Wednesday, March 29, 2017

Low Real Interest Rates and Monetary Policy

That real rates of return on government debt are at historical lows is well-established. Of course, the anticipated real rate of return on government debt - which is what matters for economic behavior - is unobservable, and that's problematic. Typically, macroeconomists resort to proxy measures as a starting point for addressing issues related to low real interest rates. For example, we could use the current twelve-month measured inflation rate as a proxy for anticipated inflation, and subtract that from some observed nominal interest rate to get a crude measure of the real interest rate. Like this, for example:
The chart shows the three-month US T-bill rate, minus the 12-month pce inflation rate. As you can see, it's not like we have never seen real rates of interest (by this measure) as low, but short-term real interest rates have never been as persistently low, at least in the post-1960 sample.

Typically, though, when low real interest rates are discussed in policy circles, the discussion does not revolve so much around actual real rates of interest, but some other real interest rate concept. And there are several such concepts, which is bound to make things confusing, if not totally impenetrable. Let's try to sort this out.

(1) The natural real rate of interest: For the average macroeconomist, this measure is well-defined, though not necessarily useful. The natural real rate of interest, or Wicksellian natural rate is the real interest rate in a New Keynesian (NK) macroeconomic model, if we remove all wage and price stickiness. For simplicity, early NK models were built so as to leave out all sources of inefficiency, except for wage stickiness (sometimes) and price stickiness (usually). These models may have efficiency loss due to monopolistic competition, but that's a by-product of the approach to price stickiness. So, essentially, the natural real rate of interest is the real rate of interest in the underlying real business cycle model with flexible wages and prices. Why am I saying this concept is "not necessarily useful?" First, while there is some complacency among NK practitioners that NK is all we need to think about in understanding monetary policy, that's a dangerous idea. The basic model has many faults, not least of which is that it neglects the essential details of monetary policy - assets actually play no role in the model, in that there is no central bank balance sheet, no open market operations, no banks, no role for credit, for money, etc. Second, the baseline NK model cannot explain why the natural real rate of interest might be low. For example, low-real-interest-rate NK macroeconomics, such as Eggertsson and Woodford's work or Werning's, typically assumes the real interest rate is low because the subjective discount factor is high. That is, the low natural rate results from a contagious attack of patience. As is well-known, preference shock "explanations" for economic phenomena aren't helpful. If you like explaining the financial crisis as a contagious attack of laziness accompanied by an increased dislike for some assets and an infatuation with some other assets, most people aren't going to listen to you - and those that do listen shouldn't. I think some NK practitioners think of the high discount factor as a stand-in for something else. If so, it would be more useful to develop explicitly what that something else is.

(2) The equilibrium real interest rate: I'll let Ben Bernanke explain this one: helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
This is where the confusion starts. Bernanke tells us this is a synonym for the "Wicksellian interest rate," suggesting that the "equilibrium rate" is the same as the "natural rate." And he says that the equilibrium real interest rate is the "rate consistent with full employment of labor and capital resources," which would tend to steer the reader in the direction of thinking this is an NK natural rate of interest. But, the remainder of the paragraph appears to describe what happens in an IS-LM model, so Bernanke is mixing theories - never a recipe for clarity. Further, "equilibrium real interest rate" is bad language for describing the natural rate of interest in the NK model, as the sticky-prices-and-wages real interest rate is in fact an equilibrium real interest rate - but it's a non-standard equilibrium concept.

(3) The neutral real interest rate: Janet Yellen covered this one in a recent speech:
Gauging the current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance at a given time. A useful concept in this regard is the neutral "real" federal funds rate, defined as the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a "neutral" policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator. Although the concept of the neutral real federal funds rate is exceptionally useful in assessing policy, it is difficult in practical terms to know with precision where that rate stands. As a result, and as I described in a recent speech, my colleagues and I consider a wide range of information when assessing that rate. As I will discuss, our assessments of the neutral rate have significantly shifted down over the past few years.
To clarify, here's what I think she means. It's common to think of monetary policy in terms of a Taylor rule, which we can write as:

R = r* + a(i-i*) + b(y-y*) + i*,

where R is the fed funds rate, r* is a constant, i is the actual inflation rate, y is the actual level of output, i* is the inflation target, and y* is full-employment output. It's typical for people to assume that a > 1 and b > 0. Then, if there is full employment and the central bank is hitting its inflation target, we have R = r* + i*. So, in the Taylor rule, r* is the neutral real interest rate, and r* + i* is the neutral nominal fed funds rate before we have "adjusted for inflation," as Janet Yellen says.

So, given that r* is low, what implications does this have for monetary policy? Of course, the answer to that question should depend on why it is low. Economists have discussed several reasons for low real interest rates:

1. Low productivity growth: In standard models, the real interest rate falls when consumption growth falls. Lower growth in total factor productivity growth implies lower growth in consumption in the long run, which implies a lower real interest rate.

2. Demographics: Demographic structure matters for savings behavior, which in turn matters for the real interest rate. In particular population growth and longevity are important. For example, lower population growth tends to increase capital per worker and lower the real interest rate, and people save more if they expect to live longer, which also will tend to increase capital per worker and reduce the real interest rate. A paper by Carvahlo et al. is an attempt to disentangle some of those effects.

3. Higher demand and lower supply of safe, liquid assets: The low real interest rates we observe are interest rates on government debt, and such assets have functions that go well beyond providing a safe vehicle for savings. Government debt is widely traded in financial markets, and is the principle form of collateral in the market for repurchase agreements, which is a key part of the "financial plumbing" that helps financial markets run efficiently. Much like money, government debt bears a liquidity premium - market participants are willing to hold government debt at lower rates of return than if they were holding it purely for its associated payoffs. Then, the higher the demand for government debt relative to its supply, the higher the liquidity premium, and the lower the real interest rate on government debt. The supply of safe collateral fell as a result of the financial crisis - some types of private collateral and sovereign debt were no longer considered safe. As well, the crisis engendered an increase in demand for safe collateral due to an increase in perceived crisis risk, and because of new financial regulations, associated with Dodd-Frank and Basel III, for example.

I tend to think that (3) is most important, but that's based on working through some models, like this one and this one, and my own informal views on what is going on in the data. On that note, I should add a fourth factor:

4. Monetary policy: Indeed, the real rate of interest on government debt may in part be low because of monetary policy. First, conventional monetary policy can make the real interest rate permanently low. For example, in this paper, if safe collateral is scarce, a reduction in the nominal interest rate also reduces the real interest rate - permanently. That's because the open market operation that reduces the nominal interest rate is a purchase of good collateral (same effect under a floor system with reserves outstanding). Second, an expansion in the central bank's balance sheet can reduce the real interest rate, as I show in this paper. Basically, swapping reserves for government debt reduces the effective stock of safe collateral, as reserves are an inferior asset to government debt (why else would the interest rate on reserves exceed the T-bill rate?). Thus a central bank balance sheet expansion exacerbates the problem of collateral scarcity - quantitative easing may be a bad idea.

What we need to evaluate what is going on is a model that can incorporate these factors, and can be used both to evaluate quantitatively how (1)-(4) matter, and the implications for optimal monetary policy. So what are economists in central banks up to in this respect? At the most recent Brookings paper conference, there are a couple of papers that deal with the problem, one by Kiley and Roberts, at the Federal Reserve Board, and the other by Del Negro et al. at the New York Fed.

Let's look first at the Kiley and Roberts (KR) paper. The key monetary policy problem KW perceive with low r* - and this, not surprisingly, is consistent with mainstream policy views - is that this will cause the effective lower bound (ELB) on the nominal interest rate to bind more frequently. As they say,
ELB episodes may be more frequent and costly in the future, as nominal interest rates may remain substantially below the norms of the last fifty years.
Why would this happen? Going back to our Taylor rule, a lower r* implies that, when the central bank is hitting its targets, then the nominal interest rate has to be lower. So, if the economy is being hit by shocks which cause the central bank to move the nominal interest rate up and down, and if the average nominal interest rate is lower, then the central bank will find itself more frequently constrained by the ELB. Then, periods at the ELB will be periods when the central bank departs from its goals, and there is nothing (other than unconventional policy) that the central bank can do about it. Faced with this perceived problem, some policymakers contemplate increases in the central bank's inflation target - inflation would on average be higher, which may imply a welfare loss but, as the argument goes, there are benefits from being constrained by the ELB less frequently.

This is basically Fisherian logic. Over the long run, a higher nominal interest rate will be associated with higher inflation. Perhaps curiously, KR studiously avoid mention of Irving Fisher, though Jonas Fisher gets several mentions. The one callout to I. Fisher is this:
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
By the "Fisher equation" they mean the long-run Fisher effect, I think. Supposing that the long run real interest rate is a constant, r*, the long run relationship between the nominal interest rate and inflation is R = r* + i. But, of course, in the quote they have the causality going the wrong way. In their models, it's the central bank that controls inflation by controlling the nominal interest rate, so it's the nominal interest rate that's causing the inflation rate to be what it is, not the other way around. That's basic neo-Fisherism.

So what do KR do? They simulate a couple of models to determine what the potential losses are from retaining a 2% inflation target in a low-r* environment. The first model (and this won't surprise you if you know anything about quantitative policy analysis at the Board) is the FRB/US model. For the uninitiated, the FRB/US model is basically a relic of the 1960s - the type of large-scale econometric model that Lucas convinced us in 1976 should not be used for policy analysis. And, 41 years later, here's FRB/US - being used for policy analysis. As KR say:
As emphasized in Brayton, Laubach, and Reifschneider (2014) and Laforte and Roberts (2014), the FRB/US model is extensively used in monetary-policy analysis at the Federal Reserve and captures features of the economy that reflect consensus views across macroeconomists, but is not strictly “micro-founded” in the manner used in many academic analyses.
So, apparently, economists at the Board choose to ignore academic standards (no reputable academic journal would - or should - publish an article about the policy predictions of FRB/US), and go about "extensively" using FRB/US to think about policy.

And you can see where it goes wrong. Here's what FRB/US tells us about what happens in a low-r* world:
... the ELB binds often and inflation falls systematically short of the 2 percent objective; in addition, output is, on average, below its potential level.
Basically, FRB/US is an extended IS/LM/Phillips curve model. In it, long-run inflation is exogenous (2% basically), and inflation will deviate in the short run from its long run value due to Phillips curve effects. So, not surprisingly, in this type of framework, when the ELB binds, output is below "potential" and this causes inflation to fall short of its target. But, by neo-Fisherian logic, if on average the nominal interest rate is too high, because it keeps bumping up against the ELB, inflation should, on average, be exceeding its target. For example, in recent history in the US, some people think that the inflation rate was persistently below target because the nominal interest rate was effectively at the ELB, and we could have done better (have had higher inflation) if the nominal interest rate were permitted to go below zero. Not so. The fact that inflation was persistently below target indicates that the ELB was not a binding constraint. The nominal interest rate was too low.

What else are KR up to? They also use an off-the-shelf DSGE model, developed by Linde, Smets, and Wouters, to address the same policy question. Is this model an better-equipped to answer the question than the FRB/US model? No. Such models, though smaller and more manageable than old-fashioned large-scale macroeconometric models like FRB/US, certainly can't lay any claim to structural purity - there are plenty of ad-hoc features (adjustment costs, habit persistence) thrown in to fit the data, and the model certainly was not set up to capture the phenomenon at hand. Though this DSGE model can certainly capture a decline in productivity (feature (1)) there's nothing much in there with regard to (2)-(4), and the monetary policy detail is shockingly weak. So, I don't think we should take the results seriously.

The second paper, by Del Negro et al. (DGGT) is more of a straightforward time series exercise - but there's some DSGE in this one too. This paper confronts the data in a useful way, focusing on the "convenience yield" on government debt (which I called a "liquidity premium" above), and showing, for example, that corporate debt does not share this convenience yield, which is important. The analysis documents a fall in the real rate of interest beginning in the 1990s, and the estimate of the current real interest rate is 1.0-1.5%. The econometrics in DGGT is sophisticated, but ultimately I'm not sure if I trust it more than what I see in the chart at the beginning of this post. Currently, the 3-month T-bill rate rate is about 0.80%, and the last reading for the twelve-month pce inflation rate is 1.9%. So, by my crude measure, the current real interest rate is -1.1%. If someone is giving me an estimate of 1.0-1.5%, I'm going to think that's way too high. If, given current policy settings, inflation is roughly at target, as is labor market tightness, then the nominal interest rate must be about right, if we follow our Taylor-rule logic.

Monday, March 20, 2017

Do policymakers need more advice from sociologists?

Sociologists sometimes feel neglected. And this can cause them to complain - about economists. Economics is a successful social science. While most social sciences do well in attracting undergraduate students, economics has performed well off campus. An undergrad economics major pays well, and an economics PhD provides entry into plentiful high-paying jobs on Wall Street, and in government, central banks, and academia. As well, policymakers care what economists think, and seek their advice (current occupants of the executive branch excepted).

But life isn't so easy for the downtrodden sociologist, which has led to writing like this piece in the Journal of Economic Perspectives. I discussed that article in this blog post. Seems the upshot of the authors' critique is that economics would be much better if it adopted ideas from other social sciences - sociology in particular.

Economics is hardly perfect. To move forward as a science, we need to be objective, heartlessly self-critical, and outward-looking - ready to absorb new and useful ideas from other fields. So what does sociology have to offer us? Neil Irwin, at the New York Times, suggests that there are some key ideas in sociology that economists, and policymakers, are not absorbing. Irwin says:
They say when all you have is a hammer, every problem looks like a nail. And the risk is that when every policy adviser is an economist, every problem looks like inadequate per-capita gross domestic product. Another academic discipline may not have the ear of presidents but may actually do a better job of explaining what has gone wrong in large swaths of the United States and other advanced nations in recent years.
So, (i) things have gone wrong in the US and elsewhere. (ii) We may be ignoring better explanations for these things than what economists are supplying.

That other academic discipline with the explanations is sociology, of course. Neil then interviews a sociologist, to get her perspective:
“Once economists have the ears of people in Washington, they convince them that the only questions worth asking are the questions that economists are equipped to answer,” said Michèle Lamont, a Harvard sociologist and president of the American Sociological Association. “That’s not to take anything away from what they do. It’s just that many of the answers they give are very partial.”
So apparently we have been somewhat conspiratorial, whispering in the ears of the Washington elite that economics is it - and all the time neglecting some important stuff. But what exactly are we missing?

The rest of Neil's article details what he views as important contributions of sociology, that help us understand current problems:

1. “Wages are very important because of course they help people live and provide for their families,” said Herbert Gans, an emeritus professor of sociology at Columbia. “But what social values can do is say that unemployment isn’t just losing wages, it’s losing dignity and self-respect and a feeling of usefulness and all the things that make human beings happy and able to function.”

2. Jennifer M. Silva of Bucknell University has in recent years studied young working-class adults and found a profound sense of economic insecurity in which the traditional markers of reaching adulthood — buying a house, marrying, landing a steady job — feel out of reach.

3. “Evicted,” a much-heralded book by the Harvard sociologist Matthew Desmond, shows how the ever-present risk of losing a home breeds an insecurity and despondency among poor Americans.

4. ...a large body of sociological research touches on the idea of stigmatization, including of the poor and of racial minorities. It makes clear that there are harder problems to solve around these issues than simply eliminating overt discrimination.

So, unemployed people feel really bad, young people worry about the future, poverty is horrible, and stigma exists. I would hope that most people would know these things, and that they shouldn't need sociologists to point out the importance of these observations. But, if the role of sociologists is to inform otherwise-oblivious people about this stuff, then good for them.

But we're looking for something more, I think. Surely sociologists have ideas about solutions to these problems that they have spent so much time studying? Well, no.
And trying to solve social problems is a more complex undertaking than working to improve economic outcomes. It’s relatively clear how a change in tax policy or an adjustment to interest rates can make the economy grow faster or slower. It’s less obvious what, if anything, government can do to change forces that are driven by the human psyche.
Apparently sociology is so much harder than economics that sociologists are bereft of solutions. And no one's asking them anyway, so why bother?
But there is a risk that there is something of a vicious cycle at work. “When no one asks us for advice, there’s no incentive to become a policy field,” Professor Gans said.
Still glad to be an economist, I think.

Sunday, March 19, 2017

What is full employment anyway, and how would we know if we are there?

What are people talking about when they say "full employment?" Maybe they don't know either? Whatever it is, "full employment" is thought to be important for policy, particularly monetary policy. Indeed, it typically enters the monetary policy discussion as "maximum employment," the second leg of the Fed's dual mandate - the first leg being "price stability."

Perhaps surprisingly, there are still people who think the US economy is not at "full employment." I hate to pick on Narayana, but he's a convenient example. He posted this on his Twitter account:
Are we close to full emp? In steady state, emp. growth will be about 1.2M per year. It's about *twice* that in the data. (1) Employment is growing much faster than long run and inflation is still low. Conclusion: we're well below long run steady state. end
Also in an interview on Bloomberg, Narayana gives us the policy conclusion. Basically, he thinks there is still "slack" in the economy. My understanding is that "slack" means we are below "full employment."

So what is Narayana saying? I'm assuming he is looking at payroll employment - the employment number that comes from the establishment survey. In his judgement, in a "steady state," which for him seems to mean the "full employment" state, payroll employment would be growing at 1.2M per year, or 100,000 per month. But over the last three months, the average increase in payroll employment has exceeded 200,000 per month. So, if we accept all of Narayana's assumptions, we would say the US economy is below full employment - it has some catching up to do. According to Narayana, employment can grow for some time in excess of 100,000 jobs per month, until we catch up to full employment, and monetary policy should help that process along by refraining from interest rate hikes in the meantime.

Again, even if we accept all of Narayana's assumptions, we could disagree about his policy recommendation. Maybe the increase in the fed funds rate target will do little to impede the trajectory to full employment. Maybe it takes monetary policy a period of time to work, and by the time interest rate hikes have their effect we are at full employment. Maybe the interest rate hikes will allow the Fed to make progress on other policy goals than employment. But let's explore this issue in depth - let's investigate what we know about "full employment" and how we would determine from current data if we are there or not.

Where does Narayana get his 1.2M number from? Best guess is that he is looking at demographics. The working age population in the United States (age 15-64) has been growing at about 0.5% per year. But labor force participation has grown over time since World War II, and later cohorts have higher labor force participation rates. For example, the labor force participation rate of baby-boomers in prime working age was higher than the participation rate of the previous generation in prime working age. So, this would cause employment growth to be higher than population growth. That is, Narayana's assumptions imply employment growth of about 0.8% per year, which seems as good a number as any. Thus, the long-run growth path for the economy should exhibit a growth rate of about 0.8% per year - though there is considerable uncertainty about that estimate.

But, we measure employment in more than one way. This chart shows year-over-year employment growth from the establishment survey, and from the household survey (CPS):
For the last couple of years, employment growth has been falling on trend, by both measures. But currently, establishment-survey employment is growing at 1.6% per year, and household survey employment is growing at 1.0% per year. The latter number is a lot closer to 0.8%. The establishment survey is what it says - a survey of establishments. The household survey is a survey of people. The advantages of the establishment survey are that it covers a significant fraction of all establishments, and reporting errors are less likely - firms generally have a good idea how many people are on their payrolls. But, the household survey has broader coverage (includes the self-employed for example) of the population, and it's collected in a manner consistent with the unemployment and labor force participation data - that's all from the same survey. There's greater potential for measurement error in the household survey, as people can be confused by the questions they're asked. You can see that in the noise in the growth rate data in the chart.

Here's another interesting detail:
This chart looks at the ratio of household-survey employment to establishment-survey employment. Over long periods of time, these two measures don't grow at the same rate, due to changes over time in the fraction of workers who are in establishments vs. those who are not. For long-run employment growth rates, you should put more weight on the household survey number (as this is a survey of the whole working-age population), provided of course that some measurement bias isn't creeping into the household survey numbers over time. Note that, since the recession, establishment-survey employment has been growing at a significantly higher rate than household-survey employment.

So, I think that the conclusion is that we should temper our view of employment growth. Maybe it's much closer to a steady state rate than Narayana thinks.

But, on to some other measures of labor market performance. This chart shows the labor force participation rate (LFPR) and the employment-population ratio (EPOP).
Here, focus on the last year. LFPR is little changed, increasing from 62.9% to 63.0%, and the same is true for EPOP, which increased from 59.8% to 60.0%. That looks like a labor market that has settled down, or is close to it.

A standard measure of labor market tightness that labor economists like to look at is the ratio of job vacancies to unemployment, here measured as the ratio of the job openings rate to the unemployment rate:
So, by this measure the labor market is at its tightest since 2001. Job openings are plentiful relative to would-be workers.

People who want to argue that some slack remains in the labor market will sometimes emphasize unconventional measures of the unemployment rate:
In the chart, U3 is the conventional unemployment rate, and U6 includes marginally attached workers (those not in the labor force who may be receptive to working) and those employed part-time for economic reasons. The U3 measure is not so far, at 4.7%, from its previous trough of 4.4% in March 2007, while the gap between current U6, at 9.2% and its previous trough, at 7.9% in December 2006, is larger. Two caveats here: (i) How seriously we want to take U6 as a measure of unemployment is an open question. There are problems even with conventional unemployment measures, in that we do not measure the intensity of search - one person's unemployment is different from another's - and survey participants' understanding of the questions they are asked is problematic. The first issue is no worse a problem for U6 than for U3, but the second issue is assuredly worse. For example, it's not clear what "employed part time for economic reasons" means to the survey respondent, or what it should mean to the average economist. Active search, as measured in U3, has a clearer meaning from an economic point of view, than an expressed desire for something one does not have - non-satiation is ubiquitous in economic systems, and removing it is just not feasible. (ii) What's a normal level for U6? Maybe the U6 measure in December 2006 was undesirably low, due to what was going on in housing and mortgage markets.

Another labor market measure that might be interpreted as indicating labor market slack is long term unemployment (unemployed 27 weeks or more) - here measured as a rate relative to the labor force:
This measure is still somewhat elevated relative to pre-recession times. However, if we look at short term unemployment (5 weeks or less), this is unusually low:
As well, the insured unemployment rate (those receiving unemployment insurance as a percentage of the labor force) is very low:
To collect UI requires having worked recently, so this reflects the fact that few people are being laid off - transitions from employment to unemployment are low.

An interpretation of what is going on here is that the short-term and long-term unemployed are very different kinds of workers. In particular, they have different skills. Some skills are in high demand, others are not, and those who have been unemployed a long time have skills that are in low demand. A high level of long-term unemployed is consistent with elevated readings for U6 - people may be marginally attached or wanting to move from part-time to full-time work for the same reasons that people have been unemployed for a long time. What's going on may indicate a need for a policy response, but if the problem is skill mismatch, that's not a problem that has a monetary policy solution.

So, if the case someone wants to make is that the Fed should postpone interest rate increases because we are below full employment - that there is still slack in the labor market - then I think that's a very difficult case to make. We could argue all day about what an output gap is, whether this is something we should worry about, and whether monetary policy can do much about an output gap, but by conventional measures we don't seem to have one in the US at the current time. In terms of raw economic performance (price stability aside), there's not much for the Fed to do at the current time. Productivity growth is unusually low, as is real GDP growth, but if that's a policy problem, it's in the fiscal department, not the monetary department.

But there is more to Narayana's views than the state of the labor market. He thinks it's important that inflation is still below the Fed's target of 2%. Actually, headline PCE inflation, which is the measure specified in the Fed's longer-run goals statement, is essentially at the target, at 1.9%. I think what Narayana means is that, given his Phillips-curve view of the world, if we are close to full employment, inflation should be higher. In fact, the long-run Fisher effect tells us that, after an extended period of low nominal interest rates, the inflation rate should be low. Thus, one might actually be puzzled as to why the inflation rate is so high. We know something about this, though. Worldwide, real rates of interest on government debt have been unusually low, which implies that, given the nominal interest rate, inflation will be unusually high. But, this makes Narayana's policy conclusion close to being correct. The Fed is very close to its targets - both legs of the dual mandate - so why do anything?

A neo-Fisherian view says that we should increase (decrease) the central bank's nominal interest rate target when inflation is too low (high) - the reverse of conventional wisdom. But maybe inflation is somewhat elevated by increases in the price of crude oil, which have since somewhat reversed themselves. So, maybe the Fed's nominal interest rate target should go up a bit more, to achieve its 2% inflation target consistently.

Though Narayana's reasoning doesn't lead him in a crazy policy direction, it would do him good to ditch the Phillips curve reasoning - I don't think that's ever been useful for policy. If one had (I think mistakenly) taken Friedman to heart (as appears to be the case with Narayana), we might think that unemployment above the "natural rate" should lead to falling inflation, and unemployment below the natural rate should lead to rising inflation. But, that's not what we see in the data. Here, I use the CBO's measure of the natural rate of unemployment (quarterly data, 1990-2016):
According to standard Friedman Phillips-curve logic, we should see a negative correlation in the chart, but the correlation is essentially zero.

Friday, March 3, 2017

What's Up With Inflation?

In the past year, inflation rates have increased in a number of countries. Are these increases temporary or permanent? What do they imply for monetary policy?

One of the more stark turnarounds in inflation performance is in Sweden. To see what is going on, it helps to look at CPI levels:
Sweden had four years of inflation close to zero, but in the last year prices have been increasing, and the current 12-month inflation rate is 1.4%, which is getting much closer to the Riksbank's 2% inflation target. The path - actual, and projected by the Riksbank - for the Riksbank's policy interest rate looks like this:
So, the Riksbank's policy rate has been negative for about two years, and it envisions negative rates for the next two years.

For the Euro area, the story is similar. Here's the Euro area CPI:
The difference here, from Sweden, is that the inflation rate has been at zero for only three years, but you can see a similar increase in the inflation rate in the last year, with the current 12-month Euro area inflation rate at 1.6%. And the overnight interest rate in the Euro area looks like this:
As you can see, overnight nominal interest rates entered negative territory in 2015, and went significantly negative last year.

Another instance of increasing inflation is the UK:
In this case, it's more like two years of inflation close to zero, followed by an increase in 2016. The current 12-month inflation rate in the UK is 1.9%. The Bank of England's policy interest rate was targeted at 0.50% from March 2009 to August 2016, when it was reduced to 0.25%.

What's the most likely cause of the increase in the inflation rate in these three countries? I don't think we have to look far:
Crude oil prices fell from $100-110 in mid-2014 to about $30 in January 2016, and have since increased to $50-55. While changes in relative prices should not matter in the long run for inflation, a strong regularity is that, in the short run, shocks that cause large relative price movements are reflected in changes in inflation rates. As is well-known, that's particularly the case for crude oil prices, which are highly volatile and tend to move aggregate price indices in the same direction.

The timing certainly seems to suggest that oil price increases are responsible for the increase in inflation in Sweden, the Euro area, and the UK. But, of course, the monetary policies of the Riksbank, the ECB, and the Bank of England were specifically designed to increase inflation. These policies included low or negative nominal interest rate targets and large-scale asset purchases by the central bank. Most of the central bankers involved tend to subscribe to a simple Keynesian story: inflation expectations are fixed (i.e. "anchored"); lower interest rates reduce real rates of interest, which increase spending, output, and employment; inflation increases through a Phillips curve effect. Why can't we always see these effects? True believers might appeal to "long and variable lags" and a "flat Phillips curve." Those are dodges, I think. IS/LM/Phillips curve isn't a helpful framework for thinking about monetary policy if I have to worry about whether it's going to take six weeks or six years for monetary policy to work, or if I need to be concerned whether the Phillips curve is just resting, flat, sloping the wrong way, or deceased.

Further, there are countries in which extreme forms of negative interest rate monetary policy and a large central bank balance sheet don't appear to have moved inflation in the desired direction. One is Switzerland. Here's the Swiss CPI:
So, the recent history in Switzerland if one of unabated trend deflation. And overnight interest rates in Switzerland look like this:
Next, since April 2013 the Bank of Japan has resorted to every trick in the book (massive quantitative easing, low and negative nominal interest rates) to get inflation up to 2%. Here's the result:
I've told this story before, but it bears repeating. Since the BoJ's easing program began in April 2013, most of the increase in the CPI level has been due to an increase of three percentage points in the consumption tax in April 2014 in Japan. Inflation has averaged about zero for almost three years.

What's the conclusion? For all these countries, recent data is consistent with the view that persistently low nominal interest rates do not increase inflation - this just makes inflation low. If a central bank is persistently undershooting its inflation target, the solution - the neo-Fisherian solution - is to raise the nominal interest rate target. Undergraduate IS/LM/Phillips curve analysis may tell you that central banks increase inflation by reducing the nominal interest rate target, but that's inconsistent with the implications of essentially all modern mainstream macroeconomic models, and with recent experience.

But, even if we recognize the importance of Fisher effects, that will not make inflation control easy. (i) Shocks to the economy - for example large changes in the relative price of crude oil - can push inflation off track. (ii) The long-run real rate of interest is not a constant. As is now widely-recognized, the real rate of return on government debt, particularly in the United States, has trended downward for the last 35 years or so, and shows no signs that it will increase. By Fisherian reasoning, a persistently low real interest rate implies that the short-term nominal interest rate consistent with 2% inflation is much lower than it once was. But what's the best guess for the appropriate nominal interest rate currently, in the United States? Here's the inflation rate, and the 3-month T-bill rate in the United States (I'm using the T-bill rate to avoid questions as to what overnight rate we should be looking at):
So, the Fed's preferred measure of inflation (raw PCE inflation), at 1.9%, is very close to its target of 2%, after two interest rate hikes (in December 2015 and December 2016), which some claimed would reduce inflation and/or push the economy off a cliff. Looking at this same data in another way, subtract the 12-month inflation rate from the 3-month T-bill rate to get a measure of the real interest rate:
So, from mid-2012 to mid-2014, the real interest rate averaged about -1.3%, before oil prices fell. Now that the price of crude oil has again increased somewhat, the real interest rate is back in that ballpark again, with inflation close to the 2% target. So, what would a neo-Fisherian do? (i) There's no good reason to think that oil prices will keep going up, so the effects of the recent oil price increases should dissipate. So, with no change in monetary policy, we might expect a small reduction in the PCE inflation rate. (ii) There's no good reason to anticipate an increase in the long-run real rate of return on government debt, given our knowledge of what makes the real interest rate low (a shortage of safe assets, low average productivity growth). Therefore, a neo-Fisherian inflation-targeting policy maker might want another 1/4 point increase in the fed funds target, but not much more.