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Wednesday, November 1, 2017

Monetary Regime Change Update

I recently made the case that we got a monetary regime change in 2008 that explains the stubbornly low inflation since that time:
A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.


The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  
Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path.  
Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. 
I went on to say this is the monetary regime change no one asked for. It is also one that many observers seem to miss in their analysis of Fed policy since the crisis.  

Well, I was on twitter discussing long-term treasury yields and monetary policy with Tim Duy and Joel Wertheimer. I decided to whip up some charts comparing 1-year head NGDP forecasts from the Philadelphia Fed's Survey of Professional Forecasters against 10-year treasury yields. The results, in my view, are consistent with the claim that there was a monetary regime change in 2008. 

First, here is the chart for the 1980:Q1-2007:Q4 period. It shows a fairly strong relationship between expected NGDP growth and long-term treasury yields:


The next figure shows the relationship for the period since 2008:Q1. Say goodbye to that relationship:

Just to be robust, I took out the outliers in the above chart (which are for the periods 2008:Q4-2009:Q2) and got the following chart:


So something has changed in the relationship between expected NGDP growth and long-term treasury yields. The monetary regime change story outlined above coincides closely with this breakdown. Here is one way to connect these two developments. Before 2008 the Fed allowed its tightening to follow the pace of recovery, whereas afterwards the Fed has tended to get ahead of the recovery in its desired and actual rate hikes. If so, the Fed's tightening post-2008 would have slowed down the recovery and lowered the expected future path of short-term interest rates. This overreacting by the Fed would have kept long-term interest rates from rising with expected rises in NGDP growth. This type of behavior would also be consistent with a monetary regime change where only low rates of NGDP growth and inflation are tolerated. This is what appears to have happened in 2008. 

Saturday, October 21, 2017

The Financial Regulatory Laffer Curve

Lawrence J. White has an interesting article where he considers the optimal size of our financial regulatory structure. He acknowledges that the structure it is "maddenly complex" and that it "easy to make a case for drastic simplification." Larry also notes, however, that there are benefits to having some regulatory diversity. We need to recognize this tradeoff, he contends, when considering the simplification of our financial regulatory system. 

To help us better understand this tradeoff, Larry lays out the case for reducing the number of financial regulators:
Regulatory decisions could be made faster, especially in a crisis, when policymakers need timely access to sensitive, proprietary information, and must coordinate actions both domestically and internationally. There would be fewer “turf wars” that can delay decisions. There would be less duplication and redundancy and less need for coordination among separate regulatory agencies... Regulatory costs would decrease, both for government (and thus for taxpayers) and for regulated firms. And there would be fewer opportunities for a race to the bottom, whereby a financial services firm tries to avoid (or reduce the burden of) regulation by “forum shopping” among regulators with parallel responsibilities who must compete for regulatees (their fee-paying clients). There also would be fewer incentives for one regulator to impede competition from financial firms under a different regulator.
He then discusses the costs to streamlining the number of financial regulators:
But there are also potential downsides. To see this, let’s really go to the limit:  Suppose that there were only a single regulator for all of the financial system. And suppose someone has a new idea for the kinds of financial services that could be made available, or for how certain services can be more effectively delivered to users. 
With a single regulator, there is an obvious risk: If that regulator has the authority to reject the idea and does so before it is implemented, the game is over. There is no place else for the innovator to turn (except, perhaps, to regulators in another country).  But with multiple regulators, there is an increased chance that—if the idea is worthwhile—one or more of the regulators will see the merit in the idea. 
In essence, an important assumption that underlies the potential benefits to simplification is that regulators will “get it right”: that they won’t make mistakes. By contrast, the argument for multiple regulators is an argument for diversity: that in a world where mistakes can be made, having some diversity can reduce the costs of error and increase the likelihood that worthwhile ideas will be able to take root.
This is good economic analysis. It recognizes the tradeoff to simplifying the U.S. financial regulatory structure. Mark Calabria, Norbert Michel, and Hester Pierce similarly note this tradeoff in their call to reform U.S. financial regulation. They see the need for reform, but also want to avoid going to a single 'super' regulator for the reasons outlined above. 

It hit me when reading these two pieces this financial regulatory tradeoff could be summarized with a Laffer curve-type framework. I sketched it out below with the rate of financial innovation on the vertical axis and the number of financial regulators on the horizontal axis. The number of financial regulators ranges from 1 (a single 'super' regulator) to N. The optimal number of financial regulators is the peak of this curve.

The framework should be uncontroversial. What is controversial is where we are at on the financial regulatory Laffer curve. Are we closer to point A or point B? I suspect we are closer to point B.


Friday, October 20, 2017

The Other Side of the Fed's Balance Sheet

Who controls the Fed's balance sheet? The answer may seem obvious. The Fed, after all, determines the size of its balance sheet. It also controls what happens to the asset side of its balance sheet. Its power over the liability side, however, is limited.

This diminished control arises because the public's demand for currency, bank regulations, and U.S. Treasury cash balances all influence the composition of the Fed's liabilities.1 These are exogenous forces that have the potential to create some economic bumps on the road ahead as the Fed normalizes the size of its balance sheet. 

So far, though, little attention has been paid to these liability-side issues. Most focus has been given to the asset side of the Fed's balance sheet. This focus, in my view, is misguided. I see the real dangers lurking on the liability side of the Fed's balance sheet--the very side where the Fed has less control. 

This post, then, is attempt to direct some attention to the liability side of the Fed's balance sheet. In it, I first explain how the public's demand for currency, bank regulations, and the U.S. Treasury cash balances are beyond the Fed's control but affect its balance sheet. I then explain how these forces and current Fed policy could interact in a disruptive manner.  

The Public's Demand for Currency
Consider first the public's demand for currency. It grows as the dollar size of economy grows. This growing demand for currency is met by banks turning reserves into currency. Some of this growing demand for currency comes from foreigners and some from domestic residents. As seen in the figure below, both have grown over the past decade. In total, currency grew from around $800 billion in 2007 to $1.58 trillion today. The almost $800 billion increase in currency means, ceteris paribus, a similar-sized decline in reserves over the same period.


This development matters because the nearly $800 billion loss of reserves and gain in currency, though fairly predictable, was largely beyond the Fed's control. Put differently, the Fed controls the initial level and form of bank reserves, but it loses control over time. If the Fed were trying to stabilize a certain level of reserves--say to keep its floor system working--this steady growth of currency demand makes it harder. This is a powerful force with which the Fed has to contend. 

Now the currency demand growth may be seen as plus since it reduces the amount of balance sheet reduction required going forward. But it also poses some challenges that I will discuss later. For now, note that the growth in currency demand is an exogenous force that steadily tugs at the composition of the liability side of the Fed's balance sheet. 

New Bank Regulations
There have been a lot of new bank regulations since the crisis, but here I want to focus specifically on the liquidity coverage ratio (LCR). It requires banks to hold enough "high-quality liquid assets" (HQLA) to withstand 30 days of cash outflow. Unsurprisingly, the LCR has increased demand for HQLA assets. In particular, it has increased demand for bank reserves and treasury securities which can be held at full value (other assets, like GSEs can be held but at a discount). The LCR was implemented in January 2015.

Per the LCR, bank reserves and treasuries are equally safe and banks should be indifferent between holding them for regulatory reasons. Per the banks, however, they are not the same. The IOER paid on excess reserves has been consistently higher than the yield on short-term treasury bills as seen below. This raises the demand for bank reserves relative to treasury securities.  


So the IOER being greater than other short-term market rates raises the relative demand for bank reserves and the LCR, which is beyond the Fed's control, intensifies this demand. 

U.S. Treasury Cash Balance
The U.S. Treasury Department is also an exogenous force affecting the Fed balance sheet. There are several channels of influence, but here I want to focus on Treasury's cash balances that are deposited at various places. These deposits can broadly grouped into two categories: (1) interest-earning deposits held at private financial firms and (2) non-interest earning deposits held at the Fed in the Treasury General Account (TGA).

Prior to 2008, Treasury kept most of its cash balances outside the Fed. This earned interest for the taxpayers and also made life easier for the Fed since the TGA was small. After 2008, this pattern reversed: Treasury parked most of its cash balances at the Fed and vastly expanded their size. This can be seen in the figure below:


The main reason for this big shift in 2008 was that the IOER rate has been higher than short-term market interest rates. Here is why this matters. Treasury funds deposited at private banks become reserves that get redeposited at the Fed so that banks can earn IOER. The IOER payments going from the Fed to the banks are payments not going to Treasury. Moreover, the IOER payments exceed what Treasury can earn on their deposits at private banks because IOER exceeds short-term deposit rates.2 

Treasury, consequently, was losing income after IOER. Treasury officials quickly realized they could minimize this loss by pulling their funds out of private financial firms and instead park them at the Fed in the TGA.By doing so, however, Treasury officials were pulling out reserves from the banking system and therefore shrinking the aggregate level of bank reserves. This change in the composition of the liability side of the Fed's balance sheet was beyond the Fed's control. 

Putting it All Together
So we have we have currency demand growth, LCR, and the TGA all exogenously affecting reserves on the liability side of the Fed's balance sheet. In addition, the Fed is affecting the demand for reserves with IOER being greater than market interest rates. The Fed is also draining reserves via its balance sheet reduction program and its overnight reverse repo program (ON-RRP). The table below summarizes these developments.


The figure below shows how these forces have affected the growth of the liability side of the Fed's balance sheet so far:


Potential Disruptions Ahead
These developments matter because, as seen in the table, they are pushing the supply and demand for reserves in opposite directions. 

Bank reserves have been shrinking because of currency demand growth, the TGA, and ON-RRP. At the same time the demand for reserves has been elevated because IOER is greater than short-term market rates. Since 2015, this demand has been elevated because of the LCR. And now the Fed is about to further heighten this imbalance by draining reserves as it begins shrinking its balance sheet. 

The figure below shows this is more than just a theoretical concern. It shows the level of bank reserves since 2015 (when the LCR started) plotted against the spread between the overnight dollar libor rate and the 1-month treasury rate. There is a negative relationship which means as reserves fall the libor rises relative to the treasury bill rate. The increases are not terribly large and this only explain a third of the variation in the spread since 2015, but it does suggest further tightening will occur moving forward if nothing else changes as the Fed shrinks its balance sheet. 


So what should the Fed do? It could curtail the shrinking of its balance sheet, but that is not the path I would chose. The balance sheet reduction is already baked into market expectations and it should continue for other reasons outlined here

What it should do, in my view, is aim to bring the IOER closer to market interest rates. I am not sure how easy this task would be, but it would reduce the heightened demand for reserves, lower the TGA, and soften the bite of the LCR.  One way to help push the IOER closer to market rates would be for the Fed to announce a corridor system as the final destination for the Fed's balance sheet reduction. This has not happened yet, but it should be something the FOMC seriously considers.

1 There are some other exogenous forces on the liability side that I ignore here. The biggest one being foreign official accounts at the Fed. These, however, generally are not too large and therefore less consequential.
2 This was due both to IOER being greater than short-term market interest rates, but also because by law Treasury can only earn 25 basis points less than the federal funds rate at depository institutions. Treasury can also park funds in repos and in term deposits, but even these earn less than the IOER. See this NY Fed piece for more on Treasury cash balances.
3The IOER incentive to park funds in the TGA was reinforced by new Treasury policy in 2015 that raised the minimum size of the account to $150 billion. 

Sunday, October 8, 2017

From a Floor System to A Corridor System

So I was looking at the Fed's 2016 annual report and was able to construct the following chart:


Several observations from this figure. First, the sharp growth in the Fed's income is unsurprising as it is a natural consequence of the Fed's QE programs. These large scale asset purchase programs expanded the Fed's assets from around $900 billion in late 2008 to $4.5 trillion today. Moreover, the Fed's portfolio has changed from being mostly short-term treasury securities to one of long-term treasury and agency securities. In addition, the Fed also started paying interest on excess reserves (IOER) to banks during this time. Together, these two developments have effectively turned the Fed into the largest fixed-income hedge fund in the world. Hence, the surge in the Fed's income. 

Second, the Fed's net expenses have also grown rapidly since 2008. Fed officials will point to new financial regulations they have to enforce as the main culprit, but there is arguably a political economy story to the surge as well. Interestingly, this surge accelerated between 2015 and 2016 as seen in the figure. There is no mystery behind this uptick. It is almost entirely the result of the larger IOER payments going to banks as interest rates have gone up. This can be seen in the following numbers:

The IOER payments are expected to grow as the Fed continues to tighten policy. Assuming this tightening does not get ahead of the recovery and cause a recession, future IOER payments should grow as seen in this chart fromThe Economist:



The Fed estimates these payments could hit $50 billion by 2019. And, as a reminder, most of these payments will be going to large domestic banks and foreign banks as they hold most of the excess reserves. This can be seen in the figure below:


So expect the Fed's net expenses to keep growing at a healthy pace for the next few years as it pays out larger and larger IOER payments to large domestic and foreign banks. As I have argued before, this is bad optics and will make the Fed's large balance sheet an increasingly toxic issue for Fed officials. Something will have to give.

Here is my suggestion for the Fed: move to a corridor system. It would still give the 'interest rate control' feature the Fed desires but with a much smaller balance sheet. In a corridor system, the IOER would become the floor for the federal funds rate and the discount rate (or the TAF) would set the ceiling. The figure below shows the difference between a corridor system and floor system. As noted by Stephen Williamson and George Selgin, a corridor system has been working well in Canada with a relatively small balance sheet. 1



Not only is the Fed's large balance sheet bad optics, it really does not pack much punch in normal economic circumstances. So a corridor system makes a lot of sense: it maintains interest rate control, facilitates better politics, and creates a concrete end goal for the Fed's normalization plans that is not disruptive.  Moving to a corridor system should be one of the key objectives for the next Fed chair and the FOMC. 2

1Technically, the Fed has what Stephen Williamson calls a 'sub-floor' system or what George Selgin calls a 'leaky floor' system. Thus, there is a floor beneath the floor, the RRP rate which catches the  financial 'leaks' which make it through the IOER rate. Still, the IOER guides all the other rates and is the main instrument of policy.
2It goes without saying that another key objective for the next Fed chair and the FOMC should be a move towards a NGDPLT. Both this and the move to a corridor system would be complementary. 

Thursday, September 21, 2017

The Future Path of the Monetary Base and Why It Matters

Now that the shrinking of the Fed's balance sheet has been announced, I thought it worth nothing what it means for the future path of the monetary base. Drawing upon the Fed's median forecast of its assets through 2025 that comes from the 2016 SOMA Annual Report, I was able to create the figures below. 

The figures show the trend growth path of currency and a series I call the 'permanent monetary base' extrapolated to 2025. The latter series is the monetary base minus excess reserves. This measure has been used by Tatom (2014) and Belongia and Ireland (2017) as a more reliable indicator of the monetary base that actually matters for monetary conditions. These two measures, which reflect the liability side of the Fed's balance sheet, are plotted along side the projected path of the asset side of the Fed's balance sheet. The first figure below shows this exercise in terms of dollars and the latter one is in log-levels.

What is interesting is that the Fed's median forecast of its assets eventually converges with the trend growth of currency which historically has made up most of the monetary base. Unsurprisingly, the permanent measure of the monetary base also tracks currency's trend path. Jim Hamilton does something similar here.  

So what are the takeaways? First, the Fed is expecting to confirm the temporary nature of the monetary expansion  under the QE programs. That is, the only major growth in the monetary base the Fed expects to persist is that coming from the normal currency demand growth that follows the growth of the economy. This endogenous money growth would have happened in the absence of QE. 

Second, the temporary nature of the QE programs, implied by these figures, is a key reason why these programs did not spur a robust recovery. For reasons laid out in this blog post and in this forthcoming article, there needed to be some exogenous permanent increase in the monetary base to spur robust aggregate demand growth. It never happened and neither did the much-needed recovery.  Instead we got the monetary regime change we never asked for.





Update I: See George Selgin's take on why QE was not very effective.

Update II: Brian Bonis, Jane Ihrig, and Min Wei from the Board of Governors just posted a note with the latest forecast of the Fed's balance sheet. It is updated to include the latest information from the recent FOMC meetings. My figures come from an earlier forecast and are a bit dated relative to these numbers. Their forecasted end value for the SOMA holdings ranges from $2.6 to $3.2 trillion. The median forecast I used above ends up at $3.2 trillion. So my trends would fit their high end estimates. 

However, their note is more nuanced than my graphs above. While they recognize that currency demand growth will be a big determinant of the future size of the Fed's balance sheet, they also recognize that depending on what the Fed does and what happens to banking regulation there could be an additional buffer in the Fed's balance sheet from excess reserves. Here is an extract:
Normalization of the size of the balance sheet occurs when the securities portfolio reverts to the level consistent with its longer-run trend. This trend is determined largely by the level of currency in circulation and a projected longer-run level of reserve balances. There is a great deal of uncertainty about the longer-run level of reserves, which could be affected by factors such as structural changes in the banking system, the effects of regulation on banks' demand for reserves, and the Committee's ultimate choice of a long-run operating framework. We show two scenarios. We assume that the longer-run level of reserve balances is either $100 billion (as in our April 2017 projection) or $613 billion (the median response from the Federal Reserve Bank of New York's June 2017 Survey of Primary Dealers and Survey of Market Participants)
Here are the relevant charts from their note:



The Political Economy of Shrinking the Fed's Balance Sheet

Most folks know the arguments for and against shrinking the Fed's balance sheet on purely economic terms. For a good recap of these arguments see Cardiff Garcia, Henry Curr, and Nick Timiraos. There are however, other political economy forces at work that potentially play into the Fed's decision to shrink its balance sheet.

Most folks do not go there because it is a controversial approach. For it takes a more cynical view of government officials. It goes beyond the view of the Fed as a technocratic institution filled with saintly people doing their best to stabilize the business cycles. It recognizes that people are people no matter where they work and are responsive to political incentives. Now to be clear, many good people work at the Fed because they believe in the mission. But to say the mission is the only thing they consider would be naive. Fed officials, like most people, also care about their own well-being. On the margin, this influences their decision making at the Fed.

This political economy critique of the Fed is not a new one. Mark Toma has entire book on the topic. But most observers, including myself, rarely apply it to the Fed. This includes recent discussions about the Fed's decision to shrink its balance sheet.

I wrote an OpEd for The Hill that bucks this trend. It looks at two countervailing political economy forces weighing on the Fed's decision to shrink its balance sheet. The first force incentives the Fed to keep its balance sheet large:
The large-scale asset purchasing program, better known as quantitative easing, caused the Fed’s balance sheet to grow from roughly $900 billion in late 2008 to $4.5 trillion. 
This vast expansion, combined with the introduction of the Fed’s program to pay interest on excess reserves (IOER) to banks, effectively transformed the Fed from a standard central bank into one of the most profitable financial firms on the planet... 
Over the past few years, it has averaged near $100 billion in profits. Prior to the crisis, its profits averaged only $25 billion per year. The Fed’s profitability has allowed its budget to grow 4.1 percent per year between 2007 and 2017, compared to 2.4 percent for the federal government. 
Given the profitability, prestige and jobs created by maintaining the Fed’s large balance sheet, it will not be painless for the Fed to shrink it.
Yes, the Fed remits most of its profits to the Treasury, but its own budget has grown relatively fast under its large balance sheet as noted above. Here is a chart from the Fed's 2016 annual report that illustrates this development:



Now some may say this increased spending is due, in part, to the new regulatory responsibilities the Fed has taken on since the crisis. Maybe so, but the Fed has been one of the biggest champions of its new regulatory role. Whether you believe the Fed is a good regulator or not, it has an incentive to expand its budget, prestige, and influence over finance via its regulatory role. Keeping its balance sheet large helps facilitate this expansion. So this is a political economy force for keeping its balance sheet large.

The second force I note in my OpEd incentives the Fed to shrink its balance sheet:
[T]he Fed may be eager to unwind its balance sheet [because] it is bad optics politically. The large expansion of the Fed’s asset holding accompanies a similar-sized expansion of its liabilities. 
Most of the increased liabilities have been in the form of banks’ excess reserves. Banks deposit these at the Fed and earn the IOER payment. As seen in the figure below, almost all of the excess reserves parked at the Fed are cash holdings of foreign and large domestic banks. 


That means foreigners and the U.S. banks bailed out during the crisis are getting most of the interest payments from the Fed. If the Fed’s balance sheet was maintained and short-term interest rates eventually rose to 3 percent (as expected), these banks would get approximately $66 billion a year from the Fed. 
To illustrate this point, we again go back to the Fed's 2016 annual report. It shows the Fed's net expenses jumped from roughly $11 billion in 2015 to $17 billion in 2016. That is a huge percentage increase. Almost of all it came from the large IOER payments the Fed had to pay in 2016 because of higher interest rates. Specifically, the IOER payment went from $6.8 billion in 2015 to $12.1 billion in 2016. This is horrible optics: the Fed's expenses are ballooning because it is paying more to foreign banks and the large U.S. banks we bailed out. The Fed can avoid this controversy by shrinking its balance sheet.

As I note in the piece, it is not often that an important government agency voluntarily agrees to actions that will reduce its budget and reach. Yet, the Fed is doing just that by shrinking its balance sheet. It suggests to me that the IOER issue, in conjunction with the other reasons stated by the Fed for shrinking its balance sheet, may be more important than many observers now realize. 

P.S. The above assumes the Fed actually goes through with shrinking its balance sheet. I mention in a previous post that the IOER-treasury bill spread if left uncheck may prevent that from happening.

Monday, September 18, 2017

Is Larry Summers a Fan of Nominal GDP Level Targeting?



You are going to have listen to my podcast with him to find out the answer. Here is a hint: we spent a portion of the show talking about NGDP level targeting (NGDPLT) and what it would take to actually get it implemented it at the Federal Reserve. So listen to the show to find out Larry's thoughts on NGDPLT as well as his views on secular stagnation, Fed policy since the crisis, and macroeconomic policymaking in real time. It was a fun interview. 

P.S. You can also read the transcript of our interview.
P.P.S. For those interested in NGDPLT here is my latest policy brief on it and here is a longer research paper on it.

Will Shrinking the Fed's Balance Sheet Matter?

This week the Fed is expected to announce it will begin shrinking its balance sheet. Will it matter? 

To answer that question it is useful to first recall how and why the Fed's balance sheet was expanded. Between December 2008 and October 2014 the Fed conducted a series of large scale asset purchases (LSAPs) that expanded its balance sheet from about $900 billion to $4.5 trillion. That is an expansion of about 500 percent. 

The Fed turned to LSAPs for additional stimulus when its target for the federal funds rate—the traditional tool of U.S. monetary policy—hit the zero lower bound in late 2008. The main theory the Fed used to justify the LSAPs was the portfolio balance channel. It says that because of market segmentation the Fed's purchase of safe assets would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower long-term interest rates, and push up asset prices. This would help the recovery. 

LSAPs were supposed to trigger the portfolio balance channel by reducing the relative supply of safe assets to the public. This reduction in safe asset supply to the public can be seen by looking at the growing share of safe assets held by the Fed under the various QE programs. The Figure below shows this development for marketable U.S. treasury securities:


This figure also shows another development that has taken place since late 2014: the Fed's share of treasuries has been shrinking. I call this the Fed's "reverse QE" program. Per the portfolio channel, this should be a passive tightening of monetary policy as the Fed's share of safe assets has fallen. Put differently, this should be portfolio rebalancing in reverse that causes long-term treasury yields to rise. 

The figure below, however, shows the opposite has happened under "reverse QE". Other than the Trump bump, 10-year treasury yields have been heading down. Even if we focus just on the ZLB period of "reverse QE"--October 2014 through December 2015--we still see this pattern:



So what does this all mean? It suggests that outside of the 2008-2009 crisis period the portfolio balance channel never really mattered. There are good theoretical reasons for this conclusion as noted by Michael Woodford, John Cochrane, and Stephen Williamson.1 It is not clear, then, that QE2 and QE3 made much difference to the recovery. To be clear, there is some empirical evidence that shows some small-to-modest results for these programs. Even if these results are taken as given, however, most evidence points to this success coming from the signaling channel rather the portfolio balance channel.2

This implies the Fed's shrinking of its balance sheet should not be a big deal. The Fed has been signaling for some time it would start shrinking its balance sheet this year. It even released a detailed plan in June of how it will happen. So there should be no surprises--the Fed is carefully using the signaling channel to keep markets calm. Given this signaling and the lack of a binding portfolio balance channel,  the concerns about the shrinking of the Fed balance sheet causing monetary policy to tighten are mostly noise.

I say mostly noise because there is one potential concern. It is the financial pressure caused by the new regulatory demands of the liquidity coverage ratio running up against the spread between IOER and treasury bills. I wrote about this issue awhile back in an OpEd:
The second reason the scaling back of the Fed's balance sheet may be challenging is that post-2008 regulation now requires banks to hold more liquid assets. Specifically, banks now have to hold enough high-quality liquid assets to withstand 30 days of cash outflow. This liquidity coverage ratio has increased demand for such assets of which bank reserves and treasury securities are considered the safest. So, in theory, as the Fed shrank its balance sheet, the banks could simply swap their excess reserves (that the Fed was pulling out of circulation) for treasury bills (that the Fed was putting into circulation). The challenge, as observed by George Selgin, is that the Fed's interest on excess reserves has been higher than the interest rate on treasury bills. This creates relatively higher demand for bank reserves.  
Banks would not want to give up the higher-earning bank reserves at the very moment the Fed was trying to pull them out of circulation. This tension could create an effective shortage of bank reserves and be disruptive to financial markets. The solution here would be for the Fed to lower the interest on excess reserves to the level of treasury bill interest rates.
The figure below illustrates this potential problem. It shows the Fed's upper and lower bounds on the federal funds rate and the 1-month treasury bill interest rate. These upper bound is the IOER and the lower bound is the reverse repo rate. The reverse repo rate has (sort of) anchored the 1-month treasury bill yield, but the issue is the spread between it and the IOER. Why would  banks want to give up bank reserves for treasury bills when reserves earn at least 25 basis points more than treasury bills? The Fed will be pushing against this demand when it tries to pull the excess reserves out of the banking system. Good luck wth that. 


To summarize, we need not worry about the portfolio balance channel kicking into reverse as the Fed begins shrinking its balance sheet. We should, however, worry about the distortions created by the positive IOER-treasury bill yield spread as Fed unwinds its asset holdings. The Fed can fix this problem by equalizing IOER and short-term market interest rates.

Update: Cardiff Garcia reviews a research note by Nomura's Lew Alexander on shrinking the Fed's balance sheet. Also, Nick Timiraos has a nice long piece on the Fed's LSAPs in the WSJ.
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1Theoretical Problems with the Portfolio Balance Channel. The portfolio balance channel as envisioned by the FOMC relied on controversial assumptions about segmented markets and the Fed being a more efficient financial intermediary than other financial firms. On the first assumption, if the Fed can truly affect long-term treasury interest rates because the long-term treasury market is segmented from other markets, then by definition actions in the treasury market should not spill over into other markets. Put differently, portfolio rebalancing cannot take place in truly segmented markets. On the second assumption, if the Fed takes duration risk off of private-sector balance sheets via LSAPs, the risk really has not gone away since those long-term assets are now on the Fed’s balance sheet which, in turn, is backed-up by the tax payer. The private sector is still bearing the risk. The Fed, in other words, is not some special financial intermediary that can transform and diversify away the riskiness of the assets it purchases. This is the Modigliani-Miller theorem critique applied to central bank asset purchases as shown by Wallace (1981). Ben Bernanke acknowledged this theoretical tension by famously quipping that the “problem with QE is it works in practice not in theory.”

During the financial crisis the above assumptions were probably reasonable when markets froze up and the Fed become the lender of last resort. So QE1 probably made a meaningful difference. But after the crisis it is hard to make a convincing case for the assumptions holding. That is why QE2 and QE3 probably did not pack much punch. See Stephen Williamson, John Cochrane, or Michael Woodford (p. 61-65) for more on the theoretical problems with the Fed's understanding of the portfolio balance channel.

2The signaling channel is based on the idea that the LSAPs indicate a firm commitment by the Fed to keep interest rates low for a long period that would not be evident in the absence of the LSAPs.

Friday, September 15, 2017

Monetary Regime Change: Mission Accomplished

Christina Romer, former CEA chair, called for a monetary regime change several times between 2011 and 2013. It is now several years later and it appears we did finally get a monetary regime change. Unfortunately, it is not the kind of regime change Christina advocated and actually goes in the opposite direction. 

Christina called for the Fed to adopt a nominal GDP level target that would restore aggregate demand to its pre-crisis growth path. Instead, we got a regime change that has effectively lowered the growth rate and the growth path of aggregate demand. This regime change, in my view, is behind the apparent drop in trend inflation that Greg Ip recently reported on in the Wall Street Journal. 

It is not easy to change trend inflation--just ask Paul Volker--but the Fed and other forces seemingly accomplished just that over the past decade. Since the end of the crisis, the average inflation rate on the Fed's preferred measure of inflation, the core PCE deflator, has fallen to 1.5 percent The headline PCE deflator average has fallen to 1.4 percent over the same period. Both are well below the Fed's target of 2 percent. 

This persistent shortfall of inflation has received a lot of attention from critics, including me. Lately, some Fed officials are also beginning to see the inflation shortfall as more than a series of one-off events. Governor Lael Brainard's recent speech is a good example of this change in thinking with her acknowledgement that trend inflation may be falling.

Still, there is something bigger going on here that is being missed in these conversations about the inflation rate. A monetary regime change has occurred that has lowered the growth rate and growth path of nominal demand. Since the recovery started in 2009Q3, NGDP growth has averaged 3.4 percent. This is below the 5.4 percent of 1990-2007 period (blue line in the figure below) or a 5.7 percent for the entire Great Moderation period of 1985-2007. Macroeconomic policy has dialed back the trend growth of nominal spending by 2 percentage points. That is a relatively large decline. This first development can be seen in the figure below.



The figure above also speaks to the second part of this regime change: aggregate demand growth was not allowed to bounce back at a higher growth rate during the recovery like it has in past recessions. Historically, Fed policy allowed aggregate demand to run a bit hot after a recession before settling it back down to its trend growth rate.  This kept the growth path of NGDP stable. You can see this if the figure above by noting how the growth rate (black line) typically would temporarily go above the trend (red line) after a recession.  

Had macroeconomic policy allowed aggregate demand growth to follow its typical bounce-back pattern after a recession, we would have seen something like the blue line in the figure. This line is a dynamic forecast from a simple autoregressive model based on the Great Moderation period. This naive forecast shows one would have expected NGDP growth to have reached as much as 8 percent during the recovery before settling back down to its average. Instead we barely got over 3 percent growth. This is why NGDP has never caught back up to its pre-crisis trend path. 

Again, these two developments are, in my view, the real story behind the drop in trend inflation. And to be clear, I think both the Fed's unwillingness to allow temporary overshooting and the safe asset shortage problem have contributed to it. So this is a joint monetary-fiscal problem that has effectively created a monetary regime change.

So yes, we got a monetary regime change, but no it is not the one Christina Romer and most of us wanted. 

Tuesday, August 22, 2017

The IOER Debate Redux

Back in the glory days of macroeconomics blogging there was a lot of electronic ink spilled over interest on excess reserves (IOER). Commentators, including myself, debated whether IOER mattered to the recovery or if it was just another innocuous tool for the Fed to control interest rates. 

I generally argued that the IOER did matter for the economy--it was more than just a new tool. It began with a call I  made in October 2008 that the introduction of IOER that month was likely to be contractionary. In later conversations, I acknowledged that, yes, the Fed does sets the aggregate level of reserves. Even so, I retorted, banks could still influence the composition of all those reserves based on their investing decisions. These decisions, in turn, could be influenced by the level of IOER. That is, if IOER were set high relative to other safe asset yields then banks might decide to invest in excess reserves rather than in other safe assets like treasury bills. This could stall the 'hot potato' process and affect the recovery. For example, imagine the economy starts heating up and, as a result, the demand for loans picks up. Banks facing this increased pressure for money creation might opt to invest in excess reserves instead of loans if the risk-adjusted return on excess reserves were high enough. That could happen by raising IOER sufficiently high. Consequently, IOER mattered to macroeconomic policy and needed to be set appropriately.

The above paragraph roughly summarizes my position during the many IOER debates that took place over the past decade. Needless to say, I got plenty of pushback and there were many spirited debates. These exchanges sharpened my thinking on the topic. Here, for example, is a long write up from Cardiff Garcia at FT Alphaville on one such debate in 2012. Those were fun times, but folks generally moved on to other conversations.  

One person, though, who kept the IOER conversation going is George Selgin. He has written extensively on IOER, most recently in a 60-page testimony to the House Committee on Financial Services. In it, Selgin argues that the Fed has, in fact, set the IOER too high and this has been a drag on the recovery. Along these lines, he presented a chart on page 20 that shows what appears to be a systematic relationship between (1) an IOER and comparable market interest spread and (2) the relative demand for excess reserves. 

The chart was intriguing, but its sample period did not span the whole IOER period. So I wanted to see if the relationship was robust across the period. Also, I thought it would be useful to look at the actual holders of the excess reserves. The figure below shows the combined cash assets of "large domestically-charted banks" and "foreign-related" banks as reported in the Fed's H8 report. These combined cash assets track excess reserves fairly closely. These two types of banks, then, are the main holders of excess reserves.


Following Selgin's example, I plotted the (1) spread between the IOER and the overnight LIBOR and (2) cash assets as percent of total assets. I did so for both the foreign-related and large domestic banks. If the IOER spread does in fact cause banks to hold more excess reserves relative to other assets, then we would expect the banks share of excess reserves in the portfolios to go up with the spread. 

The figure below confirms that this is the case for the foreign-related banks for the period December 2008 - July 2017. The relative yield on excess reserves does seem to influence the real demand for excess reserves. 


The next figure puts these two series together in a scatterplot. The IOER - excess reserve relationship is strong with a R2of 73%.



Next, I looked at domestically-chartered banks. There is still a positive relationship here, but it is weaker as seen in the next two figures.




The last figure shows the relationship is not trivial--it has an R2of 41%--but it is nowhere near the strength of the foreign banks. So for some reason the IOER-Libor spread  creates a stronger incentive for foreign banks to hold comparatively more excess reserves.  That is an interesting observation worthy of future exploration.

The main takeaway, though, from the above figures is that it appears Selgin's claim is correct. A rise in the IOER spread does seem to influence the relative demand for excess reserves, with the effect being  strongest for foreign banks in the United States.This implies the IOER is more than just a new interest rate tool for the Federal Reserve. George Selgin may have just rekindled the IOER debate. 

Friday, July 21, 2017

Assorted Musings

Some Assorted Musings:

1.  I have a new policy brief at the Mercatus Center that makes the case for a Nominal GDP level target from the knowledge problem perspective. It is a non-technical paper meant to be accessible by policy makers and lay people. It echoes some of the  more technical arguments made in this paper by Josh Hendrickson and myself. 

 2. George Selgin testified this week before the House Financial Services Committee as part of the hearing Monetary Policy v. Fiscal Policy: Risks to Price Stability and the Economy. His testimony is a tour de force through the issue of interest on excess reserves

3.  Scott Sumner pushes back against all the macro moralists waving their finger at Germany for running current account surpluses. He argues it is mistaken to blame Germany's current account surplus for dragging down global demand growth. 

4. Is any part of potential GDP endogenous to the level of aggregate nominal demand? This is a question we have looked at before on this blog. A new paper reexamines this issue and concludes the answer is yes. Below are the key figures from the paper. The first one shows the standard CBO potential GDP estimates over time against a new estimate. Matthew Klein reports on the paper. 



Wednesday, July 5, 2017

An Alternative to Raising the Inflation Target

Ramesh Ponnuru and I have a new article in the National Review where we make the case that a better alternative to a higher inflation target is a NGDP level target:
Does the U.S. economy need more inflation? A group of 22 progressive economists has written a letter to the Federal Reserve urging it to appoint a blue-ribbon commission to study whether the central bank should raise its target for inflation above its current 2 percent. Fed chairman Janet Yellen, in her press conference following the latest interest-rate increase, called it “one of the most important questions” facing the organization. The economists’ advice shouldn’t be rejected out of hand, but it should be rejected. They make some valid points in their diagnosis of the ills of the current monetary regime. But the Fed can and should address these problems without raising inflation...  
These arguments for a higher inflation target are reasonably strong if you accept the premise that keeping inflation stable should be the Fed’s principal task in the first place. There is, however, a superior alternative. That alternative would stabilize the growth of nominal spending: the total amount of dollars spent throughout the economy...  
This policy would capture the benefits of inflation targeting...A key difference between the two policies is that a nominal-spending target would allow inflation to fluctuate over the short term in response to movements in productivity. 
In general, a nominal GDP level target allows for more inflation flexibility than is currently seen in practice while keeping the growth path of nominal demand stable. This rule would also improve over  current approaches by better risk-sharing in the financial system, better aligning of the Fed's interest interest rate with the natural interest rate, and better maintenance of money neutrality. Finally, its an target that invokes the imagery of Chuch Norris and Jean-Claude Van Damme.

Friday, June 16, 2017

Monetary Disequilibrium



This week on the podcast I had a great time talking the monetary disequilibrium view of business cycles with Steve Horwitz. This perspective sees the deviation between desired and actual money holdings as the cause of business cycles.  Since money is the one asset on every market, all one needs to do is disrupt monetary equilibrium and you have disrupted every other market. This is not true for any other asset. The monetary disequilibrium view, in short, takes money seriously.

This understanding is different than the dominant view today that sees business cycles being the result of deviations between the expected paths of the natural and actual real interest rate. After the show I asked Steve if there was mapping between these these two views and he said yes. The views should be complementary. Nonetheless, the monetary disequilibrium view rarely get a hearing so I was really glad to do this interview with Steve. 

I have also posted below a presentation I used to give my undergraduates on monetary disequilibrium. It provides some of the graphs Steve mentioned in the interview. Finally, I highly recommend Leland Yeager's book The Fluttering Veil: Essays on Monetary Disequilibrium. Yeager was a leading advocate of this view and his book provides an accessible introduction to the topic. [Update: for those wanting a formal treatment see this Josh Hendrickson paper (ungated version)]

Wednesday, June 14, 2017

Musings on June's FOMC Meeting

The FOMC decided today to raise its target interest rate so that it now sits in the 1.00-1.25 percent range. This move was largely expected and the FOMC continues to signal via its economic projections that it wants one more interest rate hike this year. Nothing terribly new here, but there were several developments today that caught my attention and are worth considering.

First, the FOMC released a surprisingly detailed plan of how it will unwind its balance sheet later this year. Fed chair Janet Yellen also said during the press conference these plans could be "put in effect relatively soon" if the data come in as expected. The announcement today can be seen as part of the FOMC's ongoing efforts to get the markets ready for the shrinking of its balance sheet. 

To shed light on this development, recall that the main theory the Fed used to justify the the large scale asset purchases was the portfolio channel. It says the Fed's purchase of safe assets would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower long-term interest rates, and push up asset prices. In turn, these developments would support the recovery.

A key step in this story was the Fed reducing the relative supply of safe assets to the public. One way to see it is through the growth of the Fed's share of marketable treasury securities. This can be seen in the figure below. 


In addition to the QE programs, the figure reveals a rather striking development. Since about September 2014 the Fed's share of marketable treasury securities has been falling. This has been a passive development for the Fed--it has maintained a fixed level of treasury holdings while total government debt has grown--but it is effectively QE in reverse. Per the portfolio channel, this reverse QE should have caused long-term treasury yields to rise. Instead, they have more or less been falling over this period:


Put differently, the Fed has been effectively shrinking its balance sheet for several years now and it has been much ado about nothing. Whatever influence QE had, its seems to be dwarfed by other economic forces driving long-term treasury yields.

It should not be surprising, then, that the Fed's announcement today about how it plans to shrink its balance sheet and Janet Yellen's follow-up comments did not create another taper tantrum. Yes, the Fed has been conditioning the market for the eventual reduction for several months, but maybe the bigger story here is that QE really did not have that big of an effect on interest rates and the recovery in the first place. Jim Hamilton reaches a similar conclusion:
[T]oday’s evidence seems to reinforce the conclusion that many have drawn about the effects of the Fed’s large-scale asset purchases–whatever effects these may have had on long-term interest rates were likely less important than other fundamentals. That appeared to be the case on the way to building up the Fed’s balance sheet, and so far appears to be the case in the long process of bringing the balance sheet back down.
To be clear, QE1 probably had a meaningful effect since it was applied in the midst of the financial crisis. However, I am becoming less convinced that QE2 and QE3 mattered much except for signaling purposes. As I have written elsewhere, the fundamental flaw with these programs was that they were beholden to the Fed's desire for rigidly low inflation and therefore consigned to be temporary monetary injections. Which leads me to the other development that really caught my attention.

Second, during the FOMC press conference, Fed chair Janet Yellen once again attributed the unexpectedly low inflation in recent months to one-off events.  She specifically attributed the below-target inflation to lower prices for cell phones and pharmaceutical. Here was my real-time response on twitter:


Yep, either the Fed is the most unlucky institution in the world or the Fed has a problem. I think the latter. The Fed appears to have begun having a problem with 2 percent inflation around the time of the Great Recession. This can be seen in the FOMC's summary of economic projections (SEPs) figure below. It shows for each FOMC meeting where SEPs were provided to the public the central tendency forecast of the core PCE inflation rate over the next year. The horizon for these forecasts depend on the time of the year they were released and range from one year to almost two years out. The forecast horizons are long enough, in other words, for the FOMC to have meaningful influence on the inflation rate.


The figure shows that since 2008, the FOMC has consistently forecasted at most 2 percent inflation. Note that The FOMC’s description of the SEP states (emphasis added) “Each participant's projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant's assessment of the rate to which each variable would be expected to converge under appropriate monetary policy…” As former FOMC member Naranaya Kocherlakota notes, this means the projections reflect what members think inflation should be if they had complete control over monetary policy over the forecast horizon. It reveals their preferences for the future path of monetary policy. Consequently, the central tendency of FOMC members since 2008 indicates that they see the optimal inflation rate not at 2 percent, but at a range between 1 and 2  percent. 

The actual performance of the Fed's preferred inflation measure, the PCE deflator, has been consistent with this view. It has averaged about 1.5 percent since the recovery started in mid-2009. That is a revealed preference, not a series of accidents caused by bad  luck.

To be clear,  the Fed has only been explicitly targeting inflation at 2 percent since 2012, but many studies have shown it to be implicitly doing so since the 1990s. So this truly has been an eight-year plus problem for the Fed and one that makes Janet Yellen's remarks all the more disappointing to hear. One would think after almost a decade of undershooting 2 percent inflation there might be an acknowledgement from the FOMC like the one that came from Minneapolis Fed President Neel Kashkari (my bold):
[O]ver the past five years, 100 percent of the medium-term inflation forecasts (midpoints) in the FOMC’s Summary of Economic Projections have been too high: We keep predicting that inflation is around the corner. How can one explain the FOMC repeatedly making these one-sided errors? One-sided errors are indeed rational if the consequences are asymmetric. For example, if you are driving down the highway alongside a cliff, you will err by steering away from the cliff, because even one error in the other direction will cause you to fly over the cliff. In a monetary policy context, I believe the FOMC is doing the same thing: Based on our actions rather than our words, we are treating 2 percent as a ceiling rather than a target. I am not necessarily opposed to having an inflation ceiling...  I am opposed to stating we have a target but then behaving as though it were a ceiling.
It is time for the FOMC to come clean on what it really wants to do with inflation. Until it does so continue to expect confusion and  repeated questions to Fed officials over the Fed's inflation target.