Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide


Wednesday, February 15, 2017

A public finance case for keeping the Fed's balance sheet large

Former Fed Chair Ben Bernanke recently asked a question concerning the optimal long-run size of the Fed's balance sheet (Should the Fed keep its balance sheet large?). Bernanke comes down on the side of "keeping the balance sheet close to its current size in the long run." While he does not explicitly say how "size" is defined, I think it's clear he means the size of the balance sheet measured relative to the size of the economy (say, as measured by nominal GDP). According to this measure of size, the Fed would have to grow its balance at the rate of nominal GDP growth.

In addition to the reasons reported by Bernanke, I think there's a public finance argument to be made for keeping the Fed's balance sheet large--at least, under certain conditions--like ensuring that the inflation mandate is met. Let me explain.

Let's begin with a picture that most people are familiar with. 
Prior to 2008, the Fed's balance sheet was under one trillion dollars in size. Prior to 2008, it grew roughly at the same rate as the economy. Most of these assets consisted of short-term U.S. treasury securities. Most of these asset acquisitions were financed with zero-interest money (currency in circulation). Since 2008, the Fed's balance sheet has grown to 4.5 trillion dollars. The composition of assets has moved away from short-term government debt to longer-term debt and mortgage-backed securities. Most of these asset acquisitions were financed with low-interest money (reserves).

Is 4.5 trillion a big number? Well, yes. But then, the U.S. is a big economy: the U.S. nominal GDP for 2016 is close to 19 trillion dollars. So in measuring the size of the Fed's balance sheet, it probably makes more sense to measure size as a ratio. The following graph plots the size of the Fed's balance sheet as a ratio of nominal GDP.
Prior to 2008, the size of the Fed's balance relative to the economy averaged about 6%. The balance sheet size peaked in 2014 at just over 25%. Note that by this metric, the Fed's balance sheet has been contracting since 2014.
 
For the record, note that the large expansion in the supply of Fed money was associated with historically low rates of inflation:
Now let's talk about the business of banking. I like to think of a bank as an asset transformer: a bank converts relatively illiquid assets into relatively liquid liabilities. The Fed buys relatively high-yielding (but safe) securities, like U.S. treasury bonds and AAA-rated mortgage-backed securities. It pays for these acquisitions by issuing liabilities (printing money) in the form of low-interest reserves.
The Fed transforms high-interest government debt into low-interest Fed liabilities (money).

The difference between the interest the Fed earns on its assets and the interest it pays on its liabilities is an interest rate spread. Isn't it wonderful to be able to borrow at low rates and invest at high rates? This is precisely what the Fed did with its large scale asset purchase (LSAP) program. Apart from any other effects that this intervention had on the economy, it resulted in huge profits for the Fed. Keep in mind that any profit made by the Fed is remitted to the U.S. Treasury (and thus, ultimately, to the U.S. taxpayer).

So just how much money does the Fed return to the treasury each year? I'm glad you asked, here you go:
In recent years, the Fed has been returning about $80-90 billion per year to the U.S. Treasury. While interest rates were higher in the past, the Fed's balance sheet was much smaller--and so while the profit margin was high, the volume was low. Today the profit margin is smaller, but the balance sheet is much larger. (The distance between the red and blue lines represents the Fed's foregone profit since it started paying interest on reserves in 2008).
 
What sort of rate of return does the Fed make on its portfolio? The following graph plots Fed payments to the Treasury as a ratio of the Fed's assets.
Since the bulk of the Fed's assets are in the form of U.S. government bonds, it should be no surprise to learn that the rate of return has generally followed the path of market interest rates downward. Still, in recent years, the annual rate of return is about 2%. Given that the Fed is presently financing these assets with cash (0%), ON RRP (0.25%) and IOER (0.50%), the profit margin is still significantly positive (though one wonders about the scope for further policy rate hikes if market rates remain low).

In light of this analysis, why are some people calling for the Fed to reduce the size of its balance sheet? Usually the concern is that a large balance sheet portends higher future inflation. But we've been living in a world of lowflation for many years now and we're likely to stay there for the foreseeable future (though central banks should of course remain vigilant!). There is, in fact, some theoretical support for the notion of reducing the Fed's policy rate (subject to the dual mandate and financial stability concerns); see, for example: The Inefficiency of Interest-Bearing National Debt.

Reducing the Fed's balance sheet at this point in time seems like a needless loss for the U.S. taxpayer. Given that the Treasury is marketing a bond, who do you want to hold it? If the debt is held outside the Fed, the government needs some way to pay the 2% carry cost of the debt. The government will in this case have to reduce program spending, increase taxes, or increase the rate of growth of debt-issuance. Alternatively, if the Fed holds the debt, the carry cost is generally much lower. This cost-saving constitutes a net gain for the government. So why not take advantage of it?

***
P.S. I realize there are some who argue that a central bank enables big government. Since the government is too large, we need to end central banking and, in this manner, starve the beast. But this argument amounts to "let's make the government less efficient in terms of financing their operations--that'll force it to get smaller." This line of argument strikes me as na├»ve--I'm not sure what would prevent the government from simply substituting into different methods of finance. If you want smaller G, then lobby Congress to make G smaller. But given that smaller G, it should still be financed in the most efficient manner possible. And that means following the prescription above.

Friday, December 30, 2016

Can the blockchain kill fake news?

Not actually fake news, but still good for a laugh.
Bloomberg View columnist Megan McArdle has an interesting article on fake news: Fact-Checking's Infinite Regress Problem. Fake news constitutes blocks of information fabricated either wholly or in part from falsehoods to serve a political end. It is an act of commission, as opposed to a related act of omission: reporting blocks of true information chosen selectively to serve a political end.

A natural response to the problem of fake news is the emergence of fact-checkers. But on what basis are these elected or self-appointed fact-checkers to be trusted? Who will guard the guardians? The solution cannot be to appoint another layer of super-fact-checkers, since this process results in an infinite regress. Ultimately, the solution will have to reside in an answer like: "The guarded must guard the guardians."

Fake news--or fake history, for that matter--is not something new. Every society is built on a store of publicly accessible information--a shared history--that evolves over time. But who is assigned write-privileges to this public ledger and how can they be trusted? How can we be sure that Caesar, for example, didn't fabricate much of what is recorded in his Commentaries?

This the problem with public ledgers where everyone has a write-privilege, as we do with the Internet. But the problem is an ancient one. In small social groups, individuals sometimes spread fake news about others or themselves. Whether this information becomes part of the group's shared history may at times depend more on its truthiness than its truthfulness. And false rumors sometimes do destroy individual reputations. A society that cannot guard against individuals freely rewriting its history for personal/political gain at the expense of the community is almost surely doomed to fail. This is not to say that societies cannot function if they rely on a shared history consisting of fake news. Indeed, they may even flourish if fake news takes the form of (say) nation-founding myths designed to promote social cohesion.

You might be wondering what any of this has to do with blockchain. Well, a blockchain is simply a shared (distributed) database (history) where the database is updated and kept secure through some communal consensus algorithm. In this piece "Why the Blockchain should be familiar to you" I argue that blockchain technology has been around for a long time. Unfortunately, there are limitations to what a distributed network of human brains talking to each other through traditional methods can accomplish as communities grow larger. But recent advancements in our brain power (computers) and communications technologies (Internet) have now made a global blockchain possible. This is exactly what Bitcoin has accomplished.
 
And so, as 2016 comes to a close, I put forth a whimsical question. Can blockchain (somehow) kill fake news? No, I don't think so. Well, maybe yes, in some circumstances. (Did I mention that I'm an economist?)

The answer depends on what parts of our shared history we can expect to manage through a computer-based blockchain (and on the details of the consensus protocol). The Bitcoin blockchain appears to have solved the fake news problem for its particular application (essentially, debiting/crediting money accounts--though broader applications appear possible). Might the same principles be used to manage the database at, say, Wikipedia (see How Wikipedia Really Works: An Insider's Wry, Brave Account)?

Ultimately, I'm afraid that the fundamental problem with fake news is not that we don't have the technology to prevent it. The problem seems more deeply rooted in the natural (if unbecoming) human trait of preferring truthiness over truth, especially if truthiness salves where the truth might hurt. I'm not sure there's a solution to this problem apart from trying to instill in ourselves these good Roman virtues (veritas and aequitas, in particular).

Happy New Year everyone! Wishing you all the best for 2017.

***
PS. Just came across this interesting piece: Can Geeks Defeat Lies? Thoughts on a Fresh New Approach to Dealing with Online Errors, Misrepresentations, and Quackery.

Monday, December 12, 2016

Some recent economic developments in Japan

Most economic commentators seem to agree that the Japanese economy has been languishing for a very long time.  What is it about Japan that gives this impression? In this post, I suggest that while Japan certainly has its share of difficulties, the common impression of stagnant economic performance seems overstated.

For some people, almost everything you need to know about Japanese macroeconomic performance is encapsulated in this diagram:
This chart tells us that the Japanese economy produced about the same total yen value of goods and services in 2016 as it did in 2000. By way of contrast, the U.S. economy increased the total dollar value of its production by 80% over the same period of time.

But of course, our material living standards do not depend on the amount of dollars or yen an economy produces--these are just units of measurement. The diagram above would be fine to use as a comparison of macroeconomic performance if the purchasing power of dollars and yen remained stable over time. The following diagram shows that this has not been the case.
The general price level (a measure of the cost of living) rose by about 40% in the U.S. since 2000, while it declined by over 10% in Japan over the same period of time. (Note: the consumer price index behaves similarly in the U.S., but is flat for Japan over this sample period.) To put things another way, the U.S. economy has experienced inflation, while the Japanese economy has experienced deflation.

If we correct for the falling (rising) purchasing power of the dollar (yen), the first diagram above is altered as follows:
That is, since 2000, real income (nominal income adjusted for the cost of living) has risen by 35% in the U.S. and by 13% in Japan. That's still a big gap between the two countries, though not nearly as big as the gap in nominal GDP.

But there's something else to consider as well. The total income of a country also depends on population size. How much of the difference above is accounted for by different population growth rates? The following diagram provides the answer:
Real per capita income in both the U.S. and Japan is up about 13% and 10%, respectively, since 2000. That's not a highly significant difference in my books, especially if we take the following into consideration. First, the recession in 2009 seems to have hit Japan much harder than the U.S. Second, in the middle of a sharp recovery dynamic from the 2009 recession, Japan suffered a severe earthquake/tsunami shock in April 2011. And third, just as the economy appeared to be recovering from this latter disaster, the Japanese government increased the consumption tax in April 2014.

There are a couple of other things I'd like to mention about the comparison above. The growth in per capita RGDP in Japan in the early 2000s largely coincided with the Koizumi era. I've written about this here: Another Look at the Koizumi Boom. This growth episode was driven largely by a boom in private investment. It occurred at time of declining government investment spending, a sharp reversal of the the Bank of Japan's QE program in 2006 and, of course, continued deflation. In the U.S. in the meantime, per capita RGDP grew by almost 9% over the three years 2003-2006. That's a pretty high rate of growth by historical standards--did people really believe this to be sustainable? (Related post here: Secular Stagnation, Then and Now).

A big concern these days has to do with productivity growth. The value of production per employed person rose at more or less the same rate in both countries from 2000-2008. But labor productivity in Japan has lagged the U.S. since then.
I suspect that some of the divergence since 2008 might be explained by composition bias. That is, in a recession, the average quality of labor rises because it is the less-skilled that are let go. We know that the employment to population ratio declined sharply in the United States in 2009 and has not yet recovered, while it declined only slightly in Japan and has since then recovered.

Here is what the picture looks like in terms of production per hour worked (data only available until 2014):
It's interesting to compare this labor productivity dynamic with real wage rates. Here, I report two measures of real wages, each of which tell the same basic story:

Note: I'm not entirely sure whether bonuses or non-wage benefits are included in the compensation measures used to compute real wages above. Assuming that these measures are roughly comparable, the divergence between the two series is really quite striking. In Japan, in particular, while labor productivity has generally been rising, the compensation to labor has essentially flat lined. I suspect that some of the post 2014 productivity and wage dynamic for Japan may be related to the increase in the employment of low-wage workers.

Prime Minister Shinzo Abe's policy reforms (Abenomics) are motivated by a desire to increase long-run economic growth (RGDP or per capita RGDP). It's not clear to me how monetary policy is supposed to help in this endeavor. I do not believe that achieving the 2% inflation target will have any significant consequences for real economic growth. (And in any case, I do not think the target is even feasible given present circumstances, see: The Failure to Inflate Japan.) On the fiscal policy front, I think the April VAT increase was a mistake--I do not think Japan's fiscal situation is as dire as many make it out to be (see previous link). The third of Abe's arrows--structural reform--seems like the only real hope. Some of these reforms are evidently targeted at relaxing restrictions on immigrant labor. But it's unlikely in my view that this will do much to mitigate the effects of Japan's aging (and declining) population. And it's not entirely clear what effect the proposed reforms will have on Japan's stagnating real wages.

Tuesday, November 29, 2016

The failure to inflate Japan

On January 22, 2013, the Government and the Bank of Japan issued a rare joint statement on overcoming deflation and achieving sustainable economic growth. The purpose of the statement was to introduce a two percent inflation target. It was issued jointly to emphasize that the monetary and fiscal authorities could be expected to coordinate for the purpose of achieving their shared goal--a clear attempt to enhance the credibility of the new inflation target.

On April 4, 2013, the BOJ explained how it intended to achieve the inflation target: Quantitative and Qualitative Easing. QQE is (more or less) standard monetary policy, except on a larger than normal scale. That is, the policy entails the creation of bank reserves (money) which are then used to purchase securities--primarily government bonds (JGBs).

At the time, I was skeptical that the policy would work as intended (see here). My skepticism has not abated since then. This post is about explaining why. In a nutshell, my argument is that while the BOJ seems willing to increase inflation, it is largely unable to--and while the government is able to increase inflation, it seems unwilling to. In short, the necessary policy coordination appears to be absent.

Let's begin with some basics. First, note that a JGB is basically an interest-bearing claim to (possibly) interest-bearing BOJ money. The total nominal government debt is the sum of BOJ money and JGBs. The fiscal authority controls the total supply of debt. The monetary authority determines its composition (between money and bonds). Quantitative easing increases the supply of money and reduces the supply of bonds held in the wealth portfolios of private agents. That is, it changes the composition of government debt without changing its level.

Because bonds are normally discounted (that is, they generally earn a higher yield than money), an open-market operation that alters the composition of government debt will generally have real and nominal consequences. But in present circumstances, the yield and risk characteristics of Japanese money and bonds are very similar.  In the limiting case where money and bonds are perfect substitutes (we're not quite there yet), altering the composition of government debt (without affecting its level) is inconsequential. It's like swapping one hundred dollars worth of $10 bills for one thousand $1 bills. Such an operation--even it is permanent--is not likely to have any measurable effect on the economy, including the price-level. Why should it? Empirically, it didn't seem to have any measurable impact on inflation the first time Japan tried QE from 2002-2006 (see also my 2003 paper here, section VI).


For the rate of inflation to rise, one of two things must happen: [1] the growth rate in the supply of nominal government debt must rise; or [2] the growth rate in the demand for government debt must fall.

One interpretation of what has happened in Japan (and elsewhere) is that a persistently bearish sentiment has led to an elevated growth in the demand for safe securities, like JGBs (at the expense of private investment). The effect of this force is to drive down bond yields and create deflationary pressure (deflation is a market mechanism for increasing the growth rate of the real quantity of nominal object when it is in short supply.) While the supply of nominal debt has been rising, ultra-low bond yields and lowflation suggest that the demand for debt has been rising even more rapidly.

According to the joint statement mentioned above, the government's commitment to helping the BOJ achieve the 2% inflation target amounts to reducing the demand for government debt by implementing reforms intended to create a bullish investment climate designed to stimulate real economic growth (the third of Abe's three arrows). While this is fine as far as it goes, what's the contingency plan in case the third arrow cannot be released or misses its mark?

In my view, the appropriate contingency plan would involve a promise to use nominal debt to finance (say) social security payments or tax cuts as long as inflation remains below target. This is essentially "helicopter money." The "money" in this case is government debt (whether the BOJ monetizes new debt or not is irrelevant if the two objects are perfect substitutes). Importantly (and as far as I understand), the BOJ has no authority to engage in helicopter money. Only the government can do this. And in present circumstances, my view is that only a commitment on the part of the government to adjust money/debt-finance expenditures to meet the inflation target can render it credible. The question is whether the government has expressed any willingness to support the inflation target in this manner. All the evidence I can find suggests that the answer is no.

To begin, the Japanese government appears to be very concerned with the size (and growth) of its public debt. From the joint statement above:
In addition, in strengthening coordination between the Government and the Bank of Japan, the Government will steadily promote measures aimed at establishing a sustainable fiscal structure with a view to ensuring the credibility of fiscal management.
Now don't get me wrong--everyone agrees that a "sustainable fiscal structure" is a good thing. The question is in determining what is sustainable. Of course, the debt-to-GDP ratio cannot rise forever. But it may certainly rise to a much higher level, even from its current elevated position, especially in light of how low interest rates presently are.

The government of Japan, however, appears almost obsessively concerned with deficit reduction. Publications from the Ministry of Finance seem to go out of their way in raising debt-sustainability alarm bells. Consider the contents of this Japanese Public Finance Fact Sheet, for example. Most of the document stresses the need for "fiscal consolidation" (deficit reduction) and includes lessons to be drawn from the European debt crisis. The graph of total government expenditure on page 4 strangely includes spending on the repayment of debt. And on page 3, there is the familiar and misleading "here is what a family's balance sheet would look like if it behaved like the government" exercise. This is a great way to promote the government's seriousness about stabilizing the debt-to-GDP ratio. But it is not, in my view, a policy that is consistent with helping the BOJ achieve its 2% inflation target.

And by the way, just how serious is the government debt problem in Japan? Japan's debt-to-GDP ratio is presently 250%, or so we are told. As it turns out, this figure overstates the level of public debt (see here, section 3.1). The 250% figure represents gross debt, which includes government loans and certain intragovernmental transfers, all of which should be netted out. Once this is done, the net debt-to-GDP ratio is closer to 150%.


Moreover, if one further accounts for the sizable quantity of government assets, the ratio falls to 100% (see the balance sheet of the central government here on page 51). And finally, if one was to view the fact that 40% of government bonds are held by the BOJ and likely to remain monetized, the ratio falls further still. In my view, the very low yield on JGB's reflects the market's assessment that public finances in Japan are nowhere near being out of order (a caveat to this view here).

So, relative to the market demand for their product, the government of Japan appears to be in "austerity" mode--it is bent on limiting the supply of highly-valued JGBs. In the meantime, the BOJ is aggressively purchasing the limited supply of JGBs to the point where it is now worried that the supply of bonds available for purchase will soon be exhausted (story here).



How can the BOJ credibly promise to continue with its bond purchases until its inflation target is met? It can't. Not without the proper support from the government, which appears not to be coming anytime soon. And so, after a transitory blip in inflation following the austerity-induced VAT, headline CPI is back near zero territory.


Partly out of a concern over running out of eligible securities to purchase, the BOJ recently announced a new negative interest rate policy (NIRP) with yield curve control (YCC); see here. The intervention appears to have little impact on inflation expectations (inflation and inflation expectations today are similar to the early 2000s, prior to the financial crisis).


Let me conclude. First, this post is not meant as an argument in favor of the 2% inflation target. Second, it should not be construed as an argument against the Japanese government's debt management strategy. Nor is it an argument against the BOJ's asset purchase program. I will discuss these issues in a subsequent post.

The point of this post is as follows. IF the monetary and fiscal authorities wish to implement a 2% inflation target, THEN success of the policy (in present circumstances) requires a sufficiently accommodative fiscal policy (deficit financed expenditures and/or tax cuts) when inflation and inflation expectations are running below target. Absent this commitment on the part of the fiscal authority, the endeavor is ultimately doomed (if an overall bearish outlook persists) and--as a consequence--the credibility of a monetary authority that keeps promising an inflation it cannot deliver may at some point be jeopardized.

Additional readings:
[1] Understanding lowflation.
[2] A model of U.S. monetary policy before and after the great recession.

Thursday, November 10, 2016

U.S. postwar growth and the pop in epop

Here's the picture of real per capita GDP growth in the postwar United States.

While this is an impressive record of economic development, the recent trajectory away from (log-linear) trend has many people concerned. I share this concern. But I sometimes wonder whether the assumption of (log-linear) trend does not distort our view a little bit. In particular, one might alternatively view the pattern of economic development as "naturally" alternating between episodes or more or less rapid growth, kind of like this...


This representation of "trend and cycle" is a little disconcerting in that it suggests that there is no obvious reason to expect "mean-reverting growth" any time soon. On the other hand, perhaps there is some comfort to be drawn as well. In particular, we've been there before and we somehow managed--not only to survive--but also recover. (Related post: Secular stagnation then and now).

In today's post, I want to look a little more closely at that recovery phase. While I think that a growth recovery is in the cards at some point, I'm not sure we should be expecting it to be as robust as what we experienced in the immediate postwar period or in the 1980-90s. The latter growth episode in particular was driven at least in part by a demographic force that appears to have largely dissipated. The pop in epop has popped, so to speak:


Whatever drives secular growth, it obviously cannot rely on an ever-rising employment-to-population ratio (EPOP). But EPOP can nevertheless rise for decades, as it did in the 1975-2000 period, giving the impression of secular (rather than transitory) growth.

How much did the transitory increase in EPOP contribute to GDP growth? To get a rough answer for this question, suppose that EPOP remained fixed at 58% throughout the entire sample period and subtract the amount (EPOP(t) - 0.58)*GDP(t) from the actual real per capita GDP at date t. Here's what we get:


That is, unlike the economic boom of the immediate postwar period, the more recent 80-90s boom was driven in part by a pop in EPOP. For those that prefer a log scale:


Viewed from this perspective, the growth spurt beginning in the early 1980s does not look as impressive, though it's still pretty good. And unless there's reason to believe that a similar pop in EPOP is in store in the near future, it might be prudent to scale back our forecasts for longer-term economic growth accordingly.

Thursday, September 29, 2016

Beveridge curves

The Beveridge Curve refers to relationship between job vacancies and unemployment or, more generally, between business sector recruiting activity and household sector job search activity.

Theoretically, the Beveridge Curve should be negatively-sloped in V-U space. When economic prospects look promising, firms wanting to expand capacity begin to post more vacancies. For a given level of unemployment, there is an increase in labor market tightness (V/U) which makes finding a job easier for unemployed workers. The unemployment rate declines as the vacancy rate rises. The reverse holds true when economic prospects are diminished.

Empirical Beveridge Curves don't always have the clean shape suggested by theory. Sometimes, the Beveridge Curve appears to "shift." Beginning with Lilien (1982), there's been an inclination to interpret shifts in the Beveridge Curve as reflecting the effects of "structural" shocks as opposed to the "cyclical" shocks that drive the normal U-V dynamic. For some recent work in this area, see my interview with Gianluca Violante here: "What Shifts the Beveridge Curve? Recruitment Effort and Financial Shocks."

I'm not going to provide much in the way of analysis in what follows. The primary purpose of this post is just to share some data that may or may not stimulate some hypotheses. Let me begin with the BC using the JOLTS data.


Here you see the familiar cyclical pattern driven by the Great Recession and recovery. Except that the BC appears to have shifted outward. In other words, given present levels of recruiting intensity, we would have expected (based on historical experience) the unemployment rate to be significantly lower. The pattern is similar if we instead use an alternative measure of job vacancies from the HWOL (the Conference Board Help Wanted Online series).


Because the size of worker flows between employment and out-of-the-labor-force are as large as the flows between employment and unemployment, I sometimes like to use a broader measure of job search (available to work) like nonemployment (you may prefer one of the alternative measures listed here.)




This representation of the data suggests that the U.S. labor market looks a lot different today than it did prior to the Great Recession.

One of the benefits of the HWOL data is that measurements are available at the MSA level. (I also have the benefit of a great research assistant, Andew Spewak, who did all the leg work for us.) Here are few examples.


 Or, in terms of nonemployment rates...






So some MSAs display a relatively stable BCs in V-U and V-N space, whereas others do not.

To get some additional sense of the heterogeneity existing at the MSA level, consider the following data, which plots the ppt change in vacancies and unemployment over the recession (2007-09) and the recovery (2009-16) for a set of selected MSAs (most of the largest ones).


Not surprisingly, the unemployment rate shot up across all the MSAs in this sample and the vacancy rate declined, though not by very much in many jurisdictions. Here is how the same set of MSAs behaved during the recovery.


 Again, not a very surprising pattern, apart from the extent of the heterogeneity. If we repeat the exercise above replacing the unemployment rate with the nonemployment rate, during the recession we see,


And during the recovery,


That is, recruiting intensity in the recovery appears to be up across the board. One would expect the employment rate to be up across the board as well. But it is not. MSAs like Seattle, Denver, and Phoenix, for example, have experienced declines in the employment rate despite marked increases in their respective job vacancy rates. These differences are interesting and could have implications for (say) the relative merit of policies targeted at the aggregate vs. sectoral/regional level.

Friday, August 26, 2016

Jackson Hole and Fed Communication

Fed chair Janet Yellen gave what I considered to be a good speech at this year's Jackson Hole conference (see here).  Not everyone seems impressed, however. The Fed has no credibility, it seems. For example, it keeps saying it's going to do things, like raise its policy interest rate, only to repeatedly back off. I mean, what the heck? Don't they even know what they're doing?

At some level, this degree of frustration is understandable. (I am less sympathetic, however, when it comes to informed journalists and market traders, who should know better.) Let me try to help ease your frustration.

The first thing to keep in mind is that monetary policy is not a precise science. Much remains to be discovered, especially since the environment (technology in particular) continues to evolve. Keep in mind that most central banks employ the services of research divisions. As Einstein is purported to have said: "If we knew what it was we were doing, it would not be called research, would it?"

That's not to say that monetary policy makers are completely clueless. Evidence. Theory. Discussion. Debate. Experience. Wisdom. They all have a role to play in the process of formulating monetary policy. There is considerable consensus along some dimensions (e.g., keeping inflation low and stable). There is outright disagreement along other dimensions. That's just the way it is. And it's likely to remain this way for the foreseeable future. But in the meantime, if you live in the U.S., try to take some solace in this:

Annual Inflation Rates
Now, in terms of Yellen's Jackson Hole speech, what are people complaining about? Well, consider this WSJ article: Yellen Cries Wolf, with the subtitle: Fed chairwoman tries to convince market that a rate rise is coming but investors aren't listening. Of course, digging deeper into the article, the author clarifies that Yellen did not actually say that, only that she came "close" to saying it. Sigh.

The main issue here, I think, is what people expect in the way of Fed communication in terms of its economic outlook and its description/explanation of its policy rule. These are two conceptually distinct objects and are often confused.

My own personal view is that a central bank should make its policy rule clear, but that it should refrain from providing an economic outlook. So, for example, the Fed should want to make it clear that a sharp uptick in inflation would be met with a correspondingly sharp increase in its policy rate (assuming that this is an appropriate policy response). But what would be the use in having the Fed provide an outlook (a probability assessment) over future inflation? All that people need to know, really, is that the Fed is committed to keeping inflation in check. The credibility of this belief is ultimately based on reputation (see diagram above). As for forecasting the contingencies that would trigger this or that policy response, let the private forecasters do their job.

But some people want more from the Fed. They want the Fed to tell them how the economy is going to evolve in the foreseeable future (and in some cases, beyond). As if the Fed, or anyone for that matter, can actually know.

Now, if people generally appreciated the inherent difficulty in offering forecasts of this sort, I'd say that it would do no harm for a central bank to offer its economic outlook--a prognosis that would find its way in a portfolio of outlooks generated by other agencies. Market participants could then combine the information in these outlooks and, together with the Fed's clearly stated policy rule, make their own forecast of (say) the future path of short-term interest rates.

But perhaps I'm being naive. If a central bank was to just state its policy rule and refrain from offering its outlook, it would surely be criticized for not providing the market with enough "guidance." It is the demand for this "guidance" that compels central bankers to offer an economic outlook. Here is the outlook provided by JY (emphasized phrases my own):

Looking ahead, the FOMC expects moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to 2 percent over the next few years. Based on this economic outlook, the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives. Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee's outlook
And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight. For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide--a point illustrated by figure 1 in your handout...The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted.

And so, there you have it. Evidently, the Fed plans to raise its policy rate soon. And if it doesn't, its credibility will be diminished. Or if it does raise rates even though conditions do not warrant it, its credibility will be again be diminished. Or, as the fan chart above demonstrates, the Fed evidently has no idea where interest rates will go. There's no winning this game. Go back and look at the first diagram again and give it a rest.