that the Fed needs to understand everything and try to control -- or at least monitor -- everything. If 8 years of nonstop research have led to so little, is not the program of understand heterogeneity, nonlinearity, inequality, financial "frictions" and linkages, crises and bubbles, and then masterfully address them all, just a little hopeless?

Would the Fed not do better both economically and as an institution to say, "look, our job is the price level. We take care of inflation, we do it independently and a-politically. We are not the master planner of the economy."

6. General comments

As some of the commenters point out, the speech is pretty remarkable for its implicit admission of the fact that the Fed really has very little idea of how its policies work. The jump from cocktail party speculation about, say "hysteresis" or "secular stagnation" or "anchored expectations" to serious consideration of such effects at high levels is pretty short, by scientific standards.

But in defense of Mrs. Yellen and the Fed, Mrs. Yellen is remarkably in touch with the best there is (such as it is) on these questions. I cannot imagine the top-level administrator of any other government agency, from cabinet secretaries on down, anywhere near as conversant with the state and limitations of current research.

Indeed, there is not great academic research answering these questions. And not for want of effort. Saying snarky things about the state of macroeconomics is easy. Coming up with serious answers to Mrs. Yellen’s questions is a lot harder. She is remarkably honest about her, and the Fed’s, limited understanding of the system they are trying to manage.

Compare the Fed here to the rest of the economic policy world -- the FTCs regulation of mergers (about 50 years behind anti-trust economics and legal scholarship), the FCC's regulation of the internet, the SEC's regulation of financial markets, the FSOC (indulging the Fed) regulation of "financial stability,” the CFPB “protection” efforts and so on. Anchoring, hysteresis and heterogeneity are scientific bedrock compared to "contagion," “liquidity," "abuse" and all the other mumbo-jumbo these agencies think they understand and control. And their pretense of knowledge is off the charts greater than Ms. Yellen's humility.

(Thanks to commenters ona previous post who brought up the speech and have active and thoughtful commentary going on.)

New Paper - Barokong

August 03, 2020    Comment   

New Paper - Barokong

A draft of a new paper is up on my webpage, "Michelson-Morley, Occam and Fisher: The Radical Implications of Stable Inflation at Near-Zero Interest Rates." This combines some talks I had given with the first title, and a much improved version of "does raising interest rates raise or lower inflation?"

Abstract:

The long period of quiet inflation at near-zero interest rates, with large quantitative easing, suggests that core monetary doctrines are wrong. It suggests that inflation can be stable and determinate under a nominal interest rate peg, and that arbitrary amounts of interest-paying reserves are not inflationary. Of the known alternatives, only the new-Keynesian model merged with the fiscal theory of the price level is consistent with this simple interpretation of the facts.

I explore two implications of this conclusion. First, what happens if central banks raise interest rates? Inflation stability suggests that higher nominal interest rates will result in higher long-run inflation. But can higher interest rates temporarily reduce inflation? Yes, but only by a novel mechanism that depends crucially on fiscal policy. Second, what are the implications for the stance of monetary policy and the urgency to “normalize?” Inflation stability implies that low-interest rate monetary policy is, perhaps unintentionally, benign, producing a stable Friedman-optimal quantity of money, that a large interest-paying balance sheet can be maintained indefinitely. However, with long run stability it might not be wise for central bankers to exploit a temporary negative inflation effect.

The fiscal anchoring required by this interpretation of the data responds to discount rates, however, and may not be as strong as it appears.

Big novelties in this draft -- at least things I have learned recently:

1) There is now a mechanism that produces a temporary decline in inflation from a rise in interest rates. It comes out of the fiscal theory of the price level and long term debt. If the Fed unexpectedly raises interest rates, that lowers nominal bond prices. If the real present value of surpluses does not change (if monetary policy does not change fiscal policy), then a lower nominal value of the debt and unchanged real value of the debt require a drop in the price level. It works, but it has nothing to do with your grandfather's ISLM, "aggregate demand,'' Phillips curve, money, sticky prices, and so on.

2) In this case and more generally, a temporary decline in inflation when interest rates rise unexpectedly does not rescue traditional policy advice!

It's only temporary! So you do not get long-lasting disinflation or stabilization out of raising rates. Raising rates gives you a temporary disinflation, then inflation gets worse. This is a mechanism perhaps for the 1970s, when each rate rise fell apart in more stagflation -- Chris Sims calls it "stepping on a rake" -- not the 1980s. For that sort of disinflation you need fiscal policy too.

And since only unexpected rate changes have the negative inflation effect, it can't be the basis of systematic, expected policy, like the Taylor rule in old-Keynesian models.

3) If unexpectedly raising interest rates lowers inflation temporarily, and then they go up, and vice versa, that doesn't mean it's a good idea for the Fed to exploit this mechanism for fine-tuning the path of inflation. the Fed is likely better off just raising interest rates and waiting.

In sum, there is a big difference between a temporary negative sign and a long run positive sign, long run stability, and the traditional view which is a temporary and permanent negatives sign and long-run instability.

4) All of this stability needs fiscal backing or "anchoring." Why do people want government debt so much with awful prospective deficits? The only reasonable answer is that we live in a time of very low interest rates. The present value of surpluses is high because the discount rates are low, not because prospective surpluses are large, but because discount rates are low. Discount rates could change quickly.

There will be a few more drafts of this paper and slides and talks. Unless one of you finds a big mistake and clears up my thinking on it.

The fact: interest rates hit zero, and nothing happened. No deflation spiral. No sunspot volatility. It seems that inflation is stable when interest rates are pegged.

Eight Heresies of Monetary Policy - Barokong

June 25, 2020    Comment   

Eight Heresies of Monetary Policy - Barokong

Eight Heresies of Monetary Policy

This is a talk I gave for Hoover, which blog readers might enjoy. Yes, it puts together many pieces said before. This post has graphs and uses mathjax for equations, so if it isn't showing come back to the original. Also here is a pdf version which may be more readable.

Background

As background, the first graph reminds you of the current situation and recent history of monetary policy.

The federal funds rate is the interest rate that the Federal Reserve controls. The funds rate rises in economic expansions, and goes down in recessions. You can see this pattern in the last two recessions. Since about 2012, though, when following history you might have expected the funds rate to rise again, it has stayed essentially at zero. Very recently it has started to rise, but very slowly, nothing like 2005.

The black line is reserves. These are accounts that banks have at the Fed. Crucially, these bank accounts now pay interest. Starting in 2008, reserves grew dramatically from about $20 billion to $2,500 billion. The three cliffs are the three quantitative easing' episodes. Here, the Fed bought bonds and mortgage backed securities, giving banks reserves in exchange.

Inflation initially followed the same pattern as in the last recession. It fell in the recession, and bounced back again in 2012.Inflation has been slowly decreasing since. 10 year government bonds have been quietly trending down, with a bit of an extra dip during the recession.

The next graph plots US unemployment and GDP growth.

You can see we had a deeper recession, but then unemployment recovered about as it always does, or if anything a little faster. You can see the big drop in GDP during the recession. Subsequent growth has been overall too low, in my view, but it has been very steady. If anything, both growth and inflation are steadier in the era of zero interest rates than they were when the Fed was actively moving interest rates around.

These central facts motivate my heresies: Inflation, long term interest rates, growth and unemployment seem to be behaving in utterly normal ways. Yet the monetary environment of near-zero short term rates and huge QE is nothing but normal. How do we make sense of these facts?

Heresy 1: Interest rates

• Conventional Wisdom: Years of near zero interest rates and massive quantitative easing imply loose monetary policy, "extraordinary accommodation,'' and "stimulus.''
• Heresy 1: Interest rates are roughly neutral. If anything, the Fed has been (unwittingly) holding rates up since 2008.

What does a central bank look like that is holding interest rates down? Such a bank would lend money to banks at low interest rates, that banks could turn around and re-lend at higher interest rates. That's how to push rates down.

What does a central bank look like that is pushing rates up? Such a bank takes money from banks, offering to pay banks a higher interest rate than they can get elsewhere.

What's our central bank doing? In bigger format, the top panel of the next graph presents excess reserves. This is money that banks voluntarily lend to the Fed, and on which they receive interest.

Top: Reserves. Bottom: Interest on excess reserves, Fed funds rate and 1-month Treasury rate

The bottom panel is the interest that the Fed pays on excess reserves, along with the Federal Funds rate and the rate on one month treasurys, to give a sense of market rates. As you can see, the Fed pays more than banks can earn elsewhere. So, on this basis, the Fed looks like a central bank pushing rates up, if anything.

Now, as we used to say at the University of Chicago, ok for the real world, but how does that work in theory? How can it be that zero interest rates -- lower than we have seen since the great depression -- are not an unusual stimulus?

Well, it's certainly possible. Remember, the nominal interest rate equals the real interest rate plus expected inflation. If the real interest rate is, say negative 1.5%, and inflation is +1.5%, then a nominal interest rate of zero is neutral.

And, there are plenty of reasons to suspect that the "natural'' real rate has been negative for much of the period since the financial crisis. More savers than investors, low marginal product of capital in a real slow growth environment, and so on are easy stories to tell.

In this view, by the way, as the real rate recovers along with the economy, if the actual nominal interest rate is stuck at zero, then inflation should gently decline. That is also what we see.

Plus, after 8 years, if monetary policy were really "stimulating'' quite so much, where is the inflation and boom?

Heresy 2: Quantitative easing

As we have seen, in its quantitative easing (QE) the Fed bought nearly $3 Trillion of Treasurys and mortgage backed securities, giving banks interest-paying reserves in return.

• Conventional Wisdom: QE lowered long-term interest rate rates, and provided a big stimulus. QE's stimulative effect is permanent and continues to this day, so unwinding QE is vital to "normalizing'' policy.
• Heresy 2: QE did basically nothing to interest rates, or to stimulus.

The next graph is a plot of ten year rates and mortgage rates along with reserves. Again, the steep rises in reserves are the QE episodes.

Ten year treasury rate, 30 year mortgage rate, and reserves

Maybe the first QE is associated with a one percentage point drop in rates. But it bounces right back. Large transactions can move prices, but in the rest of finance we see these as temporary, not permanent movements. In the second and third QE, interest rates rise during the QE episode, exactly the wrong sign.

The bottom panel takes a longer view of interest rates Here you can see that interest rates have been on a steady downward trend since 1985. Can you see any difference in the behavior of these interest rates during the QE period from the late stages of the last three expansions? I can't.

Well, again, so much for the real world, how does it work in theory. As Ben Bernanke himself recognized, QE "works in practice'' or so he thought, but not in theory. We should worry about any proposition that has no theoretical basis. Sometimes facts are ahead of theory, but not often.

The Fed is in essence a huge money market fund. Banks sell bonds to the Fed, and get a money market account, backed by the Fed's holdings of the bonds. Just how much difference does it make for banks to hold treasurys through the Fed rather than directly?

We can think of them as open change operations. Reserves are government debt. So it's as if the Fed took a bunch of your $20 bills and gave you 2 $5s and a $10 in exchange. It's hard to see that having a big effect on your spending.

QE is catch 22. The usual story told is that bond markets are "segmented.'' The 10 year treasury market is cut off from other markets. Then, if the fed buys a lot of them it can raise the prices of 10 year treasurys. But the point of QE was not to lower Treasury rates, it was to lower rates that might influence investment. To affect the economy, the markets must not be segmented. For the Fed to affect the 10 year rates, they must be segmented, and the rates don't spill over to the rest of the economy.

Finally, the Treasury has been selling faster than the Fed has been buying. The next graph has all Federal debt, and federal debt less the part bought by the Fed. That bottom line is still growing. So, the Fed did not remove any bonds from the market. Overall, markets held more debt.

Federal Debt held by the public, and the same less debt held by the Fed.

Moreover, the Treasury was trying to move to a longer maturity structure. Treasury debt is much like your mortgage. If you take the 30 year fixed, you protect yourself against interest rate increases. If you take the floating rate ARM, you get a lower rates, but if rates go up you might be in a squeeze. The Treasury chose the fixed rate, trying to move to longer bonds. The Fed bought those long bonds right back up, issuing short term debt (reserves) instead, and undoing the insurance that the Treasury bought. Fed and Treasury need to get together and decide who is in charge of the maturity structure!

Heresy 3: Low rates, QE and financial markets

• Conventional Wisdom: QE and low interest rates set off a "reach for yield,'' "asset price bubbles,'' though artificially low risk premiums.
• Heresy 3: The risk premium is not unusually low for this stage of the business cycle. In any case, the Fed has nothing to do with risk premiums.

A quote from one of my otherwise favorite financial analysts expresses the view nicely:

"QE and negative interest rates manipulated prices of risk-free assets, and by artificially boosting risk-free assets central banks have sent investors on a hunt for yield, which in turn artificially boosted prices of risky assets and significantly distorted prices in financial markets.''

Again, this story gets passed on and on, but does it line up with the facts, and does it make any sense?

Risk premiums are about the spread between borrowing and lending. You take on risk by borrowing to invest. Now, if you borrow at 1 % and lend at 3%, that is exactly the same thing as borrowing at 3% and lending at 5%. Risk taking depends on the spread between risky and risk free rates, not the level of rates.

Yes, we can cook up stories, involving the affairs of specialized intermediaries. But recognize those are second-order stories, and hard to get risk premiums on widely traded stocks and bonds to go substantially wrong for years.

Let's look at the facts. Are there unusually low risk premiums or high asset prices, and are those tied to low interest rates or QE?

Spread between BAA and 10 year Treasury rate

This graph is the interest rate spread between Baa corporate bonds and 10 year Treasuries, a sign of the premium for holding the risk of corporate defaults. The premium is low now. But we are in the late September of the business cycle, and the corporate spread was even lower in each of the last three business cycles.

Risk premiums are always low in late stages of the business cycle. Risk is low, people are doing well, and willing to take risks despite low premiums. In fact, corporate premiums are still if anything surprisingly high for this stage of the business cycle, a fact often attributed to bank's unwillingness to trade much under the more stringent capital standards.

The next graph presents Bob Shiller's long-run price/earnings ratio. The price/earnings ratio is high. But it's also always high at the late stage of expansions, as people are more willing to take stock market risk in good times.

Price-earnings ratio on S&P500. Source: Robert Shiller

Moreover, looking at this century of data, the current time period with zero rates and massive QE does not stand out as particularly different from events we have seen many times before.

(Not: ignore the interest rate in the chart. It is the nominal interest rate, which reflects inflation, and is not relevant to the question here. I just copied Shiller's chart so didn't remove the line.)

Even so, it still seems high, but the price earnings ratio reflects the level of interest rates as well as the spread. The classic Gordon growth formula states that the price / earnings ratio equals one divided by the stock's rate of return minus the growth rate of dividends. We can also break down the stock rate of return into a real risk free rate and a risk premium. \[ \frac{P}{E} = \frac{1}{E(r)-g} = \frac{1}{r^f + E(r-r^f)-g} \] Now, suppose the real risk free rate goes down by one percentage point, leaving the risk premium alone. If the price/earnings ratio starts at 25, or expected returns four percentage points above growth, \[ \frac{P}{E} = 25 = \frac{1}{0.04} \] a 1% decline in real rate gives \[ \frac{P}{E} = 33 = \frac{1}{0.03} \] with no change in risk premium. That's just about the amount by which the price/earnings ratio is unusually high

Heresy 4: Real rates

All of my heresies revolve around the question of low interest rates, and you might object that yes, interest rates are low, but that's because you think the Fed is keeping interest rates low.

• Conventional Wisdom: The Fed is the primary force behind movements in the real rate of interest and GDP growth rates.
• Heresy 4: The Fed has little to do with real interest rates or economic growth rates (past $\approx$ 1 year).

This is just economics 101. The two most basic economic descriptions of interest rates are \[ \text{real rate} = \text{impatience} + (\approx 1-2) \text{growth rate} \] \[ \text{real rate} = \text{marginal product of capital} \] If people are impatient, you have to pay them higher interest rates to get them to save. If the economy is growing quickly, and people know they will be better off in the future, you have to pay them higher interest rates to get them not to consume today. And the interest rate is determined in the end by companies' ability to make real returns from borrowed money.

As we go in to an economic expansion, with higher growth, real interest rates will naturally rise, Fed or no Fed. As we go into a period of low or no growth and poor investment opportunities, real interest rates will be low, Fed or no Fed.

And after a few years, growth comes from productivity only, not anything the Fed can arrange.

Now, there are many stories told for low growth and low "natural '' real rates -- a "savings glut,'' a demographic bulge of middle age savers, low investment productivity from distorting taxes and regulation, and so on.

Moreover, real rates are low everywhere in the world. It isn't specific to the Fed.

In sum, the Fed is nowhere near as powerful as conventional wisdom suggests.

Heresy 5: Is the economy stable?

The Fed, in an unstable vs. stable world.

• Conventional wisdom: If interest rates are stuck or pegged, inflation or deflation will spiral out of control. The economy, on its own, is unstable. The Fed must constantly move interest rates, like the seal must move his nose, to keep inflation under control.
• Heresy 5: The economy is stable. If interest rates don't move, eventually inflation will adjust to that interest rate minus the natural real rate of interest.

Conventional wisdom makes a clear prediction. When the interest rate gets stuck at zero, deflation will spiral out of control. The next graph gives a simulation of a standard (adaptive expectations, ISLM) model. A deflationary shock hits, and inflation declines. The Fed lowers interest rates, but soon runs in to zero. When the interest rate hits zero, the deflation spiral breaks out.

The model in this figure is: \begin{align*} x_t &= -\sigma (i_t - \pi_{t-1} - v^r_t)\\ \pi_t &= \pi_{t-1} + \kappa x_t; \\ i_t &= \max[i^\ast + \phi (\pi_t -\pi^\ast),0] \end{align*}

Simulation of an old-Keynesian deflation spiral at the zero bound.

The facts deny this central clear prediction. Remember the lesson of the first graph, on what happened when interest rates hit zero and stayed there. There was no spiral.

Modern theory and fact agree: Inflation and economy are stable with fixed rates.

That does not mean that fixed interest rates are a good thing. They are possible, but not necessarily desirable. Remember \[ \text{interest rate} = \text{real rate} + \text{expected inflation} \] If interest rates are fixed, then as real rates vary -- remember, real rates should be low in recessions and high in booms -- inflation must vary, and in the opposite direction. Prices are a bit sticky and volatile inflation is not desirable. So even in the view that inflation is stable with fixed interest rates, it is still a good idea for the Fed to raise rates in boom times and lower them in recessions. The Taylor rule is alive and well. But the zero bound or slightly slow to move rates are not a spiral-tempting disaster.

Heresy 6: How does this thing work anyway?

• Conventional wisdom: Raising interest rates lowers inflation, & vice-versa.
• Heresy 6 (Implication of stability & modern theory). After a short run negative effect, persistently higher interest rates raise inflation.
• Are we past bump, at the point that persistently low rates have led to low inflation?

If inflation is stable around fixed interest rates, then if you raise rates and leave them there, inflation must eventually rise to meet the interest rates.

It's not as nutty as it seems. Most of our experience is the short run relationship, which is negative.

However, this possibility -- this consequence of stability -- suggests that after 8 years near zero, we have gotten over any negative response of inflation to rates, and low interest rates are attracting low inflation. And that if the Fed raises rates, it will eventually cause the inflation that it will, in the event, pride itself for foreseeing.

Consistent with this view, consider Japan and Europe in the next plot. Both of them have lower -- negative -- interest rates than we do. And inflation is drifting down in both places. Which is the chicken, and which is the egg?

Heresy 7: The Phillips curve

Conventional wisdom, largely reflected in Federal Reserve statements, has a clear view of where inflation comes from.

• Inflation comes from "tight markets,'' principally tight labor markets.

As I write, conventional wisdom says that the low unemployment rate, and other measures such as many unfilled job openings presage wage inflation, which will be passed through to price inflation. This view motivates the hawkish case for raising interest rates, even though current inflation remains below the Fed's 2% target, and accounts for the fact that the Fed has raised rates at all.

The conventional view of monetary policy acts through this causal channel. Lower interest rates will stimulate aggregate demand, which will stimulate output, which will cause companies to hire more people, which will tighten labor markets, which will lead to higher wages, which will lead to higher prices.

Sometimes, the correlation between inflation and unemployment is read the other way. (We economists seem to specialize in reading correlations as causal relationships, and forgetting that there are two curves that may shift in any set of observations.) In the recession, if only the Fed could raise inflation, the story went, it could thereby reduce unemployment. Bring on the helicopters full of money.

In any case, even the Phillips curve correlation has vanished, if it ever was there.

Core inflation and unemployment. Top: time series. Bottom: Inflation (y) vs. unemployment (x) since 2007

The top panel of this graph shows the time series of inflation and unemployment through the last two recessions. You can see inflation blip down and unemployment rise in the bottom of a recession. Even that correlation vanishes though in the subsequent expansion and most of all in the last one. Inflation quickly bounces back to a bit below 2%, while unemployment remains high. There is just no relation all between the level of labor market "slack'' and the rate of inflation.

The bottom panel shows the data since 2008 as a scatterplot, with inflation on the left and unemployment on the bottom. Your eye may wish to draw a negatively sloped line. But really the evidence there is on the right hand side -- inflation dipped down and came back up while unemployment stayed high. The traditional scatterplot is a bit misleading because the points are not randomly chosen, but follow each other as you can see in the first plot.

The plot really shows that there is essentially no relationship between inflation and unemployment -- the line is flat. Furthermore, there is a lot of vertical scatter -- the line isn't really a line.

(A clever Fed economist once parried, yes, the line is nearly flat! That's great news. It means if we could only get inflation up half a percent we would instantly cure unemployment. The vertical scatter emphasizes that the line is really just mush, not an exploitable flat line.)

Well, once again, so much for the real world, how does it work in theory? Nothing seems more obvious than the proposition that if labor markets are tight, if there are more jobs than people who want to work, that employers will offer higher wages, right?

No, as a matter of fact. If employers want to attract more workers, they must offer higher wages relative to prices. Saying "I'll pay you in pennies'' doesn't do any good. Both prices and wages rising at the same time does nothing to attract workers. If wages are "sticky'' then the only way to have wages rise is for product prices to fall -- we should expect tight labor markets to result in less inflation in goods prices!

Likewise, perhaps inflation comes from tight product markets, and what could be more natural than the idea that if there is more demand than supply that companies should raise prices. But that also only works for relative prices.

This is one of the first, most important, and most forgotten lessons of macroeconomics. What works for an individual market does not work for the economy as a whole. The overall price level is a different object than (relative) prices or wages. (And, similarly, trying to raise everyone's income by raising everyone's relative income, handing out protections to each industry and to labor, is equally doomed. No, we cannot pull ourselves up by our bootstraps.)

Now (of course) there are economic theories of the Phillips curve, and good ones. To get the overall level of prices and wages to correlate with labor or product market slack, you need some second-order effect, some "friction.'' The easiest one to understand is Bob Lucas' classic theory. In this context, employers can fool people into working harder for a little while by posting higher wages. If the people don't know that prices are going up too, they will think the real wage (relative to price) is higher, and not realize they are just being paid in devalued currency. Once they figure it out, of course, the boost to employment vanishes. (Also, this is a theory of causality from unexpected inflation to higher employment, not the other way around.)

The point here is not that there is no theory of the (apparently vanished) Phillips cure. The point here is that the simple commonsense idea that tight markets cause inflation is wrong. If you want a theory, you need to go past obvious supply and demand and add some friction to pricing or to information processing, and then you need to think the Fed understands and can exploit this friction to guide us to better outcomes than we get to on our own.

Maybe that's not how the economy is wired. Maybe labor market "tightness'' and "slack'' is not the root of inflation.

Heresy 8: Inflation Dangers

Source: CBO

• Conventional Wisdom: The danger of inflation comes if the Fed does not raise rates quickly enough. Then we have a positive spiral.
• Heresy 8: The inflation danger comes from fiscal policy. A Greek unwind. As past low-rates and pegs evaporated due to fiscal problems. And then Fed will be powerless to stop it.

If inflation is indeed stable, then small mistakes in monetary policy will not lead to spiraling inflation.

Inflation, like all crises, usually comes from unexpected sources. Our fiscal situation leads to a chance of inflation. If interest rates rise to 5%, our government will have to pay $ 1 trillion per year of additional debt service. It can't. This event could pile on top of a new financial crisis and recession occasioning a few more trillion dollars of borrowing, on top of unreformed taxes and entitlement spending. People seeing that crisis coming will unload government debt, try to buy real things, and drive inflation. If that happens, there is nothing the Fed can do about it.

This possibility is not a forecast. It's a risk, and a small risk, like living above an earthquake fault that breaks every few hundred years. That doesn't mean you should rush out of the house right now. But that doesn't mean we're safe either. Bond markets still trust the US to sort out our fiscal mess. But if they ever lose that faith, we get inflation -- stagflation -- that will seem to the Fed, and to conventional wisdom, to have come from nowhere.

Summers tweet stream on secular stagnation - Barokong

June 14, 2020    Comment   

Summers tweet stream on secular stagnation - Barokong

Larry Summers has an interesting tweet stream (HT Marginal Revolution) on the state of monetary policy. Much I agree with and find insightful:

Can central banking as we know it be the primary tool of macroeconomic stabilization in the industrial world over the next decade?...There is little room for interest rate cuts..QE and forward guidance have been tried on a substantial scale....It is hard to believe that changing adverbs here and there or altering the timing of press conferences or the mode of presenting projections is consequential...interest rates stuck at zero with no real prospect of escape - is now the confident market expectation in Europe & Japan, with essentially zero or negative yields over a generation....The one thing that was taught as axiomatic to economics students around the world was that monetary authorities could over the long term create as much inflation as they wanted through monetary policy. This proposition is now very much in doubt.

Agreed so far, and well put. "Monetary policy" here means buying government bonds and issuing reserves in return, or lowering short-term interest rates. I am still intrigued by the possibility that a commitment to permanently higher rates might raise inflation, but that's quite speculative.

and later

Limited nominal GDP growth in the face of very low interest rates has been interpreted as evidence simply that the neutral rate has fallen substantially....We believe it is at least equally plausible that the impact of interest rates on aggregate demand has declined sharply, and that the marginal impact falls off as rates fall.  It is even plausible that in some cases interest rate cuts may reduce aggregate demand: because of target saving behavior, reversal rate effects on fin. intermediaries, option effects on irreversible investment, and the arithmetic effect of lower rates on gov’t deficits

Central banks are a lot less powerful than everyone seems to think, and potentially for deep reasons. File this as speculative but very interesting. Larry has many thoughts on why lowering interest rates may be ineffective or unwise.

The question is just how bad this is? The economy is growing, unemployment is at an all time low, inflation is nonexistent, the dollar is strong. Larry and I grew up in the 1970s, and monetary affairs can be a lot worse.

Yes, the worry is how much the Fed can "stimulate" in the next recession. But it is not obvious to me that recessions come from somewhere else and are much mitigated by lowering short term rates as "stimulus." Many postwar recessions were induced by the Fed, and the Great Depression was made much worse by the Fed. Perhaps it is enough for the Fed simply not to screw up -- do its supervisory job of enforcing capital standards in booms (please, at last!) do its lender of last resort job in financial crises, and don't make matters worse.

But how bad is it now? Here Larry and I part company. Larry is, surprisingly to me, still pushing "secular stagnation"

Call it the black hole problem, secular stagnation, or Japanification, this set of issues should be what central banks are worrying about...We have come to agree w/ the point long stressed by Post Keynesian economists & recently emphasized by Palley that the role of specific frictions in economic fluctuations should be de-emphasized relative to a more fundamental lack of aggregate demand.

The right issue for macroeconomists to be focused on is assuring adequate aggregate demand.

My jaw drops.

The unemployment rate is 3.9%, lower than it has ever been in a half century. It fell faster after about 2014 than in the last two recessions.

Labor force participation is trending back up.

Wages are rising faster and faster, especially for less skilled and education educated workers.

There are 8 million job openings in the US.

Why in the world are we talking about "lack of demand?

Larry had a point about secular stagnation in about 2014. The Great Recession was dragging on seemingly forever. There was a good debate about "secular stagnation" vs. sand in the gears -- the cumulative effects of Obamacare, Dodd Frank, and the regulatory war on capital. But those days are over. How can anyone be seriously talking about "lack of demand" now?

Yes, despite the clearly full employment labor market, GDP is growing more slowly than I think is possible, and I can infer Larry agrees. But at full employment slow GDP growth comes from too slow productivity growth.

Let me suggest the alternative:

The right issue for macroeconomists to be focused on is assuring adequate aggregate supply.

[This is me, not Larry]. We need now a "pro-growth" agenda. When you're out of recession and financial crisis, further growth comes from "supply." And there is plenty to work on there. Alas, supply requires a Marie Kondoing of our public life, not a grand new initiative. Fix all they little things: zoning, agricultural policy, tax reform, reducing disincentives of social programs, continued regulatory reform, cutting tariffs, occupational licensing, and on and on. Macroeconomists (and growth economists) should be focusing on microeconomics.

Larry goes utterly in the opposite direction:

Obviously fiscal policy needs to be a major focus, especially given what low or negative interest rates mean for the sustainability of deficits.

But the level of demand is also influenced by structural policies: e.g. pay-as-you-go social security, higher retirement ages, improved social insurance, support for private infrastructure investment, redistribution from the high-saving rich to the liquidity-constrained poor.

OMG. In case you can't read between the lines, the first paragraph means deliberate even larger deficits. "infrastructure investment" in the US today means more $4 billion per mile subways and high speed trains to nowhere. Redistribution to the liquidity constrained means forcibly taking away hard earned money to give it to people who have maxed out their credit cards.

(The latter is an especially pernicious argument. If the point is to give money to those who will consume it more effectively than us hopelessly frugal savers, then give it to the liquidity constrained rich too, and do not give it to the frugal poor.  This is a classic case of an answer in search of a question, as the question does not lead to income-based redistribution.)

Larry isn't quite at the Magical Monetary Theory and Green New Deal blowout here. But I only infer that from his previous statements critical of those for going too far. This is darn close and all in the same direction.

One might defend Larry that previously he was talking about contingency plans for stimulus in a recession. But these are permanent, structural policies that come and stay for a generation.

I thought of Larry as the epitome of centrist, sensible, technocratic Democratic Party stalwarts, alongside say Alan Blinder, who wrote quite sensibly in the WSJ warning against the excesses of Green New Deal and health care for all. I still have hope that that sensible wing of the party will prevail, and join with the sensible wing of Republicans (there still is one) to fix the supply end of our country. But this is an amazing sharp left turn.

Larry's closers with another intriguing thought.

The high inflation and high interest rates of the 1970s generated a revolution in macroeconomic thinking, policy and institutions. The low inflation, low interest rates and stagnation of the last decade has been longer and more serious and deserves at least an equal response

Well put and yes indeed. But in my view, Alvin Hansen's 1939 speculations about eternal lack of demand and a soft version of AOC-Sanders-Warren deficit financed spending blowout and "redistribution" aren't it. Marie-Kondoing the massive clutter and disincentives on the growth side of our economy is.