Sunday, September 10, 2017

Lael Brainard: Phillips Curve Confusion

As background for this piece, you can read this forthcoming St. Louis Fed Review article,
"Inflation Control: Do Central Bankers Have It Right?"
and/or the accompanying slides from a presentation for the Australasian Macroeconomics Society in Canberra, August 2017. The paper gathers together informal stuff I have written on so-called Neo-Fisherism and monetary policy.

Conventional central banking inflation control is typically driven by Phillips curve (PC) theory. Roughly, PC theory says that current inflation increases as the difference between some measure of actual aggregate economic activity and some measure of potential economic activity decreases, and increases as some measure of anticipated inflation increases. I've never seen a central bank policy statement that didn't contain some explicit or implicit reference to the PC. For example, from the Bank of Canada's press release on September 6:
While inflation remains below the 2 per cent target, it has evolved largely as expected in July. There has been a slight increase in both total CPI and the Bank’s core measures of inflation, consistent with the dissipating negative impact of temporary price shocks and the absorption of economic slack. Nonetheless, there remains some excess capacity in Canada’s labour market, and wage and price pressures are still more subdued than historical relationships would suggest, as observed in some other advanced economies.
So, the Bank tells us that inflation is currently below its 2% target, but is expected to come back to target as "excess capacity" goes away - basically a PC mechanism.

In the old days, Lucas developed a theory of the Phillips curve, the upshot being that, as emphasized in the Lucas critique paper, policymakers should not be using observed PC relationships to guide policy, as such relationships are not structural. Indeed, the theory tells us that PC correlations could be positive or negative, and the slope of the PC curve depends on the policy regime in place. In more recent times, PC theory re-emerged in the New Keynesian (NK literature), but if we take NK models seriously, they give us more reasons to doubt the invariance of PC parameters to changes in policy rules (e.g. wage and price setting should change with policy).

In addition to theoretical concerns, the incoming data has not been kind to PC adherents. Lael Brainard, in her September 5 speech to the Economic Club of New York, recognizes this:
...what is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization.
If anything, this understates the case. Here's a plot of year-over-year headline PCE inflation vs. the difference between the unemployment rate and the CBO's measure of the natural rate of unemployment:
In the chart, the line connects post-recession quarterly observations, from right to left. That's certainly not tracing out a nice PC. More often than not, inflation and unemployment were actually moving in the same direction. And, in case you're thinking the most recent observations look more promising for the PC, consider the PCE deflator data, in levels:
In this chart, you can see a noticable recent reduction in inflation. Year-over-year, the inflation rate is 1.4%, and the average inflation rate since the beginning of 2017 is about zero. Consistent with what Brainard says, it appears the labor market is unusually tight. The unemployment rate is 4.4%, and the CBO claims that the natural rate of unemployment is 4.7%. If you really believe in PCs, that might make you think. Brainard says this is "troubling," which I guess means that the PC is in trouble, policymakers are in trouble, we are all in trouble, or some convex combination of the three.

As Brainard explains, if one has a PC view of the world, it's going to be hard to understand why inflation is so low. But she's going to give it a try:
In many of the models economists use to analyze inflation, a key feature is "underlying," or trend, inflation, which is believed to anchor the rate of inflation over a fairly long horizon. Underlying inflation can be thought of as the slow-moving trend that exerts a strong pull on wage and price setting and is often viewed as related to some notion of longer-run inflation expectations.
This makes is sound like this "underlying inflation" thing resides in most of the models that macroeconomists work with. While some (most?) undergraduates are taught some version of IS/LM/PC with exogenous inflation expectations, no monetary economist I know tries to analyze inflation in a model with exogenous "underlying or trend" inflation. And that's certainly not a feature of typical NK models, except versions with sticky expectations. But trend inflation is indeed a variable in the Board's FRB/US model, if you have the patience to wade through the documentation. Indeed, essentially everything important in FRB/US (real GDP for example) ultimately reverts to some exogenous trend. Board governors and Board economists have certainly been known to treat FRB/US very seriously, so it's not surprising that Brainard is like-minded.

Do we think inflation expectations have fallen? Perhaps the best we can do is to rely on market-based measures, for example the 10-year breakeven rate (nominal 10-year Treasury yield minus 10-year TIPS yield) looks like this:
The most recent observation is about 1.8%, which is certainly lower than the 2.2%-2.7% we typically observed before the financial crisis, but 1.8% is not all that low. Accounting for the fact that TIPS are indexed to the CPI (rather than the PCE), and adjusting for risk and other factors, this might perhaps translate to an anticipated PCE inflation rate of 1.5% or thereabouts for the next 10 years. If people are actually anticipating 1.5% inflation, that would seem to call for a modest adjustment of some sort in monetary policy, as the clear intent of the Fed is that people should anticipate 2% inflation forever, and be pretty sure about it.

But what sort of policy adjustment are we talking about? Is inflation too low because the Fed has been doing a bad job? Brainard says no. According to her, the problem is that the Fed has been constrained.
[An] explanation may be the greater proximity of the federal funds rate to its effective lower bound due to a lower neutral rate of interest. By constraining the amount of policy space available to offset adverse developments using our more effective conventional tools, the low neutral rate could increase the likely frequency of periods of below-trend inflation. In short, frequent or extended periods of low inflation run the risk of pulling down private-sector inflation expectations.
What's Brainard saying? First, the real rate of return on safe assets is low. For example, here's the fed funds rate minus the 12-month inflation rate - a proxy for what we're interested in:
By this crude measure, the real rate of return on overnight fed funds averaged -1.20% post-recession, and the most recent observation is -0.25%. But Brainard doesn't make reference to the actual real interest rate. She has another animal in mind - the "neutral rate of interest." What's that? Central-bank-speak, basically. Start with a standard Taylor rule, for example,

(1) R = r* + i* + a(i - i*) + b(y - y*).

In equation (1), R is the central bank's nominal interest rate target, r* is the long-run real rate of interest (supposing this is a well-defined object), i* is the central bank's inflation target, y is some measure of aggregate economic activity, and y* is "potential" economic activity (assuming, again, that this is well-defined). According to the Taylor principle, a is a parameter larger than 1, and typically b is a positive parameter. Then, r* + i* is the neutral rate of interest - the central bank's nominal interest rate target when it is achieving all of its goals.

So, given the Fed's inflation target of 2%, if r* is lower, as is consistent with what we can see in the last chart, this means that the neutral rate of interest is also lower. If r* is low, we should observe a low nominal interest rate target, on average, with the Fed responding to random shocks and missing its ultimate inflation and output targets on the low and high sides. But, what's a good estimate of r*? For this we need a model. In standard neoclassical growth models with some sort of appended role for monetary exchange, r* is a constant, and in some models it's endogenous, and dependent on monetary policy, among other things. Certainly, if we want to explain what is going on in the last chart, we can't rely on a theory that implies constant r*.

But whatever is driving r*, (a shortage of safe assets for example), we can certainly agree that r* is low. If it's as low as what we see in the last chart, post-recession, then r* = -1.2%, and the fed funds rate is currently well above where it should be. If r* = 0, say, then the current fed funds rate, at about 1.2%, is only 80 basis points below what Brainard would consider neutral. That's certainly not the way the majority of the FOMC thinks about this problem, as you can see from the last submitted projections. Most committee members think the fed funds rate will be above 2% by the end of 2018, and about 3% in the long run. Of course, the FOMC's actual policy interest rate has come in well below its forecasts for some time, and whether the FOMC now knows its own mind remains to be seen. Thus, if the low inflation readings we have seen this year turn out to be transitory, and the FOMC finds reasons, as it has in the past, to forego interest rate increases, things should be just fine (barring some unforeseen disaster, in which case inflation control is out the window anyway).

But, and this is critical, what should the Fed do if inflation continues on the low side or, alternatively, jumps to the high side of 2%? The views of the FOMC are summarized, for the most part, in this sentence from the last FOMC statement:
The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
That's basically PC logic. According to the Committee, inflation may be low, but "accommodative" monetary policy will further tighten the labor market and, through a Phillips curve mechanism, make inflation come back to 2%. Why should the Fed continue to raise its nominal interest rate target? According to the Committee, that's preventative medicine. Tightening needs to occur in order to ward off excessive inflation, according to the majority of FOMC members, apparently.

Brainard appears to be disagreeing with that view. According to her, the Phillips curve mechanism is inoperative. But what is she recommending?
If, as many forecasters assume, the current shortfall of inflation from our 2 percent objective indeed proves transitory, further gradual increases in the federal funds rate would be warranted, perhaps along the lines of the median projection from the most recent SEP. But, as I noted earlier, I am concerned that the recent low readings for inflation may be driven by depressed underlying inflation, which would imply a more persistent shortfall in inflation from our objective. In that case, it would be prudent to raise the federal funds rate more gradually.
Basically, Brainard wants to see the inflation before increases in the policy rate occur. If inflation comes up, then she's in agreement with the rest of the committee. If if it doesn't come up, she would rather not have interest rate hikes. But, if the PC is inoperative, how will low nominal interest rates make inflation go up? How do low nominal interest rates cure the problem of "depressed underlying inflation" that she thinks exists?

Brainard suffers from Phillips curve confusion, and so does the rest of the FOMC, though in each case it's a different form of the disease. As I summarize in my recent paper, central bankers generally have inflation control wrong. Mainstream macroeconomic theory tells us that a central bank that raises its nominal interest rate target permanently raises the inflation rate - in the short run and in the long run. These models also tell us that a central banker armed with a Taylor rule and following the Taylor principle inevitably falls into a pit of frustration featuring low nominal interest rates and low inflation. That's in accord with the empirical evidence - with adjustments for factors other than monetary policy that matter for inflation and real interest rates. But central bankers aren't really interested in mainstream macroeconomic theory - for some reason they prefer to be led astray by undergraduate IS/LM/PC models. Why? Beats me.

Monday, June 26, 2017

The 2% Inflation Target

There's been a lot of talk recently about the 2% inflation target, and whether or not it would be a good idea to raise it, or change the nature of the target - to price level or nominal GDP targeting, for example. It's instructive, I think, to use as a starting point the letter addressed to Janet Yellen and the Board, and signed by some of my friends, acquaintances, and people I know of but have never met.

The authors of the letter argue that it's a good time to revisit the Fed's 2% inflation target. In case you haven't been following this, the Fed is a latecomer to inflation targeting. The Reserve Bank of New Zealand appears to have been the first inflation-targeting central bank, followed by the Bank of Canada, the Bank of England, the ECB, the Swedish Riksbank, the Swiss National Bank, and the Bank of Japan (not necessarily in that order, chronologically), among others. There are few deviants from the 2% inflation target, though central banks differ according to the price index they have chosen to measure inflation. The Fed stated its inflation targeting policy in January of 2012, in its "Statement of Longer-Run Goals and Monetary Policy Strategy," most recently amended in January 2016. The amended statement reads:
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, 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, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.
Here's the key takeaway from that:

1) 2% inflation is a "longer run" goal, so we should expect to see deviations from 2% inflation in the short run. How long do we have to wait for the longer run? How large are the deviations the FOMC is willing to tolerate? Not specified.
2) The chosen price index that is used by the FOMC to measure inflation is the headline PCE. Not the CPI, the CPI excluding food and energy prices (core CPI), the core PCE, the Dallas trimmed mean index, etc. The headline PCE, dammit.
3) The inflation target is symmetric. The FOMC thus states that it's just as bothered by 3% inflation as by 1% inflation.

What's left out?

1) What's the time horizon? It makes a big difference whether the FOMC is interested in year-over-year inflation (last 12 months), or average inflation over the last 10 years. If it's the former, then past inflation quickly becomes a bygone - no need to make up for a period of low inflation with higher inflation in the future. If it's the latter, then the central bank has to be much more concerned about making up for previous misses.
2) How is the FOMC going to achieve its target? Will it use monetary aggregates as instruments, as in the 1980s or will it use as an instrument an overnight nominal interest rate, as is currently the case? Should there be a large central bank balance sheet or a small-footprint balance sheet? And given the instrument or instruments, which way does the FOMC move each instrument, and how much, in response to deviations in the inflation target?
3) Why 2%? Why not 10%, 0%, -2%, 5%?

The authors of the aforementioned letter first seem to want to argue that it's about time that the Fed's inflation target was revisited - after all it's been 10 years since the onset of the financial crisis. But, as should be clear from the above discussion, the Fed has not been at this game (inflation targeting) for long, and they have actually thought carefully about it as recently as last year (note the amendment to the Statement). Why is the issue so pressing? Is the FOMC missing its inflation target? Let's look:
That's a conventional inflation measure - 12-month headline PCE inflation. Inflation was fairly low in 2015, but from late last year the FOMC has been doing well. Inflation even exceeded the target early this year, and the last observation is 1.7%. To give us a ballpark idea how we might evaluate that performance, consider that the Bank of Canada (inflation targeters since 1991) sets a target range of 1% to 3% (though they look at a whole set of inflation measures). So, by the Bank of Canada's criterion, the FOMC hasn't been out of the 1-3% range very much since the last recession. So, the FOMC's inflation targeting performance, according to the goalposts it set up for itself, has been pretty good over the last 7 or 8 years.

But maybe, in order to accomplish so much on the inflation front, the FOMC has been sacrificing a lot on some other front. What does the FOMC think it is trying to achieve in terms of the second leg of its mandate? Again, back to the Statement of Longer Run Goals:
The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC’s Summary of Economic Projections.
So, to paraphrase, the FOMC is worried about deviations from "normal" unemployment rates and rates of output growth, and cautions that there are forces outside the control of monetary policy that determine what those normal rates are.

So, what's the recent behavior of the unemployment rate? I'll even go one better and use a conventional measure of labor market tightness - the ratio of the number of job openings to the number of unemployed:
Since the BLS has been collecting job vacancy data, the only higher observation than the last one in April 2017 was in January 2001. Currently, what exists is an abnormally tight labor market. Real GDP growth, at about 2% per year since the last recession ended, is historically low, but it's well recognized that this ia due to low productivity growth - a factor outside the Fed's control. Some might argue that the employment/population ratio is abnormally low, or that U6 (including marginally attached workers, and part-time employed wanting full-time work) unemployment is somewhat abnormally high, but again it's hard to argue that's not due to factors (demographics, fiscal policy, skills mismatch) outside of the Fed's control.

Thus, in terms of the FOMC's own criteria, and qualifications to those criteria, there's nothing happening on the maximum employment front that somehow represents a sacrifice incurred in the fight to control inflation.

So what could the letter-writers be complaining about?
In years past, a 2 percent inflation target seemed to give ample leverage with which the Fed could lower real interest rates. But given the evidence that the equilibrium interest rate had fallen substantially even prior to the financial crisis, and that the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted. Such a reassessment is particularly appropriate when the lack of evidence that moderately higher inflation would harm Americans’ standard of living is juxtaposed with the tremendous evidence that a tighter labor market would improve Americans’ standards of living.
What's that about? First, as is widely recognized by now, real rates of return on safe government debt have been falling for some time, and that's a worldwide phenomenon. Here's a crude, but straightforward, measure of the overnight real interest rate - the nominal fed funds rate minus the PCE inflation rate (as a proxy for anticipated inflation):
I've used quarterly data to provide some smoothing. Even though this real rate measure is crude, I think it's about the best we can do. Some sophisticated measures that people have constructed require taking a stand on the theory, and the measure I've used is agnostic. Note that periods of low real interest rates are not uprecedented, but before the last recession, a low real interest rate tended to be temporary and associated with the tail end of a recession. A period of persistent negative real interest rates in a recovery period, as we've seen since 2009, is indeed unprecedented. The last observation (2017Q1) is -1.3%, and the average since the end of the last recession is -1.2%. Given what we know about the causes of low real rates (high demand and low supply of safe assets, low consumption growth), we have no reason to think that low real interest rates will not persist up to or beyond the time horizon that is relevant for monetary policy decisions. So, our first fact is:

1. The real overnight interest rate is persistently, and unprecedentedly, low. This could change, but there's no good reason to expect it to.

Then, as the letter-writers say, this means that the Fed no longer has "ample leverage" to "lower real interest rates." What could that mean? The Fed's key instrument is a nominal interest rate target. It's well-established that the Fed can lower real interest rates - but only in the short run - if it lowers its nominal interest rate target. So, the letter-writers must mean that, if the real interest rate is low, then with a 2% inflation target you can't lower the nominal interest rate target when you might want to. Why? Because it won't be very high, and there's an effective lower bound on how low the nominal interest rate can go (zero in the US under current rules - though that's subject to some debate). That's just basic Fisherian (or neo-Fisherian) logic, but I don't think I've ever seen an advocate of higher inflation targets say it that way. Something about using the word "Fisher," I guess. Go figure. Second fact:

2. A persistently low real interest rate implies that, to achieve a given inflation target - say 2% - the central bank must on average set its nominal interest rate target lower than was the case in days of yore when the real interest rate was higher.

So, with the current fed funds rate at 1.16%, if we suppose the real interest rate persists at about -1.2%, this should ultimately put inflation above its target, to about 2.4%, by Fisherian logic. In the last tightening cycle, the fed funds rate reached 5.25%, and the target was reduced beginning in September 2007, to essentially zero by the end of 2008. So, if we take seriously the power of monetary policy working through reductions in the nominal interest rate in bad times, then a fed funds rate of 1.16% (or possibly more appropriately 1%) doesn't give the FOMC much room to cut, should things go south. Of course, it's possible that the effects of changes in short-term nominal interest rates on real economic activity are small, even in the short run, and/or the key tool of the central bank in a crisis, for example, is lending to illiquid financial institutions. Unfortunately, as in much of macroeconomics we can't (perhaps surprisingly) say for sure.

But next, in the letter, it's stated: "...[as] the Fed’s short-term policy rate remained at zero for seven years without sparking any large acceleration of aggregate demand growth, a reassessment of this target seems warranted." First, "aggregate demand" is not something we observe - it's an undergraduate theoretical construct which, given its vagueness, shouldn't be bandied about by grownup economists. To be more precise, what the letter-writers have in mind, I think, is a Keynesian world with sticky wages and prices. In such a world "demand deficiency" is defined to be situations in which prices and/or wages are too high relative to efficient levels. So, (i) since the last recession (when the shock hit) is now going on 9 years in the rearview mirror, surely prices and wages have had time to adjust; (ii) the key symptom of "demand deficiency" is slack in the labor market. The chart above shows that the labor market is in fact unusually tight; (iii) I think the letter-writers think that a symptom of slack is inflation lower than the 2% inflation target. Low inflation is actually a symptom of persistently low short-term nominal interest rates. Ask, the Japanese about that (22 years with low interest rates and low inflation, and no sign of a sustained increase in inflation, even after throwing everything but the kitchen sink, i.e. higher nominal interest rates, at the problem), or read this accessible piece, or this one, which summarizes most of the more technical things I've written in blog posts. Basically, mainstream theory and the empirical evidence supports the neo-Fisherian view - that central bankers need to be more cognizant of the Fisher effect. That is, increasing (decreasing) the nominal interest rate makes inflation go up (down), and we can get this effect even in the short run.

The letter-writers recognize, implicitly, that the Fisher effect is important for inflation targeting. In fact, the crux of the argument is that a higher inflation target implies a nominal interest rate that is, on average, higher, implying that there is more room to cut interest rates in a recession. But, the letter-writers don't specify how we get from here to there. Seemingly, what they imagine is that, if the Fed keeps interest rates low, either by foregoing further tightening or even lowering the fed funds target, inflation will eventually take off. Then, supposedly, the Fed can get inflation under control by raising the nominal interest rate sufficiently to its new "normal" level, and we'll be set. If only the world worked that way. Again, persistently low nominal interest rates do not lead to persistently higher inflation, in theory or in practice. The way for a monetary policymaking committee to get around this, in the face of stubborn Phillips curve beliefs, is to raise the specter of incipient inflation - "horrendous inflation is just around the corner, and we have to tighten now to get ahead of the curve." It's not a lie as, by neo-Fisherian logic, it's self-fulfilling. Given the current policy debate, you can see how even that position is an uphill battle.

But, what about the 2% inflation target? Why keep it?

1. Many people have made this point, but it's the key one. The Fed has spent the time since Paul Volcker began his term in 1979 fighting for credibility. The view that the Fed will stick to 2% inflation forever is a strong belief - among financial market participants, economists, and lay people who are paying attention. We can't make a strong case for 2% vs. 4%, say, but we can make a very strong case that messing with the target is extremely dangerous, in terms of the potential for loss of credibility. And credibility is 90% of the game in the central banking business.
2. The Phillips curve model of inflation is basically a discredited theory. The parrot is dead. Admit it and move on. But, until that happens, people are being badly mislead by the dead parrot and its supporters. A central bank run by the letter-writers simply could not generate sustained 2% inflation, let alone anything higher, so they would be better off sticking with a low target, which they would undershoot anyway. The credibility problem again - better to miss by a little than a lot.

I'll leave you with one last chart.
This shows inflation averaged over the last x months, where x is measured on the horizontal axis. So, the time since the end of the last recession is 94 months, and average inflation over that period (again, measured by headline PCE) was about 1.5%. The price of crude oil fell at about 34 months back, and you can see that in the chart. Fed "tightening" began at 16 quarters back, at which time you can see cumulative inflation increasing. Aside from some volatility in the last couple of months (completely normal), that's consistent with a neo-Fisherian view of the world: supposed "tightening" makes inflation go up. It certainly ain't going down.

Thursday, April 13, 2017

The Zero Lower Bound and Monetary Policy

Ben Bernanke has written a couple of blog posts on the zero lower bound (ZLB) on nominal interest rates, and some implications for monetary policy going forward. The first deals with the extent of the ZLB "problem," and the second with monetary policy solutions.

In a previous post I wrote about the low-real-interest-rate phenomenon, and how central bankers view the implications for monetary policy. Basically, the real rate of return on government debt in the United States, and around the world, has been persistently low because of low productivity growth, demographic factors, and - most importantly, I think - the high demand and low supply of safe and liquid assets.

In his first piece, Bernanke is primarily interested in a paper written at the Federal Reserve Board by Kiley and Roberts, which I also commented on in my earlier post. Kiley and Roberts determine, based on simulations of the Board's FRB/US model, that if low real interest rates persist into the future, then US monetary policy will more frequently be constrained by the zero lower bound - assuming that negative nominal interest rates are not an option. The consequences, according to Kiley and Roberts, are that inflation will tend to fall short, on average, of the 2% inflation target, and - by Phillips curve logic - real output will fall short of "full employment" output.

But, Bernanke finds it puzzling that most of the measures of inflation expectations he has been looking at tend to be fairly persistent at about 2%. If the ZLB were such a big problem for inflation control, in the way that Kiley and Roberts envision, shouldn't market participants be predicting low inflation? Let's look at one measure of inflation expectations - the 10-year breakeven rate (the yield on a 10-year Treasury bond minus the yield on a 10-year TIPS):
Currently, that measure has dropped a bit below 2%. Recall that TIPS are indexed to CPI inflation, not PCE inflation, which is what the Fed targets. Here's the difference between CPI inflation and PCE inflation:
As you can see, the difference is on average positive, and quite variable. But, if the 10-year breakeven rate is biased upward as a measure of anticipated inflation, then maybe anticipated inflation is in fact substantially lower than 2%. So maybe Bernanke shouldn't be so puzzled.

But suppose that we take other measures of anticipated inflation seriously, as Bernanke does (and perhaps as we should not). For example, professional forecasters, rightly or wrongly, tend to persistently forecast 2% inflation over the medium term. Bernanke's interpretation is that Kiley and Roberts are doing the analysis right, but they're not taking into account other aspects of policy - forward guidance and quantitative easing (QE). That is, according to Bernanke, the Fed will "do what it takes" to maintain its 2% inflation target in the future - binding ZLB or not.

Perhaps unsurprisingly, Bernanke's advice for hitting the 2% inflation target given a frequently binding ZLB constraint is to do what he did:
One possibility, which seems desirable in any case, is just to build on and improve the approaches used between 2008 and 2015. Strategies the Fed used to address the zero lower bound included aggressive rate-cutting early on, quantitative easing, forward guidance about future rate paths, and a “risk-management” strategy that entails a very cautious liftoff from the zero bound when the time comes.

It seems to me that Bernanke has mischaracterized the problem and, given that, he's not going to do well in solving it. Here's my take on this:

1. A persistently low real interest rate, if it is a problem for inflation control, would imply that the central bank on average misses on the high side. This is just the logic of the Fisher effect. As Kiley and Roberts say,
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
But they don't seem to understand that a corollary is that, if the ELB (effective lower bound) is encountered more frequently, this implies that the nominal interest rate is on average higher than what is required to hit the 2% inflation target. So, "according to the Fisher equation," as they say, inflation will be higher, on average, than 2%, not lower.

I've written a paper about this. My model can accommodate a number of things - sticky prices, money, credit, open market operations, collateral, safe asset shortages. And it's got neo-Fisherian properties, as all mainstream macroeconomic models do. In the model, one can work out optimal monetary policy, and I do this in the context of different frictions, to separate out how these frictions matter for policy. With just a basic sticky price friction, the model exhibits a Phillips curve, and if the ZLB binds in the optimal monetary policy problem, due to a low real interest rate, then inflation and output are too high. If we take this version of the model seriously, an interpretation in terms of recent history, is that low real interest rates have not been impinging on monetary policy in the United States. Inflation has persistently come in below the 2% target, and the Fed was doing the right thing in raising nominal interest rates, so as to increase inflation.

2. If forward guidance works, it does so through commitment to higher future inflation. And this promise is carried out with a higher future nominal interest rate. Again, this is just standard neo-Fisherian logic. The current nominal interest rate determines anticipated future inflation. So, if the problem is a binding ZLB constraint, and current inflation is too high as long as the ZLB binds, then the central bank can reduce current inflation while at the ZLB by promising higher inflation when the ZLB no longer binds. But, according to the Fisher effect, the central bank achieves higher inflation through a higher setting for the nominal interest rate. That's in my paper too.

Conventional ZLB economics doesn't work that way. Work by Eggertsson and Woodford and Werning derives results that Bernanke describes as "make-up" policy. That is, the central bank makes up for a period during which the ZLB binds by committing to staying at the ZLB for longer than it othwerwise would. As far as I can make out, these results are particular to how these authors set up the problem. I can turn the results on their head in a model with sticky prices, demand-determined output, and a Phillips curve. And I can do it in a way that doesn't yield various "paradoxes" - a paradox such as less price stickiness being a bad thing (Werning).

But that's forward guidance in theory. I have yet to see forward guidance work in practice. Indeed, Bernanke's execution of forward guidance in the post-financial crisis period is an example of how not to do it.

3. Quantitative easing as an approach to inflation control? Forget it. A great example here is Japan, which I most recently discussed in this post. QE appears to be ineffective in pushing up inflation in a low-nominal-interest-rate environment - the solution if inflation is too low is what comes naturally: increase the nominal interest rate.

In conclusion, if low real interest rates persist, at the levels we have seen, then this should not be a problem for inflation control. The Fed can control inflation, albeit with a lower average level of short-term nominal interest rates than we have seen in the past. Potentially, problems could be encountered, not with inflation control, but in affecting real economic activity. Though neo-Fisherism says increases in the central bank's nominal interest rate target make inflation go up, these ideas do not suggest that an increase in the nominal rate makes output go up. The conventional notion that monetary stabilization policy is about reducing interest rates in the face of shocks that make output go down seems to be strongly supported by the data. Thus, if there is a problem for monetary policy in a low-real-interest-rate environment, it's that the nominal interest rate cannot fall enough in the face of a recession. Between mid-2007 and late 2008, the fed funds rate target fell from 5.25% to (essentially) zero. But, if the average fed funds rate is 3%, or 2%, it can't fall by 500 basis points or more in the event of a downturn.

But how do we know that historical Fed behavior was optimal, or even close to it? Standard New Keynesian theory says that, if the real interest rate is sufficiently low, then the nominal interest rate should go to zero. But in my paper, if we're explicit about the reasons for the low real interest rate - in this case a tight collateral constraint - then the low real interest rate implies that the nominal interest rate should go up. That is, a low real interest rate reflects an inefficiently low supply of safe collateral, and an open market sale by the central bank can mitigate the collateral shortage, which results in higher nominal and real interest rates.

Sunday, April 2, 2017

Plain Speaking

Andy Haldane, Chief Economist at the Bank of England, gave a speech last Friday at the San Franciso Fed titled "A Little More Conversation, a Little Less Action." What was Haldane trying to get across? He wants to build "trust and legitimacy" by "rethinking how and with whom central banks engage." Why should we do this?
...two recent developments mean that central banks’ engagement strategies may need to be widened and deepened. First, the global financial crisis has dealt a trust-busting blow to many institutions, including central banks. Second, the way trust is built has been fundamentally reconfigured. Where once trust was anonymised, institutionalised and centralised, today it is increasingly personalised, socialised and distributed.
Andy's speech was about central bank communication, but he started by saying something general about the place of institutions in contemporary society. First, according to Andy, the financial crisis changed things. With respect to central banks, there has been more questioning of what central banks and economists do. And a lot of the that criticism is coming from economists - including Andy Haldane himself. In this article, from earlier this year, Haldane is quoted as saying:
It’s a fair cop to say the profession is to some degree in crisis.
So, seemingly, one of the trust-busting punches to central banks and economists was thrown by Andy Haldane, and now Andy Haldane wants to tell us how we can built up the trust he is helping to destroy. Let me emphasize at this point that the economics profession is not in crisis. The profession is fundamentally healthy and, like any science, is constantly reinventing itself in its usual methodical ways.

Haldane's second point is... wtf? Let me repeat it again, so we can attempt to dissect it:
Second, the way trust is built has been fundamentally reconfigured. Where once trust was anonymised, institutionalised and centralised, today it is increasingly personalised, socialised and distributed.
What is trust? My online dictionary says:
firm belief in the reliability, truth, ability, or strength of someone or something.
So, trust cannot be "anonymous." It has to be attached to someone or something we can name - Andy Haldane, or the Bank of England, for example. Was trust "institutionalised?" What would that mean, exactly? As per the definition, we could trust an institution, such as the Bank of England, or we could think of trust being built up as a kind of implicit institution - the institution of trust, as it were. Is trust now "socialised?" Now I'm really befuddled. Is it distributed? Haven't a clue. Who would be doing the distribution? Does it distribute itself or what? You can see that, in giving a speech on how to communicate, Andy isn't exactly demonstrating the state of the art.

After the preliminaries, Haldane then settles in to what is, in part, a fairly conventional speech on central bank communication. He talks about some of the history of central bank communication and why we do it. Though he uses the word "trust" a lot, we could translate this into the standard language of "commitment," I think, without any loss. What are Haldane's recommendations for improvement in central bank communication? You could summarize this as:

1. Understand who you're talking to.
2. Speak and write simply and clearly.
3. Listen.
4. Be on the lookout for new ideas.
5. Tell people what you're doing.

And that's about it. This paragraph in the conclusion sums things up nicely:
It is an irony, and not one lost on me, that this speech is a classic example of one-way central bank communications. Worse still, it comes in at around 11,500 words, contains 2,000 adverbs and adjectives and has a reading grade score of around 11. Perhaps central bankers, like this one, have always been better at preaching than practicing. If so, that needs to change. And when better to change than now.
Yes, Andy, no time like the present. In plainspeak, cut the bullshit.

That said, Andy's topic is very important - communication is the key problem for central bankers, and we don't always do it well. In order to do our jobs, and to ensure that our institutions survive and thrive, we have to communicate well. How should we do it? In his speech, Andy mentions the songs of Elvis Presley. Though Elvis was indeed a great communicator, he didn't actually write songs. One song that Elvis sang but didn't write is "Baby, Let's Play House," written by Arthur Gunter. For "Baby Let's Play House," even the title communicates well - you know exactly what this song's about. Here's the first verse, the way Elvis sang it:
Oh, baby, baby, baby, baby baby. Baby, baby baby, b-b-b-b-b-b baby baby, baby. Baby baby baby. Come back, baby, I wanna play house with you.
Genius. Gunter - speaking through Elvis - tells you exactly what's on his mind. But he also wants to sell some records, and he knows he can't do that if he actually spells it out. He communicates precisely to the listener, but in a way that will slip by the censors. However, though 50s rock and roll is great communication, I don't think Janet Yellen would be bringing Elvis - or Arthur Gunter - to her press conferences to explain things, if they were still alive.

So, to get more specific about monetary policy, here's a piece of Fed communication, from the last FOMC statement:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
Who is the intended audience for this? Who should it be? Clearly, one would need to know some economics to understand the above paragraph - it can't be intended for the general public. Should it be targeted to a less-specialized audience? Probably not. Maybe it's better for the Fed to communicate in more simple, direct, language in other forums. That's typically done in talks given by Governors and Fed Presidents to lay audiences. Other people at the Board and the regional Feds do that too. But, in the FOMC statement, the language needs to be precise - the FOMC wants to get across to financial market participants, and others who care about the nitty gritty of monetary policy, why it is doing what it's doing, and what it intends to do in the future.

What does the paragraph say? I'll take a stab at translating it into plainspeak: The FOMC has interpreted its dual mandate, specified by Congress, to be maximum employment and a symmetric 2% inflation target. The Committee currently attempts to achieve this goal, in part, through adjustments in the target range for the federal funds rate. Changes in the fed funds rate target range are made in response to all available information. The Committee is currently normalizing policy, which implies that further increases in the target federal funds rate range are expected, but such changes will probably occur gradually. That was actually harder than I thought it would be, and the end result is still not as simple as we might like. What's a "symmetric 2% inflation target," anyway?

But what's wrong with the original paragraph in the FOMC statement? It both says too much, and too little. Do people need to be told the Fed is looking at everything? Don't they understand that? The Fed is going to monitor actual and expected inflation developments, but so what? What's it going to do in response to what it sees? What exactly are the levels of the fed funds rate that are expected to prevail in the long run? An informed person would know that some of that information is in the Summary of Economic Projections, but why isn't there a reference to that in the statement?

People have agonized and argued at great length over the wording of FOMC statements. Sometimes a single word can get considerable attention. But, if the goal is communicating with the informed public, all the effort in crafting the statement has perhaps been wasted if people can't understand it, or if they feel it leaves them no better informed. But perhaps the FOMC statement serves as a vehicle for obtaining consensus among the Committee's members and achieving continuity in its decisions. Maybe it's not about communication with the outside world at all - possibly we should just think of the statement as a small window through which we can view some of the intricacies of FOMC decisionmaking.

But, I think the Fed is actually pretty effective at communicating with the public, and communication is a two-way street. If there are people complaining that the Fed isn't keeping them up to speed, they should first spend some time on the receiving end of Fed communications, and see if their attitude changes. What's the Fed doing, with respect to communications? I'll give you a sample, based on what I know about the activities of the St. Louis Fed:

1) The St. Louis Fed President, Jim Bullard, has a very active schedule of speeches and interviews. Jim is a great communicator (though whether he's at Elvis level I'm not sure) and does a first rate job of getting ideas into the public forum.

2) There are many people at the St. Louis Fed who give public presentations and interviews. For example, Research department economists are trained in media relations, and some of the community outreach we do is through our branches - in Memphis, Louisville, and Little Rock. Economists do presentations for Boards of directors, and for members of the general public at these institutions.

3) The St. Louis Fed has been a world leader in consolidating economic data, and making it accessible to the public. That's what FRED, Geofred, and Fraser are about. These products help promote financial literacy, and allow people to engage with economic ideas.

4) You probably didn't know this, but the St. Louis Fed is an educator, through its econlowdown program. The group responsible for these programs was awarded the 2017 Excellence in Financial Literacy Education (EIFLE) Award for Education Program of the Year: Children, General.

5) An annual event at the St. Louis Fed is Dialogue with the Fed, where an economist gives a prepared talk to the public, and a panel then answers questions from the audience.

6) The St. Louis Fed has an array of publications. On the higher end is the St. Louis Fed Review, for which some knowledge of economics is required; the Regional Economist is a more widely-accessible economics publication, and there are shorter pieces in Economic Synopses, and the On the Economy Blog.

So, I think the state of central bank communication - at least the part of it I know something about - is very healthy. That said, the issues are technical, and sometimes complicated, and a lot more can be done by central banks and educators to make those issues better-understood.

Wednesday, March 29, 2017

Low Real Interest Rates and Monetary Policy

That real rates of return on government debt are at historical lows is well-established. Of course, the anticipated real rate of return on government debt - which is what matters for economic behavior - is unobservable, and that's problematic. Typically, macroeconomists resort to proxy measures as a starting point for addressing issues related to low real interest rates. For example, we could use the current twelve-month measured inflation rate as a proxy for anticipated inflation, and subtract that from some observed nominal interest rate to get a crude measure of the real interest rate. Like this, for example:
The chart shows the three-month US T-bill rate, minus the 12-month pce inflation rate. As you can see, it's not like we have never seen real rates of interest (by this measure) as low, but short-term real interest rates have never been as persistently low, at least in the post-1960 sample.

Typically, though, when low real interest rates are discussed in policy circles, the discussion does not revolve so much around actual real rates of interest, but some other real interest rate concept. And there are several such concepts, which is bound to make things confusing, if not totally impenetrable. Let's try to sort this out.

(1) The natural real rate of interest: For the average macroeconomist, this measure is well-defined, though not necessarily useful. The natural real rate of interest, or Wicksellian natural rate is the real interest rate in a New Keynesian (NK) macroeconomic model, if we remove all wage and price stickiness. For simplicity, early NK models were built so as to leave out all sources of inefficiency, except for wage stickiness (sometimes) and price stickiness (usually). These models may have efficiency loss due to monopolistic competition, but that's a by-product of the approach to price stickiness. So, essentially, the natural real rate of interest is the real rate of interest in the underlying real business cycle model with flexible wages and prices. Why am I saying this concept is "not necessarily useful?" First, while there is some complacency among NK practitioners that NK is all we need to think about in understanding monetary policy, that's a dangerous idea. The basic model has many faults, not least of which is that it neglects the essential details of monetary policy - assets actually play no role in the model, in that there is no central bank balance sheet, no open market operations, no banks, no role for credit, for money, etc. Second, the baseline NK model cannot explain why the natural real rate of interest might be low. For example, low-real-interest-rate NK macroeconomics, such as Eggertsson and Woodford's work or Werning's, typically assumes the real interest rate is low because the subjective discount factor is high. That is, the low natural rate results from a contagious attack of patience. As is well-known, preference shock "explanations" for economic phenomena aren't helpful. If you like explaining the financial crisis as a contagious attack of laziness accompanied by an increased dislike for some assets and an infatuation with some other assets, most people aren't going to listen to you - and those that do listen shouldn't. I think some NK practitioners think of the high discount factor as a stand-in for something else. If so, it would be more useful to develop explicitly what that something else is.

(2) The equilibrium real interest rate: I'll let Ben Bernanke explain this one: helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
This is where the confusion starts. Bernanke tells us this is a synonym for the "Wicksellian interest rate," suggesting that the "equilibrium rate" is the same as the "natural rate." And he says that the equilibrium real interest rate is the "rate consistent with full employment of labor and capital resources," which would tend to steer the reader in the direction of thinking this is an NK natural rate of interest. But, the remainder of the paragraph appears to describe what happens in an IS-LM model, so Bernanke is mixing theories - never a recipe for clarity. Further, "equilibrium real interest rate" is bad language for describing the natural rate of interest in the NK model, as the sticky-prices-and-wages real interest rate is in fact an equilibrium real interest rate - but it's a non-standard equilibrium concept.

(3) The neutral real interest rate: Janet Yellen covered this one in a recent speech:
Gauging the current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance at a given time. A useful concept in this regard is the neutral "real" federal funds rate, defined as the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a "neutral" policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator. Although the concept of the neutral real federal funds rate is exceptionally useful in assessing policy, it is difficult in practical terms to know with precision where that rate stands. As a result, and as I described in a recent speech, my colleagues and I consider a wide range of information when assessing that rate. As I will discuss, our assessments of the neutral rate have significantly shifted down over the past few years.
To clarify, here's what I think she means. It's common to think of monetary policy in terms of a Taylor rule, which we can write as:

R = r* + a(i-i*) + b(y-y*) + i*,

where R is the fed funds rate, r* is a constant, i is the actual inflation rate, y is the actual level of output, i* is the inflation target, and y* is full-employment output. It's typical for people to assume that a > 1 and b > 0. Then, if there is full employment and the central bank is hitting its inflation target, we have R = r* + i*. So, in the Taylor rule, r* is the neutral real interest rate, and r* + i* is the neutral nominal fed funds rate before we have "adjusted for inflation," as Janet Yellen says.

So, given that r* is low, what implications does this have for monetary policy? Of course, the answer to that question should depend on why it is low. Economists have discussed several reasons for low real interest rates:

1. Low productivity growth: In standard models, the real interest rate falls when consumption growth falls. Lower growth in total factor productivity growth implies lower growth in consumption in the long run, which implies a lower real interest rate.

2. Demographics: Demographic structure matters for savings behavior, which in turn matters for the real interest rate. In particular population growth and longevity are important. For example, lower population growth tends to increase capital per worker and lower the real interest rate, and people save more if they expect to live longer, which also will tend to increase capital per worker and reduce the real interest rate. A paper by Carvahlo et al. is an attempt to disentangle some of those effects.

3. Higher demand and lower supply of safe, liquid assets: The low real interest rates we observe are interest rates on government debt, and such assets have functions that go well beyond providing a safe vehicle for savings. Government debt is widely traded in financial markets, and is the principle form of collateral in the market for repurchase agreements, which is a key part of the "financial plumbing" that helps financial markets run efficiently. Much like money, government debt bears a liquidity premium - market participants are willing to hold government debt at lower rates of return than if they were holding it purely for its associated payoffs. Then, the higher the demand for government debt relative to its supply, the higher the liquidity premium, and the lower the real interest rate on government debt. The supply of safe collateral fell as a result of the financial crisis - some types of private collateral and sovereign debt were no longer considered safe. As well, the crisis engendered an increase in demand for safe collateral due to an increase in perceived crisis risk, and because of new financial regulations, associated with Dodd-Frank and Basel III, for example.

I tend to think that (3) is most important, but that's based on working through some models, like this one and this one, and my own informal views on what is going on in the data. On that note, I should add a fourth factor:

4. Monetary policy: Indeed, the real rate of interest on government debt may in part be low because of monetary policy. First, conventional monetary policy can make the real interest rate permanently low. For example, in this paper, if safe collateral is scarce, a reduction in the nominal interest rate also reduces the real interest rate - permanently. That's because the open market operation that reduces the nominal interest rate is a purchase of good collateral (same effect under a floor system with reserves outstanding). Second, an expansion in the central bank's balance sheet can reduce the real interest rate, as I show in this paper. Basically, swapping reserves for government debt reduces the effective stock of safe collateral, as reserves are an inferior asset to government debt (why else would the interest rate on reserves exceed the T-bill rate?). Thus a central bank balance sheet expansion exacerbates the problem of collateral scarcity - quantitative easing may be a bad idea.

What we need to evaluate what is going on is a model that can incorporate these factors, and can be used both to evaluate quantitatively how (1)-(4) matter, and the implications for optimal monetary policy. So what are economists in central banks up to in this respect? At the most recent Brookings paper conference, there are a couple of papers that deal with the problem, one by Kiley and Roberts, at the Federal Reserve Board, and the other by Del Negro et al. at the New York Fed.

Let's look first at the Kiley and Roberts (KR) paper. The key monetary policy problem KW perceive with low r* - and this, not surprisingly, is consistent with mainstream policy views - is that this will cause the effective lower bound (ELB) on the nominal interest rate to bind more frequently. As they say,
ELB episodes may be more frequent and costly in the future, as nominal interest rates may remain substantially below the norms of the last fifty years.
Why would this happen? Going back to our Taylor rule, a lower r* implies that, when the central bank is hitting its targets, then the nominal interest rate has to be lower. So, if the economy is being hit by shocks which cause the central bank to move the nominal interest rate up and down, and if the average nominal interest rate is lower, then the central bank will find itself more frequently constrained by the ELB. Then, periods at the ELB will be periods when the central bank departs from its goals, and there is nothing (other than unconventional policy) that the central bank can do about it. Faced with this perceived problem, some policymakers contemplate increases in the central bank's inflation target - inflation would on average be higher, which may imply a welfare loss but, as the argument goes, there are benefits from being constrained by the ELB less frequently.

This is basically Fisherian logic. Over the long run, a higher nominal interest rate will be associated with higher inflation. Perhaps curiously, KR studiously avoid mention of Irving Fisher, though Jonas Fisher gets several mentions. The one callout to I. Fisher is this:
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
By the "Fisher equation" they mean the long-run Fisher effect, I think. Supposing that the long run real interest rate is a constant, r*, the long run relationship between the nominal interest rate and inflation is R = r* + i. But, of course, in the quote they have the causality going the wrong way. In their models, it's the central bank that controls inflation by controlling the nominal interest rate, so it's the nominal interest rate that's causing the inflation rate to be what it is, not the other way around. That's basic neo-Fisherism.

So what do KR do? They simulate a couple of models to determine what the potential losses are from retaining a 2% inflation target in a low-r* environment. The first model (and this won't surprise you if you know anything about quantitative policy analysis at the Board) is the FRB/US model. For the uninitiated, the FRB/US model is basically a relic of the 1960s - the type of large-scale econometric model that Lucas convinced us in 1976 should not be used for policy analysis. And, 41 years later, here's FRB/US - being used for policy analysis. As KR say:
As emphasized in Brayton, Laubach, and Reifschneider (2014) and Laforte and Roberts (2014), the FRB/US model is extensively used in monetary-policy analysis at the Federal Reserve and captures features of the economy that reflect consensus views across macroeconomists, but is not strictly “micro-founded” in the manner used in many academic analyses.
So, apparently, economists at the Board choose to ignore academic standards (no reputable academic journal would - or should - publish an article about the policy predictions of FRB/US), and go about "extensively" using FRB/US to think about policy.

And you can see where it goes wrong. Here's what FRB/US tells us about what happens in a low-r* world:
... the ELB binds often and inflation falls systematically short of the 2 percent objective; in addition, output is, on average, below its potential level.
Basically, FRB/US is an extended IS/LM/Phillips curve model. In it, long-run inflation is exogenous (2% basically), and inflation will deviate in the short run from its long run value due to Phillips curve effects. So, not surprisingly, in this type of framework, when the ELB binds, output is below "potential" and this causes inflation to fall short of its target. But, by neo-Fisherian logic, if on average the nominal interest rate is too high, because it keeps bumping up against the ELB, inflation should, on average, be exceeding its target. For example, in recent history in the US, some people think that the inflation rate was persistently below target because the nominal interest rate was effectively at the ELB, and we could have done better (have had higher inflation) if the nominal interest rate were permitted to go below zero. Not so. The fact that inflation was persistently below target indicates that the ELB was not a binding constraint. The nominal interest rate was too low.

What else are KR up to? They also use an off-the-shelf DSGE model, developed by Linde, Smets, and Wouters, to address the same policy question. Is this model an better-equipped to answer the question than the FRB/US model? No. Such models, though smaller and more manageable than old-fashioned large-scale macroeconometric models like FRB/US, certainly can't lay any claim to structural purity - there are plenty of ad-hoc features (adjustment costs, habit persistence) thrown in to fit the data, and the model certainly was not set up to capture the phenomenon at hand. Though this DSGE model can certainly capture a decline in productivity (feature (1)) there's nothing much in there with regard to (2)-(4), and the monetary policy detail is shockingly weak. So, I don't think we should take the results seriously.

The second paper, by Del Negro et al. (DGGT) is more of a straightforward time series exercise - but there's some DSGE in this one too. This paper confronts the data in a useful way, focusing on the "convenience yield" on government debt (which I called a "liquidity premium" above), and showing, for example, that corporate debt does not share this convenience yield, which is important. The analysis documents a fall in the real rate of interest beginning in the 1990s, and the estimate of the current real interest rate is 1.0-1.5%. The econometrics in DGGT is sophisticated, but ultimately I'm not sure if I trust it more than what I see in the chart at the beginning of this post. Currently, the 3-month T-bill rate rate is about 0.80%, and the last reading for the twelve-month pce inflation rate is 1.9%. So, by my crude measure, the current real interest rate is -1.1%. If someone is giving me an estimate of 1.0-1.5%, I'm going to think that's way too high. If, given current policy settings, inflation is roughly at target, as is labor market tightness, then the nominal interest rate must be about right, if we follow our Taylor-rule logic.

Monday, March 20, 2017

Do policymakers need more advice from sociologists?

Sociologists sometimes feel neglected. And this can cause them to complain - about economists. Economics is a successful social science. While most social sciences do well in attracting undergraduate students, economics has performed well off campus. An undergrad economics major pays well, and an economics PhD provides entry into plentiful high-paying jobs on Wall Street, and in government, central banks, and academia. As well, policymakers care what economists think, and seek their advice (current occupants of the executive branch excepted).

But life isn't so easy for the downtrodden sociologist, which has led to writing like this piece in the Journal of Economic Perspectives. I discussed that article in this blog post. Seems the upshot of the authors' critique is that economics would be much better if it adopted ideas from other social sciences - sociology in particular.

Economics is hardly perfect. To move forward as a science, we need to be objective, heartlessly self-critical, and outward-looking - ready to absorb new and useful ideas from other fields. So what does sociology have to offer us? Neil Irwin, at the New York Times, suggests that there are some key ideas in sociology that economists, and policymakers, are not absorbing. Irwin says:
They say when all you have is a hammer, every problem looks like a nail. And the risk is that when every policy adviser is an economist, every problem looks like inadequate per-capita gross domestic product. Another academic discipline may not have the ear of presidents but may actually do a better job of explaining what has gone wrong in large swaths of the United States and other advanced nations in recent years.
So, (i) things have gone wrong in the US and elsewhere. (ii) We may be ignoring better explanations for these things than what economists are supplying.

That other academic discipline with the explanations is sociology, of course. Neil then interviews a sociologist, to get her perspective:
“Once economists have the ears of people in Washington, they convince them that the only questions worth asking are the questions that economists are equipped to answer,” said Michèle Lamont, a Harvard sociologist and president of the American Sociological Association. “That’s not to take anything away from what they do. It’s just that many of the answers they give are very partial.”
So apparently we have been somewhat conspiratorial, whispering in the ears of the Washington elite that economics is it - and all the time neglecting some important stuff. But what exactly are we missing?

The rest of Neil's article details what he views as important contributions of sociology, that help us understand current problems:

1. “Wages are very important because of course they help people live and provide for their families,” said Herbert Gans, an emeritus professor of sociology at Columbia. “But what social values can do is say that unemployment isn’t just losing wages, it’s losing dignity and self-respect and a feeling of usefulness and all the things that make human beings happy and able to function.”

2. Jennifer M. Silva of Bucknell University has in recent years studied young working-class adults and found a profound sense of economic insecurity in which the traditional markers of reaching adulthood — buying a house, marrying, landing a steady job — feel out of reach.

3. “Evicted,” a much-heralded book by the Harvard sociologist Matthew Desmond, shows how the ever-present risk of losing a home breeds an insecurity and despondency among poor Americans.

4. ...a large body of sociological research touches on the idea of stigmatization, including of the poor and of racial minorities. It makes clear that there are harder problems to solve around these issues than simply eliminating overt discrimination.

So, unemployed people feel really bad, young people worry about the future, poverty is horrible, and stigma exists. I would hope that most people would know these things, and that they shouldn't need sociologists to point out the importance of these observations. But, if the role of sociologists is to inform otherwise-oblivious people about this stuff, then good for them.

But we're looking for something more, I think. Surely sociologists have ideas about solutions to these problems that they have spent so much time studying? Well, no.
And trying to solve social problems is a more complex undertaking than working to improve economic outcomes. It’s relatively clear how a change in tax policy or an adjustment to interest rates can make the economy grow faster or slower. It’s less obvious what, if anything, government can do to change forces that are driven by the human psyche.
Apparently sociology is so much harder than economics that sociologists are bereft of solutions. And no one's asking them anyway, so why bother?
But there is a risk that there is something of a vicious cycle at work. “When no one asks us for advice, there’s no incentive to become a policy field,” Professor Gans said.
Still glad to be an economist, I think.

Sunday, March 19, 2017

What is full employment anyway, and how would we know if we are there?

What are people talking about when they say "full employment?" Maybe they don't know either? Whatever it is, "full employment" is thought to be important for policy, particularly monetary policy. Indeed, it typically enters the monetary policy discussion as "maximum employment," the second leg of the Fed's dual mandate - the first leg being "price stability."

Perhaps surprisingly, there are still people who think the US economy is not at "full employment." I hate to pick on Narayana, but he's a convenient example. He posted this on his Twitter account:
Are we close to full emp? In steady state, emp. growth will be about 1.2M per year. It's about *twice* that in the data. (1) Employment is growing much faster than long run and inflation is still low. Conclusion: we're well below long run steady state. end
Also in an interview on Bloomberg, Narayana gives us the policy conclusion. Basically, he thinks there is still "slack" in the economy. My understanding is that "slack" means we are below "full employment."

So what is Narayana saying? I'm assuming he is looking at payroll employment - the employment number that comes from the establishment survey. In his judgement, in a "steady state," which for him seems to mean the "full employment" state, payroll employment would be growing at 1.2M per year, or 100,000 per month. But over the last three months, the average increase in payroll employment has exceeded 200,000 per month. So, if we accept all of Narayana's assumptions, we would say the US economy is below full employment - it has some catching up to do. According to Narayana, employment can grow for some time in excess of 100,000 jobs per month, until we catch up to full employment, and monetary policy should help that process along by refraining from interest rate hikes in the meantime.

Again, even if we accept all of Narayana's assumptions, we could disagree about his policy recommendation. Maybe the increase in the fed funds rate target will do little to impede the trajectory to full employment. Maybe it takes monetary policy a period of time to work, and by the time interest rate hikes have their effect we are at full employment. Maybe the interest rate hikes will allow the Fed to make progress on other policy goals than employment. But let's explore this issue in depth - let's investigate what we know about "full employment" and how we would determine from current data if we are there or not.

Where does Narayana get his 1.2M number from? Best guess is that he is looking at demographics. The working age population in the United States (age 15-64) has been growing at about 0.5% per year. But labor force participation has grown over time since World War II, and later cohorts have higher labor force participation rates. For example, the labor force participation rate of baby-boomers in prime working age was higher than the participation rate of the previous generation in prime working age. So, this would cause employment growth to be higher than population growth. That is, Narayana's assumptions imply employment growth of about 0.8% per year, which seems as good a number as any. Thus, the long-run growth path for the economy should exhibit a growth rate of about 0.8% per year - though there is considerable uncertainty about that estimate.

But, we measure employment in more than one way. This chart shows year-over-year employment growth from the establishment survey, and from the household survey (CPS):
For the last couple of years, employment growth has been falling on trend, by both measures. But currently, establishment-survey employment is growing at 1.6% per year, and household survey employment is growing at 1.0% per year. The latter number is a lot closer to 0.8%. The establishment survey is what it says - a survey of establishments. The household survey is a survey of people. The advantages of the establishment survey are that it covers a significant fraction of all establishments, and reporting errors are less likely - firms generally have a good idea how many people are on their payrolls. But, the household survey has broader coverage (includes the self-employed for example) of the population, and it's collected in a manner consistent with the unemployment and labor force participation data - that's all from the same survey. There's greater potential for measurement error in the household survey, as people can be confused by the questions they're asked. You can see that in the noise in the growth rate data in the chart.

Here's another interesting detail:
This chart looks at the ratio of household-survey employment to establishment-survey employment. Over long periods of time, these two measures don't grow at the same rate, due to changes over time in the fraction of workers who are in establishments vs. those who are not. For long-run employment growth rates, you should put more weight on the household survey number (as this is a survey of the whole working-age population), provided of course that some measurement bias isn't creeping into the household survey numbers over time. Note that, since the recession, establishment-survey employment has been growing at a significantly higher rate than household-survey employment.

So, I think that the conclusion is that we should temper our view of employment growth. Maybe it's much closer to a steady state rate than Narayana thinks.

But, on to some other measures of labor market performance. This chart shows the labor force participation rate (LFPR) and the employment-population ratio (EPOP).
Here, focus on the last year. LFPR is little changed, increasing from 62.9% to 63.0%, and the same is true for EPOP, which increased from 59.8% to 60.0%. That looks like a labor market that has settled down, or is close to it.

A standard measure of labor market tightness that labor economists like to look at is the ratio of job vacancies to unemployment, here measured as the ratio of the job openings rate to the unemployment rate:
So, by this measure the labor market is at its tightest since 2001. Job openings are plentiful relative to would-be workers.

People who want to argue that some slack remains in the labor market will sometimes emphasize unconventional measures of the unemployment rate:
In the chart, U3 is the conventional unemployment rate, and U6 includes marginally attached workers (those not in the labor force who may be receptive to working) and those employed part-time for economic reasons. The U3 measure is not so far, at 4.7%, from its previous trough of 4.4% in March 2007, while the gap between current U6, at 9.2% and its previous trough, at 7.9% in December 2006, is larger. Two caveats here: (i) How seriously we want to take U6 as a measure of unemployment is an open question. There are problems even with conventional unemployment measures, in that we do not measure the intensity of search - one person's unemployment is different from another's - and survey participants' understanding of the questions they are asked is problematic. The first issue is no worse a problem for U6 than for U3, but the second issue is assuredly worse. For example, it's not clear what "employed part time for economic reasons" means to the survey respondent, or what it should mean to the average economist. Active search, as measured in U3, has a clearer meaning from an economic point of view, than an expressed desire for something one does not have - non-satiation is ubiquitous in economic systems, and removing it is just not feasible. (ii) What's a normal level for U6? Maybe the U6 measure in December 2006 was undesirably low, due to what was going on in housing and mortgage markets.

Another labor market measure that might be interpreted as indicating labor market slack is long term unemployment (unemployed 27 weeks or more) - here measured as a rate relative to the labor force:
This measure is still somewhat elevated relative to pre-recession times. However, if we look at short term unemployment (5 weeks or less), this is unusually low:
As well, the insured unemployment rate (those receiving unemployment insurance as a percentage of the labor force) is very low:
To collect UI requires having worked recently, so this reflects the fact that few people are being laid off - transitions from employment to unemployment are low.

An interpretation of what is going on here is that the short-term and long-term unemployed are very different kinds of workers. In particular, they have different skills. Some skills are in high demand, others are not, and those who have been unemployed a long time have skills that are in low demand. A high level of long-term unemployed is consistent with elevated readings for U6 - people may be marginally attached or wanting to move from part-time to full-time work for the same reasons that people have been unemployed for a long time. What's going on may indicate a need for a policy response, but if the problem is skill mismatch, that's not a problem that has a monetary policy solution.

So, if the case someone wants to make is that the Fed should postpone interest rate increases because we are below full employment - that there is still slack in the labor market - then I think that's a very difficult case to make. We could argue all day about what an output gap is, whether this is something we should worry about, and whether monetary policy can do much about an output gap, but by conventional measures we don't seem to have one in the US at the current time. In terms of raw economic performance (price stability aside), there's not much for the Fed to do at the current time. Productivity growth is unusually low, as is real GDP growth, but if that's a policy problem, it's in the fiscal department, not the monetary department.

But there is more to Narayana's views than the state of the labor market. He thinks it's important that inflation is still below the Fed's target of 2%. Actually, headline PCE inflation, which is the measure specified in the Fed's longer-run goals statement, is essentially at the target, at 1.9%. I think what Narayana means is that, given his Phillips-curve view of the world, if we are close to full employment, inflation should be higher. In fact, the long-run Fisher effect tells us that, after an extended period of low nominal interest rates, the inflation rate should be low. Thus, one might actually be puzzled as to why the inflation rate is so high. We know something about this, though. Worldwide, real rates of interest on government debt have been unusually low, which implies that, given the nominal interest rate, inflation will be unusually high. But, this makes Narayana's policy conclusion close to being correct. The Fed is very close to its targets - both legs of the dual mandate - so why do anything?

A neo-Fisherian view says that we should increase (decrease) the central bank's nominal interest rate target when inflation is too low (high) - the reverse of conventional wisdom. But maybe inflation is somewhat elevated by increases in the price of crude oil, which have since somewhat reversed themselves. So, maybe the Fed's nominal interest rate target should go up a bit more, to achieve its 2% inflation target consistently.

Though Narayana's reasoning doesn't lead him in a crazy policy direction, it would do him good to ditch the Phillips curve reasoning - I don't think that's ever been useful for policy. If one had (I think mistakenly) taken Friedman to heart (as appears to be the case with Narayana), we might think that unemployment above the "natural rate" should lead to falling inflation, and unemployment below the natural rate should lead to rising inflation. But, that's not what we see in the data. Here, I use the CBO's measure of the natural rate of unemployment (quarterly data, 1990-2016):
According to standard Friedman Phillips-curve logic, we should see a negative correlation in the chart, but the correlation is essentially zero.