Monday, May 2, 2016

Macro Musings Podcasts: Cardiff Garcia




My latest Macro Musings Podcast is with Cardiff Garcia, U.S. senior editor of  FT Alphaville and host of the podcast FT Alphachat. After spending many years engaging with Cardiff in the econ blogosphere, it was a lot of fun having he come into studio for the podcast. Thanks Cardiff for making it happen!

In our wide-ranging conversation, we were able to talk about what it is like to be a journalist covering macroeconomics and the debates that have raged within the profession. We also got to discuss the safe asset shortage problem, QE, fiscal versus monetary policy, asymmetric inflation targets, the Eurozone crisis, secular stagnation, and more. We ended our conversation with his career advice for young budding journalists wishing to cover economic issues. 

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player below. And remember to subscribe since more guest are coming!


Sunday, May 1, 2016

The Poisoned Chalice of Macroeconomic Policy

The Eurozone experienced a second recession in 2011-2012, just a few years after the first one in 2008-2009. This second downturn was the fatal blow that turned Europe's Great Recession into an outright depression. The standard explanation for the emergence of this second recession is the sovereign debt crisis and the increased fiscal austerity in the Eurozone periphery that occurred during this time. Is this understanding correct?

Paul Krugman says no in  a new post. He points, instead, to the ECB's raising of interest rates twice in 2011 as the cause of the second recession. I agree with Krugman. This explicit tightening of monetary policy in the Eurozone, when many of its countries had to yet to fully recover from the first recession, increased the debt burdens and gave austerity its teeth. These latter developments had an effect on the Eurozone economy, but that they were more a propagating mechanism than the initial shock. I have a new Mercatus paper coming out soon that provides extensive empirical support for this view. So I am glad to see Krugman restart the conversation on what went wrong in Europe. The Eurozone Crisis was the Lords of Finance all over again.

One question that Krugman does not address in his post is why the ECB chose to raise interest rates at this time. This, in my view, is an important question because it speaks to one of the two big shortcomings of inflation targeting that has led me to conclude its time as a monetary regime has come and gone. Unless we wrestle with inflation targeting's shortcomings, I am fairly confident we are gong to see central banks continue to repeat the ECB's mistakes in the future. To that end, I want to briefly review these shortcomings below. 

Shortcoming One: Divining the Movements in Inflation

The first shortcoming of inflation targeting is that central bankers must discern in real time whether changes in inflation are caused by demand shocks or supply shocks. This is an almost impossible task that requires an herculean ability to divine developments in the economy.

Ideally, central bankers should only respond to demand shocks since they originate from changes in monetary conditions. Moreover, they push inflation and output in the same direction so it is easy for central bankers to respond to them. For example, if banks create excess money and cause inflation and real activity to grow too fast, a central banker can respond in a helpful manner by tightening monetary conditions. This will reign in both inflation and real GDP. The economy will stabilized. 

Supply shocks, on the other hand, come from fundamental changes to the productive side of the economy and cannot be fixed by monetary policy. Central banks should avoid responding to temporary changes in inflation caused by these shocks. For example, if an important input to production--like oil or labor--suddenly becomes more scarce it will temporarily raise inflation. Central banks may be tempted to respond to such inflation, but doing so will only make matters worse. For to reign in such changes in inflation means to further constrict an already weakened economy. But this is exactly what happened to the ECB in 2011. It raised interest rates in response to inflation caused by rising commodity price shock (negative supply shocks) which were already weighing on weakened economy. The ECB also raised interest rates in 2008 for the same reason.

This divining problem is pervasive to all inflation targeting central banks. Supply shocks were an issue in 2002-2004 for the Fed when the productivity boom at that time (a positive supply shock) put downward pressure on prices and caused the FOMC to worry about deflation. They should not have been worrying since aggregate demand was rapidly growing. Nonetheless, the Fed kept interest rates low even as the housing and credit boom started taking off. Supply shocks were also an issue in 2008 when Fed officials, like their ECB counterparts, were concerned about rising commodity prices (a negative supply shock) and were hesitant to lower interest rates. Consequently, the Fed failed to lower interest rates fast enough and helped create the Great Recession.

Along these lines, Ben Bernanke, Mark Gertler, and Mark Watson argue the reason sudden increases in oil prices (a negative supply shock) have historically been tied to subsequent weak economic growth is not because of the oil prices themselves, but because of how monetary policy responds to those shocks. That is, the Fed typically has responded to the inflation created by supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this problem has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as noted above, is that in practice it often does not works. Responding to supply shocks in real time requires exceptional judgement and a lot of luck. Some researchers, in fact, believe inflation targeting was easier in the 1990s because central banks were luckier. There were fewer aggregate supply shocks with which central bankers had to contend. If this reading of history is correct, then it seems central bankers ran out of luck in the past decade.1

Shortcoming Two: Responding to Large Demand Shocks  

The second shortcoming of inflation targeting is that it does not provide enough degrees of freedom for monetary authorities dealing with large demand shocks. This is both by design and by accident. The design part is that inflation targeting is a growth rate target, not a growth path target. By targeting the growth rate it does not make up for past mistakes. Therefore, if a large demand shortfall requires a temporary surge in inflation above 2% to restore full employment, the inflation target will prevent this from happening. 

To make this clear, here is an example from my FT article. Imagine the Fed decided at the end of the Great Recession in mid-2009 to return aggregate demand (NGDP) to its pre-crisis trend path.  Below is a figure from a paper of mine where I estimate what would have happened to core PCE inflation for three different recovery paths of NGDP:  a two-year path, a three-year path, and a four-year path. The first figure shows the three NGDP recovery paths and the second figure shows the inflation forecasts associated with these paths.


On all paths, inflation is notably higher than both the actual inflation rate that occurred and the actual 2% target rate. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%. This never was gong to happen with the Fed or the ECB.

Now, as noted above, flexible inflation targeting could in theory accommodate such temporary deviations in inflation. However, revealed preferences over the past seven years suggest in practice it is not possible. Central banks have been so good at creating low inflation since the early 1990s that it is now the expected norm by the body politic. Any deviation from low inflation is simply intolerable. In the US, everyone form the media to politicians to the average person start to freak out if inflation heads north of 2%. This mentality seems even worse in Europe. Inflation-targeting central banks, in other words, have worked themselves into an inflation-targeting straitjacket that has removed the few degrees of freedom they had. It is hard to imagine Yellen and Draghi being able to raise inflation temporarily above 2% in this environment. All they can do is operate in the 1-2% inflation window. Inflation targeting's success has become it own worst enemy.

Another way of saying this is that the space for doing macro policy has shrunk to the small window of 1-2% inflation. Not only is monetary policy constrained by this, but so is fiscal policy. This is why even helicopter drops will not make much difference, a point also made by Paul Krugman

For these reasons inflation targeting has become the poisoned chalice of macroeconomic policy. It was a much needed nominal anchor in the 1990s that helped restore monetary stability. Its limitations, however, have become very clear over the past decade and now is preventing the world from having the recovery it needs. This is why we need to learn the right lessons from these past seven years and Krugman's post is a step in the right direction.

As readers of this blog will know, my solution to the above problems is NGDP level targeting. It would get past the divining problem by having central banks focus on the cause (aggregate demand shocks) and not a potentially misleading symptom (inflation) of it. As a level target, it would also be up to the task of responding to large demand shocks. To make it credible, I have proposed it be automatically back-stopped by the U.S. Treasury. Until we see a monetary regime change along these lines, we will continue to drink from the poisoned chalice of macroeconomic policy.

1I review this 'central bankers got lucky' argument in my inflation targeting critique paper.

Monday, April 25, 2016

Macro Musings Podcast: John Cochrane


My latest Macro Musing podcast is with John Cochrane, a Senior Fellow of the Hoover Institution and former professor of finance at the University of Chicago. In this week's episode I got to sit down and talk the fiscal theory of the price level (FTPL) with John Cochrane. I have been thinking a lot about FTPL lately--thanks in part to John's work on it--so it was a real treat to discuss it with him. We also got to chat about how he got into economics and the benefits of blogging for academics. It was a fascinating conversation throughout. 

Here is a previous post I did on the FTPL that may be helpful in thinking about its implication. I also have a paper on FTPL coming out soon so stay posted. 

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player below. And remember to subscribe since more guest are coming!

Related Links
John Cochrane's Website
John Cochrane's Blog
John Cochrane's Twitter Account



Monday, April 18, 2016

Macro Musings Podcast: John Taylor


My latest Macro Musing podcast is with John Taylor of Stanford University.  It was an interesting conversation throughout and we covered a lot of ground. We talked about the Taylor Rule, the Great Inflation, the housing boom period, the Great Recession, QE, the failure of the Fed to hit its inflation target, the international dimensions of Fed policy, rules versus discretion, and the latest efforts by Congress to nudge the Fed towards a more rules-based approach to monetary policy. A big thanks to John Taylor for being a part of the show!

You can listen to the podcast via iTunesStitcher, Sound Cloud, or the embedded player below. And remember to subscribe since more guest are coming!

Related Links
John Taylor's Website 
John Taylor's Blog
John Taylor's Twitter Account



Monday, April 11, 2016

A New Podcast on Macroeconomics


Today is the launch of a new podcast series on macroeconomics called Macro Musing and I am privileged to be the host. Each week, with the help of a special guest, we will get to explore in depth various macroeconomic topics. If want to go all wonky on macro this is the podcast for you! 

So far I have recorded podcasts with the following guests: Scott Sumner, John Taylor, John Cochrane, Cardiff Garcia, Miles Kimball, Ramesh Ponnuru, and George Selgin. There have been a lot of interesting conversations covering topics such as the origins of the Great Recession, the safe asset shortage problem, negative interest rates, the fiscal theory of the price level, the Eurozone Crisis, Abenomics, the Great Depression, China's economic problems, and alternative monetary regimes. In addition to these interesting topics, I have enjoyed learning how each guest got into macro, either as an academic or as an journalist, and how they see the field changing over time as new ideas and new technology emerge. I think you will find it fascinating too.

More guest are scheduled, including some Fed officials, but I would love to hear from you on what guests and topics you would like to see on the show. My first guest is Scott Sumner with whom I discuss his views on the Great Recession, NGDP targeting, and his new book on the Great Depression, The Midas Paradox.

I hope to make this a long-term project, but it success depends in part on you subscribing. So please subcribe via itunes or your favorite podcast app (update: here is the soundcloud link and here is the Stitcher link) and spread the word. Let's make this podcast a success together and who knows, maybe we can help make the world a better place. 

This podcast is part of the new Program on Monetary Policy (POMP) at the Mercatus Center at George Mason Univeristy. I am grateful for all their support in making the podcast happen.

Related Links for Scott Sumner
Retargeting the Fed
A Market-Driven Nominal GDP Target
The Great Depression
The Money Illusion

Wednesday, April 6, 2016

The Safe Asset Problem is Back: Negative Interest Rate Edition


The safe asset shortage problem is back. Actually, it never went away but drifted into the background as the symptoms of this problem--sluggish growth and low interest rates--became the norm. As the figure above shows, yields on government bonds considered safe assets have been steadily declining since the crisis broke out. 

This problem is now manifesting itself in a new form: central banks tinkering with negative interest rates. Many view this development as the latest manifestation of central banks running amok. A more nuance read is that central banks are continuing to imperfectly respond to the safe asset shortage problem. The above figure indicates the downward march of global safe yields since 2008 is a global phenomenon. This decline has occurred outside of QE and prior to negative rates. It is a far bigger development than central banks playing with negative rates. 

But many observers miss this point. They confuse the symptom--central bankers tinkering with negative interest rates--for the cause--the safe asset shortage. So I want to revisit the safe asset shortage problem in this post by reviewing what exactly it is, why it has persisted for so long, and what can be done to remedy it. 

So what exactly is the safe asset shortage? It is the shortage of  those assets that are highly liquid, expected to be stable in value, and used to facilitate exchange for institutional investors in the shadow banking system. They effectively function as money for institutional investors and include treasuries, agencies, commercial paper, and repos. During the crisis many of the privately issued safe assets disappeared erasing a large chunk of the shadow banking's money supply. This happened just as the demand for safe assets was increasing because of the panic. As recently shown by Caballero, Farhi, and Gourinchas (2016), if this excess demand for safe assets is big enough it will push down the natural interest rate below zero. Since the central bank cannot push its policy rate very far past 0%, an interest rate gap will emerge and cause output to fall below its potential. That seems to fit post-2008 fairly well. (HT Josh Hendrickson)  

This problem can be illustrated by using a standard supply and demand graph for safe assets, as seen in the two figures below. These graphs are fairly standard except for the second vertical axis which allows me to show that interest rates move inversely with bond prices. The first figure shows the supply and demand of safe asset pre-2008. Note that interest rates are near 5% which is roughly where treasury yields were during that time. 


Now comes the crisis in 2008 and two changes occur, as seen in the next figure. First, the demand for safe assets rises given the fear and uncertainty during the panic. This shifts the demand curve to the right. Second, the the supply of safe assets is reduced as many of the private-label safe assets disappear. This pushes the supply curve to the left.

Given these developments, two rather striking results emerge. First, because of the zero lower bound (ZLB), interest rates remain too high. The ZLB, therefore, acts as price floor that prevents the market from clearing along the interest rate dimension. Second, the ZLB also means safe asset prices are too low. It creates a price ceiling that prevents the market from clearing along the bond price dimension.
This implies treasury prices have been too low since the crisis!


Sometimes I am asked how can there be a safe asset shortage? Shouldn't safe asset prices simply adjust upward to meet the increase demand for them? The above analysis shows why this cannot happen with the ZLB. The safe asset market has been constrained by the ZLB and prevented from working its market-clearing magic.

Why has this problem persisted for so long? Why are safe assets yields still so low? I am not entirely sure. I suspect the demand for safe assets has remained elevated given the ongoing spate of bad news shocks since the crisis: Eurozone crisis, China concerns, fiscal cliff talks, 2016 recessions fears, etc. Also, some of the new banking and finance regulations is probably suppressing the growth of private-label safe assets. That is has taken this long, though, is a bit puzzling.



 So what are the solutions to safe asset shortage problem? One solution is for the government to issue more safe assets. That the 10-year U.S. treasury is now 1.73% seven years after the crisis suggest there is still strong appetite for treasury securities. This is the solution proposed by folks like Stephen Williamson and Paul Krugman. Another solution is for policymakers to 'shock and awe' the public into believing a robust recovery is coming and thereby decrease their demand for safe assets. QE was supposed to do this but was not that effective. Scott Sumner and Michael Woodford's call for NGDP level targeting would also fall under this option. The final option is that policy makers could try to work past the ZLB via negative interest rates. Under this option policymakers would help the safe asset market clear by pushing interest rates and prices to their market-clearing levels.

As  noted by Narayana Kocherlakota, the difficulty of doing the first two options seems to be making negative interest rates the default option.  I am not convinced it will be very effective given how it is being implemented (very different than Miles Kimball's suggested approach). But it is a response--a groping in the dark by central bankers--to the deeper safe asset shortage problem. And that is something we all need to better understand. 

Wednesday, March 16, 2016

Fed Commentary

I have a a couple of pieces out this week on the Fed. The first is an article in Politico on the Fed's influence on the global economy. Here are some excerpts:
Through both its policy actions and its written words, the Federal Reserve has mistakenly tightened monetary policy in fear of rising inflation. That mistake has not just hurt the U.S. economy, it is reverberating around the globe. 
This week, the Fed has an opportunity to admit its error when the Federal Open Markets Committee meets to set monetary policy. It’s critical that Fed board members understand how their actions are hurting economies around the world, which has a corresponding negative effect on the U.S. Otherwise, the Fed will continue to tighten policy — and the economic recovery will continue to sputter. 
The Fed began tightening policy in 2014 when, despite a slow start, the U.S. economy made significant advances with some observers believing an economic boom was under way. This improved economic outlook and the need for Janet Yellen’s Fed to prove its inflation-fighting credibility led U.S. monetary officials to start talking up future interest rate hikes... 
By talking about future interest rate hike, the Fed was indicating that tighter monetary conditions would exist in the future. That, in turn, worsened the economic outlook and caused companies to cut back on their spending plans. The Fed’s talking up of interest rate hikes, therefore, amounted to an effective tightening of monetary policy long before the actual raising of interest rates in December 2015. It affected not only the U.S. economy but also the many emerging economies whose currencies are pegged to the dollar, colloquially known as the “dollar bloc countries.”
This should be a familiar argument to readers of this blog. The only thing I would add to the Politico piece is that the Fed's slowing down of global aggregate demand since mid-2014 is a non-trivial reason why oil prices have declined so sharply since then. Along these lines, here is the OECD's leading indicator index for China and the United States:


The second piece is an a podcast interview I did with Cardiff Garcia on FT Alphachat. We discuss NGDP level targeting and my call for an automatic treasury backstop to the target. Another way of thinking about this proposal is that an automatic treasury backstop to a NGDPLT is simply an automatic stabilizer tied to a target. It is way of doing 'helicopter drops' in a rule-based manner that actually works. What many people miss is that doing an ad-hoc helicopter drops in inflation-targeting regime will not do much good. It has to be tied to a level target to matter. (See Paul Krugman on this point too). Finally, this proposal adds credibility to the NGDPLT in a manner that Chuck Norris and Jean-Claude Van Damme would appreciate.

Update: the Fed held steady today and signaled there would be fewer rate hikes this year. This was a slight move to easing and good news for China.  Interestingly, the Fed listed "global economic and financial developments" as one reason for its response today. Here is Yellen in her press conference:
"Chinese growth hasn't proven a great surprise.  We have anticipated that it would slow over time, and it seems to be slowing as well.  Japanese growth in the fourth quarter was negative.  That was something of a surprise.  And with respect to the Euro area, recent indicators suggest perhaps slightly weaker growth.  So there's been a number of emerging markets, as you know, where suffering under the weight of declines in oil prices that are affecting their economic activity.  Our neighbors both to the north and south, Canada and Mexico, are feeling the impacts of lower oil prices on their growth.”
Notably absent from her response is the role the strong dollar is playing in these developments. The Fed is almost connecting the dots.