Tuesday, August 27, 2013

Reverse Repos and Fed Intervention

A key piece of information that I missed in the minutes from the July 30-31 FOMC meeting, is this:
In support of the Committee's longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee's ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives. The staff also identified several key issues that would require consideration in the design of such a facility, including the choice of the appropriate facility interest rate and possible additions to the range of eligible counterparties. In general, meeting participants indicated that they thought such a facility could prove helpful; they asked the staff to undertake further work to examine how it might operate and how it might affect short-term funding markets. A number of them emphasized that their interest in having the staff conduct additional research reflected an ongoing effort to improve the technical execution of policy and did not signal any change in the Committee's views about policy going forward.
So, what does that mean? If you check the state of the Fed's balance sheet, you'll see that the current size of the Fed's balance sheet is about $3.6 trillion. On the liabilities side, the Fed has reserve balances outstanding of about $2.2 trillion, and the Fed's assets include about $1.3 trillion in mortgage-backed securities and about $2 trillion in long-maturity Treasury notes and bonds. The Fed currently holds no Treasury bills. Thus, relative to pre-financial crisis times, the Fed has issued a very large stock of reserves in order to expand its asset portfolio. Further, that portfolio, which used to have a composition that looked roughly like the composition of the federal government debt outstanding, now is tilted heavily toward the long-maturity end of the spectrum, and includes assets which, though passed through public hands, are essentially private. For a very long time, the Fed is likely to have a balance sheet that is very large relative to what it has been historically, and it is not likely to be selling off assets or if it does sell assets, to sell them at a high rate.

Thus, the Fed is likely to be operating under a "floor system" for a long time. Under a floor system, there are excess reserves outstanding in financial markets each night, and the interest rate on reserves plays a key role in determining short-term interest rates. But, given the complications of the law governing payment of interest on reserves, GSEs (Fannie Mae and Freddie Mac) hold reserve accounts but cannot be paid interest on reserve balances by the Fed. Indeed, it seems that most of the current activity on the fed funds market consists of GSEs lending reserves overnight to financial institutions that receive interest on reserve balances. Arbitrage would seem to dictate that fed funds would trade at 0.25%, the interest rate on reserves (IROR), but that's not what happens, as you can see in the chart. There is something inhibiting arbitrage - the GSEs are poor bargainers, fed funds borrowing has implications for deposit insurance premia, for example.
And it's not like the friction in the market is going away. Currently the margin between the IROR and the fed funds rate is about as large as at any time since the Fed started paying interest on reserves.

So, what happens when the Fed reaches the "liftoff point," when it decides that the IROR should go up? Possibly the margin between the IROR and the fed funds rate stays at about 5 to 15 basis points. Maybe that margin increases. We might make some predictions based on what we think is determining the spread, but those predictions could be wrong, which could be embarrassing for the people running the Fed. For most of the financial system, the relevant opportunity cost of overnight funds is the IROR, not the fed funds rate. But, the Fed sticks to the fiction that the policy rate it cares about is the fed funds rate. The key wrinkle is that, officially, the IROR is set by the Board of Governors, not by the FOMC.

Suppose that the Fed, two years from now, announces that it intends to tighten. Suppose further that this tightening takes the form of an increase from 0.25% to 0.50% in the IROR. But what does the FOMC tell us about its target is for the fed funds rate in these circumstances? Currently the IROR is 0.25%, and the FOMC claims the "target" for the fed funds rate is 0-0.25%, which is obviously pretty safe, as 0 and 0.25% bound the possible outcomes. When tightening happens, suppose that the FOMC says its fed funds target is 0.25%-0.50%. Obviously that doesn't look like pre-financial crisis policy - it's not "normal" for the FOMC to be giving a range for the fed funds target. How does the Fed explain that? Alternatively, suppose the FOMC says the fed funds target is 0.30%, but it can't get the fed funds rate to go that high? What then? And what happens at higher levels for the IROR? Given the importance people attach to the policy rate, how is the Fed going to explain itself?

When the Fed first broached the idea of using reverse repurchase agreements (reverse repos) and term deposits, they sold the idea as "introducing reserve-draining tools." Initially, I thought this either represented a misconception about what causes inflation on the part of the Fed. Maybe they didn't understand that this change in the composition of the Fed's liabilities through the use of these tools would have little or no effect on inflation. Or maybe the idea was to reassure people who thought that reserves are money waiting to bust loose and cause a hyperinflation - if you give the reserves another name maybe those people won't be so bothered. Now I'm thinking this might be the brightest idea the Fed has come up with in a long time - at least the reverse repo part.

What's a reverse repo, in this instance? The New York Fed has experimented with small volumes of these transactions, in order to get some practice. As the excerpt above, from the FOMC minutes, indicates, the Fed reverse repo intervention will proceed as follows. The Fed will set a rate at which it will borrow in the overnight repo market, using the government bonds and mortgage-backed securities in its portfolio as collateral. The effect of such a reverse repo transaction is to change the composition of the Fed's liabilities - reserves outstanding are reduced, replaced by a collateralized loan to the Fed from the private sector. You might ask why a loan to the Fed needs to be collateralized. Surely the Fed is going to be good for it. But the Fed already has unsecured liabilties - those are called reserve accounts.

But what could this possibly accomplish? First, take a look at the newly-expanded list of reverse-repo counterparties, from the New York Fed's web site. This list includes the GSEs - Fannie Mae and Freddie Mac. Thus, reverse repos are a roundabout way of paying interest on reserves held by the GSEs, while staying within the bounds of the law. Further, the repo market potentially has a wider list of participants than the fed funds market does, and the fact that the lending is secured (fed funds lending is unsecured) makes the overnight repo rate a potentially better policy rate from the Fed's point of view.

It's possible then, that engaging in reverse repos allows the Fed to tighten up its control over short-term interest rates, while giving the public a better read on the effects of Fed's policies, and on Fed intentions. But, presumably what will happen post-liftoff is that the balances in GSE reserve accounts will disappear overnight into reverse repos with the Fed. There will then essentially be no activity on the fed funds market, and the fed funds rate will become meaningless. Maybe the fed has plans to supply data on overnight repo rates. Maybe such data exist (if so, please let me know). Of course, if the Fed reverse repos enough of its portfolio, it can reduce reserves to pre-crisis levels, which would presumably produce an active fed funds market. Maybe that's what the Fed wants. I know next to nothing about the practicalities of financial market trading, but wouldn't rolling over more than $2 trillion in reverse repos every day be a costly endeavor?

In any case, I think there is more to the reverse repo idea than might meet the eye. I think the Fed should tell us more about it.

Thursday, August 22, 2013

What the FOMC is Thinking: Parsing the FOMC Minutes

Minutes for the July 30-31 FOMC meeting were released this week. There are a few interesting tidbits in them that are worth discussing. You'll recall that, up to and around the June 18-19 meeting, the FOMC was having trouble getting its message across. Apparently driven by the interpretation of statements by Fed officials - primarily Ben Bernanke - the real yields on TIPS (see the chart for the 10-year yield) increased substantially from early May, and took a big jump around the time of the June FOMC meeting. The chart also shows the breakeven rate on ten-year Treasury bonds (nominal yield minus TIPS yield), which fell during the same period, though it has increased somewhat since June.

In the June meeting, the FOMC took an unusual step in authorizing Bernanke to expand on the FOMC statement in a press conference. The key extra information that Bernanke added concerned how "tapering" might take place. Basically, Bernanke said that the rate of long-maturity asset purchases by the Fed could be reduced toward the end of the year, and might be reduced to zero at about the time the unemployment rate crossed the 7% threshold. Perhaps surprisingly, none of that information actually made it into the FOMC statement following the July 30-31 meeting. Clearly, given what you see in the chart, the FOMC appears to have thought that communication had not gone so well. What financial market participants seem to have read in the tea leaves was a tightening message, but that wasn't the message that the Fed wanted to transmit.

Here's the spot in the July 30-31 meeting where the FOMC tries to figure out what happened:
In discussing the increases in U.S. longer-term interest rates that occurred in the wake of the June FOMC meeting and the associated press conference, meeting participants pointed to heightened financial market uncertainty about the path of monetary policy and a shift of market expectations toward less policy accommodation. A few participants suggested that this shift occurred in part because Committee participants' economic projections, released following the June meeting, generally showed a somewhat more favorable outlook than those of private forecasters, or because the June policy statement and press conference were seen as indicating relatively little concern about inflation readings, which had been low and declining. Moreover, investors may have perceived that Committee communications about the possibility of slowing the pace of asset purchases also implied a higher probability of an earlier firming of the federal funds rate. Subsequent Federal Reserve communications, which emphasized that decisions about the two policy tools were distinct and underscored that a highly accommodative stance of monetary policy would remain appropriate for a considerable period after purchases are completed, were seen as having helped clarify the Committee's policy strategy.
First, the bit about "little concern about inflation" reflects Bullard's dissent at the June meeting. Presumably Bullard thought that the important news at the June meeting was that inflation was lower than expected. So the message the markets should have received was "easing" rather than "tightening." Second, the part about "decisions about the two policy tools" being distinct doesn't make any sense. If decisions about the two policy tools currently in play - quantitative easing (QE) and forward guidance - are not linked, then they certainly should be. Maybe that's why people are confused.

There follows a discussion of what Bernanke said in the press conference following the June meeting, and the committee seems to have "reaffirmed" this - they don't have quarrels with the general idea. But the FOMC appeared gun-shy about putting any of that stuff in the FOMC statement:
participants considered whether it would be desirable to include in the Committee's policy statement additional information regarding the Committee's contingent outlook for asset purchases. Most participants saw the provision of such information, which would reaffirm the contingent outlook presented following the June meeting, as potentially useful; however, many also saw possible difficulties, such as the challenge of conveying the desired information succinctly and with adequate nuance, and the associated risk of again raising uncertainty about the Committee's policy intentions. A few participants saw other forms of communication as better suited for this purpose. Several participants favored including such additional information in the policy statement to be released following the current meeting; several others indicated that providing such information would be most useful when the time came for the Committee to begin reducing the pace of its securities purchases, reasoning that earlier inclusion might trigger an unintended tightening of financial conditions.
So, they are learning. Too much information can be a bad thing.

Following that, there is a discussion in the minutes about tweaking forward guidance. Should the 6.5% unemployment rate threshold be lowered? Should there be more information about what happens after the threshold is crossed? Thankfully, those ideas appeared to have been killed. In this case, I think simpler is better.

This gives you an idea about the fuss that goes into some words in the FOMC statement:
The Committee decided to indicate in the statement that it "reaffirmed its view"--rather than simply "expects"--that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.
You might think there's not much difference between reaffirming your view about what you expect as opposed to just expecting - e.g. "Jane reaffirmed she is pregnant." But, it might actually matter to people whether the Fed just decided today that they expected something rather than deciding, say, six months ago.

So, what to expect now? Here's my prediction: Tapering will be announced at the October meeting, and the Fed will reduce asset purchases by $10 billion per month until the purchases end in mid-2014. Then, the 6.5% unemployment rate threshold will be crossed in mid-2015. Then, who knows? Of course, some dramatic event - financial crisis in China, foreign exchange problems in other countries, whatever - could blow that forecast out of the water.

Tuesday, August 20, 2013

APK On the Warpath

A few posts back, I introduced you to the Anti-Paul Krugman, APK. Remember that APK is a right-wing hack. He (I think it's a he) has a PhD in Economics from the University of Chicago, circa 1980, is a registered Republican, an NRA member, and his favorite Democrats are Anthony Weiner and Bob Filner, though he leans to Filner. While APK's fellow right-wing cretin economist friends were acquiring the tools of conservatism - dynamic programming, models with market-clearing prices (ick!)- APK coasted through graduate school with what he had learned as an undergrad. Basically, he's a die-hard AD-AS guy. He can differentiate in a pinch, but would rather not. Don't ask him to integrate.

APK is pressuring me to write this, but he's making me uncomfortable. Unfortunately he's a rather scary guy (wears his NRA card on his chest), so I'm not inclined to argue. APK has been reading Brad DeLong and Paul Krugman, and boy, is he pissed. You'll recall what he said about Christy Romer the other day, which doesn't bear repeating. He was well beyond his usual smeariness, I'd say.

To get to the point, APK loves John Cochrane (though his love may well be unrequited), and so was seething with hateful venom when he read DeLong's and Krugman's posts, and practically ruptured an artery when he read
"hayters gotta hate; bullshitters gotta bullshit." It's what they do. It's who they are.
This comment from DeLong, which of course hits the nail on the head - Jane Austen couldn't have said it better - was wittily seconded by Krugman, who referred to Cochrane as "remarkably dense."

To no avail, I tried to convince APK of the wisdom in Krugman's post. Surely it's obvious that, in a liquidity trap, the Treasury should fill bottles with Federal Reserve Notes and bury them in coal mines. APK is just one of those people who, as Krugman says, "...find this sort of thing absurd on its face." Well, people are so stupid, I must say.

Anyway, after two hours of target practice to rid himself of excess rage, APK sat at his desk and scribbled out a rebuttal. You'll recall APK's analysis of our liquidity trap predicament, in the figure on my last post. In APK's model, which is essentially the same as Krugman's, except the AD curve is flatter, there is excessive aggregate demand in a liquidity trap. APK now has a litany of paradoxes:

1. The paradox of small government: Government spending goes down, and this makes output go up. Why? The decrease in government spending increases prices, reducing the real value of private debts, which causes an explosion of private expenditure.

2. The paradox of the multiplier: It's negative! See (1).

3. The anti-paradox of thrift: An increase in autonomous saving increases output. See (2).

4. The paradox of housing: Tax housing construction and output goes up. See (2)

After reading this, I had the following conversation with APK:

Me: But surely, you don't expect anyone to buy this, do you? It doesn't even pass the smell test.
APK: No, no. It's great. It's so simple. Everyone will get it. In fact, I've been talking to Newt about it. He's planning another run, and loves my economics. I can be Treasury Secretary if I play my cards right.
Me: Actually, I was thinking of the economics profession. They'll all think you're an idiot. Back in the day, Lucas said "beware an economist bearing free parameters," or something like that. What was that paper Sargent wrote? Something about "demand and supply curves." Read that again, and tell me what you think. Seriously, anyone under 60 is going to think you're a real clown.
APK: No, no. Reading that high-minded stuff is just a waste of time. Everyone out there has the attention span of an earthworm. Look, Krugman gets away with this big time, and he's making a fortune. This is where the money is.
Me: Fine, it's your funeral.

Then, APK left with his friends to shoot pumpkins off fence posts. Hopefully gone for good, but with my luck he'll be back.

Monday, August 19, 2013


No, Bob Lucas did not "smear" Christy Romer, and why Paul Krugman keeps repeating this is beyond me, particularly given that Lucas's non-smeary comments come from a Q&A from more than four years ago. I dealt with the issue in this post.

Sunday, August 18, 2013

Krugman to Farmer: "Show Me Your Trailer, or I Won't Watch Your Movie"

Paul Krugman has replied to Roger Farmer's letter of complaint. The bottom line is that Krugman finds Farmer impenetrable:
I’ve tried [to read Farmer's stuff], a couple of times, but found it very hard to penetrate and gave up — and several other economists I’ve talked to had the same reaction.

Krugman is on to something here. Though not always a paragon of transparency myself, I have at times found Farmer's work confusing. But there can be a nugget in there that is worth taking the trouble to dig for. Here's a tip for Krugman: Ignore the words that Roger writes, and just try to sort through the model. Typically, he's not doing anything that's technically difficult for the average economist with a PhD - the models typically have standard features.

A couple of years ago, I was confused by this paper by Roger. But, I think I figured it out, and the idea is fairly straightforward, and interesting enough that I wrote this paper, to explain Roger's idea and extend it. Krugman says:
Sorry, but I won’t commit to sitting through your two-hour movie if you can’t show me an interesting three-minute trailer.
So, here's the "trailer" for Roger's idea (different from the subject of his complaint - that's another idea):

Workers and firms are in the business of bargaining over the surplus from exchange. But how they split that surplus is indeterminate - we don't have good theories of bargaining power. What this can lead to is indeterminacy in real wages, aggregate economic activity, and the unemployment rate. There are multiple equilibria. If the unemployment rate is high, the expected payoff from searching for work tends to be low, and if the real wage is high, the expected payoff to searching for work tends to be high. In the model, equilibria with high unemployment rates and high real wages coexist with equilibria with low unemployment rates and low wages, and across these equilibria, the expected payoff to searching for work is equal to the best alternative. This encapsulates the basic Keynesian idea - private economic agents find it difficult to agree on socially beneficial terms of exchange - but in the model there is nothing left on the table. Everyone is optimizing in equilibrium, and no prices or wages are fixed. The government can fix things - this is an essential element of Keynesianism - but they do it in non-Keynesian ways. For example, Taylor rules don't work.

Though Krugman has a point, we can get carried away with sound-bite economics. As with good music, sometimes you have to live with it for a while before you get it. Then, there's no turning back. Examples:

1. Expectations and the Neutrality of Money was part of a revolution, but almost nobody got it when it was first written. And the people who got it initially were not waiting for the trailer to convince them. They were moving the research forward, and getting credit for it. Ideas progress quickly, and young economists who want to make a splash are not waiting for a three-minute spiel to convince them what the big new ideas are.

2. The economics job market: It's well-known that lazy recruiting strategies don't work. Every January, 10,000 economists converge on some city in the United States, and various academic and non-academic institutions conduct 30-minute interviews of newly-minted (or about-to-be-newly-minted) economics PhDs. Recruiters can show up for interviews without preparation, and screen candidates based solely on the 30-minute interview. That guarantees that the people who are hired are the ones who can give a 30-minute interview. Of course it's no guarantee that the candidates can actually do good research and teach effectively. The conclusion of this paper seems to be that: (i) the research payoff from the median economics PhD is pathetic; (ii)quality falls off quickly in the top-ranked schools: the top graduate from the University of Toronto is roughly as good as the #3 from Yale. Everyone knows that it is worthwhile to spend time reading job market papers - carefully. A job candidate can be an inarticulate nerd, but have the power to create beautiful research that will pay off big-time in the future.

Tuesday, August 13, 2013

Farmer on Krugman

Roger Farmer has posted an open letter to Paul Krugman. Farmer is a Keynesian, but he has his own unique view of what that means, and clearly he thinks he has differences with Krugman. Roger thinks about Keynesian ideas in terms of indeterminacy. You can explore those ideas on his website.

Friedman's Legacy

I'm not sure why, but there has been a lot of blogosphere writing on Milton Friedman recently, including posts by Paul Krugman and Tyler Cowen, among the usual suspects. Randy Wright once convinced me that we should call ourselves New Monetarists, and we wrote a couple of papers (this one, and this one) in which we try to get a grip on what that means. As New Monetarists, we think we have something to say about Friedman.

We can find plenty of faults in Friedman's ideas, but those ideas - reflected in Friedman's theoretical and empirical work - are deeply embedded in much of what we do as economists in the 21st century. By modern standards, Friedman was a crude economic theorist, but he used the simple tools he had available to develop deep ideas that were later fleshed out in fully-articulated economic models. His empirical work was highly influential and serves as a key reference point for some sub-fields in economics. Some examples:

1. Permanent Income Theory: The key idea here is that wealth is the primary determinant of consumption behavior. This serves as the basis for modern consumption-smoothing theories of consumption/savings decisions, modified to take account of various credit market frictions that we need to fit the data. The permanent income logic is a basic piece of intuition that macroeconomists use all the time - one of those ideas that are embedded in what we do.

2. The Friedman rule: Don't confuse this with the constant money growth rule, which comes from "The Role for Monetary Policy." The "Friedman rule" is the policy rule in the "Optimum Quantity of Money" essay. Basically, the nominal interest rate reflects a distortion. Eliminating that distortion requires reducing the nominal interest rate to zero in all states of the world, and that's what monetary policy should be aimed at doing, according to Friedman's logic in his paper. That logic is watertight, as it turns out there exists a wide class of conventional monetary models that yield Friedman's conclusion. We can think of plenty of good reasons why optimal monetary policy could take us away from the Friedman rule in practice, but whenever someone makes an argument for some monetary policy rule, we have to first ask the question: why isn't that rule the Friedman rule? The Friedman rule is fundamental in monetary theory.

3. Monetary history: Friedman and Schwartz's "Monetary History of the United States" was monumental. Part of the project involved data collection, including the construction of time series for monetary measures going back to the 19th century. Friedman wanted to make the case that monetary phenomena were important for economic activity, and that monetary policy matters. We may have good reasons to object to Friedman's view of how monetary policy works (if he even had a view that differed from conventional Old Keynesian ideas), or his monetarist black box, but the Monetary History is a touchstone, particularly for people who work on the Great Depression.

4. Policy rules: The rule that Friedman wanted central banks to follow was not the Friedman rule, but a constant-money-growth rule - that's in his 1968 AER paper. Friedman was successful in getting the rule adopted by central banks in the 1970s and 1980s, but the rule was a practical failure, for reasons that are well-understood. But Friedman got macroeconomists and policymakers thinking about policy rules and how they work. Out of that thinking came ideas about central bank commitment, Taylor rules, inflation targeting, nominal GDP targeting, thresholds, etc., that form the basis for modern analysis of central bank policy.

5. Money and Inflation: People seem to forget this, but in the 1970s there were many people, including prominent members of the economics profession such as Robert Solow, who thought that the way to control inflation was by way of "incomes policy." By that they meant wage and price controls. Friedman played a key role in convincing economists and policymakers that central banks could, and should, control inflation. That seems as natural today as saying that rain falls from the sky, and that's part of Friedman's influence.

6. Narrow banking: I tend to think this was one of Friedman's bad ideas, but it's been very influential. Friedman advocated a 100% reserve requirement in "A Program for Monetary Stability." Friedman thought of money as the stuff that is used in transactions - currency, transactions deposits at banks, etc. He also thought it was important to control the nominal quantity of that stuff. So, since the central bank controls the quantity of outside money (currency and reserves), if transactions deposits at banks are backed one-for-one with reserves, then the central bank controls the quantity of money (inside plus outside). Three problems with this: (i) moneyness is only a matter of degree; it's useless to try to define some stuff as "money" and other stuff as "not money." (ii) there are incentives to get around the 100% reserve requirement by starting another type of financial intermediary (a shadow bank) that isn't a bank in terms of regulations, but for all intents and purposes acts like one. (iii) financial intermediation performs a useful social role - the 100% reserve requirement is then a tax on something useful. Friedman's ideas in this respect are reflected in modern proposals for narrow banking. You can find some of that in Gary Gorton's work, for example, and I don't agree with it.

6. Counterpoint to Keynesian economics: Some people seem to think that Friedman was actually a Keynesian at heart, but he sure got on Tobin's nerves. Criticism is important - it helps to prevent and root out lazy science. Old Keynesian economics was probably much better - e.g. there would have been no "neoclassical synthesis" - because of Friedman.

If anyone wants to argue that Friedman is now unimportant for modern economics, that's like saying Bob Dylan is unimportant for modern music. Today, Bob Dylan is quite willing to climb on a stage and perform with a world-class group of musicians - but it's truly pathetic. Nevertheless, Bob Dylan doesn't get booed off the stage today, because people recognize his importance. In the 1960s, he got people riled up, everyone paid attention, and the world is much different today than it would have been if he had not done the work he did.

Monday, August 12, 2013

More Perils

In mid-2010, Jim Bullard wrote "Seven Faces of the Peril," which reflected fears at the time that the U.S. economy could be sucked into a long period of deflation such as had been experienced in Japan. Bullard's proposed solution to the problem, quantitative easing (QE), subsequently became a cornerstone of U.S. monetary policy. Bullard's reasoning was as follows. Think in terms of the long run, abstracting from any nonneutralities of money. In the long run, the Fisher relation holds, or

(1) R = i + r,

where R is the short-term nominal interest rate, i is the inflation rate, and r is the real interest rate. Assume that r is a constant. The central bank follows a Taylor rule, of the form

(2) R = max[ai +(1-a)i* + r,0],

where a > 1 is a constant and i* is the target inflation rate. In the Taylor rule, the nominal interest rate cannot fall below the zero lower bound (ZLB). This is a little different from Bullard's nonlinear Taylor rule, but it's the same idea.

In the first figure, (1) and (2) produce two long run steady states, A and B. Point B is the desirable steady state, from the central bank's point of view, as the actual inflation rate is the target rate. But there is another steady state, point A, at which the inflation rate is -r. In a large class of monetary models, point A is the Friedman rule, and r is the rate of time preference, so typically r > 0 and point A is a deflationary steady state. In some of the published work that Bullard cites in his paper, principally Benhabib et al., there are examples where "most" dynamic paths lead to A. Thus Bullard's concern.

In mid-2010, Bullard expressed his concerns, and QE2 (purchases of a total of $600 billion in long-maturity government debt by the Fed) began in the fall of 2010 and proceeded into mid-2011. The next chart shows the path of the year-over-year pce inflation rate.
As you can see, inflation rose during the QE2 period, and the Fed's approach appeared to be a big success, at least on the inflation side.

But how are we supposed to think about the first figure above, now? New Keynesians (NKs), who are driving Fed policy currently, seem to have settled on a story about what is going on. In the NK story, there was a "real" shock to the economy - that's the financial crisis. That shock is highly persistent. NK models typically don't have much going on of a financial nature, so that's captured as a preference shock - a decrease in the rate of time preference, or in r, in our parlance. Thus, the financial crisis shock becomes a contagious attack of patience.

Figure 2 is the market for nominal bonds, which plays a crucial role in a NK model. Nominal bonds are in zero net supply in equilibrium, and the demand for nominal bonds is increasing in the actual real interest rate ra. The "natural real rate," in NK parlance, is r, which is lower than the equilibrium real rate. Why? In terms of how the FOMC collectively thinks, prices are sticky, the anticipated inflation rate is a constant (expectations are "anchored"), so the real rate of interest cannot go lower because the nominal rate is at the zero lower bound. What has to adjust is the demand for bonds, which falls enough to give an equilibrium at A through a reduction in current consumption. Thus, there is an "output gap."

Though the contagious attack of patience is a persistent shock, apparently, the output gap in NK models is not so persistent. Suppose the nominal interest rate stays at the zero lower bound. As prices adjust, the output gap falls, and the real rate falls to the natural rate r in the figure. Once prices have adjusted, the equilibrium is at B. The output gap has gone away, and the inflation rate has risen.

Until mid-2011 (see the inflation chart above), things seemed to be working according to plan. The inflation rate rose as QE2 proceeded, until mid-2011, but then began to fall, and has continued to do so, on trend. Though real TIPS yields fell, employment growth and real GDP growth remained stubbornly slow. In this instance, a thinking NK person - call him or her NKT - might start thinking there is something missing in the theory that he or she would have to account for. NKT might think that, by 2011, prices had done most of their adjusting. In this person's mind, the sluggish employment and GDP growth no longer represented a sticky-price output gap, but something else. Real GDP could be low because of frictions and inefficiencies that monetary policy might be able to resolve. Or maybe this sluggishness in real economic growth either could not, or should not, be the object of monetary policy actions. In any case, NKT was confused, and in order to be un-confused, he or she went to work to find out what was going on.

But, while NKT was doing his or her work, the FOMC was meeting and wondering what to do. They needed to explain things on the spot, and make policy decisions. What seems to have taken hold is a form of Old Keynesianism (OK). In OK, you can explain essentially anything, and almost any policy can be justified - everything is OK. Without scientific discipline, anything goes. According to OK, high unemployment relative to trend always represents an output gap (an inefficiency); if inflation does not seem to be falling enough given how big you think the output gap is, then there must be some costs that are preventing it from falling more; whatever might reduce nominal interest rates at any maturity is a good thing, etc. Ultimately, given its frustrated attempts to reduce the output gap it thinks it sees, the Fed has resorted to further QE experiments, and increasingly elaborate forward guidance.

In the meantime, NKT might have come up with the following idea. By early 2012, inflation was down to 2%, and we were almost four years past the financial crisis, so the effects of price stickiness as related to the financial crisis shock had pretty much played themselves out. But, for whatever reason, the real rate of interest was still low. NKT read Bullard's 2010 paper, and might have been thinking that the situation in 2012 looked like Figure 3. In the figure, the Taylor rule is now

(3) R =ai + (1-a)i* + re,

where re is what the Fed thinks the long run real rate of interest is. The long-run real rate has fallen to r1, and so now instead of two equilibria, we have one, at point A in the figure. Fortunately, at the zero lower bound the inflation rate is i*, the target.

But, NKT says, what's going on now, in 2013? NKT is beyond thinking about contagious attacks of impatience and is pondering why the real rate of interest should be so low. NKT is thinking about incomplete markets models, borrowing constraints, private information, banking, limited commitment, and New Monetarism. He's read Rocheteau, Wright, Lagos, yours truly, etc. So, NKT thinks, maybe the real rate is low because the financial crisis effectively destroyed the value of some private assets and the sovereign debt of some countries as collateral and in financial exchange. So, there is a low supply of safe assets, which makes the price of those assets high and their real rates of return low.

But, as the financial sector mends itself, and debt problems get resolved, the scarcity of safe assets starts to go away. If the real rate rises from r1 to r2, and the Fed keeps the policy rate at the zero lower bound (and still thinks the real rate is re), we go to an equilibrium at B, with a lower inflation rate.

Further, as NKT reasons, we open up another possibility, which is an equilibrium at C. This results if the private sector anticipates a high inflation rate above i*. The Fed continues to think that re is the long-run real interest rate, and attempts to fight inflation above the target rate, by raising the nominal rate of interest to a level that simply validates the high inflation.

If NKT were really ambitious, however, he or she would have come to the Summer Workshop on Money, Banking, and Payments, at the Chicago Fed. If NKT read this paper, he or she might reason as follows. You can construct examples, using the model in that paper, where the actions of the central bank link the inflation rate to the real rate of interest. Instead of the Fisher relation in equation (1) above, you get (in the example):

(4) R = g(i) + i,

where g(i) is an increasing and concave function, with g(i) < r for i < i**, and g(i) = r, for i >= i**, for i** sufficiently high. In this case you get the equilibrium at B (zero lower bound), and a high-inflation equilibrium at D, with even higher inflation than what NKT finds if the real rate is independent of inflation.

So, if the real rate continues to rise, and the Fed keeps to its current forward guidance commitment, the inflation rate will continue to fall. Under these circumstances, the Fed simply cannot increase inflation without increasing the policy rate - the nominal interest rate on reserves in this case. You can't be in denial about Irving Fisher. But the Fed could gets things wrong in another sense. If it underestimates the actual real rate in the future, and adheres to typical Taylor-rule thinking, then there is a risk of high inflation - the Fed beating its head against the wall in thinking it is tightening, but actually sustaining the high rate of inflation. So there's pre-threshold risk on the low side, and post-threshold risk on the high side.

Modern macroeconomics supports the idea that commitment by policy makers is a good idea. But commitment to what? In the case of simple Taylor rules, there are problems. (i) How do we know what the output gap is? (ii) The short term real interest rate is not a constant in the long run, but reflects how short-term government debt is used in transactions and as collateral. (iii) The Taylor rule may have poor long-run properties.

Rules may not be a good substitute for knowing what is going on.

Wednesday, August 7, 2013

Forward Guidance in the U.K.

Mark Carney's first major move as Governor of the Bank of England was to adopt what looks like a replica of the Fed's forward guidance policy, with some potential QE in the mix as well. As with the Fed, there are some contingencies associated with this:
Carney said the unemployment target could be abandoned should the bank's internal analysis show GDP growth was the cause of a rise in prices of more than 2.5% in two years' time.
That's odd. How are we supposed to know whether a given change in GDP "caused" a given change in prices? What does that mean anyway? In a lot of macro theories, we think of exogenous shocks as driving endogenous variables - which are typically GDP, prices, etc. I guess you could write down a theory where GDP is exogenous, but that doesn't look like anything that serious macroeconomists take seriously. But what if you could write down such a theory? Then Carney seems to be saying that there might be things causing inflation other than GDP, and if those come into play, he's not going to get bent out of shape about it. More simply, I think we should interpret Carney as saying that he's going to tolerate inflation above 2.5% if he thinks the real side of the economy is weak. Forward guidance is a surefire way to confuse anyone, but Carney made this more confusing than it needed to be.

Sunday, August 4, 2013

The Right-Wing Anti-Krugman

We're going to imagine there exists a right-wing version of Paul Krugman, and we'll call him/her APK. APK has a good gig with the Wall Street Journal, or some other such right-wing rag, and is also pissed with the Obama administration. APK thinks that Obamacare is an abomination, and wants a smaller government. For some reason, dating perhaps to his time in graduate school at the University of Chicago, APK just cannot abide nerdy types, particularly the ones armed with functional equations, and would like to hoist those characters on their own petards, as it were. APK went to Chicago in 1976 expecting some kind of low-tech economics on the order of what Stigler and Friedman did, but got that idiot Lucas instead. Good God!

APK reasons that there is an army of people he/she can recruit for the cause - those who have seen only a smattering of undergraduate economics. If they have studied only principles of economics from books like Mankiw or Krugman and Wells, all the better. The game here is that he/she wants to tell an accessible story that should be convincing to this type of person - no more and no less.

The model APK is going to use is a straightforward AD/AS model with a liquidity trap. It's like Krugman's (second figure), except APK reasons that the effect of the debt overhang on the demand for goods is really large, so the AD curve should have a slope smaller than the slope of the AS curve. APK has been reading my blog too, for some reason that I can't figure out, and has come across this post and this one, and that's giving him/her some ideas.

The APK model is in the figure.
In the IS/LM part of the diagram, we have the liquidity trap case, with a flat LM curve. In the AD/AS portion of the diagram, the AD curve is positively-sloped and flatter than the AS curve because of a large negative effect of private debt (denominated in nominal terms) on the demand for goods. Point A is the initial short-run equilibrium. If there is no government intervention, the economy will ultimately settle in the long run at point B, after the nominal wage falls and the price level rises, restoring market-clearing in the labor market. Along the path to the long run equilibrium, APK reasons, the price level rises at a rate that is higher the larger is the output gap, which gives the Phillips curve in the bottom of the figure. Note that it slopes the opposite way from how we're used to thinking about, undergrads. No need to worry though. This situation is unprecedented. We're in a liquidity trap and weird shit is happening.

So, APK says, we're in a bad situation. In line with other Inflationistas - APK just had Ron Paul over for dinner - APK is worried about high inflation, as his/her model predicts that it should be well above PI*, which is the 2% anticipated rate of inflation that appears to be well-anchored by the Fed. But we don't have to suffer this high inflation for such a long time - possibly until we are all dead - as there is something we can do now now now. APK resons that we can reduce government spending, which will shift the aggregate demand curve left from AD1 to AD2, reduce the inflation rate (though of course the price level is actually higher at F than at B - but APK thinks that people are going to forget about the price level rise quickly), and get all those whiny unemployed people off our backs at point F. How does this happen? Lower government spending unleashes a torrent of private spending because of the rise in the price level that deflates private debts - there is a negative multiplier that can be very large in absolute value.

Hopefully you get the point now. I've used all the elements of Krugman's narrative, I think, and put these things into the model that he likes to argue is all we need to think about the serious macroeconomic problems of the day. And most everything goes the wrong way, in ways that some knee-jerk right-wing cretin would find very appealing. Conclusion? Though AD/AS analysis seems parked forever in undergraduate textbooks, researchers and policy analysts abandoned it long ago for good reasons. Once modern macroeconomists figured out how to incorporate all the standard tools of economic analysis - game theory, general equilibrium theory, contract theory, mechanism design, etc. - in what they were doing, the game was up. Doing it properly keeps everyone honest - we present models so that they can be taken apart and analyzed to see if they square with the preceding research in convincing ways. I don't see how we would want it any other way.

Saturday, August 3, 2013

Saturday Entertainment: What's Krugman Doing with his AD/AS Model Now?

When someone is using the wrong tool, we at least hope that they're using the tool properly. For example, suppose Paul Bunyan wants to cut down a very large tree with a very small hatchet. It will certainly work better if he holds the hatchet by the handle and strikes the tree with the head, and not the other way around. Case in point: this "wonkish" post by another Paul.

Krugman obviously didn't read this post of mine, where I try to figure out what he is up to. You'll see in Krugman's post that his current preferred AD/AS configuration is Figure 3 in my post. AD is steeper than AS, and upward sloping. Here's what Krugman says about his second Figure "AS-AD with ZLB," which is my Figure 3:
Now, the reality is that prices and especially wages are sticky — which is why we don’t see runaway deflation. But that stickiness isn’t what’s keeping unemployment high, it’s just something we have to let into our models to make sense of what we see out there.
The AD/AS model Krugman has constructed is indeed a sticky wage model. If he's thinking about the quantity of output that gets determined as being less than "full employment," then the stickiness is that the nominal wage wants to rise but it can't. You would get full employment with an increase in the nominal wage, which shifts the AS curve left, and increases the price level and output. Output goes up because the increase in the price level deflates the value of private debt, and shifts the IS curve right. So what's going on in the labor market in the background of Krugman's second figure? There is an excess demand for labor. Firms really want to hire workers, but they can't find enough people to work at the market wage. That's a very funny kind of unemployment. Maybe Krugman can explain it to us.**

The other problem is that the Krugman narrative seems to be that we would be in a deflation, but for the wage stickiness that is holding up wages and prices. But what's going on in Krugman's second figure and my Figure 3 is that the increase in prices and wages that would give us full employment is being suppressed. I'm really confused.

I've been trying very hard to understand what Krugman thinks a liquidity trap is. As far as I can tell, price stickiness seems necessary to get it. But the liqudity traps I'm familiar with are summarized nicely in this paper by Cole and Kocherlakota and in a more recent paper by Ricardo Lagos. Those papers are about Friedman rules - monetary policies that will give you zero nominal interest rates forever. The basic idea is that the restrictions on the policies that will give you this are weak. That's a liqudity trap - at the zero lower bound we can alter policy in various ways and it doesn't matter. An interesting result I can get in this paper and this one is that you can get a liquidity trap away from the Friedman rule. That's due to an asset scarcity which makes the real interest rate low. If assets are extremely scarce you can have very high inflation rates at the zero lower bound. In all of those models prices are flexible. Conclusion: Liquidity traps need have nothing to do with sticky prices and wages.

**Addendum: Can't believe I woke up in the morning thinking about this. In the short run in Krugman's figure, the real wage is indeed too high, and there is an excess supply of labor, which is part of Krugman's narrative. The key problem in the narrative for this case is that the flexible price equilibrium has a higher nominal wage and higher price level, so the problem can't be a failure of wages to fall. Further, now I'm wondering how Krugman excludes Figure 4 in my previous post. That's the one where the slope of the AD curve is smaller than the slope of the AS curve and you have excessive aggregate demand. Does he know something about how strong that negative wealth effect is?

Friday, August 2, 2013

Hawks, Doves, and Hyenas

People seem fond of categorizing central bankers as "hawks" and "doves." I think what people have in mind when they talk about the hawk/dove divide is the Phillips curve as a policy menu, much as in Samuelson and Solow. Then, hawks and doves are people who agree that what they are doing is choosing a point on the Phillips curve, but disagree about what point to pick. Hawks are more willing to substitute unemployment for inflation than are doves. You can see why someone who perceives himself or herself as a dove in this context would like the nomenclature. A hawk is someone who is trying to screw the unemployed -- worse than a vulture, who just eats what dies of natural causes. The hawk kills, and then eats.

Currently, that's not a helpful way of thinking about, for example, the members of the FOMC, and why they might disagree with each other. Fundamentally, these people don't agree on the theories they are using to guide their decisions. Some people might argue that preferences determine the choice of theories (that seems to be the crux of what Krugman has to say), but I don't think so. Here's a better guide to how people think:

New Keynesians: These are people who have absorbed modern macroeconomics, and have bought into the framework developed by Mike Woodford and others. That framework was an outgrowth of the neoclassical growth model (Cass-Koopmans), Brock and Mirman, and Kydland-Prescott, incorporating monetary factors, and with a role for monetary policy. This is the theory that is dominant on the committee. It's what's principally driving the forward guidance aspect of current monetary policy, i.e. promises about future policy that are supposed to have beneficial effects today. The hard-core New Keynesians are Williams (San Francisco), Evans (Chicago), and Kocherlakota (Minneapolis). Bullard (St. Louis) has some New Keynesian sympathies, as does Plosser (Philadelphia), I think.

Old Keynesians: This is some version of IS-LM, AD-AS, Phillips curve, much like what you would find in some undergraduate textbooks (not in my favorite one, as Mankiw would say). This is pretty loosey-goosey, and can incorporate almost anything. Fortunately for the Old Keynesians, the New Keynesians (for just this reason) have taken pains to describe what they do in the language of Old Keynesians - you can often find words like "IS curve" and "Phillips curve" in there. The rationale for quantitative easing (QE) - a cornerstone of current policy - is pretty much Old Keynesian. To the extent anyone justifies it, it's done using pre-1970 theory. The "transmission" mechanism that Fed officials describe for QE - purchase assets, interest rate falls, investment goes up - sounds like something straight out of a principles of economics textbook. The most prominent Old Keynesian on the FOMC is Janet Yellen.

Old Monetarists: This is literally a dying breed. Hard-core monetarism is represented best by the views of Milton Friedman: (i) monetary factors are very important, but attempts by the central bank to intervene to influence real activity in a good way are likely to go haywire; (ii) there exists a stable money demand function; (iii) central banks should be targeting money growth so as to control inflation. Views (ii) and (iii) died in most, if not all, central banks in the 1980s. But Plosser has some old monetarist views.

There are some outliers in there. George (Kansas City), Fisher (Dallas), and Lockhart (Atlanta) are hard to place. Rosengren is a Keynesian with some background in banking, and Lacker doesn't fit into a neat macro pigeonhole. The others I don't know much about.

Increasingly important, and I think surprisingly overlooked in light of the financial crisis, are the backgrounds of monetary policymakers in general economics. What do they know about banking theory, incentives, and information problems? What do they know about banking and monetary history and how the financial systems in different countries work? In the next financial crisis, we want a person running our central bank who understands what too-big-to-fail is about, the nature of long-run moral hazard, and how moral hazard can work against the central bank even during a crisis.

As well, in the context of run-of-the-mill macro monetary policy, different views about the mechanism by which monetary policy works can be irrelevant. Everyone appears to accept that there is some short-run nonneutrality of money at work. Everyone accepts that it is important that the central bank control inflation. The key differences are in views about the persistence of monetary nonneutrality, and how to spot inefficiencies that the central bank is capable of correcting. Some people look at the state of the world now and think that the difference between real GDP today and what it would have been if it had continued to grow at 3% per year since the end of World War II is all inefficiency. You can find other people who think that where real GDP is today is about the best we can do. There are a lot of other people who aren't sure one way or the other.

So, how would either Larry Summers, or Janet Yellen, fit in as leader of this group? Brad DeLong tells us that other people think that Summers is a "right-wing hyena," but he thinks Summers is a good guy. DeLong fits nicely in the Old Keynesian camp, so maybe Summers is an Old Keynesian. But clearly Paul Krugman does not like Summers. He seems to like Yellen better. Krugman is certainly an Old Keynesian too, and maybe DeLong is just sticking up for his friend and coauthor Summers, so maybe Summers is not so Old Keynesian after all.

Janet Yellen is firmly Old Keynesian. Her training happened before the revolution in macroeconomics took place, and it's quite clear that she thinks about the world in a conventional IS-LM, Phillips curve, demand-management style.

If we were to choose a Fed chair based on academic records, then this would be no contest. Summers, in spite of being occupied as a policy wonk for a considerable period of time, still has a REPEC ranking of 25. That's a #25 ranking in the world among economists, based on publications in academic journals, quality of publications, citations to those publications, etc. Yellen's ranking is 805. Summers was tenured at Harvard at age 28, while Yellen never made it past the assistant professor rank there. Of course we know that central banking requires some different skills from what it takes to publish papers. Some of our colleagues should definitely not be let out in public.

A good Fed Chair should be collegial. That means making FOMC members feel comfortable in expressing their views, so that diverse information can be forged into some kind of coherent synthesis, as part of the policy process. Bernanke has been very good at exploiting the strengths of the unusually-decentralized Federal Reserve System. The regional Presidents have their own staffs, their own views, and Bernanke by all reports is willing to listen, and has used ideas from the regional Feds as part of the monetary policy program. As well, the regional Presidents seem free to speak their minds in public, and they often do. I think all of that is healthy.

Some clues to how Summers thinks are in the transcript and video for this forum on "new economics." The worst it gets is when Summers says this:
When I was in the government, I got a lot of papers in the mail. To the first approximation, I attempted to read all the ones that used the words ‘leverage,’ ‘liquidity,’ ‘deflation’ or ‘depression.’ And I attempted to read none of the ones that used the words ‘neoclassical,’ ‘choice theoretic,’ ‘real business cycle,’ or ‘optimizing model of.’ (laughter) There were more in the second category than there were in the first. But there were a reasonable number in the first, and they told you a lot.

There is a lot in Badgett [sic] that is about the crisis we just went through. There’s more in Minksy and perhaps more still in Kindleberger.2 There are enormous amounts that are essentially distracting, confusing, and problem denying in the stuff that is the substance of the first year courses in most PhD programs.

So I think economics knows a fair amount. I think economics has forgotten a fair amount that’s relevant. And it has been distracted by an enormous amount.

You can find other things in that forum, and in what Summers has said in other contexts, that put him in a more favorable light, but I think that quote is telling. It's interesting to read Bagehot, or Minsky, or Kindleberger, but we're going to find a lot more serious ammunition to bring to bear on thinking about financial problems in work on money, banking, information economics, mechanism design, contracts, and incentive problems, that people have been working on in the last 30 years or so. Summers has revealed himself here to be shockingly closed-minded - he wants to ignore a large segment of research that the mainstream of the economics profession takes very seriously. A leader of central bankers needs to dig into all the alternatives and understand them, even if he or she doesn't agree with everything. Summers seems to impress people as always wanting to demonstrate that he is the smartest person in the room. He is quick to come to a conclusion, and can be an intellectual bully. Not exactly Mr. Collegial.

If you have never seen Janet Yellen in action, here's a speech she gave at the Haas Business School at Berkeley. She's clear, articulate, and thoughtful, I think. Yellen has a reputation in the Fed system as being a good listener - she's certainly collegial. There is no reason to expect that she would not follow Bernanke's example in encouraging independent thinking in the hinterland - places like St. Louis. Yellen may be overly inclined to see everything going on in the U.S. economy as a demand management problem, but maybe that's not the worst flaw we could have in a central banker.

Summers has the additional problem of being too closely allied with various power structures. He is part of the Cambrige, MA clique. He has worked for hedge funds and too-big-to-fail banks. Not good for central bank independence.

I think I'm with Krugman on this one. Though there are potentially better choices around, Janet Yellen would be fine, and I think Larry Summers is just too risky a bet, though he might surprise us.