Wednesday, January 17, 2018

Bank of Canada meeting

As expected (see my post from yesterday), the Bank of Canada increased its target interest rate to 1.25% today. The risk they see on the horizon is a potential collapse in NAFTA.

In the first paragraph of the press release, the Committee summarizes its reasons:
Recent data have been strong, inflation is close to target, and the economy is operating roughly at capacity.
This might seem like a justification for doing nothing. The Bank has achieved its goals, so no action is warranted. This only makes sense if Bank people are forecasting that an economy operating "roughly at capacity" will wake up the Phillips curve and cause more inflation, which they think they should tamp down with higher interest rates - now, not when the inflation happens.

But, further on in the press release is this:
Recent data show that labour market slack is being absorbed more quickly than anticipated.
That seems inconsistent with the quote above. How can the economy be operating "roughly at capacity," with labor market slack? I'm running roughly as fast as I can, but I continue to run faster!

Finally, the forward guidance hasn't changed:
While the economic outlook is expected to warrant higher interest rates over time, some continued monetary policy accommodation will likely be needed to keep the economy operating close to potential and inflation on target.
Still no clarification as to why these higher interest rates should be warranted, and under what conditions rates will or will not rise in the future. And why is the current policy seen as "accommodative?" Short-term nominal interest rates may be unusually low, but it's generally accepted that the real effects of monetary policy actions dissipate over time. So, the real effects of monetary policy we should be seeing now are the effects of interest rate hikes last year. Certainly that's not accommodative. In terms of the effects on inflation of interest rate increases, again I think the Bank of Canada has the sign wrong - though they have good company in that belief. Inflation control is about moving the central bank's nominal interest rate target in the direction you want inflation to go. That's what the weight of theory and empirical evidence tells us.

Tuesday, January 16, 2018

Canadian Monetary Policy

The Bank of Canada's Governing Council will be meeting on Wednesday to decide on a setting for the Bank of Canada's policy rate target, so now is as good a time as any to get you (and me) up to speed on Canadian monetary policy. We'll start with basics. In Canada, the Bank of Canada operates under the Bank of Canada Act, passed in 1935, and amended since then. Policy decisions are made 8 times per year, at pre-specified dates, roughly 2 to 3 weeks before each FOMC meeting in the US. US monetary policy is important for what the Bank of Canada does, thus the synchronization of policy meetings, but presumably the Bank of Canada does not want to look like it is always following the Fed.

The decision making body at the Bank of Canada is the Governing Council, which consists of the Governor, the Senior Deputy Governor, and four Deputy Governors. All of those people are appointed by the Bank's Board of Directors. The Board of Directors, in turn, consists of the Governor, the Senior Deputy Governor, and a group of people appointed by the cabinet of the federal government. The mandate of the Bank as specified in the Bank of Canada Act, is to "promote the economic and financial welfare of Canada." That's of course pretty vague, but since 1991 the Bank has had an explicit inflation target, worked out as an agreement with the Government of Canada. This agreement is reviewed and renewed every five years. Currently, the inflation target is specified as a 2% target for CPI headline inflation, with a range of 1-3%.

Some critical differences between the Bank of Canada and the Fed:

1. The public doesn't know what happens in a Governing Council meeting. There are no minutes or transcripts, and no reported vote. After the meeting, a statement is issued, and at every other meeting there is a press conference.

2. The top Bank of Canada officials are somewhat shy. They don't speak in public as much as, for example, Jim Bullard, the President of the St. Louis Fed. As well, Bank of Canada officials generally speak with one voice. Public dissent is not a thing.

3. To properly deal with the public in Canada, Bank of Canada officials have to be bilingual. So, when they stand up in public, they'll talk to you in both English and French.

4. The actual mechanics of monetary policy implementation are considerably different. There is an overnight market in which the Bank of Canada intervenes, but there is a small number of participants in this market. As well, the Bank operates in an environment in which overnight reserves are essentially zero. The Bank of Canada never went in for a large balance sheet and large-scale asset purchases after the financial crisis, in contrast to the US, the Euro area, Japan, the UK, etc.

Let's review the state of the Canadian economy. Here's the recent time series for real GDP in Canada, normalized to 100 in first quarter 2007, so that we can compare this to the US:
As you may have expected, the behavior of real GDP is not so different in Canada and the US. North America is a highly interconnected economy, given the high volume of trade in goods, services, and assets. However Canada has a somewhat different sectoral composition of output from the US, for example Canada depends more on natural resource industries. That's what the slowdown from 2014-16 is about, which follows the drop in the price of crude oil. But recently, real GDP growth has been strong. Here's what year-over-year growth rates of real GDP look like, since 2010:
Growth rates are roughly synchronized in Canada and the US, over this period, but you can see somewhat more volatility in Canadian growth rates. As well, the average growth rate over this period is somewhat higher in Canada. Recently, growth has been quite strong in Canada, particularly in the second and third quarters of 2017 (in the 3-3.5% ballpark).

What about the labor market? The unemployment rate looks like this:
So, the unemployment rate is the lowest it's been for the last 18 years - indicating a tight labor market. We could go deeper into some other labor market variables, for example the participation rate:
As you can see, labor force participation has dropped somewhat in Canada since 2008, but not to the same degree as in the United States. Indeed, the Canadian population has a similar age structure to the US population - for example the post-WWII baby boom phenomenon is similar in the two countries. Yet, the Canadian participation rate is currently three percentage points higher than in the US. It's not clear what explains this or if, for example, one can explain all of the decline in the Canadian participation rate with demographic factors.

The employment/population ratio looks like this:
Again, Canada experienced a one-time drop in the employment/population ratio during the last recession, but the drop was not as large as in the US, and Canadians currently work harder than Americans, to the tune of about two percentage points in the employment/population ratio. In terms of employment growth rates, here is how it looks in Canada, year-over-year, along with growth in the labor force:
So, recent employment growth rates, year-over-year, have been in the vicinity of 2%, but with labor force growth hovering around 1%, that sort of rapid employment growth cannot be sustained.

Finally here is how the Bank of Canada is doing with respect to its inflation target:
With respect to headline CPI inflation, the Bank of Canada has tended to miss on the low side for the last five years, though inflation is current right at target. I've included a core measure inflation (excluding food and energy prices), but I'm not a big fan of stripping prices out of the index - better to have an idea how persistent the effects of particular shocks are on inflation.

The Bank of Canada increased its policy target twice during 2017. The target for the overnight interest rate went from 0.5% to 0.75% in July and then to 1.00% in August. So what will the Bank do on Wednesday? Given the data I showed you, it looks like the Canadian economy is performing well - somewhat better than the US economy, with relatively strong real GDP growth and employment growth, and a labor market that looks fairly tight. And the Bank is hitting its inflation target. So why should the Bank do anything?

Well, how do Bank of Canada officials look at the world? To figure this out, the press release after the December meeting might help. The two last paragraphs are important, I think:
Inflation has been slightly higher than anticipated and will continue to be boosted in the short term by temporary factors, particularly gasoline prices. Measures of core inflation have edged up in recent months, reflecting the continued absorption of economic slack. Revisions to past quarterly national accounts have resulted in a higher level of GDP. However, this is unlikely to have significant implications for the output gap because the revisions also imply a higher level of potential output. Meanwhile, despite rising employment and participation rates, other indicators point to ongoing­ – albeit diminishing – slack in the labour market.

Based on the outlook for inflation and the evolution of the risks and uncertainties identified in October’s MPR, Governing Council judges that the current stance of monetary policy remains appropriate. While higher interest rates will likely be required over time, Governing Council will continue to be cautious, guided by incoming data in assessing the economy’s sensitivity to interest rates, the evolution of economic capacity, and the dynamics of both wage growth and inflation.
That's certainly Phillips curve language, so the Bank thinks that measures of excess capacity or slack tell us something about where inflation should be going. Here are some such measures that the Bank likes to look at, apparently. Like all Phillips curve believers, Bank officials have to be puzzled by their recent tendency to undershoot their inflation target in the face low unemployment. That's why they think there's still slack in the economy. Like the Fed, people at the Bank of Canada have gone on a slack hunt, looking for labor market variables that might justify a view that the economy is still underperforming. But, the statement above also says that "higher interest rates will be required over time." That is a form of forward guidance, but what's it telling us? The statement doesn't tell us why these higher interest rates might be required, or under what conditions increases might happen.

But, to fill in the gaps, my best guess is that Steve Poloz thinks like Janet Yellen, who believes that interest rate hikes are justified so as to head off higher future inflation. That's a convenient fiction that allows interest rates to go up - otherwise true Phillips-curve-believer central bankers would just get stuck in a policy trap with low nominal interest rates and low inflation forever - everyone turns into Japan, basically. In this instance, a Neo-Fisherian approach might justify another increase. On average, inflation has been below the target somewhat, so another 25 basis points north won't hurt - it'll make inflation go up. The Governing Council, using a get-ahead-of-the-curve approach - basically Phillips curve wakes up and asserts itself - will likely go for the 25 basis point increase in the policy rate, which of course will be self-fulfilling. News since the last meeting has been good in terms of labor market performance for example - the unemployment rate dropped two points - and inflation has gone up. Best guess is that the policy rate goes up tomorrow.

Friday, December 29, 2017

The Corporate Tax Rate, Part 2

John Cochrane posted a reply to my previous post on how changes in the corporate tax rate might affect investment. The key issues seem to relate to the specifics of what the tax code will allow as an expense. In my analysis, I treated investment spending by the firm as fully-expensed, which is not correct. However, the tax code does permit businesses to deduct interest on their debt, and depreciation, which I didn't include. What I'll do here follows - I think - a comment by Francois Gourio (Chicago Fed) on Twitter.

So, let's write down the firm's problem again, assuming a constant real interest rate r, which the firm's shareholders face (an important assumption - I'm neglecting taxes affecting the sharelholders). We'll assume that dividends are paid period-by-period to the firm's shareholders, with the firm maximizing the present value of dividends:
Here, K is the capital stock, N is the labor input, w is the wage rate, b is the firm's debt, and d is the depreciation rate. The firm's debt comes due in one period. Net proceeds for the firm in the current period consist of output minus the wage bill plus new debt issued, minus interest and principal on the debt issued in the previous period, minus investment, minus corporate taxes. The corporate tax rate t applies to output minus the wage bill, minus the interest payments on the debt, minus depreciation.

If the firm were to fund investment out of retained earnings (provided this does not violate a nonnegativity constraint) then a reduction in the corporate tax rate will indeed raise the after-tax marginal net payoff to investing. Alternatively, suppose that the firm always funds new investment by issuing debt, then pays the interest on the debt, retires debt as capital depreciates, and otherwise rolls the debt over. This implies that the firm's outstanding debt is always backed one-for-one by the firm's capital, or
Then, we can rewrite the first equation as
So, the firm's choice of labor input in each period, and its choice of capital in periods 1,2,3,... (equivalent to choosing investment) is independent of the tax rate t. Essentially, debt financing of investment permits full expensing of the investment expenditure - indirectly, through expensing of interest on the debt and depreciation.


1. We need to worry about how the household is taxed, which in this formulation determines what the objective function is for the firm.
2. To do a proper job here, we need to determine the optimal financial structure for the firm.

This is potentially quite complicated (not blog material), though I'm sure someone has addressed related problems in the taxation literature. To do the problem justice, we need a complete general equilibrium model. That said,

1. There's no presumption that the corporate tax rate reduction is going to matter much for intensive-margin decisions of the firm - decisions about labor input and investment.
2. Where the change in the corporate tax rate should matter is for entry decisions - here we need to start worrying about nonconvexities - e.g. fixed costs of entry. But some entry, relating to the treatment of pass-throughs, would just be a renaming of the productive unit - call yourself a business and you can be taxed at a lower rate. As well, firms may choose to relocate from other countries to the U.S., though as I mentioned in my previous post, those other countries won't give up without at fight.
3. There's a clear redistributive effect, as I mentioned in my previous post. Owners of stocks will benefit, and they tend to be richer people. Long-term, government transfers and expenditures on goods and services have to fall, and the burden of those reductions will be borne by the relatively poor.
4. If the Republican Congress actually wanted to increase investment spending, there are straightforward ways to do this through the tax code - an investment tax credit, for example.

Wednesday, December 27, 2017

Where's the Fallacy?

Here's John Cochrane, writing about the "buyback fallacy:"
Many commenters on the tax bill repeat the worry that companies will just use tax savings to pay dividends or buy back shares rather than make new investments.
But, John concludes:
Investment will increase if the marginal, after-tax, return to investment increases. Lowering the corporate tax rate operates on that marginal incentive to new investments. It does not operate by "giving companies cash" which they may use, individually, to buy new forklifts, or to send to investors. Thinking about the cash, and not the marginal incentive, is a central mistake.
But, suppose that we use a simple model of firm behavior, along the lines of what we teach to undergraduates (see for example, Chapter 11, of this fine intermediate macro book). In each period i = 0,1,2,..., the firm hires labor and invests in new capital. Output is produced using labor and capital each period, using a constant-returns-to-scale technology. Each period the firm hires labor on a competitive market, produces output, and invests in new capital. The firm's profits (the return to capital, not economic profits) are P(i) in periods i = 0,1,2,..., and the firm maximizes the present value of profits. Suppose no uncertainty, and that the real interest rate is a constant r forever. Capital depreciates at a constant rate. The firm maximizes the after-tax present value of profits
Profits are ultimately distributed as dividends to the firm's shareholders, but the firm can borrow and lend freely at the interest rate r, so the timing of the dividend payments is irrelevant.

What happens if the corporate tax rate goes up permanently, with the tax rate constant forever, or t(i)=t? This has no effect on investment or on the firm's hiring decisions in any period. That is, if VB is before tax profits, then (1-t)VB = V, so maximizing VB is the same as maximizing V, and the tax rate is irrelevant, not only for investment decisions, but for the firm's hiring decision. In the aggregate, there is no effect on labor demand, and therefore no effect on wages.

Basically, investment is an intertemporal decision for the firm. But the corporate tax rate affects per-period after-tax profits in exactly the same way in every period, so there is no effect on the after tax rate of return on investment the firm is facing. Therefore, the firm won't invest more with a lower corporate tax rate - if it's permanent. How can a change in the corporate tax rate make investment go up in 2018? If the corporate tax rate were temporarily higher in 2018, returning to its former level permanently in 2019, that would do the trick.

I could be missing some subtlety in the tax code, for example in how the firm's financing decisions are affected by taxation, but I don't think so. Please fill me in if you think there's something important I've left out.

So, I don't think there's any fallacious thinking in the popular view of the effect of changes in corporate taxation included in the tax bill. The primary effect is redistributive. Ownership of stocks is concentrated among the relatively wealthy, and a permanently lower corporate tax rate will show up immediately in higher stock prices, as we've seen. Owners of stocks can hold them and receive their higher future dividends, or they can sell their stocks at any time and realize their capital gain. As more GDP doesn't magically come out of nothing, higher spending by these richer folks has to be offset by less spending by poorer folks.

If there are effects of changes in the corporate tax rate, these could come from two places. First, the change in the US rate relative to corporate tax rates elsewhere in the world matters. In some instances, this will have no implications for the location of production for the firm (e.g. management consulting done in various locations in the world), but will matter for the firm's choice of corporate tax home. The tax rate goes down, which reduces tax revenue, but more firms choose the US as a corporate tax home, which increases tax revenue. The net effect on tax revenue depends on how elastic corporate tax home is with respect to the US corporate tax rate. Also, some firms producing tangible goods may choose to relocate production to the US. This necessarily implies some increase in domestic investment expenditure, but the effect is temporary, and probably small, particularly as we can't take for granted that other countries will not provide inducements to prevent firms from moving production to the US.

Second, there is another effect on the extensive margin. Some economic activity that would formerly show up as labor income will now be classed as business income, so as to qualify for the lower tax rate. As I showed, there are no implications for investment expenditure. The effects are lower tax revenue and redistribution to the rich from the poor, who either can't do this, or can't afford to pay an accountant.

If the intent of the tax bill had been to increase investment spending, there are obvious ways to to that - an investment tax credit for example. But, the tax bill is not about investment. The primary effect is redistribution. In the short run, the tax bill makes the rich richer and the poor poorer, and it lowers tax revenue. Permanently lower tax revenue has to show up, in the long run, as permanently lower government transfers and lower spending on government-provided goods and services. This will hit the poor disproportionately. So, this isn't tax legislation that appears to work on marginal anything - it's just wealth redistribution.

Sunday, November 5, 2017


Will Jay Powell do a good job of running the Board of Governors and the FOMC? He's certainly not an obvious choice. If Powell had not been appointed to the Board in 2011, nobody would be thinking of him as a candidate for the Chair's job now. Powell is a lawyer, with no formal training in economics (beyond the odd undergrad course), which puts him at a disadvantage in the Fed system. On the up side, he has a willingness to learn:
“When he showed up at the Fed, he basically did not know much about macroeconomics or monetary policy,” says Seth Carpenter, chief U.S. economist at UBS who spent 15 years at the Fed, including time overlapping with Powell. “He made a conscious decision to spend a lot of time with staff and colleagues to learn as deeply and completely as possible.”
So, Powell appears to be conscientious in seeking advice about things he doesn't know much about. But, the Board may actually not be a great place to learn macroeconomics - the Board staff aren't known for their independent thinking, for example. Further, a Board Governor is not in the best position to learn, as he or she does not have a staff, and is dependent on more-or-less randomly assigned economists to get their work done. Indeed, a Governor's job is thankless in more ways than one. He or she currently earns $179,700 per year, which is less than what a good Associate Professor in Economics is paid at a top research school. And the Presidents of the regional Feds are much better remunerated. Dudley (New York Fed) earns $469,500, Williams (San Francisco Fed) earns $468,600, and Bullard (St. Louis Fed) earns $359,100, for example.

But any of those salaries pale in comparison to what Powell had to be earning in the private sector, judging from his accumulated wealth, which appears to be between $20 million and $55 million. So, to his credit, we can infer that Powell is genuinely interested in public service, otherwise he would still be in the private sector, further feathering his own nest. At six years in, he has been at the job longer than is typical for Board Governors, who are appointed for 14 years, but rarely serve the full term, or anything close.

What are Powell's views on monetary policy? He certainly has not been outspoken about it. Brainard and Tarullo have had differences with the consensus view on the FOMC, and weren't shy about talking about it. Stan Fischer, given his long experience as an academic economist and central banker, certainly had a lot to say, and clearly had his own views on policy. Powell, not so much. A quick look through some of Powell's speeches indicates that he typically did not speak specifically on monetary policy. When he did, for example in a 2016 speech, it's boilerplate - basically the consensus FOMC view. I've seen Powell in action only once. I know he said something, but I can't remember what it was. You might say my memory isn't so great, but from the same occasion, I can remember key details of what Kocherlakota, Evans, Brainard, Lacker, Fischer, and Yellen were talking about. Powell, in the general view, is collegial, reasonable, and intelligent. But in instances where we need depth of experience in central banking and knowledge of economics, he'll have to be looking to other people. That's worrisome.

So why was Powell chosen? Some have suggested that, relative to Yellen, Powell leans more toward less financial regulation. That's too deep for Trump, though, I think. Most official high-level Trump appointments are of three types: (i) person bent on destroying the institution he or she is assigned to run; (ii) General - either active or retired; (iii) rich white male. Powell is type (iii). Just be thankful he isn't type (i) or (ii).

But why didn't Trump just stick with Janet Yellen? After all, he claimed he liked her, right? Well, Yellen is neither male nor rich, so she has two strikes against her, in Trump's mind. Further, Trump seems convinced that people he appoints owe him favors. In Trumpland, an Obama appointee just can't have the right predilections.

But is Yellen a great loss? The New York Times editorial board thinks so. Adam Davidson, in the New Yorker, says that Janet Yellen is a "master of thinking in public." Jena McGregor, in the Washington Post, collects a lot of favorable quotes relating to Yellen's record as Fed Chair, and remarks on the loss of a woman in a position of power, where there currently are few.

From my point of view, Yellen was successful in forging consensus on the FOMC. Apparently, she didn't force her views on others (unlike Greenspan, for example), and the FOMC seems to have operated in a collegial fashion for the last four years. There were some dissents, but given the context there really wasn't that much friction. After all, the Fed was dealing with a unique situation - the large balance sheet that had been built up under Bernanke, and an unprecedentedly long period of essentially-zero overnight nominal interest rates. Deciding when and how to unwind that was no easy task. That said, Yellen's training (PhD 1971) put her out of touch with modern macroeconomics, and she appeared to have a religious devotion to the Phillips curve. With respect to the latter, she has plenty of company in the rest of the central banking community, but that's no excuse. As well, Yellen is well-known for her reluctance to appear in public - Adam Davidson's characterization of her as a "master of thinking in public" is nonsense, I think. As far as I can tell, thinking in public and walking on hot coals are more or less equivalent for Janet Yellen. This is, I think, why Yellen persisted in holding press conferences only after every other FOMC meeting - a decision that implied that nothing would ever happen at FOMC meetings held in January, May, July, or October. Yellen always insisted that all meetings were live, but the off meetings were live in the sense that a person who is unconscious and on a respirator is live - he or she isn't about to get up and run around.

That said, it's hard to see how the Fed will be better-run under Powell than Yellen. The failure to reappoint Yellen is just another instance in this administration of a break with precedent that weakens American institutions - this time the damage is to Fed independence. Further, our progress toward being a gender-blind society has been set back, and that's a big deal.

Thursday, October 5, 2017

U.S. Monetary Policy: What's Up?

To frame the issues, let's look at some objective measures of the Fed's performance. Just to be fair, we'll evaluate performance in terms of the objectives laid out in the FOMC's January 2017 goals statement.

1. "...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." Note that the price index the Fed has chosen as most appropriate is the raw, headline pce deflator, not the pce deflator stripping out food and energy, the cpi, the core cpi, or any other measure. So we should hold them to that choice. Here's year-over-year inflation rates, since the last recession:
Obviously the Fed hasn't been hitting 2% inflation spot on, but what's actually feasible, or even desirable? The Bank of Canada, to take an example that's close at hand for me, actually sets a target band of 1-3% for inflation, so by that criterion the Fed has done pretty well - within the 1-3% band for most of the last seven years, except during 2015 after the fall in energy prices, which perhaps is understandable. The current inflation rate is 1.4%, which is tolerably close to the Fed's ideal. But the the Fed also has a "symmetric inflation goal." Missing the target sometimes is OK, but the FOMC would like to miss on the high side about as much as it misses on the low side - roughly, average inflation should be close to 2%. Over the last year, inflation was above 2% for two months, and below for 10 months, with an average of 1.6%. Not quite symmetric, but not so bad.

2. "... it would not be appropriate to specify a fixed goal for employment...Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published...For example, in the most recent projections, the median of FOMC participants’ estimates of the longer-run normal rate of unemployment was 4.8 percent." For good reasons, the FOMC doesn't want to be specific about numerical goals related to the second part of its mandate - sometimes called "maximum employment," whatever that is. There's a hint though, about what the FOMC members might care about, which is the "long run normal" or natural rate of unemployment. This is rather ill-defined and hard to measure. To my mind, the economics profession would be better off if we refrained from mention of "natural" anything. One danger associated with the natural rate, as for any other ill-defined and hard-to-measure variable, is that a policymaker can start making stuff up, so as to manipulate the policy discussion. In the FOMC's most recent projections, the range of estimates for a long-run unemployment rate fall in a range of 4.4%-5.0%, with a median of 4.6%, so notions of what is normal have fallen since January 2017, when the FOMC put together its long-run plans revision. Here's what the actual unemployment rate looks like:
The current unemployment rate, at 4.4%, is as low as any FOMC participant thinks is normal over the long run, conditional on things going really well, apparently. So, by that measure the Fed is doing great.

Just to check, we can look at another measure, which is a measure of labor market tightness (or it's inverse, as conventionally measured in the labor literature). This is the ratio of the number of unemployed to total job openings:
Shortly after the last recession ended, this measure peaked at about 6.6 unemployed people per job opening, and it's now down to close to 1 unemployed person per job opening. Indeed, that's close to the lowest reading since the BLS started collecting this particular job vacancy data. So, by conventional measures the job market is very tight, which should be viewed as extremely good performance on the Fed's part.

What about growth in real GDP?
If we think that part of the Fed's job is to smooth growth in real GDP, then that chart looks pretty good. I've put in a 2% growth path, and the deviations from that growth path are small. Of course, people might complain that 2% growth is lower than the 3% (roughly) post-WWII average, but that shouldn't be the Fed's concern. Received wisdom in the economics profession is that monetary policy can't do much for long-run growth, other than keeping inflation low and predictable.

So, what's to fix here? Inflation is tolerably close to 2%, the unemployment rate is very low, the labor market is extremely tight, and real GDP is growing smoothly. The only improvement to be made is some fine tuning so that inflation fluctuates symmetrically around the 2% target. How should that be done? I'll assume, consistent with my last post, that QE doesn't matter. So the only issue is what should be done to the fed funds target range (or, more accurately, the interest rate on reserves and the interest rate on overnight reverse repurchase agreements), so that the average inflation rate is 2%? Well, you don't have to be a neo-Fisherite to understand that, if inflation is persistently lower than what you want, on average, then the nominal interest rate needs to be, on average, higher in the future. What's needed here is some tweaking of the Fed's policy interest rate target. How much? As mentioned above, the average inflation rate over the last year is 1.6%, so one or two more interest rate hikes will do the trick. Twenty five to fifty basis points' increase in overnight interest rates is small potatoes for real economic activity - note that the labor market continued to improve in the face of the last four interest rate increases.

So, that's what I'd do. What does the FOMC have on its mind? In the last FOMC projections, the median long-run prediction of Committee members for the fed funds rate is 2.8%, with a range of 2.3%-3.5%. That's come down considerably, with recognition by the committee that the low real rates of return on government debt we are observing are likely to persist. A persistently low real rate of return on short-term safe assets implies of course that the nominal short term interest rate consistent with 2% inflation is low. I'm saying that what Janet Yellen would call the "neutral interest rate" (the interest rate target at which the Fed achieves its goals in the long run) is more like 1.5%, and not 2.3%-3.5%.

To get more information on what the FOMC is likely to do over the near future, we'll look at Janet Yellen's last speech on "Inflation, Uncertainty, and Monetary Policy." First, Yellen tells us how inflation has been low, and then says why she thinks low inflation is bad:
Sustained low inflation such as this is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions. In addition, a persistent undershoot of our stated 2 percent goal could undermine the FOMC's credibility, causing inflation expectations to drift and actual inflation and economic activity to become more volatile.
The second sentence is important. The Fed committed to a 2% inflation target because the assurance of predictable inflation minimizes uncertainty, and makes credit markets, and (by some accounts) the markets for goods and services work more efficiently. If the Fed consistently undershoots its inflation target, people will either think the Fed is incompetent, or that it is willfully abandoning its promises, neither of which is good - for the institution or the economy. But in this instance, the Fed isn't missing by much, so what's the big worry? As I mentioned above, this requires some fine-tuning, but don't get bent out of shape about it.

The first sentence in the quote was really interesting. She's got the causality backward. Pretty much all of us now accept that it's the central bank that controls inflation. That is, central bank actions or, more accurately, the central bank's policy rule, causes inflation to be what it is, combined of course with other factors outside the Fed's control - including the factors determining the long-run real rate of interest on government debt. So, low inflation does not lead to "low settings of the federal funds rate." It's the low settings for the fed funds rate that lead to the low inflation. In a world in which the central bank targets the nominal interest rate to control inflation, that's how it works, and central bankers would be wise to absorb that idea. Stop the neo-Fisherian denial, and get with the program!

The speech uses a two-equation model (written down in the appendix) to frame the issues. It's a Phillips curve model. Arrgghh. Even Larry Summers recognizes that Phillips curves are unreliable. As he says:
The Phillips curve is at most barely present in data for the past 25 years.
For example, in the recent post-recession period, here's what we get when we plot inflation against the measure of labor market tightness I used above (ratio of unemployed to job seekers):
The line connects the observations in temporal sequence from right to left. Over this period of time, I think the Fed would claim that inflation expectations are more or less "anchored." So, what we should see in the chart, if the Phillips curve is to be at all useful, is a set of observations tracing out a downward-sloping relationship. But, more often than not, inflation and my "slackness" measure are moving in the same direction. There's nothing new about macroeconomists raising issues with the Phillips curve as a cornerstone for policy. It's been in disrepute for much of the last 45 years or so, both on theoretical and empirical grounds. Unfortunately, the Phillips curve was dragged out of the gutter, dressed up, and rehabilitated by New Keynesians, which is another story altogether.

But, like a lot of people, Janet Yellen is a true believer, and her staff will aid her in that belief by going on a fishing expedition and finding a Phillips curve, and a sample period, for which all the signs in the regressions (if not the magnitudes) come out "right." Here, "right" is whatever conforms to the beliefs of the boss. Sure enough, in the appendix to Yellen's speech, there is a two-equation Phillips curve model. Core inflation is determined by past core inflation, inflation expectations, resource slack, and the relative price of imported goods, and core inflation, energy price inflation, and food inflation determine headline inflation. Yellen's worries about future inflation outcomes are essentially those of the true believer. Do we have the right slackness measure, or the right inflation expectations measure, and how much should we worry if expected inflation falls?

Though Yellen lays out an explicit model of inflation, she doesn't exactly tell us how policy is supposed to work within that framework. Even true believers will sometimes tell you that "the Phillips curve is now very flat," meaning that they think a tighter labor market will put little or no upward pressure on inflation. If we want to stick with the Phillips curve framework, what's left then? The Fed has to focus on anticipated inflation. But how do they move that around? Modern macroeconomics tells us that our views about future outcomes are shaped by what we know about policy rules, in a manner consistent with what we know about how the world works. I got no sense from Yellen's talk of how the Fed thinks its policy rule affects inflation expectations.

But here's the essence of the FOMC's current policy view:
...without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession.
So, in spite of the fact that the Phillips curve doesn't fit the data, the most recent manifestation being the failure of the very tight labor market to make inflation go up, policy going forward will be driven by the fear that the Phillips curve will somehow wake up and re-assert itself. Summers thinks that's wrong, and rightly so.

But, I think Yellen and her colleagues are actually following the right policy. Modest increases in the Fed's interest rate target in this context is the correct prescription. But doing the right thing for the wrong reason won't help you in the long run. We're fortunate, though, that not much is likely to go wrong here. If inflation stays low, and the FOMC loses its appetite for interest rate increases, so what? Low inflation is fine, and it's close enough to 2% as not to be embarrassing. No big deal.

Monetary policy is the least of our now-staggering problems. Unfortunately, the wingnut in the White House is busy creating more difficulty for us, and making the problems we have worse. Fortunately, he has as yet not screwed up the Fed, and the slate of would-be Fed Chairs doesn't include anyone outlandish. More on that later.

Wednesday, October 4, 2017

Whatever Happened to Normalization?

What's become of the Fed's normalization plans? To get this straight, recall what's been abnormal about Fed policy for the last nine years or so. Here's a chart of the effective fed funds rate, and securities held outright by the Fed:
Abnormal policy began at the height of the financial crisis in late 2008, when the FOMC agreed on a plan to target the fed funds rate in a range of 0-0.25% - a policy that continued until "liftoff" in December 2015. As well, beginning in early 2009, the Fed embarked on a sequence of quantitative easing (QE) exercises, which increased the quantity of securities held outright by a factor of more than five. Further, the Fed got rid of essentially all of its Treasury bill holdings, and increased the average maturity of Treasury bonds and notes held. The Fed also purchased a large quantity of mortgage backed securities (MBS) - close to $1.8 trillion. So, the Fed increased the size of its balance sheet substantially, lengthened the average maturity of securities held, and departed in a big way from a policy of "Treasuries only."

As outlined in this FOMC document, the FOMC began thinking seriously about how Fed policy might return to normal, and what "normal" might be, as early as June 2011. A formal normalization plan was posted by the FOMC in September 2014, and this is essentially what has been implemented since, more or less. The plan was:

(i) Begin increases in the fed funds rate target.
(ii) Reduce the size of the balance sheet by stopping the reinvestment policy, after increases in the target policy rate are well underway.

Increases in the fed funds rate target began in December 2015, and we have since had three more, with the target range increasing from 0-0.25% to 1-1.25% currently. Balance sheet reduction did not commence until October of this year, when the FOMC issued an addendum to the 2014 plan. The addendum contains explicit details about how the balance sheet reduction will occur. Reinvestment - a policy by which assets in the Fed's portfolio are replaced as they mature, holding the nominal size of the balance sheet constant - did not stop abruptly, but its cessation will be phased in. It appears that the New York Fed did not purchase assets with a view to smoothing quantities that mature over time, and the FOMC seems concerned that the balance sheet not decline in a lumpy fashion, as it would without the caps on portfolio reduction outlined in the addendum.

Some questions that might come to mind (or should) on normalization, along with my answers:

1. Why did normalization start with interest rate increases first, then reductions in balance sheet size? It might seem logical, since QE followed the reduction in the nominal interest rate target to zero (effectively), that the Fed would normalize by first reducing the balance sheet to a normal size, and then increase interest rates. Indeed, there are some good reasons why this is what should have happened. As short-term nominal interest rates increase, the profit that the Fed makes on the spread between the return on its assets and what it is paying out on its liabilities declines. As a result the Fed makes a smaller transfer to the Treasury each year. QE took place in the context of relatively low yields on Treasury bonds and MBS, and with a larger balance sheet, the asset portfolio is being financed by a larger fraction of interest-bearing reserves and a lower fraction of zero-interest currency. If short-term rates go high enough, transfers to the Treasury will stop. Economically, this is unimportant, as this amounts to the difference between interest paid on reserves by the Fed vs. interest paid on government debt by the Treasury, but politically this could be very dangerous territory. The Fed should not give ammunition to its enemies in Congress. Added to this is the argument that QE was an experiment, with poorly understood consequences. Thus, the sooner the Fed ended the program, the better. So why not reduce balance sheet size before engaging in liftoff? Likely, because the FOMC was spooked by its experience in 2013. At that time, after the FOMC meeting that ended on June 19, Ben Bernanke announced that a winding-down, or "tapering" of the Fed's QE program was likely to being later that year, and that the program would probably end in mid-2014. The financial market response to that announcement, and earlier public statements by Bernanke, is sometimes called the "taper tantrum:"
In the chart, you can see an increase of more than 100 basis points in the 10-year Treasury bond yield, observable in both the nominal yield and the inflation-indexed yield. Somehow, this wasn't the response the Fed expected, but if the market viewed Bernanke's statement as news about forthcoming interest-rate target increases, the reaction doesn't seem outlandish in retrospect. In any case, this experience appears to have colored FOMC views on the importance of QE, and made them skittish about unwinding the program. Thus the idea that interest rate increases should be well under way before the Committee would even think about balance sheet reduction.

2. What's different about raising interest rates when the Fed has a large balance sheet? In theory, when there are reserves in excess of reserve requirements in the financial system overnight, the interest rate on excess reserves (IOER) should determine the overnight rate. This is called a floor system, under which interest rate control is easy, as the overnight interest rate can be essentially administered by the central bank. But in the United States, things aren't so simple. For the details see this article, and this one. Basically, there are regulatory features of the US financial system that restrict arbitrage in the overnight market, so that the "effective" federal funds rate is typically lower than IOER. And, as was also the case before the Fed began paying interest on reserves in late 2008, all fed funds trades don't happen at one interest rate on a given day - indeed, much of the fed funds market is conducted over-the-counter. The Fed was concerned, before liftoff happened, about its ability to achieve a given target range for the fed funds rate - would the fed funds rate even go up with increases in IOER? To assure that this would happen, the Fed expanded the market for its liabilities by making use of an overnight reverse repurchase agreement (ON-RRP) facility. ON-RRPs are loans to the Fed, usually overnight, secured by securities in the Fed's portfolio. These Fed liabilities are just reserves by another name - they can be held, for example, by money market mutual funds, which are prohibited from holding reserve accounts with the Fed. Currently, IOER is set at 1.25%, the ON-RRP rate is set at 1.00%, and on most recent days the effective fed funds rate is 1.16%. Here's a chart showing what has happened with Fed interest rate control since liftoff:
The chart shows takeup on the ON-RRP facility (quantity of ON-RRPs outstanding) and the effective fed funds rate. Initially, the Fed was willing to commit up to $2 trillion in collateral to ON-RRPs, but takeup is typically in the range of $50 billion to $250 billion, running up to $400 billion to $500 billion only at quarter-end (this for regulatory reasons). As well, the effective fed funds rate has recently been coming in consistently at about 9 basis points below IOER (except at month-end, again for regulatory reasons), and more detailed data shows that most trades happen around the average. In one sense interest rate control since liftoff appears to be a success. But it's not clear that the ON-RRP facility is necessary for its stated purpose. The fed funds rate might be about where it is now even without an active ON-RRP facility. We could go further though, and question this whole operating strategy. There is no good reason for the Fed to focus on a fed funds rate target. Fed funds are unsecured, and currently most of the trade in this market is just a means for some GSEs to earn overnight interest on reserve balances. Even in pre-crisis times, it would have made much more economic sense if the Fed had announced its overnight interest rate target as a target for an overnight repo rate. In the current context, why isn't the ON-RRP rate set equal to IOER? Maybe that would kill the fed funds market, but so what?

3. What happens to reserves when Fed assets mature and there is no reinvestment? The balance sheet of the Fed balances, just as any balance sheet does, so for any transaction that occurs affecting either assets or liabilities, implying a debit or credit, there must be an offsetting debit or credit. Suppose first that the maturing asset is a MBS. The issuer of the MBS - which would be a GSE if the MBS is held by the Fed - pays the face value of the debt to the Fed, and the payment will be made by reducing the balance in the GSE's reserve account by that amount. But the MBS that the GSE issued is composed of bits and pieces of underlying mortgage debt. Suppose that the reason the MBS matured was that the underlying mortgage debt was paid off. Then, mortage payments are made to the GSE, and ultimately those payments will involve an increase in the GSE's reserve balances, and a reduction in reserve balances held by private financial institutions. So reserves held by private sector institutions (a Fed liability) and MBS holdings (a Fed asset) decrease by the same amount. Suppose, alternatively, that a Treasury security held by the Fed matures. The Treasury holds a reserve account with the Fed, and a maturing Treasury security implies that the Treasury's reserve account balance (the account is called the "General Account") falls by the face value of the debt. But that has no implications for the private sector - it's just an accounting transaction between the Fed and the Treasury, like internal budgeting transactions between the English department and the Economics department at the University (if such a thing ever happens). There would be implications for the private sector if the Treasury, now finding itself short of reserve balances to pay for stuff, issues more debt to replenish those reserve balances. Then, the new Treasury debt is purchased by the private sector (the Fed won't be buying it, as it's not reinvesting) with reserve balances, so reserves held in the private sector fall. If you think about this a bit, you'll see that, if we think the level of of reserve balances held by the private sector is part of monetary policy, then the Treasury can engage in monetary policy, by varying the quantity of reserves in its reserve account. Look at this:
Note that both the level and variability of balances in the Treasury's general account have increased by a huge amount since the financial crisis. Maybe the Treasury thinks this doesn't matter now, as it won't mess with monetary policy, but that view is at odds with what the Fed says - which is that QE matters in a big way. If QE matters so much, then the big increase in average balances in the General Account in 2016 should have been a significant "tightening" (because it implies a reduction in privately-held reserves) that the Fed would be concerned with. What's going on?

4. When will balance sheet reduction stop? What the FOMC's normalization addendum says is that they don't know, so let me fill you in on what the issues are. The Fed needs to decide on a long-run operating strategy for monetary policy. They could adopt a channel system for monetary policy, like what Canada has, for example. This would involve operating with a small balance sheet. For example, in Canada, where there are no reserve requirements, overnight reserves are essentially zero. The target overnight rate in such a system is bounded by the interest rate at which the central bank lends (the discount rate, for the Fed) on the high side, and IOER, on the low side. Alternatively, the Fed could stick with the floor system under which it operates now, according to which there are excess reserves in the system overnight. The question then is how much reserves you need to make the floor system work. Basically, financial institutions have to be more or less indifferent between lending to the Fed overnight, and lending to to private entities overnight, so that the interest rates on Fed liabilities determine all overnight rates. Evidence from the Canadian experience from Spring 2009 to Spring 2010 suggests that number is smaller than some people seem to think. Probably less than $100 billion. In addition there are issues concerning what overnight rate the Fed should be targeting. In many countries the central bank targets a repo rate, which makes sense, as the central bank should be interested in a secured overnight rate, that is not contaminated by risk. Why persist in speaking to a fed funds rate target, particularly in a financial crisis?

5. Did QE actually work? Don't expect to get good information from the Fed about this. Central bankers want to at least keep up appearances. Who wants a central banker who's not knowledgeable and trustworthy? As I mentioned above, the Fed has many enemies - in Congress and elsewhere - and it's typically optimal for the institution if Fed officials don't admit to not knowing stuff. Truth is that I've never seen any solid evidence that the people who implemented QE in the Fed system actually have a grip on how it might work - either in theory or in practice. Bernanke once said that"QE works in practice but not in theory." I've heard that repeated many times, usually by a person with a smug look on his or her face. Basically, the statement's B.S. The evidence that QE works is weak or nonexistent. I've written about this in more detail in this St. Louis Fed article. Most of the pro-QE evidence comes from questionable event studies, and the evidence we have seems consistent with QE having no effects for the Fed's ultimate objectives. For example, the Bank of Japan has for more than four years engaged in a massive QE experiment that has had no discernible effect on inflation. And QE does in fact work in theory - at least in the 1950s and 1960s vintage theories that Berananke trotted out to justify the policy in the first place. More careful thought might make one think that QE could actually be harmful, by withdrawing useful collateral from financial markets and replacing it with inferior reserves (talk to people who understand "financial plumbing," for example Peter Stella or Manmohan Singh) It's possible that QE could do some good, if the Fed had the proper liabilities at its disposal. QE is basically an attempt by the central bank to engage in debt management, which is the job assignment of the Treasury in the United States. Maybe the Fed can do a better job of debt management than the Treasury, but if so there should be a public discussion, and an explicit assignment of tasks. And if the Fed is doing debt management it needs to be able to issue tradeable debt instruments of all maturities.

So, where are we? With the unemployment rate at 4.4% and the inflation rate at 1.3%, the Fed is achieving its goals, within reasonable tolerance. We're no longer in emergency territory, yet the Fed has an emergency-sized balance sheet. The plan they have issued to reduce the balance sheet is overdue, and it's quite timid. For example, note that during the QE3 program (the final stage of the Fed's asset purchase program), the Fed bought $85 billion per month in long-maturity Treasuries and MBS and that, even after a phase-in period, under the disinvestment program the reduction will be $50 billion per month, at most. Chances are that, when a recession comes along, the balance sheet will still be large, the interest rate target will quickly go to zero, and asset purchases will resume. If the Fed's balance sheet achieves any semblance of "normal" in my lifetime, I'll be amazed.