Sunday, June 28, 2015

Was Grexit Invevitable?

So it appears the Eurozone crisis has finally crossed the rubicon. Greece is going to default on Monday and this likely will put in motion its departure from the currency union. The Eurozone as we know it may soon cease to exist.

Was this breakup inevitable? Many observers would say yes. The Eurozone, after all, is not an optimal currency area and therefore likely to create problems. Martin Feldstein, for example, in 1997 wrote this in Foreign Affairs:
Monnet was mistaken... If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe...What are the reasons for such conflicts? In the beginning there would be important disagreements among the EMU member countries about the goals and methods of monetary policy. These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements could contribute to a more general distrust among the European nations.
This does seem prescient now as the tension between core and periphery countries in general and the Troika and Greece in particular have shown the inherent tension in the currency union. So maybe this path was preordained. Maybe 'Grexit' was inevitable. 

Or maybe not. Maybe the Eurozone crisis happened when it did because of colossal policy errors rather than being a necessary outcome of a flawed currency union. I make this argument in a new working paper and contend the policy errors were the ECB's two tightening cycles in 2008 and 2010-2011. These tightening cycles were a huge mistake and arguably what set in motion the Eurozone crisis. They helped precipitate the sovereign debt crisis and gave teeth to the austerity imposed on the periphery.

In early 2008 the Eurozone began contracting, as seen in the first panel of the figure below. The growth of total money spending, a broad indicator of monetary conditions, had started declining even earlier. With monetary conditions beginning to tighten and the economy slowing down most central banks would have cut interest rates. The ECB, however, did nothing and kept its target interest rate pegged at 4 percent. Moreover, as seen in the second panel below, the ECB was signalling a rate increase which further intensified the slowdown. Thus began the first tightening cycle of the ECB in early 2008. Finally, in July 2008 the ECB raised its target interest rate to 4.25 percent and kept it there for three months. This tightening cycle was arguably that shock the triggered the Eurozone crisis. 


The second monetary policy tightening cycle began in late 2010 when the ECB began signaling again that it would be raising its policy rate to stem the burgeoning inflation. This too can be seen in second panel of the figure above. This expectation began stemming total money spending growth in early  2011. The ECB followed through on these expectations by raising its policy rate from 1 percent to 1.25 percent in April and then to 1.50 percent in July where it stayed for four months. This second  tightening cycle occurred even though Eurozone was still recovering from the first recession and is  arguably the shock the intensified the crisis in 2011.

As I show in the paper, these tightening cycles preceded the financial panic of late 2008 and sovereign debt problems and appear to have given teeth the austerity programs. How different would the Eurozone look today had the ECB had instead cut rates in 2008 and started its QE program back then? I think the Eurozone would be a lot different. And no, Grexit would not be an inevitable outcome. There would still be problems for the currency union, but they would problems that could be sorted out in an economy not beset by a depression.

The ECB, in other words, bears a lot of the responsibility for the impending breakup of the Eurozone. Keep that in mind this week as the Grexit comes to fruition.

Update: Some observers question whether ECB monetary policy was really too tight during the crisis. The answer is yes. For evidence, see my paper or this earlier post that shows a tight relationship between Taylor Rule gaps--a measure of the stance of monetary policy--and economic growth in the Eurozone. Some are also reminding me that it was Jean Claude Trichet's ECB that made the mess, not Mario Draghi's ECB. Fair enough.

Other folks are pushing back against the monetary origin view altogether saying this crisis is really a balance of payment crisis or a creditor-debtor crisis. As a proximate cause, yes, but as an ultimate cause, no. Too see this, recall that the deflation experienced in the periphery has meant creditor countries like Germany are getting real wealth transfers from the periphery. The ECB could have prevented this outcome had it prevented deflation and the lower-than-expected inflation that followed. Also consider what would have happened had the ECB adopted a price level  target. It would have required a temporary period of higher-than-normal 'catch-up' inflation that would have further moderated the imbalance between creditor-debtor countries in the Eurozone.

Country-specific developments with the higher inflation growth would have further reinforced this rebalancing. Prices would first grow faster in the regions with the least excess capacity, the core countries. During this time, goods and services from the periphery countries would then become relatively cheaper. Consequently, even though the exchange rate among the regions would not change, there would be a relative change in their price levels making the periphery countries more competitive. 

The Trichet ECB could have done a lot more to prevent the creditor-debtor problems from reaching this tipping point. Instead they behaved like Sadomonetarists, as noted Paul Krugman. There is more on the creditor-debtor point in the paper.

Thursday, June 25, 2015

The Long Unwind of Excess Money Demand

Two years ago I was part of a panel discussion on Fed policy at the American Enterprise Institute. I talked about why money still matters as way to make the case that the economy was still being plagued by excess money demand. This problem occurs when desired money holdings exceed actual money holdings. This imbalance causes a rebalancing of portfolios toward safe assets away from riskier ones and in the process causes a decline in aggregate demand. This is one way to view the long slump.

My argument back then was that even though the excess money demand problem peaked in 2009 it still was being unwound in 2013 and therefore still a drag on the economy. Among other things, I showed as evidence a chart portraying the sharp rise in the share of household assets that were liquid and noted it was still elevated in 2013. You can see it in the video or slides from the panel, but I thought I would update the chart in this post to see how much progress we made on the excess money demand problem.

The figure  below shows the liquid share of household assets and plots it against the U6 unemployment rate. In both the 2001 and 2007-2007 recessions this measure leads unemployment. It appears there may still be some residual excess money demand, but a lot of progress has been made. The most striking observation for me, though, is how long it has taken for household portfolios to return to more normal levels of liquidity. It has taken six years and appears not completely done yet! Remember this the next time someone tells you that the aggregate demand shocks were all were worked out years ago.

This next figure plots the household liquid share against small businesses concerns about sales. The latter measure comes from the following question in the NFIB's Small Business Economic Trends: "What is the single most important problem facing your firm?"  There are nine answers firms can chose, but below I plot just the one about concerns over lack of demand. Here too you see a good fit, a non-surprising result.


The fact that a large portion of the liquid share of household assets has declined over the past six years shows that its elevated rise was not a structural development but a cyclical one. It also suggests that more could have been done to hasten its return to normal levels. That is, more could have been done to satiate the excess demand for money. It should not take this long for a business cycle to unwind.

P.S. This is not to say there were no structural problems over the past six years. There were plenty. But what the above analysis speaks to is that many observers grossly underestimated the size and duration of the aggregate demand shock.

Update: I count cash, checking, saving, time, money market mutual funds, treasuries, and agencies as the liquid portion of household assets. Here is the link to the data in FRED.

Tuesday, June 23, 2015

The Penske View of Macroeconomic Policy


You can learn a lot about macroeconomic policy by driving a Penske truck. I did three years ago when I moved from Texas to Tennessee. The trip began with me driving a 26-foot Penske truck and my wife following in our car. I quickly discovered that Penske had placed a governor on the engine that limited the truck's speed to around 65 miles per hour. This was well below its true potential and made for an incredibly frustrating trip. Hills proved to be especially challenging since I could never generate enough momentum to avoid slowing down as I began ascending them. After the hills it was impossible to make up for lost time because I was prevented from accelerating the truck into catchup speed. There were also the other drivers on the road who got annoyed with my relatively slow speed. One on of those annoyed drivers turned out to be my wife. She decided she could handle the truck better than me so we switched vehicles. She may have done a better job handling the hills and traffic, but only on the margin. Overall, she too faced the same constraint I did: a upper bound on the truck's speed. Reaching our final destination took far longer than we had planned.

There are a lot of similarities between this experience and the use of macroeconomic policy over the past seven years. The U.S. economy, like the truck, has been operating well below its potential. This has meant reaching the final destination of  full employment has taken far longer than anyone expected.

As with the truck, the output gap emerged once the U.S. economy hit a hill called the Great Recession. Unlike the truck, though, this hill was so tough it not only slowed the economy down but caused it to stall and start rolling back down the hill. Fortunately, the brakes were applied, the economy got started again, and the ascent up the hill was made. Since then, the big problem has been the failure of macroeconomic policy to create enough catch-up speed to make up for lost time. More precisely, macroeconomic policy failed to generate enough growth in total dollar spending to close the output gap. 

Macroeconomic policy should have a significant, if not perfect, influence on the growth of total dollar spending through the use of monetary and fiscal policy. The absence of temporarily faster-than-normal catch-up growth in aggregate demand indicates that like the Penske truck there has been a governor placed on macroeconomic policy.

So what is this governor? It is the Fed's 2 percent inflation target. It prevents monetary policy and fiscal policy from generating temporary periods of rapid catch-up growth in aggregate demand because doing so will raise inflation above its target.

For example, imagine that in the third quarter of 2009 the Fed had been able to raise and keep the annualized growth rate of total dollar spending at 7.5 percent until it reached its previous trend (which is near the CBO's full employment level for NGDP). That would be fairly rapid catch-up growth since total nominal expenditures grew on average around 5 percent during the Great Moderation period. Based on historical relationships, this temporary surge in aggregate demand growth would also translate into a temporary surge in inflation.1 As seen below, this inflation surge would last just over two years.


The temporary inflation surge can never occur with a 2 percent inflation target. Yet, as demonstrated by Israel, it was probably needed after the crisis. In terms of the truck analogy, the deceleration of speed on the hill needed to be offset by temporarily faster speed after the hill to maintain  a stable growth path for total dollar spending.

The Penske truck experience also sheds light on two questions that still vex many observers. The first question is why did the Fed's QE programs fail to spur a robust recovery? George Selgin, for example, recently raised this question. The answer is not that these programs are inherently unable to do so. Rather, they were subject to the inflation target governor. Just like I was limited to 65  miles per hour in the truck, the 2 percent inflation target put a limit on how much aggregate demand growth can be generated by the QE programs. Put differently, the 2 percent inflation target meant that the monetary injections created by the QE programs were expected to be temporary. What was needed to spur rapid total dollar spending growth, though, was an expectation that some portion of those monetary injections would be permanent.

To be clear, the inflation target was an upper bound on how much total dollar spending growth could be created by the QE programs. It did not prevent the Fed from using QE programs to prevent a slow down. In fact, it appears 2 percent is actually an upper bound on an inflation target range of 1-2 percent. If so, the QE programs put a floor under the economy even though they were muzzled from spurring rapid aggregate demand growth.

The second question is whether more aggressive fiscal policy could have made a meaningful difference since the crisis. This question is akin to asking whether my wife made a difference when she tried driving the truck. She may have made a difference on the margin, but was ultimately still bound by the governor. Fiscal policy, like monetary policy, is also bound by a governor. It can only create aggregate demand growth up to the point it pushes inflation to the Fed's 2% target. The Fed's preferred inflation measure, the PCE deflator, averaged 1.4% since 2009. That means fiscal policy would have had 60 basis points on average with which to work over the past seven years in closing the output gap. That is not much and nowhere near the two-year run of over 2 percent inflation required to create the catch-up growth in aggregate demand seen in the figure above.2

What policymakers needed after 2009 was a new governor that would have allowed temporary catch-up growth in aggregate demand. The easiest way to have done this is to have  introduced a NGDP level target. Doing so would be similar to replacing the governor on the Penske truck with cruise control. The growth path of total dollar spending would be set and any deviations around that path would be corrected as needed with slowdown or catch up growth in aggregate demand. No matter what your view of the optimal monetary-fiscal policy mix may be, it will be challenging to implement without a NGDP level target. Moving forward,then, this reform is sorely needed. 

I never again want to drive cross country in a truck that has the governor turned on. Similarly, we should never again want to encounter a sharp recession without a NGDP level target.3

1The historical relationship is estimated by regressing the current and two lagged values of nominal GDP growth on the GDP deflator growth.  
2  If you, like Paul Krugman, believe that the Fed actually targets a1-2 percent inflation range then fiscal policy is even more limited since the 60 basis points are gone. 
3There are other reasons to favor a NGDP level target including minimizing the change of hitting a sharp recession in the first place. 

Thursday, April 30, 2015

Why the Fed Will Raise Interest Rates This Year

Despite the apparent slow down of economic activity during the first quarter of this year, it is likely the Fed will still have to raise interest rates in the near future. This reason why is that households are increasingly expecting their nominal incomes to rise and this typically leads actual wage and salary growth. This can be seen in the figures below.

The first figure shows households' expected nominal income growth over the next year. It comes from the University of Michigan/Thompson Reuters Survey of Consumers where households are asked each month how much their dollar (i.e. nominal) family incomes are expected to change over the next 12 months. This measure averaged near 5 percent prior to the crisis, but then crashed and barely budged for several years. Finally in 2013 it acquired escape velocity. Since then it has been slowing trending up with a bit of a pick-up in the last year.



The next figure plots this series against the employment cost index, but now at a quarterly frequency. The figure suggests expected nominal income growth leads actual nominal income growth. This indicates  wage and salary growth is primed to start accelerating. 


Now the data only runs through March. A lot of disappointing economic news has come out since then. So it will be interesting to see whether this trend is sustained next month. If this New York Times article is any indication, we can expect the series to continue trending up and actual incomes to follow:
WASHINGTON — The number of Americans filing new claims for jobless benefits tumbled to a 15-year low last week and consumer spending rose in March, signs the economy was regaining momentum after stumbling badly in the first quarter.
The economic outlook was brightened further by another report on Thursday showing a solid increase in wages in the first quarter.

"This morning's reports all point to an economy that is doing a lot better than the near-stagnation in first-quarter G.D.P. suggests," said Paul Ashworth, chief United States economist at Capital Economics in Toronto.
So it appears the Fed may have no choice but to tighten by the end of the year.

P.S. Justin Wolfers observes that the Q1 slowdown in GDP has become a reoccurring development. Since this is seasonally-adjusted data it should not be happening. Consequently, Wolfers notes we should not put too much faith in the Q1 numbers. This is another reason to believe that wages are primed to take off.

Update: Here is the relationship between the U6 minus U3 unemployment rate spread and the expected nominal income growth series. I have used the 5-month centered moving average trend on expected nominal income growth to make the graph clearer:

Tuesday, April 28, 2015

About that Dual Mandate...

George Selgin says we should do away with it:
The Federal Open Market Committee is in a pickle. After its last meeting, it suggested that it would soon start raising interest rates as a way to head off inflation. Recent inflation numbers, showing an uptick in the core inflation rate, make that step seem as necessary as ever.

But disappointing growth projections, along with the dollar's international appreciation, are giving committee members cold feet.

The FOMC's dilemma is rooted in the Fed's so-called "dual mandate," calling for it to achieve both "maximum employment" and "stable prices." Whenever inflation and employment seem to be headed in opposite directions, the Fed has to compromise.

Wrong compromises aggravate the business cycle; and even if the compromises are correct, the Fed's uncertain direction puts a damper on growth.

Realizing its flaws, some favor just scrapping the dual mandate's "maximum employment" clause, leaving the Fed with a solitary inflation target.

The dual mandate's champions reply that, while inflation targeting might make monetary policy more predictable, it could also call for the Fed to tighten at times — the present might just be one of them — when doing so means putting the brakes on an already slowing economy.

So what's best, a slippery dual mandate or a stable-inflation straitjacket? Neither.
You will have to read the rest of his article to find out what he thinks should replace the dual mandate. Here is a hint: he agrees with my vision for narrowing the Fed's mandate.

Monday, April 27, 2015

A Partial Solution to Income Inequality

I want to come back to one of the points from my last post. There I noted the global economy was hit by a series of large positive supply shocks beginning in the mid-1990s: the rapid advances in technology and the opening up of Asia. The former raised productivity while the latter increased the world's labor supply. Both pushed up the return to capital and put downward pressure on global inflation. 

This run of positive supply shocks continued into the 2000s--productivity growth peaked between 2002 and 2004--but was interrupted by the Great Recession. It now appears to be returning to full stride. This time, though, the supply shocks are not coming from further increases in the global supply of labor, but from further technological advances. The increased digitization, automation, and overall smart-machining of our economy is and will continue to bring huge productivity gains. For example, by the end of 2016 there will be 30 U.S. cities with driverless cars, artificial intelligence will be diagnosing illness, and 3D printers will be making practically everything including themselves. And oh yea, robots will be delicately picking fruit. These examples highlight what Erik Brynjfolsson and Andrea McAfee call the second machine age where we will see rapid productivity growth that will reinforce the high return to capital.

How the world handles this second machine age over the next few decades will be, in my view, one of the biggest economic challenges going forward. Rapid technological advances are ultimately good for long-run growth, but in the short run they can be very disruptive to many jobs and industries. This has always been true, but the pace and size of these disruptive supply shocks are likely to increase. It is true that we do not see much evidence in the data yet for this process, but I chalk that up to measurement problems and that we are only the cusp of these changes. In any event, I suspect that this issue will make the present-day concerns over secular stagnation, liquidity traps, saving gluts, and the Japanification of Europe look quaint. 

One widely-held concern about large positive supply shocks is that they will shift income from labor to capital. This concern can be seen in this The Economist's discussion of the Asian supply shock back in 2005:
China's impact on the world economy can best be understood as what economists call a “positive supply-side shock”. Richard Freeman, an economist at Harvard University, reckons that the entry into the world economy of China, India and the former Soviet Union has, in effect, doubled the global labour force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation and triggered changes in the relative prices of labour, capital, goods and assets. 
The new entrants to the global economy brought with them little capital of economic value. So, with twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labour has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labour and capital, it goes a long way to explain recent trends in wages and profits.
The trends, of course, being , the higher share of income going to capital and the slow growth of real wages. It is a natural consequence, the article argues, of the higher returns to capital generated by such supply shocks. The rapid technological advances, therefore, will only reinforce these developments since they too raise the return to capital. Woe is the labor share of income.

Another related concern is that that this growth in global capacity will not be matched by sufficient demand given the declining share of income going to labor. There will be a persistent demand shortage as argued Dan Alpert in his "Age of Oversupply". He worries there will be a persistent global glut.

So what should be done? Left-of-center solutions range from more government spending to make up for the spending shortfall to a basic income policy to offset the decline in labor's share of income. One of the more interesting proposals, in my view, from the left is to have the federal government invest in the SP500 on behalf of its citizens. Any earnings from this investment would be distributed among households. This would make everyone a capitalist and thereby empower them to benefit from the gains of the second machine age.

Eric Lonegran and Mark Blyth, for example, argue the U.S. government should create a sovereign wealth fund (SWF) to do just that. They would have the federal government sell more treasury securities to fund the SWF which would then invest the funds in a stock market index fund. The earnings would be sent to its shareholders, U.S. taxpayers. From a macro-finance perspective this is a clever idea, but from a political-economy perspective I worry that investing decisions would become very political and messy. 

So let me propose another solution, one that allows markets to support growth in labor's share of income. It is a very simple solution: let the price level reflect changes in productivity while stabilizing nominal income growth. Put differently, central banks should aim to stabilize the growth of nominal wages, but ignore changes in the price level. This would allow real wages to more closely follow the rapid productivity growth.

To see how this would work recall the large positive supply shocks from Asia and technology that culminated in the productivity boom of 2002-2004. Both of these developments raised the return to capital and put downward pressure on inflation. All else equal, the higher return to capital should have resulted in a higher market-clearing or 'natural interest rate' while the downward drift in inflation should have supported the growth of real wages. Instead, the Fed offset the decline in inflation by lowering its target interest rate. Given the Fed's monetary superpower status, this lowering of short-term interest rates was replicated across much of the world. So just as the fundamentals of the global economy were pointing to higher real interest rates and lower inflation, the Fed and other central banks moved in the opposite direction to keep inflation stable. These actions served to raise firm's profits while reducing labor's share of income.1

Here's why. A permanent rise in productivity means lower per unit production costs for firms. In turn, this means greater profit margins for a given sales price. Firms will respond to this development by building more plants. This expands the productive capacity of the economy and causes, given competitive pressures, firms to lower their sales prices in an attempt to gain market share. Their profit margins, though, should remain relatively stable because the drop in their output prices is matched by a drop in their unit costs of production.

Note that all firms are lowering to varying degrees their output price because of this process. Consequently, the price level, an average of firms’ output prices, will also fall. This spreads the benefits of the productivity gains to all workers through higher real wages. And with these higher real wages workers can provide the demand needed for full employment.

Now imagine central banks respond to this productivity-driven deflation by easing monetary policy, as they would under inflation targeting. Sales prices are stabilized, but given sticky input prices like wages this action also leads to expanded profit margins. So instead of allowing the productivity gains to be shared with labor through a gently falling price level, monetary policy has instead served to increase the share of income going  to capital. 

This, in my view, explains a meaningful amount--though not all--of the growth in capital income since the mid-1990s. And my fear is that in the second machine age with rapid productivity growth this trend will worsen. Below is a figure from a recent paper of mine that lends support to this interpretation:


Now I want to be clear. I am not advocating the malign deflation that comes form a collapse of aggregate demand, as seen in the 1930s. What I am talking about is allowing productivity shocks to be gently reflected in the price level while stabilizing aggregate demand growth. This is a benign form of deflation and yes, it has happened.

Under this kind of deflation, the standard problems associated with deflation--the zero lower bound (ZLB), financial intermediation, and real debt burdens--are less of an issue. The higher productivity growth implies a higher real interest rate that should counter the downward pressure on the nominal interest rate and therefore minimize the chance of hitting the ZLB. Financial intermediation should not be adversely affected either, since the burden of any unanticipated increase in real debt coming from the benign deflation would be offset by a corresponding unanticipated increase in real incomes. Collateral values, meanwhile, should not decline but increase given expectations of higher future earnings from the productivity growth. 

By keeping output price growth stable, inflation targeting inadvertently contributes to the rising share of income going to capital in periods of rising productivity. So what kind of monetary policy would stabilize aggregate demand growth and allow changes in productivity growth to be reflected in the price level and thus in real wages? The answer is a NGDP target. Under this rule, the Fed would aim to stabilize the growth of total dollar spending (or equivalently nominal income) and quit worrying about changes in inflation. Some like George Selgin would further focus the Fed target explicitly on the expected growth of nominal wages. Either way, the Fed would let productivity be reflected in the price level.

So a partial solution to the growing income inequality between labor and capital income is to have monetary policy adopt a NGDP target of some kind.  For those who have little faith in monetary policy hitting a NGDP target this approach can be operationalized with the help of fiscal policy. 

1Since output prices have been stabilized, workers are still getting the real wage they were expecting ex-ante. Hence, there is not the same motivation to ask for a wage increase allowing this condition to persist for awhile. Workers, however, will begin to grumble as they see the increased share of income going to capital as is now the case.

Wednesday, April 22, 2015

Was Monetary Policy Loose During the Housing Boom?

Did the Fed's set its policy interest rate rate below the market-clearing or 'natural' interest rate level in the early-to-mid 2000s? Or did it simply lower its policy interest rate down to a depressed natural interest rate level during this time? The answers to these questions determine whether U.S. monetary policy was loose during the housing boom. 

John Taylor believes the Fed pushed interest rates below their natural interest rate level. He views this departure from a neutral stance as a key contributor to the housing boom. Ben Bernanke and Larry Summers believe otherwise. They see the Fed simply doing its job back then by adjusting its policy rate down to a low natural interest rate level. Bernanke believes the natural interest rate level was low because of a saving glut while Summers holds that its was depressed because of secular stagnation. Either way, both individuals do not blame the Fed for any role the low interest rates played in fostering the housing boom. The Fed''s lowering of interest rates was simply an endogenous response.

George Selgin, Berrak Bahadir, and I recently published an article that lends support to John Taylor's view of Fed policy during this time. It received some pushback from Scott Sumner who is sympathetic to both the saving glut and secular stagnation views. At the same time, Tony Yates provided a critique of John Taylor's argument on the financial crisis that was heartily endorsed by Paul Krugman. So the debate over the Fed policy during this period continues.

What I want to do here is to step back from this debate and review what I see as the key economic developments that affected U.S. interest rates at this time. Then, given these considerations, I will jump back into the debate and ask whether Fed policy pushed interest rates in the same direction as that implied by these developments.

The key developments as I see them are threefold: a falling term premiums, a spate of large positive supply shocks, and the emergence of a monetary superpower. Let us consider each one in turn.
I. Falling Term Premiums on Long-Term Treasuries
The term premium is the extra compensations investors require for the risk of holding a long-term treasury bond versus a sequence of short-term treasury bills over the same period. The term premium had been declining since the early 1980s and therefore put downward pressure on long-term interest rates. This development can be seen in the figure below which is created using the Adrian, Crump, and Moench (2013) data. (For more on this data see here.)


The decline has been attributed to several factors. First, there was a decline in inflation volatility and an overall improvement in macroeconomic stability during this time that made investors less risk averse to holding long-term bonds. They therefore demanded less compensation. Second, regulatory and accounting changes for certain firms increased their demand for treasury securities relative to their supply. This further reduced the term premium. Third, globalization was taking off, but without a concurrent deepening of financial markets in many of the affected countries. That meant that global income was growing faster than the world's ability to produce safe assets. Consequently, many developing countries started turning to the United States for safe assets. This further depressed the term premium and is the basis for Bernanke's saving glut theory.

A close look at the above figure shows this term premium decline intensified in 2003, falling about 1.4 percentage points over the next two years. This happened right during the time the Fed pushed its policy rate to record-low levels. This, then, appears to support the endogenous view of the low policy rates argued by Bernanke and Summers.

However, this conclusion needs to be tempered. For the next two developments discussed below suggest that a sizable portion of the declining term premium at this time may have been an endogenous response to the Fed's low interest rates policy during that time. 

II. A Spate of Large Positive Supply Shocks
The second important development is that the global economy got buffeted with a series of large positive supply shocks from the  opening up of Asia--especially China and India--and the rapid technology innovations that reached a crescendo in the early-to-mid 2000s. Global growth accelerated because of these developments as seen in the figure below:



The opening up of Asia significantly increased the world's labor supply while the technology gains increased productivity growth. The uptick in productivity growth, which peaked between 2002 and 2004, was widely discussed in the early 2000s and raised long-run expected productivity growth at the time. This can be seen in the figure below which shows a consensus forecast of annual average productivity growth over a ten year horizon:


Note that the rise in the labor force and productivity growth rates both raised the expected return to capital. The faster productivity growth also implied higher expected household incomes. These developments, in turn, should have lead to less saving and more borrowing by firms and households and put upward pressure on the natural interest rate. Interest rates, in short, should have been rising given these large positive supply shocks during this time. 

III. Emergence of a Muscle-Flexing Monetary Superpower 
The third development is that in the decade leading up to the financial crisis that the Fed became a monetary superpower that could flex its muscles. It  controlled the world's main reserve currency and many emerging markets were formally or informally pegged to dollar. Thus, its monetary policy got exported across much of the globe, a point acknowledged by Fed chair Janet Yellen. This meant that the other two monetary powers, the ECB and the Bank of Japan, were mindful of U.S. monetary policy lest their currencies became too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy got exported to some degree to Japan and the Euro area as well. Chris Crowe and I provide formal evidence for this view here as does Colin Gray here.
Now let's tie all these points together and see what it says about the Fed's role in the housing boom. Let's begin by noting that when the large positive supply shocks buffeted the global economy they created disinflationary pressures that bothered Fed officials. They did not like the falling inflation. So Fed officials responded by easing monetary policy. Recall, though, that the supply shocks were raising the return to capital and expected income growth and therefore putting upward pressure on the natural interest rate. The Fed, consequently, was pushing down its policy rate at the very time the natural interest rate was rising. Monetary policy was inadvertently being loosened.

This error was compounded by the fact that the Fed was a monetary superpower. The Fed's easing in the early-to-mid 2000s meant the dollar-pegging countries were forced to buy more dollars. These economies then used the dollars to buy up U.S. treasuries and GSE securities. This increased the demand for safe assets and ostensibly reinforced the push to transform risky private assets into AAA assets. To the extent  the ECB and the Bank of Japan also responded to U.S. monetary policy, they too were acquiring foreign reserves and channeling  credit back to the U.S. economy.  Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.  The 2003-2005 decline in the term premium, in other words, was to some extent an endogenous response to the easing of Fed policy during this time.

The figure below highlights this relationship for the period 1997-2006. It comes from my work with Chris Crowe and shows that almost 50% of the foreign reserve buildup was tied to deviations of the federal funds rate from the Taylor Rule. Colin Gray estimates several regression models on this relationship and finds that for every 1% point deviation of the federal funds rate below the Taylor Rule, foreign reserves grew by $11.5 billion. The Fed, therefore, was putting downward pressure on interest rates not only directly via the setting of its federal funds rate target, but also by raising the amount of credit channeled into the long-term U.S. securities.


Given these points, I think it is reasonable to conclude the Fed contributed to the housing boom. I hope they give Scott, Tony, and Paul something to think about.

Let me be clear about my views Even though the Fed kept its policy rate below the natural rate for a good part of the housing boom period, the opposite happened after the crash due to the ZLB. This is a point Ramesh Ponnuru and I made in a recent National Review article. So unlike some observes who see the Fed as being eternally loose, I take a different view: the Fed was too loose during the boom and too tight during the bust. 

Update: There are multiple measures of the output gap that show the U.S. economy overheating during this time. Below is a figure from this article that compares the real-time and final measures of the U.S. output gap. Everyone shows ex-post an overheating economy during the housing boom: