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. 

Friday, February 23, 2018

Assorted Macro Musings

Some assorted macro musings from the week

A Monetary Correction
Ramesh Ponnuru and I have a new article in the National Review where we make the contrarian case that monetary policy was actually tight over the past decade relative to its own inflation target and past trends in the growth of aggregate nominal spending. We note the following:
The economy seems largely to have adjusted to the new, lower pace of spending growth. The problem now is not that monetary policy is erring on the side of tightness and thus holding back the economy’s potential. It’s that the Fed’s apparent bias against letting spending and inflation drift higher, even temporarily, makes it more likely that the next economic downturn will again be severe and the next recovery will again be sluggish.
As evidence for our claim on a trend decline in the growth of nominal spending, we show the following figure:

Asymmetric Inflation Fears
I often chastise the Fed for effectively having an asymmetric 2% inflation target. The truth is, though, that the Fed's undershooting of its inflation target is mild compared to the asymmetric inflation fears many of financial commentators. When the CPI hit 2.1% last week the financial pundits began to freak out like it was the 1970s all over again.  The Wall Street Journal OpEd shown below is a good example of this thinking:

Where was this concern when inflation was undershooting for so long? Recall that the official target of the Fed, the PCE deflator inflation rate, has been running about 50 basis points below its target for almost a decade. (Yes, the Fed was implicitly targeting 2% before 2012 so it has been a decade.) 

Comments on January's FOMC Minutes
The January FOMC minutes came out this week and I had a few things to say about them on twitter. Below is a screen shot of my first tweet. I also did a quick write up of these points at The Bridge.

Israel Monetary Awesomeness Update
In the past some of us have pointed to the Bank of Israel(BoI) as a central bank that does flexible inflation targeting right.  We noted that the BoI allows for truly flexible countercyclical inflation that on average hits its inflation target. It does it so well that nominal demand growth has been relatively stable. Below are a few pictures to illustrate this point

Consider first Israel's inflation rate, as measured by the GDP deflator. Since 2007, this inflation rate has moved in a countercyclical fashion. The BoI officially targets inflation within a range of 1%-3%, but has allowed inflation to touch 5% two times over the past decade when real GDP decline. It also has allowed inflation to fall when GDP has soared. Over this sample period, the GDP deflator inflation rate has average just over 2%. Imagine that: a symmetric inflation target over the business cycle!

As a result of this inflation flexibility, nominal demand has been relatively stable. Well done BoI. Here's hoping that some at the Fed are taking notice.

Floors vs Corridors: Fed Edition
This week on the podcast I interviewed George Selgin. We discussed the difference between a corridor and floor system and what that means for the Fed. Among other things, we discuss how a floor system can create a liquidity-trap like situation above the ZLB, what a car in neutral can tell us about a floor system, and what we know about the legality of IOER. Take a listen.

Wednesday, January 24, 2018

Summer Program on Monetary Policy for Students

Here is a great summer program for advanced undergraduate or beginning graduate student that are interested in monetary economics. Scott Sumner and I will be presenters and St. Louis Fed President Jim Bullard will be the keynote speaker. Your travel and lodging will be covered, but you need to apply by January 31. 
Alternative Money University (AMU) is an academic workshop for advanced undergraduate and beginning graduate students with a particular interest in monetary economics. During three days of intensive seminars, students will learn from leading scholars in the field about subjects not typically addressed in undergraduate or graduate economics courses — including topics in monetary history, the theory and practice of monetary policy, and the workings of unconventional monetary arrangements. Between them, the subjects covered and the seminar-style of the sessions are intended to provide students with a solid foundation upon which to build their own, future contributions to the field.
Held in Washington, DC, expenses for attending AMU — including travel and accommodations — will be covered by Cato’s Center for Monetary and Financial Alternatives. Admission is limited to 30 students, who must be in or about to enter either their ultimate year of undergraduate study or their first year of graduate studies. Selections will be based on students’ academic records and demonstrated interest in monetary economics.
Click here for more information. I hope to see you there!

Sunday, January 14, 2018

Do Changes in Potential Output and Data Revisions Make NGDP Targeting Impractical?

It's Back...
Over the past few months there has been increasing chatter about the need for a new framework for U.S. monetary policy. The Peterson Institute for International Economics (PIIE), for example, recently had its Rethinking Macroeconomic Policy conference where, among other things, Ben Bernanke called for the Fed to adopt a temporary price-level target. PIIE also launched Angel Ubide's new book  on reforming monetary policy. Similarly, at the AEA meetings there was a session titled Monetary Policy in 2018 and Beyond where Christina Romer again made the case for a NGDP level target. Likewise, the Brookings Institute held a recent conference on whether the Fed should abandon its 2 percent inflation target. There, Jeff Frankel shared the arguments for a NGDP level target and Larry Summers endorsed it. Others at the conference, like San Francisco Fed President John Williams called for a price level target.

I am glad this conversation is happening. It is not new--some of us have been having it since 2009--but I get the sense that it is gaining traction. The turnover at the Fed and the opportunity it creates for new thinking makes this conversation about new monetary policy frameworks incredibly important now. 

As this conversation continues to grow, so will the interest in the options available including nominal GDP level targeting (NGDPLT). Obviously, I have much to say here, but for now I want to respond to two critiques often applied to NGDPLT: (1) changes in potential output and (2) data revisions make NGDPLT an impractical rule to implement. I think these concerns are misplaced as explained below.

Critique 1: Changes in Potential Output: A Feature or a Bug for NGDPLT?
Since NGDP growth is approximately the sum of real GDP growth and inflation, many observers are concerned that changes in potential output will cause wide swings in inflation. Here, for example, is Goodhardt et al. (2013):
[A]ny overestimation of the sustainable real rate of growth... could force [a central bank], subject to a level nominal GDP target, to soon have to aim for a significantly higher rate of inflation. Is that really what is now wanted? Bring back the stagflation of the 1970s...?
Put differently, some worry that a NGDP target will not provide a stable nominal anchor. For these folks this is a bug in NGDPLT. This concern is unwarranted for several reasons.

First, a NGDPLT target does provide a nominal anchor. It pins down the long-run growth path of nominal income. Put differently, it approximately stabilizes the growth path of nominal wages. Yes, it will allow more flexibility with inflation but as argued later that may be a good development.

Second, on a practical level, a NGDP target would never have generated 1970s-type swings in inflation given the actual history of potential output growth. The figure below illustrates this point. It assumes a 5% NGDP target and takes the year-on-year growth rate of the CBO's potential real GDP measure (blue line) as given. The trend inflation rate (black line) implied by this counterfactual monetary policy is plotted in the figure.

In this counterfactual, the inflation trend rate averages 1.97 over the entire 1960-2017 period. At most, it temporarily hits just above 4 percent right after the crisis. There is no 1970s inflation. Fears that a NGDPLT will bring back 1970s-type inflation is a red herring.

Interestingly, this counterfactual would have led to lower inflation in periods of high-trend real GDP growth periods like the 1960s and led to higher inflation in low-trend GDP growth periods like the present. To the extent there is hysteresis and potential real GDP is not truly exogenous to monetary policy, the counterfactual higher inflation (as a symptom of higher nominal demand) may have actually reduced the collapse in potential output over the past decade.In any event, a NGDPLT since 1960 would not have led to soul-crushing swings in inflation that some claim.

What many observers miss is that with a NGDPLT target the central bank does not need to worry itself over the latest changes to potential output. As the chart shows above, these changes happen fairly regularly. A NGDPLT lets these potential output changes be absorbed through reasonably-sized changes in the inflation rate. Inflation flexibility provided by a NGDPLT is a virtue here.2

Monetary policy, as it is currently practiced, does not have freedom. Most inflation-targeting central banks loosely follow something like a Taylor rule where they need to know the output gap in real time. That requires knowing both real GDP and potential real GDP in real time--an impossible task.

A NGDPLT acknowledges this ignorance and says to simply focus on stabilizing nominal demand. Potential output changes are therefore a feature rather than a bug for NGDPLT.

Critique 2: Data Revisions Make NGDP an Impractical Framework
There are two replies to this. First, as noted above, inflation targeting as it currently practiced requires real-time knowledge of both real GDP and potential real GDP.  This Taylor-rule framework is therefore is also subject to data revisions. Moreover, it subject to two of them. A NGDPLT target, on the other hand, only faces one variable subject to data revisions. So if data revisions make NGDPLT impractical even more so for the current inflation targeting framework.

Second, as Josh Hendrickson and I show in a recent paper, the Fed's forecast of NGDP for the current period is not biased (i.e. the forecast error is stationary). That means even if there are data revisions to the official statistics, the Fed can rely on its forecasts of NGDP to avoid this challenge. Below is chart from our paper that captures this ability of the Fed:

We also show in the paper that the Fed's forecast of the potential GDP is biased (i.e. the forecast error has a unit root). Consequently, the data revision argument against NGDP is not a convincing one, while it is a serious one for flexible inflation targeting.

For me, then, I do not worry about the above two critiques. The real issue with NGDPLT, in my view, is how to credibly implement it. But that is a topic for another post.

As commentator John notes, these problems could also be addressed by Scott Sumner's NGDP futures contracts idea. I would also note that directly targeting a monthly nominal wage index in the manner outline by George Selgin would be another fix.

Related Links
NGDPLT and the Problem of Permanent vs Temporary Monetary Base Injections 
NGDPLT and the Eurozone Crisis

1 A forceful case for hysteresis in the U.S. economy is made by Reifschneider, Wascher, and Willcox (2013)J.W. Mason (2017), and Coibion, Gorodnichenko, and Ulate (2017).
2There are other reasons why the countercyclical inflation created by a NGPDLT would be beneficial. It would lead to better risk-sharing between creditors and debtors as shown in Koenig (2013), Sheedy (2014), and Bullard et al. (2015).

Wednesday, January 10, 2018

Yes, IOER Continues to be Bad Political Optics

So the Federal Reserve is reporting that interest on excess reserves (IOER) payments hit $25.9 billion in 2017. This amount is more than double the dollar size of the IOER payments in 2016 as seen below. 

This increase is understandable given the rise in the Fed's short-term interest rate target and the size of its balance sheet. But, as I have noted before, this is horrible optics. For the largest recipients of the IOER payments are large domestic banks and foreign banks. As seen in the figure below, they hold most of the excess reserves and therefore earn most of the IOER payments. 

Put differently, the systematically-important or "too-big-to-fail" banks that were bailed out during the crisis and are still implicitly subsidized by the government as well as foreign banks are the main recipients of IOER. It gets worse. Note in the table above that the higher IOER payments are associated with declining remittances to the Treasury Department. The Fed, in other words, is allocating more funds to big banks and less to the public. This is easy fodder for the "Wall Street vs. Main Street" critics. Because of this, I suspect the IOER in its current form will be increasingly a tough sell to make to Congress.

There is an easy fix to this problem. The Fed can move from its current floor system to a corridor system. Under the latter, the balance sheet can shrink down so that there are few reserve balances in the banking system1. The Fed can still have IOER, but it would be less than short-term market interest rates.2 The IOER would set an floor for short-term interest rates and the Fed's lending rate would be the ceiling for short-term market interest rates. Together this would constitute a corridor system and give the Fed ample control over interest rates. 

Update: To clarify the difference between a corridor and floor system, here is a figure distinguishing the two approaches from the NY Fed. Note in both cases the IOER remains.

1Just because a corridor system would have fewer reserves does not mean it would necessarily be a "scarce-reserve" balance sheet. Reserve scarcity is not about the quantity of reserves, but about their supply relative to their demand. All a smaller Fed balance sheet does is affect the supply of reserves. The Fed can also reduce reserve demand by lowering IOER. Depending on how it adjusts IOER will determine whether there is reserve scarcity. Consequently, observers need to be careful to avoid automatically associating small reserve balances with reserve scarcity.
2In the current floor system, IOER is above short-term market interest rates and is the source of many problems with the system. 

P.S. George Selgin in Congressional testimony today makes the case for the Fed moving to a corridor system. Norbert Michel also makes the case in his testimony.