Sunday, April 20, 2014

Deflation in Sweden: Svensson's Advice is the Problem, Not the Solution

As Lars Svensson notes, Sweden now has inflation that ranks among the lowest in the world. From the Riksbank's website, CPI inflation in Sweden looks like this:
The Riksbank has a 2% inflation target, so clearly they are missing on the low side. Of course, given the typical wishful thinking of central bankers, you can see from the chart that they are forecasting that they will hit the target a year from now, and exceed it later in 2015 and 2016.

So, why is inflation so low in Sweden? Svensson claims:
The deflation has been caused by the Riksbank’s tight monetary policy since the summer of 2010.
In Sweden, the Riksbank's policy rate is the repo rate, which is set by the Executive Committee of the central bank, and has followed this path since 2008 (again, from the Riksbank's web site):
So, does the repo rate path in the last chart represent a policy that was too tight, i.e. was the policy rate too high? How could we answer that question? Svensson might think about policy in terms of a Taylor rule, so it might help to look at the performance of the real side of the economy in Sweden. Here are real GDP growth rates (from the Riksbank's web site again):
For good measure, we should look at the real GDP levels too:
So, in the last two charts, you can see that the downturn in Sweden during the recession was larger, but the recovery was stronger than in the US, with Swedish real GDP returning to its pre-recession level earlier than in the U.S. But there has been lower growth in Sweden in 2012-13 so, relative to 2007Q4, the US and Sweden are in essentially the same place.

The Riksbank kept the policy rate at 0.25% well into 2010 and then, as the recovery proceeded at a normal pace and inflation increased, the policy rate went up, in typical Taylor-rule fashion. The policy rate reached a peak of 2% (not very high, right?) in late 2011, and then, as the Riksbank started to see real GDP growth below 3% and inflation below the 2% target, it quite promptly began cutting the policy rate. The policy rate is currently at 0.75%, and plans for its future path, conditional on the forecast, can be seen in the second chart. But what happens if the inflation rate stays low? From the Riksbank's last policy statement:
Monetary policy needs to remain highly expansionary to contribute to inflation rising towards the target. Although inflation has been somewhat lower than expected, only a minor revision has been made to the inflation forecast. The Executive Board of the Riksbank has therefore decided to hold the repo rate unchanged at 0.75 per cent. It is judged appropriate to begin gradually raising the repo rate in one year's time, when inflation has picked up.

As economic activity strengthens, inflationary pressures are expected to rise. However, it is uncertain how quickly inflation will rise, particularly as it has been weaker than expected for some time now. The repo-rate path has therefore been adjusted down somewhat and reflects a greater probability of a repo-rate cut in the near term compared with the assessment made in February.
That's from a section titled "Low Interest Rate Until Inflation Picks Up." Clearly, if inflation remains low, the policy rate will remain low.

So, it seems to me that the Riksbank has been, and is, playing pretty much by the Old-Keynesian/New Keynesian book. Why Svensson doesn't like what the Riksbank was and is doing is not apparent from the data. We need to dig deeper to find out why he's so critical. Svensson was a Deputy Governor of the Riksbank from May/2007 to May/2013. At a critical juncture in June 2010, the Executive Board of the Riksbank voted to increase the policy rate 1/4 point to 0.5%. Svensson dissented:
Deputy Governor Lars E.O. Svensson entered a reservation against the repo-rate path and advocated a repo-rate path with a repo rate of 0.25 per cent through the fourth quarter of 2010, and thereafter a gradual return to the repo-rate path of the main scenario. Lars E.O.Svensson maintained that such a repo-rate path results in a better outcome for both resource utilisation and inflation, with both lower unemployment and CPIF inflation closer to the target.
After leaving the Riksbank, in September 2013 Svensson wrote this post, in which he claims that, if the Riksbank had not only done what he had recommended in June 2010, but kept the policy rate at 0.25% until the current time, the inflation rate would be at the 2% target, and unemployment would be lower. In Svensson's September 2013 post, it is not clear to me what model he used to come up with his counterfactual, but suffice to say that, whatever the model is, it tells us that a short-term real interest rate of -1.75% can be sustained for 3 1/2 years, which seems goofy. One thing I would be interested in seeing is the output this model produces under the actual path for the policy rate. My guess is that it predicts inflation well above what actually occurred. Off the top of my head, I would say that, under Svensson's policy scenario, the inflation rate would currently be lower, and the unemployment rate would be about the same as what we're actually seeing in Sweden now.

Of course, this is just quibbling over history. What does Svensson think the Riksbank should do now if it wants to hit its 2% inflation target?
The most important thing is that the Riksbank takes the inflation target seriously and stops neglecting it. In order to get inflation back to target soon, the policy rate has to be lowered quickly to 0.25 percent or even zero. If this does not help, the Riksbank – as other central banks at the zero lower bound with too low inflation and too high unemployment – will have to use unconventional (but by now frequently tested) policy measures. These include a negative policy rate, large-scale asset purchase to lower long interest rates (quantitative easing), a low policy-rate path for a longer period with different variants of “forward guidance”, foreign-exchange interventions to depreciate the currency or at least (as in Switzerland) prevent it from becoming too strong, and to aim to overshoot the inflation target for a few years.
By now, it should be well known that Taylor rules have some very undesirable properties. In particular, a central bank which follows a Taylor rule blindly can get stuck in a policy trap, in which the policy rate is at the zero lower bound, and inflation is low or negative. The central bank wants higher inflation, and thinks it will achieve this by lowering the policy rate, which is not feasible, so the policy rate stays at the lower bound and - given that the Fisher relation holds in the long run - inflation stays low or negative. This is the policy trap that Svensson's advice would lead the Riksbank into.

Once the Riksbank is stuck at the zero lower bound, what would Svensson have it do? Unconventional policy is the prescription. As Svensson notes, unconventional policy has been "frequently tested." So how did that work out? In the U.S., as you know, the Fed has been deeply into unconventional policy for the last five years - quantitative easing (QE) and forward guidance in particular. But apparently those experiments have not been so successful, as the inflation rate has been falling for the last two years or more:
Another notable experiment is the Bank of Japan's "Quantitative and Qualitative Monetary Easing Program," which began in April 2013. Here's how that's going:
While there was a bit of a burst in inflation toward the end of 2013, the year-over-year inflation rate in Japan is now less than 1/2%.

In Sweden, the Riksbank cannot consistently meet its inflation target of 2% if the policy rate stays low or goes to zero. The Fisher relation guarantees that. In order to meet its inflation target, the Riksbank has to increase the policy rate - there's no other way to do it.

In addition to the standard Taylor-rule policy-trap problem, there are two elements of Svensson's unconventional policy recommendations that further exacerbate the problem, in terms of how Svensson looks at it. First, if QE works in the long run the way I've modeled it, then it will ultimately produce less inflation, not more, if the policy rate stays low or at the zero lower bound. Second, consider Svensson's "negative policy rate" recommendation. This appears to be a variant of the idea that, if our problem is a binding constraint on the nominal interest rate at zero, then we should relax the constraint by somehow taxing the liabilities of the central bank. Miles Kimball loves this idea. Basically, the central bank could tax reserve accounts, and there are schemes that might allow taxation of currency or its electronic replacement.

What would be the effect of taxing central bank liabilities? For simplicity, think about a world with perfect certainty. In the long run, standard asset pricing gives us the Fisher relation, which is

R = r + i,

where R is the short-term nominal interest rate, r is the real interest rate, and i is the inflation rate. If central bank liabilities are not taxed, then arbitrage gives us the zero lower bound, i.e. R cannot fall below zero. But if we tax central bank liabilities at the rate t per period, then the lower bound on R is -t. Therefore, in the long run, if R is targeted at its lower bound by the central bank,

i = - r - t

So, if we think that r is invariant to monetary policy in the long run, then if the central bank pegs the nominal interest rate at its lower bound, and central bank liabilities are taxed, this will make long-run inflation lower.

Basically, people who advocate for taxes on central bank liabilities as a means for increasing inflation are making the same error as are people who are concerned that the currently large stock of reserve balances in the United States might ultimately produce more inflation (a group of people that may or may not have once included yours truly). For example, you might think that, if you tax central bank liabilities, then people have less inducement to hold those liabilities, and inflation results due to some kind of hot-potato effect. Similarly, you might think that, as assets other than money become more attractive (as the economy recovers and real returns rise), that inflation might rise, for a similar reason. Well, that logic is wrong. To induce people to hold central bank liabilities when the nominal interest rate has been at its lower bound for a long period of time, the inflation rate must be sufficiently low, so that the real return on money is sufficiently high. If we tax central bank liabilities, or the real returns on alternative assets are higher, the inflation rate must be all the lower in the long term, in order to make central bank liabilities sufficiently attractive that people will hold them.

Wednesday, April 9, 2014

The FRB/US Model and Inflation

The Board of Governors has posted details on the structure of the FRB/US model, the data used in estimating the model, published work using the model, etc. If you have access to EViews, it appears you can also run simulations. There is even a long disclaimer, presumably to cover cases where someone takes the model too seriously, uses it for retirement planning or some such, and then wants to sue the Fed. On this, I have a proposal, which is a blanket disclaimer to cover everything - public speaking by Fed employees, casual chit-chat in the coffee shop, whatever:
Please don't ever pay close attention to what we say, or take any action based on such utterances. We're only joking most of the time anyway. If you really think we're saying something important, you're not as smart as you look.
That should do it, I think. The Fed can state this once, and then never say it again.

The FRB/US model, used by the Board for forecasting and policy analysis, is the culmination of perhaps 45 years of work. Various generations of management at the Board have directed some smart people to work on this thing, and you can feel the weight of the large quantity of quality-adjusted hours of work that went into putting it together. But is it any good? Could the Board do just as well or better at forecasting with a much simpler tool? Could a well-educated and well-informed economist do a respectable job of central banking without ever looking at the output of the FRB/US model?

Long ago in a galaxy far far away, large-scale macroeconometric models were taken very seriously. This 1959 paper by Adelman and Adelman was published in Econometrica. They simulated the Klein Goldberger model on an IBM 650, which was the first mass-produced computer. Here's what that looked like (from Wikipedia):
The Klein-Goldberger model was small relative to the FRB/US model - 15 equations. It was first estimated in 1955 using electro-mechanical desk calculators. In those days running a regression was a big job - you will understand the magnitude of the task if you have ever had to invert a matrix by hand. By the late 1960s, the Klein-Goldberger model had evolved into the large-scale FRB/MIT/Penn model, which is a distant ancestor of the FRB/US model.

But shortly after large-scale models had been warmly embraced by policymakers in central banks and governments, they were trashed by the upstarts of the macroeconomics profession. I think the modern notion of the Lucas critique is that it calls into question "reduced-form" economics, "implicit theorizing," and such. But Lucas's paper actually had a more narrow focus. Lucas was criticizing large scale macroeconometric models. This is the key quote from his paper:
The thesis of this essay is that it is the econometric tradition, or more precisely, the "theory of economic policy" based on this tradition, which is in need of major revision. More particularly, I shall argue that the features which lead to success in short-term forecasting are unrelated to quantitative policy evaluation, that the major econometric models are (well) designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies. These contentions will be based not on deviations between estimated and "true" structure prior to a policy change but on the deviations between the prior "true" structure and the "true" structure prevailing afterwards.
Clearly, this was not taken to heart at the Board, as the FRB/US model - in spite of some claims to the contrary - does not look so different from early macroeconometric models. Indeed, if Klein and Goldberger were alive, I don't they would find the FRB/US model an unfamiliar object, though the documentation is dressed up in the language of modern macroeconomics as practiced in most central banks. So, was Lucas wrong, or what?

There's a lot going on the the FRB/US model, but suppose we focus on something the Fed cares about, and is instructed to care about: the inflation rate. Inflation determination appears to be in a New Keynesian spirit. So, one thing that has changed from 1970s-era large scale macroeconometric models is that the money demand function has disappeared, and monetary quantities appear to be nonexistent. Inflation is determined - roughly - by an output gap and trend inflation, which is a survey measure of the ten-year-ahead inflation rate. For example, if a shock occurs in the model which causes a positive output gap, then inflation rises, and over time inflation will revert to the long run trend, which is exogenous.

So, this is purely Phillips-curve inflation determination, which certainly does not square with how I think about the inflation process. Neither does it square with the data, which is notoriously at odds with the view that output gaps are important in explaining or forecasting inflation, or the view that Phillips curves are stable. The Phillips curve does particularly badly over the past couple of years or so. Here is the output gap measure used in the FRB/US model:
So, given that, the FRB/US model tells us that inflation should have been rising recently. But headline pce inflation and core pce inflation have been falling:
If you look at Flint Brayton's memo on "A New FRB/US Price-Wage Sector," in the FRB/US documentation, you can get some idea of how the Board staff think about this. Staff members of course monitor how the model is predicting out of sample, but the model had not been doing well:
Inflation in the recent recession and its aftermath did not decline nearly as much as the 1985-2007 estimates would have predicted, a result that is common to many models of inflation.
So, apparently they found that the Phillips curve they had estimated was not stable - during the recession it was making inflation forecasting errors on the low side. The solution was to re-estimate:
ML estimation over a longer sample period that ends in 2012 reduces the sector’s unemployment slope coefficient by more than half.
ML is maximum likelihood. So, if the sample is extended to 2012, the Phillips curve starts to go away - the slope coefficient gets much smaller. But the Board staff doesn't seem to like this:
An alternative and more cautious re-assessment of the unemployment slope is obtained with Bayesian methods. Using the 1985-2007 ML parameter estimates and their standard errors as a prior, Bayesian estimation over the longer sample reduces the slope coefficient by one-third.
So, apparently being "cautious" is when you ignore the data and go with your intuition.

This is important, as it tells us something about how the Governors and the FOMC chair think about monetary policy decisions. The FRB/US model seems to be producing the Board's forecast and some policy scenarios that are used as input at FOMC meetings. And we know that Janet Yellen takes FRB/US quite seriously. The FOMC is predicting that the inflation rate will rise over time to 2%, and Janet Yellen has told us that she thinks that, under that scenario, the Fed's policy interest rate should start rising in spring 2015. Some people want to interpret that as a hawkish statement, but I don't think so, because I think the forecast - and FRB/US - is wrong. The FOMC has also stated that the policy rate will stay low if inflation continues to be low or falls, and I think that is the likely outcome, for reasons I have discussed before. So, given what the FOMC has told us about its policy rule, my prediction is that the policy rate will be where it is for considerably longer than Janet Yellen thinks it will.

Monday, March 31, 2014

Taylor Rules

John Taylor has a blog post which reviews the origin of the Taylor rule and why we should think it's good guidance for central bankers. In making his points, Taylor quotes from a reply I made to a comment on one of my posts, so I'll supply that reply in full:
When Taylor first wrote down his rule, he didn't make any claims that there was any theory which would justify it as some welfare-maximizing policy rule. It seemed to capture the idea that the Fed should care about inflation, and that there exist some non-neutralities of money which the Fed could exploit in influencing real economic activity. He then claimed that it worked pretty well (in terms of an ad hoc welfare criterion) in some quantitative models. Woodford used the Taylor rule to obtain determinacy in NK models, and even argued that it was optimal under some special circumstances. But NK models are very special. Typically they ignore financial factors that I think we can agree are important, and certainly don't address issues to do with what you're calling "financial stability."

So what's optimal? I don't think we have a good grip on this. I don't think we understand fully the nature of the central bank's influence on real economic activity, and we don't fully understand the costs of inflation. 2% inflation is optimal? Why?

You might hope that we could muddle along with a simple Taylor rule driving central bank behavior. It's simple, and maybe close enough to optimal, given what we know. But it's well-known that it can have bad long run properties. For example, the Fed can think that 2% inflation is optimal, but converge to a long-run equilibrium in which inflation is too low. Or the Fed can have incorrect beliefs about the long-run real interest rate, or the output gap, which will imply that the policy is wrong.
Taylor seems to agree with some of that, but he clearly has some differences. Let's focus on his last paragraph:
Later research (which Steve mentions) was very important. The proof of exact optimality of the rule in certain simple models as shown by Mike Woodford (and also Larry Ball) helped improve people’s understanding of why the rule worked well. Finding robustness to a surprisingly wide variety of models was quite useful, as was the historical finding that when monetary policy was close to such a rule, performance was good and when it departed, performance was not so good. But this all depended strongly on the economic theory and policy optimization results in the original research.
What Taylor does not mention is the evidence, for example from Benhabib et al., that Taylor rules can yield unintended consequences - convergence to steady states with inflation below the central bank's target. People might have thought of those results as theoretical curiosities, but some central banks in the world appear to be in danger of exactly that unintended consequence. For example, in the United States, the recent path for the year-over-year pce inflation rate looks like this:
The FOMC took great pains to explain its Taylor rule in the last FOMC statement. But, in spite of the fact that the FOMC's target inflation rate is 2%, and Keynesian output gaps are falling, inflation has been falling for two years, and is well below 2%. Seems not to be working according to plan, don't you think? It's surprising though, that this should surprise anyone.

John Cochrane has more on this in a post from last week. Basically, he sketches a theory to make sense of the notion that, in order to raise the inflation rate to achieve its target, the Fed will have to raise it's nominal policy rate. As he points out, it's important to be specific about the relationship between monetary and fiscal policy. What's left out of his story is the determination of the real interest rate, which is important, but of course John is just giving us a sketch.

Thursday, March 27, 2014

Money Creation: Propagating Confusion

I'm a little late on this, but I saw some commentary on this Bank of England article by McLeay, Radia, and Thomas, "Money Creation in the Modern Economy." The article appears intended for lay people, as a basic introduction to how banking, money, and monetary policy work. If this accurately represents how Mark Carney thinks about these things, we're in trouble.

The article's authors claim that there are some popular misconceptions about how money creation works, and the central bank's control over that process. They seem to want to clear things up for us. Some people have had strong reactions to the article, and Simon Wren-Lewis links to some of that. It's a confused article, so it's really not surprising that it's lead to confused reactions.

As the authors cite Tobin's Commercial Banks as Creators of "Money," and refer to it extensively, it's useful to start there. Tobin's paper, written in 1963, is one of my favorite papers in monetary economics. You can guess where Tobin is going from the scare quotes in the title. Here are Tobin's conclusions:
The key insight - as important today as in 1963 - is that we sometimes take the word "money" far too seriously. In reality, assets exist on a spectrum in terms of what we think of as liquidity, and there is not much point in drawing some arbitrary line between what is money and what is not. Further, we should not draw a line between financial intermediaries that issue highly-liquid liabilities, and those that do not. Particularly given the financial crisis, I think it is now more widely understood that the financial system works as a whole - it can't be compartmentalized into institutions that the central bank should be concerned with, and those it should not.

For the arguments in the article, Tobin's point 4 is particularly important. Tobin thought it best that we think of commercial banks as financial intermediaries and, as such, to analyze their role in terms of normal economics. Indeed, people lose their grip on reality when they start thinking of central banking, and "money" creation, as some kind of hocus-pocus.

So, McLeay, Radia, and Thomas (MRT) begin their article by clearing up two "misconceptions." The first one is:
...that banks act simply as intermediaries, lending out the deposits that savers place with them.
Well, that's a really bad start, as that's not a misconception, but a very useful way to begin thinking about what a bank does. A bank is indeed a financial intermediary - it borrows from one set of people and lends to another set of people. The second "misconception":
...is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.
I'm on board with that. The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system - such as what exists in Canada, the UK, or New Zealand - where there are no reserve requirements, and they won't be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.

But, though MRT recognize that the money multiplier story may not be illuminating, that traditional story is actually part of their anti-misconception for "misconception" #1. The authors state:
...rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
Well, in the money multiplier stories I heard, that actually seemed to be important. In the traditional textbook account, the central bank conducts an open market operation by purchasing government debt with reserves. Banks have more reserves, which they cannot collectively rid themselves of, but they start lending more, as they have reserves in excess of their reserve requirements. When a bank makes a loan, it simply gives the borrower a deposit at the bank. The borrower will presumably spend the funds in the deposit account, but the deposit balance stays in the banking system, and the multiplier process continues until the reserve requirement binds.

That's essentially the story that MRT are telling, but without the initial reserve injection. I think Tobin would object just as strongly to what MRT are saying as to the money multiplier story that he wrote about in 1963. Here's why. Lending by a bank does not somehow create the deposit liabilities that support that lending. For example, suppose bank 1 makes a loan for $20,000, and credits $20,000 to the borrower's deposit account. Then, the borrower purchases a car for $20,000, and when the transaction clears the borrower's deposit account at bank 1 is debited $20,000, and the deposit account of the car dealer at bank 2 is credited $20,000. Bank 1 also receives a debit of $20,000 to its reserve account, and Bank 2 receives a credit of $20,000 to its reserve account. Now, suppose that the car dealer withdraws the $20,000 from its deposit account in cash. Now, bank 2 is in the same position as before - there is no net change in its deposit liabilities or its reserve account balance. At bank 1, liabilities are no different than initially, but the composition of assets has changed. Reserves are now $20,000 lower, and loans are $20,000 higher. But, suppose that the car dealer who sold the borrower the car had taken out a loan from bank 1 in order to finance the car as inventory. Further, suppose the car dealer pays off the loan - with $20,000 in cash. So loans fall by $20,000 and reserves rise by $20,000 at bank 1. So now the banking system looks exactly the same as initially.

I just made up a series of transactions, but that story makes as much sense as what MRT describe as a "money creation" process. The story simply is not helpful. It would be much more useful to tell a story for lay people that focuses on the bank as a financial intermediary, with deposits and loans determined jointly by the behavior of depositors, borrowers, and banks. Basically, it's a general equilibrium problem, and we have to get this across in a way that people will understand. Making up stories about transactions and balance sheets doesn't help.

Then, once people understand something about financial intermediation and asset transformation, it's more straightforward to tackle central banking and what that is about. Basically, the central bank is just another financial intermediary, that competes with private sector intermediaries. To the extent its actions matter, that's because the central bank has some special advantages or powers in providing intermediation services.

MRT go further astray when they discuss how monetary policy works. Again, it seems their intention is to clear up a misconception:
Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate. Rather, they focus on prices — setting interest rates.
And again, they don't get it right. My understanding of the Bank of England's operating strategy is that the Bank sets the Bank Rate, which is the counterpart of the U.S. discount rate, and also the interest rate on reserves. Correct me if I'm wrong, but this is a channel system with no channel - effectively the overnight rate, the central bank lending rate, and the interest rate on reserves, are identical. So, in pre-financial crisis times, the overnight rate target was the Bank Rate, and the Bank of England would hit its target through intervention in the repo market. So, pre-financial crisis, the Bank did not literally "set" the overnight rate. It achieved a particular market outcome through a standard type of intervention, which would literally adjust the quantity of outside money to hit the target. So, the Bank of England seemed to have been doing what its economists said it was not doing.

Post financial crisis, you can see the state of the Bank of England's balance sheet here. As in the U.S., the central bank's balance sheet has grown, as has the stock of reserves. It therefore appears that (and this may not be quite correct, as I had trouble finding detailed Bank of England balance sheet information - please help me out if you know where to find it), as in the U.S., the interest rate on reserves determines the overnight rate, and repo market intervention (at the margin) is irrelevant. So, the current environment comes somewhat closer to what MRT are describing, though their view of bank behavior leaves a lot to be desired.

My last complaint is about MRT's analysis of the effects of QE (quantitative easing). The example they give again involves balance sheet entries. You can find this in the section beginning on page 8 of the article. It turns out they want us to think of QE as a central bank action that "creates broad money directly." What a funny idea. In the example, illustrated on Figure 3 on page 11, the Bank of England purchases government debt from a pension fund, which has no reserve account. The effect of the central bank action is to reduce the pension fund's holdings of government debt, and increase the pensions fund's bank deposits. In turn, the pension fund's bank sees an increase in its deposit liabilities and an increase in its reserve balances. Then the claim is that the pension fund proceeds to readjust its portfolio, which it is now apparently unhappy with, so QE has some effect.

Well, hold on. By this logic, if the Bank of England purchased T-bills from the pension fund, this would have the same effect. But MRT's argument is based on being in a liquidity trap. So, they have to show why it makes a difference that the asset purchases are of long-maturity government debt rather than short maturity government debt. Further, suppose that the pension fund has a reserve account, so that the asset purchase is a swap of reserves for government debt. Surely that can't make a difference to the ultimate effect of the purchase, but clearly MRT think it's critical that inside money increase as a result of the purchase in order for it to have an effect.

If you find that weird, then you'll also find "Quantitative Easing Explained," from the Bank of England's website, just as weird:
This policy of asset purchases is often known as 'Quantitative Easing'. It does not involve printing more banknotes. Furthermore, the asset purchase programme is not about giving money to banks. Rather, the policy is designed to circumvent the banking system. The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies. These investors typically do not want to hold on to this money, because it yields a low return. So they tend to use it to purchase other assets, such as corporate bonds and shares. That lowers longer-term borrowing costs and encourages the issuance of new equities and bonds to stimulate spending and keep inflation on track to meet the government’s target.
Central bankers in the U.S. typically use market-segmentation stories as arguments for why QE works. But in those stories, there is segmentation in the market for government debt - by maturity. The Bank of England is telling us that there are two key segments to the financial market - banks and non-banks. The banking sector is not integrated with the non-banking sector perhaps, as MRT seem to want to argue, because banks have reserve accounts and non-banks do not. That's wrongheaded. Either you knew this before the financial crisis (for example by reading Tobin's 1963 paper), or you learned it during the financial crisis: It's foolish to draw a line between financial intermediaries that are "banks" and those that are not; indeed it can get us into big trouble.

Wednesday, March 19, 2014

The March 19 FOMC Statement

As anticipated, the FOMC statement contains new forward guidance language. The language is vague, and rather loquacious. If I'm not mistaken, this is the longest post-FOMC-meeting press release on record.

The important novelties in the statement are in paragraphs 5 and 6. Paragraph 5 reads:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
Any numerical targets - except a reaffirmation of the 2% inflation goal - are now left out, which I think is a good thing. The FOMC is telling us that it will look at everything, and that the policy rate will likely stay where it is well into next year. We're basically back to "extended period" language, but it seems to have taken many more words to get that idea across.

Paragraph 6 is:
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Paragraph 5 told us something vague about when "liftoff" will occur - the date at which the policy rate starts to increase. Paragraph 6 concerns post-liftoff Fed behavior. The "balanced approach" is outlined in this 2012 speech by Janet Yellen. "Balanced" means following a Taylor rule derived from a loss function with equal weights on squared deviations of the unemployment rate and inflation, respectively, from their targets. In Yellen's speech, she used 5.5% as an unemployment rate target and 2% as an inflation rate target. But the second sentence in the paragraph also tells you that, for a period of time after liftoff occurs, the policy rate will be less that what the balanced approach implies. Presumably that's to fulfill the commitment implied by the old forward guidance language (see my last post).

Two comments:

1. It's clear what the model is here. It's a 3-equation reduced form New Keynesian model ("IS" curve, Phillips curve, Taylor rule). It's the Phillips curve which is driving the Fed's inflation forecast. Essentially all of the regional Feds and the Board have inflation increasing very gradually to 2% in the long run. Thus, the Fed expects that, given the policy rule laid out in paragraphs 5 and 6, that it will be getting close to its targets of 2% inflation and (presumably) 5.5% unemployment in a couple of years. One problem is that the Phillips curve hasn't been doing so well lately as an inflation predictor (as if it ever did well), what with inflation and unemployment both falling. A second problems is that, if inflation continues to be low, that will extend the tapering period, and extend the period until liftoff. This, as we know, just leads to self-fulfilling low inflation. There is no recognition of that possibility in the statement.

2. Why use so many words to say so little?

Note that Kocherlakota dissented:
Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee's commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.
I don't quite understand his objection. If he thinks the statement implies an overshooting of the 2% inflation target (which I assume he doesn't like), that's in the second sentence of paragraph 6, not in 5. Maybe he just wanted to include an explicit 5.5% unemployment rate threshold in paragraph 5. Better left out, I think.

Tuesday, March 18, 2014

The Labor Market and the FOMC Meeting

The FOMC will meet today and tomorrow. Given that there has been little news that would change the economic forecast, the Fed is likely to continue "tapering" - the monthly reductions in the size of asset purchases that began in December. This meeting may be important though. First, this will be the first FOMC meeting chaired by Janet Yellen. Second, with the unemployment rate at 6.7% and falling on trend, the Fed's 6.5% threshold will soon be passed, so the FOMC will have to come up with a new framework for forward guidance.

In this Q&A with John Williams, President of the San Francisco Fed, he was asked about potential changes in forward guidance:
Q. You have advocated replacing the Fed’s current guidance on interest rates, which is linked to a specific unemployment rate, with a less specific description of objectives. Isn’t that necessarily a less effective kind of guidance?

A. Back in 2011 the qualitative guidance wasn’t strong enough and so we went to the data-based concrete guidance and I thought that whole period was very successful. We had a disconnect between our views of where the policy was going and what the market thought. We used some pretty strong language saying what our intentions were and that seemed to work pretty well. I think that was really helpful and in many ways successful. As we’ve gotten away from truly extraordinary times and we’re in a transition toward somewhat more normal times, then the argument for trying to put out this really strong signal about, ‘We’re not going to raise interest rates until we see this one thing happen or this other thing happen,’ I don’t think is the right approach because it puts way too much attention on one aspect of the data. My preference would be to see us moving to describing our policies in our statements much more consistently and clearly. Here are our objectives, here’s where we are relative to them, and given this progress that we’ve made, here’s the policy stance we’re taking and here’s how we’re going to adjust this going forward. If that’s more the approach we’re going to take it would be vaguer or more general than a number. But I think it would be more accurate.
So, Williams says that we went through some "extraordinary times" that required unusual forward guidance. According to him, that unusual forward guidance worked. But now times are not so extraordinary any more, so we need more ordinary forward guidance. This forward guidance will be "vaguer" but will somehow reveal how the Fed thinks about the world, so that private sector decision makers can confidently predict how the Fed will behave in particular situations.

This speech by Charles Plosser, President of the Philadelphia Fed, comes to much the same conclusion, though by a different route. Plosser says:
Economists have learned that expectations play an important role in determining economic outcomes. When businesses and households have a better understanding of how monetary policy is likely to evolve, they can make more informed spending and financial decisions. If policymakers can reduce uncertainty about the course of monetary policy, the economy is likely to perform more efficiently.
So, that seems like the kind of forward guidance that Williams wants now. But Plosser also says:
A somewhat different rationale or view of forward guidance is that it is a way of increasing accommodation when the policy rate is at or near the zero lower bound. Some models suggest that when you are at the zero lower bound, it can be desirable, or optimal, to indicate that future policy rates will be kept "lower for longer" than might otherwise be the case. Thus, policymakers may want to deliberately commit to deviating from what they would otherwise choose to do under normal conditions, such as following a Taylor-like rule. In these models, such a commitment would tend to raise inflation expectations and lower long-term nominal rates, thereby inducing households and businesses to spend more today.
That's the forward guidance for extraordinary times that Williams discussed. Plosser does not seem to think that was such a good idea:
The FOMC has not been clear about the purpose of its forward guidance. Is it purely a transparency device, or is it a way to commit to a more accommodative future policy stance to add more accommodation today? This lack of clarity makes it difficult to communicate the stance of policy and the conditionality of policy on the state of the economy.
So, Williams thinks that extraordinary forward guidance was a success, but apparently Plosser doesn't agree. He thinks that, in the private sector, people were confused - they couldn't figure out whether the Fed was speaking ordinary forward guidance or extraordinary forward guidance. Here's what I think is going on. Post-financial crisis, the Fed was under a lot of pressure to do something about the state of the labor market. At the zero lower bound, "doing something" meant doing something extraordinary, and one of the extraordinary policies the Fed adopted was a form of forward guidance. That policy received support from the academic work of Mike Woodford and coauthors. In New Keynesian (NK) models, forward guidance is a commitment to future policy actions that are not time-consistent - once the future arrives the central bank would choose a different policy action if it could. To provide stimulus at the zero lower bound, according to NK models, the central bank would need to commit to a future path for the nominal policy rate that would remain lower than it would otherwise be (given previous Fed behavior) for a longer period of time.

It could be that the Fed's motivation was wrong. Maybe NK models are a poor guide for monetary policy. But, suppose that we think NK models are the cat's meow. Then, for forward guidance to work, the FOMC would have had to clearly communicate: (i) what they were committed to; and (ii) that they were committed. The FOMC first announced that the policy rate would be low for an extended period; then, the policy rate was to be low at least until some calendar date; then that calendar date changed; then a threshold was announced in terms of the unemployment rate; then the FOMC started saying things about how the threshold didn't matter, and Fed officials began discussing other labor market indicators - the participation rate, the employment/population ratio - that might matter for its decisions. So, private sector individuals who care about these things would have a right to be confused about whether any commitment existed, and what the commitment was about. Thus, I'm very puzzled as to why Williams is calling the FOMC's extraordinary forward guidance experiment a success.

But, extraordinary forward guidance is now history, and hopefully we'll never revisit that experience. The FOMC is currently concerned with the nature of current and future ordinary forward guidance. If we want to make a prediction about the nature of what will show up in the FOMC statement on Wednesday, a good guess is that this will the "vague" guidance that Williams envisions. Plosser, who is on the other end of the spectrum from Williams, seems on board with that. In my opinion, vague language is exactly what is required. The FOMC should avoid making any commitments to numerical targets or thresholds for things it cannot control over the long run, and over which it may sometimes have little influence in the short run.

Here's something interesting in Williams's Q&A with the New York Times:
Some economists see evidence that inflation is tied to short-term unemployment. Right now we have a lot of long-term unemployment and a lot of people who have stopped looking for work. That suggests you could start to see wage and price pressures before the economy has returned to full employment.
So, let's explore that idea. This is what the recent time series of unemployment and vacancy rates looks like:
So, as the FOMC statement says, the unemployment rate remains elevated, relative to the sample in the chart, but the vacancy rate is back up to 2004 levels. If we look at this in the form of a Beveridge curve relation, with the points representing pre-recession observations, and the line connecting observations after that, the data looks like this:
In the chart, you can see the shift to the right in the Beveridge curve, but the recent data is not as far off the pre-financial crisis relationship as it was.

But Williams is arguing that there are differences if we look at short vs. long-term unemployed. If we examine unemployment rates by duration of unemployment (number of unemployed divided by total labor force), the data looks like this:
For those unemployed less than five weeks (currently about one quarter of all unemployment) the unemployment rate is the lowest it has been since late 2000. For those unemployed 5-14 weeks, the unemployment rate is lower than in 2002-04, and for 15-26 weeks, the unemployment rate is almost down to 2002-04 levels. Thus, the elevated unemployment rate is coming almost exclusively from the very long term unemployed - 27 weeks or more.

If we plot Beveridge curves by duration of unemployment, we see another version of the same story. For those unemployed less than 5 weeks, the most recent observation is well to the left of the pre-financial crisis cloud:
For 5-14 weeks, the Beveridge relationship looks stable:
For 15-26 months you can observe the rightward shift in the relationship:
And this is even more pronounced for 27+ weeks unemployed:

What about Phillips curves? At the aggregate level, using the same sample as for the Beveridge curves, except quarterly rather than monthly data, with inflation measured as the annualized quarterly percentage change in the PCE deflator:
So, you may see a Phillips curve relation in that chart, but I don't - particularly in the recent data, where we have seen falling unemployment and a falling inflation rate.

But what if we disaggregate? Here's a Phillips curve for those unemployed less than five weeks:
Maybe there's something going on there, but I wouldn't want to base a policy decision on what I see in that chart. Seems like the observed Phillips curve predicts about 3% inflation given the current unemployment rate, but we're seeing about 1%. So much for that. Here are the other Phillips curve relations - not much going on there either:

When Williams says that "some economists see evidence that inflation is tied to short-term unemployment," he may mean Robert Gordon. But I think Williams and Gordon should read this JEL paper by Mavroeidis, Plagborg-Møller, and Stock. The upshot of that work is that Phillips curve coefficient estimates are extremely sensitive to specification and changes in the data set. The conclusion that one should draw, I think, is that econometricians estimating Phillips curves are not estimating anything useful - the estimates cannot be taken seriously in a policy exercise.

As should be clear from Williams's Q&A, recent FOMC statements, and public statements by Fed officials, the Phillips curve is alive and well in policy circles. But the weight of the empirical evidence (also see my charts in this post) makes one wonder what some people on the FOMC could be thinking. The idea that some measure of slack in the economy can help explain inflation, or predict it, appears rather foolish.

In the past, however, the Phillips curve has been a convenient fiction, which allowed the FOMC cover to increase the overnight nominal interest rate target. A persistently low nominal interest rate target ultimately produces low inflation. That's a prediction common to a wide class of mainstream monetary models, and the Fisher relation is a strong empirical regularity. If the FOMC argues that a "tight" labor market predicts higher future inflation, and that the nominal interest rate should go up when the labor market is tight, that ultimately becomes self-fulfilling. But in our current circumstances, even if we're seeing "tightness" in terms of short-term unemployment, we're not going to see significantly higher inflation as long as the policy rate remains low.

Thus, it's possible that sentiments like Williams's could lead the Fed to do the right thing for the wrong reason. If the Fed wants higher inflation, the policy rate needs to rise, and this may happen if the idea catches hold with the FOMC that the labor market is tight. My guess, however, is that the idea won't actually take hold. But listen to what Janet Yellen says tomorrow. That should tell us a lot about where the committee is headed.

Tuesday, March 11, 2014

Why are Canadians Working So Much More Than Americans?

If we track real GDP in the United States and Canada since the beginning of the last recession, the history looks similar.
I have normalized real GDP to 100 for each country in 2007Q4. You can see that the recession proceeded in similar ways, with Canada coming out a bit better. Real GDP was 1.4% higher in Canada in 2013Q4 relative to the U.S, as compared to 2007Q4. However in per capita terms, the U.S. did a bit better than Canada, as population growth 2007-2014 was more then two percentage points higher in Canada than in the U.S. (due to higher immigration).

But labor market conditions in Canada and the U.S. look very different, as David Andolfatto has pointed out. I'm going to use those differences to help sort out some of the issues raised by John Cochrane regarding the behavior of the employment/population ratio in the United States.

Though I want to focus on employment, it's useful to look first at unemployment rates in Canada and the U.S., to see some of the important differences.
As you can see, from the early 1980s until 2007, the unemployment rate was substantially higher in Canada than in the U.S. - at times by as much as four percentage points. But during the recession, Canada and the U.S. reversed roles. From trough to peak, the unemployment rate increased about six points in the U.S., and by about three points in Canada. During the recession, the unemployment rate was higher in the U.S., and unemployment rates are currently about the same in the two countries.

Next, let's look at aggregate employment/population ratios.
Here, you can see that employment/population ratios were similar in Canada and the U.S. before the recession, but the ratio dropped about two percentage points in Canada, and about four in the U.S. Currently, adjusting for the size of the working age population, the number of workers is close to 5% higher in Canada than in the U.S. That's a big number.

If we look at the whole time series in the last chart, there are some interesting things going on. In particular, before 1990, the behavior of employment/population ratios in the two countries was similar, with employment a little higher in the U.S. Then, in the early 1990s, Canada experienced a drop in the employment/population ratio of a similar magnitude to what occurred in the U.S. in the last recession. Indeed, we can just reverse the labels for post-1990 and post-2007, and the behavior looks much the same. In the early episode there is a small decline in the U.S. and a big one in Canada, and the opposite occurs in the later episode. A key point here is that large and persistent declines in employment are nothing new for rich countries, and need not have anything to do with financial crises.

Next, I'll show you the differences in behavior by gender.
So, just as in Olympic hockey, the Canadian men and women are both outdoing their U.S. counterparts. Interestingly, the current gap is much larger for women than for men. And, if we look at the whole time series, we can see similar patterns in the early 1990s episode and the recent recession. In the early 1990s, there is a large decline in employment in Canada, but the drop is larger for men than for women. And in the recent recession, the employment decline for men is larger than for women in the U.S. Note that this is also true for Canada. During the last recession, the employment/population ratio declined for men, but was roughly flat for women.

Finally, we'll look at the cross-country differences by age, with 15-24 first.
(Note here that I'm using annual data instead of monthly as in the previous charts. This is just what I could easily get access to). For the young, the difference between Canada and the U.S. is currently huge. Before 1980, both countries look about the same, then employment falls for the 15-24 group in Canada, but remains stable in the U.S. However, after 2000 there is a precipitous decline in youth employment in the U.S. There is a decrease in employment in Canada in this group during the last recession, but the decline is much larger in the U.S.

Next are the prime-age workers, aged 25-54.
Here again, the current difference between employment in Canada and the U.S. is huge, though not as great as the difference for 15-24. Something that shows up quite clearly in this chart is the secular decline in the U.S. employment/population ratio that begins about 2000. This secular decline is interrupted by a period of growth that corresponds roughly to the U.S. housing boom.

Finally, the old geezers (including yours truly), aged 55-64.
(Here we're back to monthly data, but with shorter time series, starting in 1995 instead of 1976). In this age group, you see only a small decline in employment in the U.S., and the recession is not even discernible in the Canadian data. But, what was a large employment gap between the U.S. and Canada in 1995 has declined to essentially zero.

It's important to understand what is driving the trend increase in the employment rate of older workers in Canada. That's due primarily to the changing behavior of older women over time. The labor force participation rates of younger women have increased on trend since Word War II in Canada. Thus as these women move through the age cohorts, average labor force participation has increased over time. In the sample depicted in the last chart, baby boom women, who have higher labor force participation than older cohorts, are accounting for an increasing larger fraction of the 55-64 group.

People are trying to get a grip on what caused the dramatic decrease in the employment-population ratio in the U.S. during the last recession, and why that ratio has shown little increase since the recession ended. So, in light of what we have learned from the above charts, let's run through some possible explanations.

1. Aggregate demand is persistently low. In hardcore Keynesian thinking, real GDP is demand-determined. Thus, the path of real GDP is determined by aggregate demand. But, look at the first chart. In the hardcore Keynesian mind, aggregate demand has been roughly the same (adjusting for population growth) in Canada and the U.S. since the beginning of the last recession. The North American economy is highly-integrated. Yet, what we see in the third chart is a difference of about 5% in employment between Canada and the U.S. So, I'm going to dismiss this explanation as a non-starter.

2. Taxation. As Noah Smith points out, it seems this should go the other way. Apparently marginal income tax rates are higher in Canada than in the U.S., so according to Ed Prescott, maybe Americans should be working harder than Canadians. But, perhaps we should expand our notion of what "taxation" is. In Canada, there is socialized medicine, financed through the tax system. In the U.S. - at least until Obamacare came into effect - most Americans were getting health care through private insurance provided as a benefit of employment. But from my point of view, the way I pay for health care looks just like a tax. When I lived in Canada, my federal and provincial income taxes would be withheld from my paycheck. In the U.S., my health insurance premium is a before-tax deduction from my paycheck.

So, suppose I think of the resource cost of health care in the U.S. as being like a tax. From the World Bank, in 2011 Canadian taxes were supporting health care expenditures of 11.2% of GDP, while U.S. "taxes" were supporting expenditures of 17.9% of GDP. So, I think if we did the calculation, we would find a substantially higher "tax" burden in the U.S. than in Canada. In the U.S., health care is a substantial inefficiency burden on the U.S. economy. The World Health Organization tells us that Canada is #12 in the world on the life expectancy scale (80.4 for men; 84.6 for women), while the U.S. is #35 (77.4 for men; 82.2 for women). For the U.S., this is much like having a larger government that delivers a lower quality of service.

But how does inefficient health care delivery affect labor supply decisions in the U.S.? First, consider pre-Obamacare arrangements. Paying a health insurance premium through my employer is like paying a tax, but I only get the benefit if I'm working. Thus, on net, the way health care was financed in the U.S. may have served to increase employment relative to Canada. As well, the tax was lump-sum, conditional on working, so it didn't affect my choice of hours of work - the intensive margin. Indeed, the negative wealth effect would tend to make me work harder. Post-Obamacare, it's a different story. Now, I get the healthcare benefit whether I work or not, which looks more like Canada. So, this should reduce labor supply by discouraging labor force participation - the extensive margin.

The direct effects of health care inefficiencies seem not to help us in explaining employment differences in Canada and the U.S., unless perhaps those inefficiencies are reflected in relative wages, which in turn affect labor supply. For example, protection for the health care sector (monopoly power; patent protection for drug manufacturers, for example), tends to inefficiently allocate capital in the economy toward the health care sector. This makes wages lower than they would otherwise be outside of the health care sector, which reduces non-health care labor supply, and health care labor supply is constrained by the medical profession. I am not aware of any work that measures this kind of effect.

3. Demography. This paper by Kapon and Tracy at the New York Fed suggests that the decline in the employment/population ratio in the U.S. could be explained by demographics. As the population ages, on average, labor supply declines. The problem with that idea is that the age structure of the population in Canada and the U.S. is very similar. Since World War II, fertility rates in Canada and the U.S. have been roughly the same. There are differences in immigration, certainly - Canada admits more immigrants, and its immigration policy is very different - but that's not going to explain the differences in behavior post-2000 in the two countries.

4. The Financial Crisis. Canada experienced only a mild decline in housing prices and residential construction during the recent recession. Thus, though we see a similar decline in real GDP in the two countries, the differences in sectoral composition of output could be important for the labor market. There also may have been greater dispersion in the decline in aggregate activity within the U.S. as opposed to within Canada during the recession. You may not think residential construction is a large enough sector to account for the differences in employment, but if we consider all the ancillary sectors - consumer durables and services, for example - related to housing, the effects could be large in the labor market.

4. Pre-Crisis Sectoral Issues. First, it would be useful to know what caused the large drop in the employment/population ratio in Canada post-1990 (see the third chart). That might give us some clues. Second, one possible story about the U.S., post-2000, is that there was an important secular sectoral shift that commences around 2000, but was masked by the post-2000 housing boom, which was essentially construction under false pretenses. If the sectoral shift is what was driving what we see in the time series, it had to affect men more than women, the old not at all, prime age workers somewhat, and young workers a lot. This also must have been a sectoral shift that affected the U.S., but not Canada.

I'm not sure where this leaves us. As John Cochrane says, you can't work all of this out in blog posts.