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Tuesday, May 22, 2018

What Can Argentina Teach Us about the Phillips Curve?

In the United States, there has been existential angst over Phillips curves for the past few years. Fed officials and other observers have been engaged in deep soul searching as they try to reconcile a falling unemployment rate with stubbornly low inflation. The Phillips curve says this development should not be happening--inflation should rise as the economy nears full employment. And yet, it has been happening for several years. 

Various attempts have been made to reconcile the apparent breakdown in the Phillips curve relationship. Some, like Joe Gagnon, say there is a non-linear relationship that comes into play when inflation is really low. Others, like Adam Ozimek and Ernie Tedeschi claim there is no Phillips curve mystery if one simply uses the correct measure of slack: the prime-age employment rate. Another group, including Paul Krugman, points to monopsony power as explaining the breakdown in the relationship. Still others point to a variation of Milton Friedman's thermostat argument: the Fed has been so successful at targeting inflation it has eliminated any observed relationship between inflation and slack. Nick Rowe puts it this way:
[I]nflation targeting made inflation stickier than it used to be. Which means that inflation targeting became a victim of its own success. By making inflation sticky at 2%, it destroyed the very signal of deficient-demand recessions that monetary policy was supposed to respond to. The thermostat destroyed its own negative feedback mechanism.
Minneapolis Fed President Neel Kashkari makes a similar argument in the Wall Street today.  It is also the implication of this Cecchetti et al. (2017) paper that made a splash last year. This view makes the most sense to me.

To be clear, I prefer thinking of inflation from a money supply-money demand framework along the lines of David Andolfatto and Josh Hendrickson. But if one is determined to approach inflation from a Phillips curve perspective, I see the thermostat view as the most convincing explanation for the breakdown in the U.S. Phillips curve relationship. 

Paul Krugman recently suggested we look elsewhere to get further insight on the Phillips curve. He turned to Spain which appears to show a strong Phillips curve relationship. This choice of country, however, is not a clean one since its monetary policy is set externally by the ECB. It is not obvious that we would see this relationship persist if Spain set its own monetary policy. Spain, in short, does not help us better understand the U.S. experience.

One country that might be useful is Argentina, at least if we look at the non-hyperinflation years. It has its own central bank, the BCRA, and it has periods of instability that provide data not clouded by Milton Friemdman's thermostat. Interestingly, since 2010 the BCRA has tolerated double digit inflation in Argentina and currently inflation is running near 25 percent. This run of inflation has been above the central bank's inflation target of 8-12 percent so the BCRA conveniently changed its inflation target this year to 15 percent. It might interesting to see what this run of high inflation does to the Phillips curve. 

I plotted the Argentine Phillips curve below using annual data from the IMF WEO database and Focus Economics for this period of high inflation. Most of my data comes from the former source, but for the years 2015 and 2016 the IMF does not report the inflation rate presumably because of questions about the reliability of the data. Focus Economics does provide data for those missing years. The red line below shows the estimated Phillips curve relationship leaving out the questionable 2015 and 2016 observations while the blue line shows the relationship using all the all the observations.



Yikes, we got an upward slopping Phillips curve! This is a small sample, but it is consistent with notion that inflation running too high can cause problems on the real side of the economy. We should dread this Phillips curve. 

Now to be fair, if I take the IMF data back further to earliest time where there was no hyperinflation (defined as inflation greater than 50%) we get the following figure:


Now we see a more traditional-looking Phillips curve for the period 1992-2009 (excluding the 2002 outlier, the year Argentina broke the link with the dollar) of this sample. It is depicted by the black line. Most of the observations in this earlier period have inflation lower than 10 percent. That may explain why it looks more normal. For comparison, the 2010-2018 period is again highlighted by blue. 

If we plot a Phillips curve relationship over the entire sample we get the following figure. 


The takeaway, if there is any, from these Argentine figures is that a standard-looking Phillips curve may require inflation be less than 10 percent and there be periods of instability so that Milton Friedman's thermostat is not working. But if the thermostat is not working, then, the central bank is not doing its job. The Phillips curve, in other words, may never be very informative for places where central bankers are doing a great job anchoring inflation. The United States is arguably one such place. If that is the case,  Fed officials might want to try a different approach to understanding inflation. 

Thursday, May 10, 2018

The U.S. Mortgage Market: Chart Edition

Today, I interviewed Nick Timiraos of the Wall Street Journal for the Macro Musing podcast. He is on the Fed beat now, but covered the GSEs during and after the financial crisis for the paper. Consequently, he has an encyclopedic knowledge of Fannie Mae, Freddie Mac, and the other GSEs. His knowledge and experience were the basis of our conversation today. It was a fun show and should be out in about a month.

I wanted to share some figures I collected on the U.S. mortgage market in preparation for the show. They come from an amazing monthly report on housing from the Urban Institute called Housing Finance at a Glance. These figures provide a peak into my conversation with Nick.

Consider first  the historical share of mortgage debt outstanding by type of institution. This chart is actually mine from a few years ago. There are three key takeaways from it. First, the GSEs gain most of their market share in the wake of the S&L crisis. Second, the GSEs actually lose market share to the private label security (PLS) providers during the housing boom period. These PLS providers--the red line in the figure below--gained market share during this time by tapping into the Alt-A and subprime mortgage market. Eventually, the GSEs followed suit, but its was the private label security providers who went there first and did most of the damage.  Third, the GSEs  gain market share back as the PLS supply folded in the crisis. 


Next, if we look just at the share of securitized mortgages--which today makes up about 2/3 of all mortgages today--we see the dominance of the GSEs over PLS today. This can be seen in the figure below from the Urban Institute report. 


The Urban Institute also provides the dollar amount of the mortgage market going to the GSEs and other sectors. The remarkable decline in PLS is evident here too:


 The Urban Institute also provides details on the types and sources of securitized markets:


Finally, for those curious, the Urban Institute has a nice chart summarizing the total value and equity of the U.S. housing market. This chart reports that the U.S. housing equity turned positive again in 2013 and currently stands at $15.2 trillion compared to household debt level of $10.6 trillion. Happy days are here again for U.S. housing.


Again, these charts are just a small part of my conversation with Nick. It should be out in a month or so. In the meantime check out the entire Urban Institute report. 

Thursday, April 12, 2018

Why Yes, the FOMC Would Like Some Inflation Overshoot Now

The Fed claims it has a symmetric two percent inflation target. From  its 2017 and 2018 Statements on Longer Run Goals and Monetary Policy, the FOMC states:
The Committee reaffirms its judgment that inflation at the rate of 2 percent... is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored...
Numerous Fed officials have repeated this point as well. They too see the inflation target as a symmetric one, an understanding that allows for an occasional inflation overshoot. Despite these claims, however, the Fed has persistently undershoot its inflation target. If one acknowledges the Fed implicitly targeted two percent long before the explicit target was adopted in 2012, then the undershooting has lated for almost a decade.  This is not a pretty picture. 

Many observers, including myself, have taken this as evidence that the Fed's two percent target is more of a ceiling and not symmetric. This understanding has been borne out by the FOMC's own Summary of Economic Projections (SEP) forecasts for core PCE. Recall the definition of the SEP:
Each participant’s projections are based on his or her assessment of appropriate monetary policy.
So the SEP reveals FOMC members forecasts of economic variables conditional on the Fed doing monetary policy right. And for the longest time, doing monetary policy right was not overshooting 2 percent inflation in the following year, as seen in the figure below. Keep in mind that at this horizon the Fed should have meaningful influence over inflation.

It is hard to square these revealed preferences from the SEP with a symmetric inflation target. This is a point Narayana Kocherlakota has made many times and has been a source of frustration for many Fed watchers. Ryan Avent of The Economist, for example, has been asking the Fed for years to "try overshooting for once." 

Well, ask no more. FOMC members in the March FOMC meeting finally decided it was time to give inflation overshooting a try. They did not say so explicitly, but did so implicitly via the SEP. For the first time since 2009, the SEP's central tendency forecast for core PCE inflation in the next year breached 2 percent. Specifically, this central tendency forecast for 2019 ranged from 2.0 to 2.2 percent. While this is not far above 2 percent it is progress and it is an inflation overshoot.  


The FOMC minutes for the March meeting also hinted at this new tolerance for an inflation overshoot:
A few participants suggested that a modest inflation overshoot might help push up longer-term inflation expectations and anchor them at a level consistent with the Committee’s 2 percent inflation objective. 
Maybe all complaining about the lack of an inflation overshoot has finally come to fruition. If so, the irony is that this overshoot, just like Trump's expansionary fiscal policy, is probably coming several years too late. The inflation overshoot would have been much better in the 2009-2011 period. But as seen in the above figure the FOMC in its infinite wisdom thought inflation should be closer to 1 percent during that time. FOMC officials, accordingly, seem to be calling for procyclical inflation according to the SEPs. This is not the way to do monetary policy. 

P.S. If only there were a monetary policy framework that avoided these timing problems by making inflation more countercyclical. It sure would be nice if someone would come up with a monetary policy approach that caused inflation to rise during recessions and fall during booms.  You know, kind of like Israel has done per its GDP deflator:


This countercyclical inflation has in turn lead to stable aggregate demand growth. Again, if only there were some approach to monetary policy that systematically implemented this approach.


Tuesday, April 3, 2018

Macro Musing Hits the 100th Episode Mark


Macro Musings has now hit its 100th episode. It was a great show with Heather Long, Ryan Avent, and Cardiff Garcia where we look back at the past decade and look ahead to the next one. Below are a few pictures from the show. Thanks to Patrick Horan who has been a great sound engineer for most of the show. It could not have happened without him. Take a listen!




Monday, March 26, 2018

Assorted Macro Musings

Some assorted macro musings:

New NGDP Paper
My colleague Scott Sumner and Ethan Roberts have a new primer on NGDPLT. It is a very accessible introduction to the topic, but one that also gets into NGDPLT futures targeting. Check it out.

JEC Report on the Slow Recovery
The Joint Economic Committee of Congress has a new report where, among other things, it lays out a monetary explanation for the slow recovery.  A key excerpt on why QE did not create a robust recovery (page 61):
The Fed was clear from the outset that it would undo its LSAPs eventually (i.e., remove from circulation the money it created in the future). The temporary nature of the policy discouraged banks from issuing more long-term loans. Alternatively, as economist Tim Duy pointed out during the inception of the Fed’s first LSAP program: 
"Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are        intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment—a commitment to contract the money supply in the future.
Sumner (2010), Beckworth (2017), and Krugman (2018) observe similar issues. .
Obviously, I liked this part, but the entire report is good so take a look.

Follow Up to My Last Post
Since we are on the topic, I wanted to follow up on my last post. There I piggybacked off a recent Paul Krugman paper to note that the Fed's QE program could not generate significant nominal demand or inflation because the monetary base injections were not conditionally permanent. As a result, the Fed's QE programs became subject to the "irrelevance results" of Krugman (1998) and Eggertson and Woodford (2003). This is a widely understood point, but one that often gets overlooked.

To be clear, this understanding does not mean the QE programs had no effect. The consensus view is that the LSAPs did have some effect, lowering 10-year treasury yields somewhere around 100 basis points in total (though even this understanding is being challenged). And yes, we did not repeat the Great Depression. But again, we also did not have a robust recovery in nominal demand growth and that is a policy choice. So it seems QE was limited in what it could do.

With that said, I want to acknowledge there is a way QE could really pack a punch. And that is to make the LSAPs so large that they endanger the Fed's balance sheet via interest rate risk.  Imagine, for example, that the Fed had expanded its balance sheet 1000 times its pre-2008 size versus its almost 4 times increase that actually occurred. 

This is extreme but makes a point. If the Fed’s balance sheet were in fact 1000 times larger it could easily be set up to take a loss on its asset holdings. That is, since QE causes the Fed to hold longer-term securities on its balance sheet, the Fed in this scenario would be a lot more susceptible to interest rate risk. This is the risk where the price of a bond moves inversely with interest rates. The longer the bond, the more the bond’s value will swing in response to changes interest rates.  If rates were to go up, bond prices would fall and this would decimate the asset side of the Fed’s balance sheet. Meanwhile, the liability side of the Fed’s balance sheet (bank reserves and currency) would not have changed. So there would be fewer assets for the Fed to manage the monetary base. That means the Fed could not reign in the monetary base if inflation expectations started taking off, which they probably would in this extreme scenario.

Also, with a 1000-fold increase in asset holdings, it is unlikely the Fed's expected future seigniorage would be enough to cover the hole in the balance sheet. Without sufficient seigniorage, it could not simply pay more IOER since that would be increasing its liabilities and further expanding the hole in its balance sheet.

Now this balance sheet hole could be plugged by the Treasury Department bailing out the Fed. But since the Fed’s balance sheet is 1000x bigger in this scenario it is unlikely the Treasury could muster up enough resources to bailout the Fed without further debt monetization too. In short, the hole in the Fed's balance sheet would be so large the monetary base injection would be seen as permanent. As a result, QE would generate rapid nominal demand growth and roaring inflation in this scenario. 

This is obviously undesirable and an extreme scenario to show that QE could, in theory, pack a nominal demand punch. But it would be so costly and inefficient that it should give us pause about using LSAPs. If QE requires extremes like the above scenario to generate robust nominal demand growth, maybe it is best we look elsewhere for help. NGDPLT targeting, in my view, is the answer.

Ed Nelson Podcast
This week on the show is Ed Nelson. We had a great time talking monetary economics, Milton Friedman's legacy, and the conduct of monetary policy. Take a listen.

Tuesday, February 27, 2018

Paul Krugman on Temporary vs Permanent Monetary Injections

Paul Krugman looks back on the past twenty years of macroeconomic policy and finds that his 1998 paper was more prescient than he or anyone could have imagined. Back then many observers assumed that central bankers--particularly those at the Bank of Japan--need only increase the monetary base to increase the price level. It was that simple.

Ken Rogoff, for example, said the following in commenting on Krugman's 1998 article:
No one should seriously believe that the BOJ would face any significant technical problems in inflating if it puts it mind to the matter, liquidity trap or no. For example, one can feel quite confident that if the BOJ were to issue a 25 percent increase in the current supply and use it to buy back 4 percent of government nominal debt, inflationary expectations would rise.
Krugman disagreed in his 1998 paper. He showed, using a New Keynesian model, that it was more complicated than many imagined. It depended on whether the monetary injections were expected to be temporary or permanent. Here is how he summarizes his 1998 article (my emphasis):
[T]he proposition that money issuance must raise the price level was false. Or if you like, it was missing a word: permanent money issuance would raise the price level. But a monetary expansion the private sector expected to be temporary, to be wound down after the crisis had passed, would do nothing at all: the extra monetary base would just sit there. Furthermore, it was reasonable for the private sector to assume that even large increases in the monetary base in a liquidity-trap economy would be temporary, to be wound down after the crisis had passed, would do nothing at all: the extra monetary base would just sit there
He goes to note that the public should, in fact, expect large expansions of the monetary base to be temporary. Otherwise, it would imply an implausibly large jump in the price level that would not be politically tolerated. For example, if the several-hundred percent increase in the U.S. monetary base expansion under the Fed's QE were expected to be permanent then the price level would have proportionally jumped several hundred percent as well. 

Krugman notes that the actual performance of Japan's first QE program of 2001-2006 and the Fed's QE programs bore out his predictions. These large-scale asset purchase programs ultimately proved to be temporary monetary programs. 

This is an important point and one that I stress in my own work. Just to be clear, permanent means an exogenous increase in the monetary base that (1) is beyond that required to accommodate normal money demand growth and (2) is not expected to be reversed. 

To illustrate this point, I want to repeat what I showed in an earlier post. There I used the Fed's median forecast of its assets through 2025 from its 2016 SOMA Annual Report to create projections of the Fed's balance sheet. These projections 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. These two measures, which reflect the liability side of the Fed's balance sheet, are plotted along side the forecasted path of the asset side of the Fed's balance sheet.


Note 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. Consequently, the permanent measure of the monetary base roughly tracks currency's trend path.

The figure implies the Fed's balance sheet forecast confirms the temporary nature of the monetary expansion  under the QE programs. That is, the Fed expects most of the permanent growth in the monetary base in 2025 to have come from the normal currency demand growth. This endogenous money growth would have happened in the absence of QE. There is no sign of an exogenous permanent increase in the monetary base. 

Krugman's bigger point is that to have robustly raised nominal demand over the past decade required a permanent increase in the monetary base. This did not happen at the Fed or the ECB. Krugman thinks it sort of happened in Japan under Abenomics. Maybe so, but I am not completely convinced. In my view, the shackles of inflation targeting made such permanent increases very hard to do at most advanced-economy central banks over the past decade. 

So what would a permanent monetary base expansion look like in practice? In my paper, I argue one could look to the experience of Israel over the past decade. An even better example comes from the U.S. economy coming out of the Great Depression. It is fairly easy to see the permanent jump in the monetary base during the early 1940s:


That is what Krugman would call being credibly irresponsible. It took a war to accomplish this permanent jump in the monetary base. The same can be done more efficiently and in a rule-like manner with a NGDP level target. Credibly going to a NGDPLT, however, would require a major regime change to U.S. monetary policy. And that brings us back to Krugman's article:
Given the way experience has undermined much of the original case for a 2 percent inflation target, and given the severity of the economic crisis, you might therefore have expected some  revision – a rise in the inflation target, or a shift to some other kind of targeting – price level or nominal GDP targeting. But that hasn’t happened... This is quite remarkable. If the worst economic crisis since the 1930s, one that cumulatively cost advanced nations something on the order of 20 percent of GDP in foregone output, wasn’t enough to provoke a monetary regime change, it’s hard to imagine what will.
His pessimism is understandable. However, I am more hopeful as noted in my last post. We are making progress. We have changed the conversation and that is the first step forward. 

Fed Chair Jay Powell on Monetary Policy Rules

Jay Powell went to Capitol Hill today for his first congressional testimony as Fed Chair. In addition, he submitted the Federal Reserve's annual Monetary Policy Report to Congress.  A lot of ground was covered in his testimony, follow-up questions, and in the report. Here, I want to highlight one very interesting and potentially significant part of his testimony. And that is Jay Powell's endorsement of monetary policy rules.

At the end of his written testimony, Jay Powell had this to say:
In evaluating the stance of monetary policy, the FOMC routinely consults monetary policy rules that connect prescriptions for the policy rate with variables associated with our mandated objectives. Personally, I find these rule prescriptions helpful. Careful judgments are required about the measurement of the variables used, as well as about the implications of the many issues these rules do not take into account. I would like to note that this Monetary Policy Report provides further discussion of monetary policy rules and their role in the Federal Reserve's policy process...
I believe this is the strongest embrace of monetary policy rules to date by any Fed chair. This is progress in my view. But it gets even better. The monetary policy report that Jay referenced lays out a number of monetary policy rules, including a price level target rule. That is a huge departure from past practice when most rule discussions were stated in terms of some Taylor rule. For example, last year's Monetary Policy Report did not have a price level target in it. 

Below is the table from the report listing the various rules:


The inclusion of the price level rule could be signaling an important change taking place at the Fed. It comes after the minutes from the January FOMC meetings indicate members had conversations about the changing the framework for monetary policy. Here is an excerpt from those minutes:

This discussion of an inflation target range and a price level target is interesting. It reinforces the view that the expanded rules list from the Monetary Policy Report is signaling a new openness to change.  And just to be clear, an inflation target range properly done comes pretty close to what a NGDPLT looks like as noted in my previous post for the case of Israel. 

So all of the public conversations about a new monetary policy framework seem to be gaining traction at the Fed. Of course, the one rule that was not on the list in the 2018 Monetary Policy Report was a NGDPLT.  As I have argued elsewhere, there are good reasons to want it over a price level target. But the fact that the Fed is having this discussion and has added a price level target to its menu of rules is major progress.

So kudos to the new Fed chair and the FOMC for engaging in this conversation. Keep it going.

Update: It has been brought to my attention that the price-level target noted above is in practice fairly close to a NGDPLT. This is because the price-level target has the unemployment gap in it. This observation is similar to Michael Woodford's noting that his theory-based call for an output gap-adjusted price level target in practice is roughly the same as doing a NGDPLT. Fair point. I should have noted it, but failed to do so.

My preference, however, is still for a straight-up NGDPLT for two reasons. First, there is a significant knowledge problem surrounding estimates of the output gap as laid out in this article. (For a less technical discussion making the same point see this policy paper.) Second, I approach NGDPLT more from a velocity-adjusted money perspective rather than from an output gap-adjusted price level perspective. That is, I look at NGDP from the MV side of the equation rather than the PY side. Consequently, I see unobserved changes in potential output as a feature not bug of NGDPLT.

With that said, I am super excited that the Fed has effectively put a NGDPLT target on its rule list. 

P.S. Maybe if Jay Powell and the rest of the FOMC started each day with a coffee mug like this, we might see NGDPLT on the list. We need to get some over to the Eccles building. Reach out to us FOMC if you are interested in a mug and a conversation on NGDPLT.