Monday, February 8, 2016

Responding to Our Critics

Ramesh Ponnuru and I respond to the critics of our New York Times op-ed over at Bloomberg View:
Bold theses should receive skeptical reactions, and ours did. We argued in the New York Times that, contrary to what just about everyone believes, the financial crisis and the Great Recession that blew up the American economy in 2008 were not the necessary consequences of a housing bust...
Since some criticisms were directed at arguments we didn’t actually make, we should clarify a few things.

First, we are not saying that the right Fed policy would have kept any recession from happening. As we noted, the recession began in December 2007...Our argument, rather, is that [the Fed's] mistakes turned what could have been a mild recession into a “great" one.

Second, we aren't saying that better Fed policy could have prevented serious financial turmoil. Again, we explicitly note that financial stress began before the Fed’s worst errors. Our argument is the errors made that stress much worse.  
Please read the whole article. I would encourage interested readers to also see my follow-up post to the New York Times op-ed where I provide some empirical support for our claims. 

A key point we make in our Bloomberg View piece is that is one has to be careful in assessing the stance of monetary policy. Just because the Fed cut rates seven times from a high of 5.25% in September 2007 to 2.00% in April 2008 does not mean monetary policy was accommodative or even neutral. If that were that simple then the Fed would have been easy during the Great Depression when it cut its then policy rate, the discount rate, from 6.00% in October 1929 to a low 1.50% in July 1931. But almost no one believes that now. The Fed is seen as keeping monetary policy tight through the depths of the Great Depression. 

To really know the stance of monetary policy, one needs to know the market-clearing or 'natural' interest rate. If the Fed is not cutting rates as fast as the natural interest rate is falling, then, monetary policy is actually tight. This is not a controversial point. It is standard macroeconomics.

Even Atif Mian and Amir Sufi in their book “House of Debt” acknowledge this point in their discussion of the zero lower bound (ZLB). They acknowledge that if the Fed had been able to continue cutting rates pass 0% then it could have prevented the Great Recession. But don’t take my word for it, go read chapter four of their book or see this twitter conversation. Paul Krugman has similarly pointed to the ZLB as the true culprit for crisis and past seven years of sluggish growth. The point is that the Great Recession was not  inevitable had interest rates being allowed to reach their market-clearing level.

The only difference between Mian-Sufi-Krugman and us is that we believe the Fed had a chance to reach the market-clearing level of interest rates before it crossed the ZLB. We believe they had that chance through part of 2008. Had the Fed been less anxious about inflation and more aggressive in signalling it would do whatever is takes to keep economy stable the natural interest rate would have fallen far less--maybe even stabilized--making the ZLB less of a problem in the first place.

Instead, the Fed signaled during the first half of 2008 it was actually going to raise interest rates. The fear of a rate hike grew during this period, with fed fund futures rate for the 12-months ahead contract going from about 2.0 % in March  to almost 3.5% in June of 2008. Given that the natural interest rate had sharply fallen by this point, this means there was sizable gap between where interest rates needed to be and where they were expected to go. That means the Fed was strangling the already weakened economy. This only further depressed the natural interest rate. It is no surprise, then, that by mid-2008 expected inflation from breakevens started falling fast. And yet the Fed continued to fret over inflation through its September FOMC meeting of 2008. By the time it finally did cut rates and begin QE1 it was too late. The horse was already out of the barn, the ZLB had been breached.

So coming into 2008 was the economy already weak and vulnerable? Yes. Was it necessarily destined for a 'Great' recession? No. It took another shock to push it over the edge. That shock was the tightening of monetary policy in 2008. 

P.S. It appears Janet Yellen's Fed made the same mistake in its talking up of interest rates all last year.

Wednesday, February 3, 2016

More on the Fed's Mistake of 2015

Here is an interesting take on the Fed's December mistake by Jed Graham:
Janet Yellen’s Federal Reserve has done something that no other Fed has done since Paul Volcker aimed to quash runaway inflation in the early 1980s, even if it meant a recession — and it did.

New Commerce Department data out Friday show that nominal GDP grew at a 1.5% annualized rate in the fourth quarter, casting further doubt on the Fed’s decision to begin hiking its key interest rate in December. (Inflation-adjusted GDP rose just 0.7% in Q4.)With the exception of Volcker’s interest-rate hike in early 1982 amid a recession, no other Fed has raised rates during a quarter in which nominal GDP grew less than 3%, dating back to the early 1970s.
Remember, nominal GDP is simply total dollar spending--the money supply times how often it is used--on final goods sold. It is therefore a broad gauge of monetary conditions. Jed's point, then, is that the Fed chose to raise interest rates even though monetary conditions were weakening. Here is the figure from Jed's article documenting this 'historic misfire':

I like what Jed is doing here, but as noted in my previous post I think the Fed's mistakes began long before December. Nonetheless, there does seem to be a growing consensus that the Fed's tightening got ahead of the recovery as noted by Martin Sanbu. And this is not just a pundit thing. The fed fund futures market now seems to be signalling the same message.  

P.S. I was interviewed on Bloomberg TV yesterday about the Fed's policy mistake.

Monday, February 1, 2016

The Fed Did Not Make A Mistake In December

Many observers are now viewing the Fed's decision in December to raise interest rates as a "policy error". With volatility in financial markets, falling commodity prices, and a fourth quarter slowdown many believe the Fed got ahead of the recovery with the December interest rate hike. Some even are even calling it a "huge mistake"or a "historic rate hike mistake". One person even called it an "epic mistake".

I see things differently. The Fed did not make a mistake in December. It made a mistake all last year by talking up interest rate hikes and signalling a tightening of future monetary policy. Since markets are forward looking, this expectation got priced into the market and affected decision making. The Fed did this even though the economy was not back at full employment. The December rate hike was just a confirmation of these expectations.

The Fed, in other words, got ahead of the recovery well before December. Damage was already being inflicted on the economy by the time the actual rate hike occurred, as seen in the figures below. They all show the 12-month ahead expected federal funds rate plotted against various economic indicators. 

The first one shows the future federal funds rates alongside the trade weighted value of the dollar. Unsurprisingly, both start rising at about the same time in late 2014.

The trend growth of the stock market also began turning down about the same time as the expected tightening cycle began. 

The expected tightening also coincided with a sustained decline in expected inflation as seen below. Yes, this is not a perfect measure of expected inflation. It has a risk premium in it that could be overstating the decline. But as Narayana Kocherlakota notes, if this is the case it only underscores the point that Fed has been overly tight. For a rise in the risk premium means an increase in the demand for safe assets and a decrease in aggregate demand growth. 

The next figure show that the risk premium--as measured by the spread between BAA yield and 10-year treasury yield--did in fact coincide with the expected tightening signaled by the Fed. 

The slowdown in industrial production that began last year also roughly tracks the expected tightening by the Fed as seen below. 

Other indicators like the GDP in the fourth quarter, retail sales, or personal consumption also show a softening. In general, the point is that the Fed appears to have gotten ahead of the recovery well before December simply by talking up a rate hike. 

Though the focus of this post is on the domestic U.S. economy, it is worth briefly noting the international implications too. As shown above, the dollar rose in step with the expected tightening of Fed policy. The stronger dollar, in turn, has pulled up the Yuan with it and this can explain why problems in China first emerged last August. China is dealing with deep structural problems and is doing so by violating the macroeconomic trilemma. That is, China is pegging its currency to the dollar, is easing domestic monetary policy, and is allowing some capital flows in an attempt to stabilize its economy. This is an unsustainable policy mix and is already creating financial market volatility. 

Though it takes two to tango, the dollar surge over the past year helped push China into this predicament. China is now bleeding foreign reserves faster than ever and the timing of it can ultimately be traced backed to the expected tightening of Fed policy. 

So no, the Fed did not make a mistake at its December meeting. It made a mistake over the entire past year and now we are seeing the fruition of this error.

Wednesday, January 27, 2016

Revisiting the Causes of the Great Recession

Ramesh Ponnuru and I have an Op-Ed in today's New York Times:
IT has become part of the accepted history of our time: The bursting of the housing bubble was the primary cause of a financial crisis, a sharp recession and prolonged slow growth. The story makes intuitive sense, since the economic crisis included a collapse in the prices of housing and related securities. The movie “The Big Short,” which is based on a book by Michael Lewis, takes this cause-and-effect relationship as a given. 
But there is an alternative story. In recent months, Senator Ted Cruz has become the most prominent politician to give voice to the theory that the Federal Reserve caused the crisis by tightening monetary policy in 2008. While Mr. Cruz (who is an old friend of one of the authors of this article) has been criticized for making this claim, he shouldn’t back down. He’s right, and our understanding of the great recession needs to be revised.
The crux of our story is that what would have been an ordinary recession got turned into the Great Recession because the Fed failed to do its job. Readers of this blog will be familiar with this argument. For those who are not here is a brief recap of the evidence supporting our claims. 

First, the Fed contained the fallout from housing crisis for almost two years. This can be seen in the three figures below. The first two figures show that even though housing peaked in early 2006, employment and personal income outside of housing-related sectors actually grew at a stable rate up until about early-to-mid 2008.

This third figure shows that nominal spending overall continued to grow fairly stable during the initial run on the shadow banking system, as seen by the Ted spread. That run occurred from occurred from August 2007 to about May 2008. It also shows that the biggest spike in the Ted spread occurs only after the Fed allows nominal spending to start dropping.

Second, the Fed tightened policy in 2008 and did so in two phases. First, beginning around April 2008 the Fed began signalling it was planning to raise interest rates as seen in the figure below. It shows the market expectation of the federal funds rate one year in advance. It rises all the way through the summer of 2008 and remains higher than the actual federal funds rate through October 2008. This is the first phase of tightening in 2008. It was an explicit tightening, albeit of the future path of monetary policy.


The second stage, as we note, in the Op-Ed occurs in the second half of 2008. Here the natural interest rate is falling fast and the Fed fails to lower its target interest rate until October 2008. This is a passive tightening of monetary policy and is reflected in the decline in expected inflation and nominal spending that starts in mid-2008.

To summarize, our argument is that the Fed was doing a decent job responding to the housing bust up until 2008. After that point it tightened monetary policy and catalyzed the reaction that lead to the Great Recession. By the time the Fed changed course in late 2008 it was too late. Interest rates had already cross the zero lower bound (ZLB). Once that happens monetary policy as it is currently practiced cannot do much. (For more on the crossing of the ZLB see my review of Atif Mian and Amir Sufi's book on the crisis. Update: also see this twitter conversation with Amir Sufi on the ZLB.) The central bank of Australia, however, acted sooner and never faced the ZLB problem, despite having a housing and debt bubble too.

For interested readers, I would direct to the work of Richmond Fed economist Robert Hetzel who has written an article and book that makes the same argument.  Also, see Scott Sumner's early critique of Fed policy during this time as well. 

P.S. Just to demonstrate how worried the Fed was about inflation rather than growth late into the crisis, here is an excerpt from the minutes of the August 2008 FOMC meeting. Note they they were expecting to raise rates at the next meeting. 

Tuesday, January 26, 2016

The Latest Central Bank Fad: Asymmetric Inflation Targeting

I have noted many times here how the Fed's treats its 2% inflation target as more of a ceiling than a symmetric target. Apparently, the ECB is even more brazen in its asymmetric interpretation of its inflation target (my bold):
The ECB has got itself into an extraordinarily difficult position. It has missed its policy target — a headline rate of inflation at “close to but below” two per cent — for four years. The target has lost credibility. Once people have lost confidence in an inflation target, it becomes very hard for the central bank to persuade them to trust the target again. 
It was touching to hear Mr Draghi last Thursday talk about failing to reach a goal, then to try again and to fail again. I do not doubt his determination but the minutes of the December 3 meeting of the governing council tell us that not everybody supports the target in the same way... One [governor] said that he would not accept a further increase in QE unless the eurozone was once again in deflation. The implicit message of that statement is that this particular governor’s policy target must be zero per cent, not two per cent. He will only act once prices actually fall. 
[A former governing council member] confirms something I had suspected for a long while but was never able to confirm: he cares if inflation is above the target but less so when it is low. The target becomes asymmetric... Germany’s economic establishment has its unofficial inflation target, which I would put at a range of 0-2 per cent. If that were the target, no policy action would be needed now. 
To me this all shows that, as an institution, the ECB is only partially committed to its stated goal. This is one of the reasons why it keeps missing its policy target.
This can mean only one thing: it is time to update my inflation targeting chart from this earlier post. Asymmetric inflation targeting seems to be the new fad at central banks, at least the big ones. 

Monday, January 25, 2016

The Balance Sheet Recession That Never Happened: Australia

Probably the most common explanation for the Great Recession is the "balance-sheet" recession view. It says households took on took on too much debt during the boom years and were forced to deleverage once home prices began to tank. The resulting drop in aggregate spending from this deleveraging ushered in the Great Recession. The sharp contraction was therefore inevitable.

But is this right? Readers of this blog know that I am skeptical of this view. I think it is incomplete and misses a deeper, more important story. Before getting into it, let's visit a place that according to the balance sheet view of recessions should have had a recession in 2008 but did not.

That place is Australia. It too had a housing boom and debt "bubble". It too had a housing correction in 2008 that affected household balance sheets. This can be seen in the figures below:


Despite the balance sheet pains of 2008, Australia never had a Great Recession. In fact, it sailed through this period as one the few countries to experience solid growth. And, as Scott Sumner notes, it was also buffeted by a collapse in commodity exports during this time. If any country should have experienced a sharp recession in 2008 it should have been Australia.

So why did Australia's balance sheet recession never happen? The answer is that the Reserve  Bank of Australia (RBA), unlike the Fed, got out in front of the 2008 crisis. It cut rates early and signaled an expansionary future path for monetary policy. It also helped that the policy rate in Australia was at 7.25 percent when it began to cut interest rates. This meant the central bank could do a lot of interest rate cutting before hitting the zero lower bound (ZLB). So between being more aggressive than the Fed and having more room to work,  the RBA staved off the Great Recession.

This experience in Australia speaks to why the balance sheet recession view miss the deeper, more important problem behind depressions: the ZLB. Unlike the RBA, the Fed was slow to act in 2008 and that allowed the market-clearing or "natural" interest rate to fall below the ZLB. Had the Fed acted sooner or had it been able to keep up with the decline in the natural interest rate once it passed the ZLB, the Great Recession may not have been so great (See Peter Ireland's paper for more on this point).

Here is how I made this point in my review of Atif Mian and Amir Sufi's book, House of Debt, in the National Review.
Why should the decline in debtors' spending necessarily cause a recession?

Recall that for every debtor there is a creditor. That is, for every debtor who is cutting back on spending to pay down his debt, there is a creditor receiving more funds. The creditors could in principle provide an increase in spending to offset the decrease in debtors' spending. But in the recent crisis, they did not. Instead, households and non-financial firms that were creditors increased their holdings of safe, liquid assets. This increased the demand for money. This problem was exacerbated by the actions of banks and other financial firms. When a debtor paid down a loan owed to a bank, both loans and deposits fell. Since there were fewer new loans being made during this time, there was a net decline in deposits [and thus] in the money supply. This decline can be seen in broad money measures such as the Divisia M4 measure. These developments—increase in money demand and a decrease in money supply—imply that an excess money-demand problem was at work during the crisis.

The problem, then, is as much about the excess demand for money by creditors as it is about the deleveraging of debtors. Why did creditors increase their money holdings rather than provide more spending to offset the debtors? ...Mian and Sufi do briefly bring up a potential answer: the zero percent lower bound (ZLB) on nominal interest rates.
The ZLB is a floor beneath which interest rates cannot go. This is because creditors would rather hold money at zero percent than lend it out at a negative interest rate. This creates a big problem, because market clearing depends on interest rates' adjusting to reflect changes in the economy. In a depressed economy, firms sitting on cash would start investing their funds in tools, machines, and factories if interest rates fell low enough to make the expected return on such investments exceed the expected return to holding money. Even if the weak economy means the expected return to holding capital is low, falling interest rates at some point would still make it more profitable to invest in capital than to hold money. Similarly, households holding large amounts of money assets would start spending more if the return on holding money fell low enough to make household spending worthwhile. This is a natural market-healing process that occurs all the time. It breaks down when there is an increase in precautionary saving and a decrease in credit demand large enough to push interest rates to zero percent. If interest rates need to adjust below zero percent to spur creditors into providing the offsetting spending, this process will be thwarted by the ZLB.
 It is the ZLB problem, then, rather than the debt deleveraging, that is the deeper reason for the Great Recession.
Australia never hit the ZLB. That is why it avoided the Great Recession. If we want to avoid future Great Recessions we need to find better ways to avoid or work around the ZLB.

Wednesday, January 20, 2016

Has Macroeconomic Policy Been Overly Tight?

Former Fed Minneapolis Fed President Narayana Kocherlakota believes macroeconomic policy has been overly tight the past few years. Consequently, he thinks the Fed is getting ahead of the recovery with its current tightening cycle. Is he right, has macroeconomic policy really been overly tight? To answer this question, consider the four following pieces of evidence. 

1.  Inflation has consistently fallen below the Fed's two percent inflation target for the past seven years. Here is a visual representation of this this development in terms of a shooting target:

Yes, core PCE inflation has has averaged near 1.5% over the past seven years despite a 2% inflation target. It is as if someone has been doing target shooting and persistently hits the lower half of the target. Maybe the Fed is actually aiming for something other than 2%--possibly a 1%-2% inflation corridor target--or maybe the Fed in its current form is not as powerful as we thought. Either way, inflation is being systematically kept below 2%. This suggests relatively weak aggregate nominal spending growth. This is consistent with tight macroeconomic policy. 

2. The risk-free real interest rate appears to still be cyclically adjusting. That is, the 10-year treasury interest rate adjusted for the risk premium appears to be following the prolong closing of the output gap. Some have confused the low levels of real interest rates as evidence for secular stagnation. As I have argued elsewhere, this need not be the case. The long decline in real interest that most observers invoke as the smoking gun for secular stagnation is misleading because it does not correct for the rise in the risk premium during the 1970s. Once one corrects for that you get the following figure:

The black line is the 10-year risk-premium adjusted real treasury interest rate. Note that it averages just under 2%--roughly tracking the average growth rate of the economy--but deviates around that average. Since the 1980s, those deviations closely track the business cycle as seen below: 

What this implies is that slow return of risk-free real rate to a higher level is simply a reflection of the slow unwinding of this business cycle. That it has taken this long to adjust only part way suggests that macroeconomic policy has not been very supportive.  

3.  Household portfolios still inordinately weighted toward safe assets. If one looks at the holding of liquid assets by households--defined here as cash, checking, saving, time, money market mutual funds, treasuries, and agencies--as percent of total assets it shot up during the crisis and still has yet to return to pre-crisis levels.  This indicates household demand for safe assets remains slightly elevated. This can seen in the figure below. Note that this liquidity demand measure leads the broad unemployment rate.

This measure also tracks the CBO's output gap very closely as well:

Were macroeconomic policy highly accommodative we would have expected households to adjust their portfolios faster. But they have not and this suggest macroeconomic policy has been tight. That is why this measure tracks the above measures of slack so well.

4.  Total dollar spending is still below its full employment level. This last bit of evidence is model-based and is part of a paper I am finishing where I estimate various ways to gauge the appropriate level of aggregate nominal expenditures. The key point here is that the sharp drop in nominal spending during the crisis never has been fully corrected for even after adjusting for changes in potential real GDP. It is hard to reconcile this with loose macroeconomic policy.

In short, macroeconomic policy has not been very supportive of a robust recovery over the past few years. So I agree with Narayana Kocherlakota on this point. Where people can reasonably disagree, I think, is whether this was the Fed's fault. Stephen Williamson, for example, sees little that the Fed could have done. For him, it was fiscal policy that was deficient. Specifically, he thinks there should have been more U.S. treasuries to alleviate the safe asset shortage problem.

My own view is that the bigger problem is the body politic's rigid commitment to low inflation. There is no way the Fed or Treasury could have spurred significantly more nominal spending growth without there being a temporary increase in the inflation rate. And that is simply intolerable in the current environment. The safe asset shortage problem and inability of the Fed to get much traction is simply a symptom of this problem.

That is one reason why I am a big advocate of NGDP level targeting. It would allow for temporary deviations in the inflation rate while still providing a credible long-run nominal anchor. Until we get something like this, expect regular bouts of macroeconomic policy being overly tight.