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Friday, May 19, 2017

Bad Optics: the Fed's Balance Sheet Edition

Despite the all Fed talk about shrinking its balance sheets, many observers are hoping the Fed keeps it large.  They want the Fed to maintain a large balance sheet for various reasons: it earns a positive return for the government; it provides a financial stability tool via provisions of safe assets; it needs to remain big and accommodative until the economy really starts roaring. There are also complications to shrinking the Fed balance sheet.

Whatever you make of these arguments they all ignore an important political-economy consideration: a large Fed balance sheet makes for bad optics because of interest paid on excess reserve (IOER). 

The figure below explains why. Using data from the Federal Reserve's H8 report, the figure shows the cash assets of "large domestically-chartered" banks and "foreign-related" banks.  The figure reveals the cash assets of these two bank categories combined tracks excess reserves fairly closely. They are, in other words, the main holders of excess reserves and consequently the main recipients of the IOER payment. 


Think about the implications: the banks that were bailed out during the crisis and the banks owned by foreigners are getting most of the IOER payment. This is a perfect storm of financial villains for both the political left and the right. That is why I agree with Ramesh Ponnuru that it politically naive to think the Fed can maintain a large balance. 

And note, the bad optics will only look worse if the Fed's balance sheet does not shrink as interest rates go up. For the IOER payment will go up too. Imagine Fed Chair Janet Yellen having to explain to Congress the growing dollar payments going to these banks.

That is not to say it will be easy to shrink the Fed's balance sheet. There will be big challenges as I have noted elsewhere. But the bad optics do mean that it is likely the Fed will be forced to shrink its balance sheet. 

Tuesday, May 16, 2017

Talking Monetary Policy with Paul Krugman

Paul Krugman joined me for the latest Macro Musings podcast. It was a fun show and we covered a lot of ground from liquidity traps to secular stagnation to fighting the last war over inflation. Paul and I have had conversations in the blogosphere since the 2008 crisis so it was real treat to finally chat with him in person.

In our conversation there were two issues brought up that deserved more time, in my view, than we could give on the show. So I want to address them in this post.

The first one is the important distinction between temporary and permanent monetary base injections. This distinction came up up in our discussion on what it takes to reflate an economy in a zero lower bound (ZLB) environment. Krugman's 1998 paper showed that to do so requires a permanent increase in the monetary base whereas a temporary one will not work. This 'irrelevance result' was further developed by Eggertson and Woodford (2003) who showed that QE programs that are temporary in nature will not spur rapid aggregate demand growth. Others have since built upon this point and there is also earlier monetarist literature that makes a similar argument (source). Here is an excerpt from a Michael Woodford FT piece in 2011 that nicely summarizes this view1:
The economic theory behind QE has always been flimsy. The original argument, essentially, was that the absolute level of prices in an economy is determined only by a central bank's supply of base money. Because of this, at least in the long run, any increase in supply must raise prices proportionally. It followed that, in the short run, QE must also have an effect on spending levels, that will eventually tend to raise prices, even if the channels by which this occurs are obscure.  
The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan's experiment with QE, the added reserves were all rapidly withdrawn in early 2006. More worryingly for Mr Bernanke, whatever the long-run effects would have been, there was no increase in nominal growth over the five years of the experiment.  
The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.
Woodford acknowledges the Fed's large scale assets purchases can help when financial markets freeze up like during QE1, but beyond that will not create the kind of robust aggregate demand growth required to quickly escape a ZLB environment.

For me, the implication of this understanding is that the Fed should have aimed to return the price level (or nominal income) to its previously-expected growth path following the crisis. Krugman, on the other hand, is worried that might not be enough if secular stagnation is real. He, consequentially, prefers a permanently higher inflation rate whereas my approach would imply only a temporary one. In short, I want a level target for monetary policy whereas Krugman wants a higher inflation target.

I also want to be clear as to exactly what is a permanent monetary base injection. First, it is an (exogenous) injection beyond that warranted by normal money demand growth. That is, an increase above the regular growth created by currency demand, required reserves, and other normal (endogengous) sources of monetary base growth. Second, the actual permanent increase need not be very large given the long-run unitary relationship between the monetary base and the price level (after controlling for real growth). Third,  the permanent increase does not mean the monetary base injection is permanent throughout eternity. Only that it is permanent to the extent the current economic conditions that warranted the injection continues to hold. New economic developments may call for additional permanent changes to the monetary base. Finally, most central banks cannot credibly commit to such permanent increases in the monetary base, as evidenced by the record-low inflation in advanced economies since the crisis.  For more on these points see this recent paper of mine.

The second issue is my suggestion that fiscal policy could be used to stabilize the money supply. This came up near the end of the podcast when we started discussing the safe asset shortage problem. The key idea here is that the money supply properly measured includes both retail and institutional money assets. The Center for Financial Stability (CFS) has estimated such a measure. It is the Divisia M4 money supply which includes athe retail money assets in M2 plus institutional money assets. The latter include repos, commercial paper, institutional money market funds, and large-time deposits. 

As Gary Gorton and others have shown, there was a bank run on these institutional money assets during the financial crisis that led to a sizable and persistent reduction in their supply. This can be seen in the figure below which uses the M4 component data from the CFS:


This persistent shortfall in the privately-produced institutional money assets seen above was partially offset by the rise in treasury bills.  More of the shortfall could, in theory, be offset by the issuance of additional treasury bills. That was the point I was trying to make. The big question here is could the U.S. Treasury issue enough treasury bills to fill the institutional money asset shortfall without jeopardizing its risk-free status? I do not know. But it is one possible solution to the safe asset shortage problem.

The chart below builds upon the last figure by plotting the institutional money assets along side the retail money assets (or M2). Together they make up the M4 money supply. The figure reveals that even though the M4 money supply is now past its pre-crisis peak, is still far below its pre-crisis trend path. It never has fully recovered from the Great Recession. This could be part of the story for the weak recovery and, arguably, treasury could help.



Related Links
Permanent versus Temporary Monetary Base Injections: Implications for Past and Future Fed Policy
Scott Sumner on Paul Krugman's podcast

1 The Michael Woodford article ran in the Financial Times on August 26 and was titled "Bernanke Should Clarify Policy and Shrink QE3"

Friday, May 12, 2017

Dollar Domination, Robot Monetary Overloads, and Closing the AD Gap

Some assorted musings:

1. From this week's podcast with Ethan Ilzetzki comes this amazing figure. It shows that approximately 70% of world GDP is tied to the dollar. The implication is staggering: the FOMC is setting monetary conditions for much of the world.


2.  Greg Ip argues our robot fears are misplaced. If anything, we do not have enough robots destroying jobs:
From Silicon Valley to Davos, pundits have been warning that millions of individuals will be thrown out of work by the rapid advance of automation and artificial intelligence. As economic forecasts go, this idea of a robot apocalypse is certainly chilling. It’s also baffling and misguided. Baffling because it’s starkly at odds with the evidence, and misguided because it completely misses the problem: robots aren’t destroying enough jobs...  
This calls for a change in priorities. Instead of worrying about robots destroying jobs, business leaders need to figure out how to use them more, especially in low-productivity sectors.
Okay, what industries fit this description? Greg mentions the usual suspects: education, healthcare, and leisure and hospitality. Here is another one: central banking. It has not changed much in many decades and probably has low productivity. So maybe the hidden message of Greg's article is we need to get robots running the Fed?  My answer: sure, but only if they are targeting a NGDP futures market as proposed by Scott Sumner. This approach, after all, is fairly automatic by design and therefore conducive to our robot overlords taking over the Fed.

3. The CBO estimates the full-employment level of aggregate demand. They unfortunately call it "potential nominal GDP' which is horrific since the potential is truly infinite--think Zimbabwe's NGDP in 2008--so ignore the official name. The idea behind the measure is reasonable: what level of aggregate nominal spending is consistent with full employment. Here is the series lined up against actual aggregate demand as measured by NGDP. 


The figure indicates there was a sharp collapse in aggregate demand during the crisis and the full-employment level has only slowly converged to it. Therefore, there was both a sharp decline in aggregate demand (a cyclical shock) and a downward adjustment in the full-employment trend level of aggregate demand (a structural shock). This understanding is consistent with the recent Fernald et al. (2017) BPEA paper that found that there was both a demand shortfall (that ended by mid-2016) and a decline in potential real GDP. So the CBO's full-employment level of aggregate demand seems quantitatively reasonable.  


For fun, I plotted the difference between the full employment level and actual aggregate demand--the AD gap--against the latest hip labor market indicator. It is the working-age employment rate (a termed coined by Jordan Weissmann) which is more commonly known as the employment-to-population rate for prime-age workers (25-54 year olds). Nick Bunker has been a tireless advocate for using this measure to replace the unemployment rate as the headline labor market indicator. 

So how does the working-age employment rate measure up against the AD gap? Not too bad according to the figure below. The relationship is not perfect, but it is strong enough to indicate that the continued upward recovery of the working-age employment rate over the past few years has been largely due to cyclical factors. 

Thursday, May 11, 2017

Remembering All of Allan Meltzer's Work

Allan Meltzer passed away this week. He is probably best known for his multi-volume history of the Federal Reserve, the 'Meltzer Commission' that aimed to reform the IMF, and most recently his critique of Fed policy since the Great Recession. There was, however, much more to Allan Meltzer than just these developments.

One of the most important contributions, in my view, was his work with Karl Brunner during the 'Monetarist Counterrevolution'. This counterrevolution took place in the 1960s and 1970s and pushed backed against the dominant view of the time that monetary policy did not matter. Milton Friedman and Anna J. Schwartz spearheaded this movement, but it was Meltzer and Brunner who did the most to show why money mattered. They worked hard to show the mechanism through which monetary policy could actually affect the economy. This was no small feat since at the time many economists did not believe in monetary policy. Their insights now permeate modern macroeconomics.

Sadly, however, I suspect many observers will only remember Allan for his critique of Fed policy since 2008. While I disagreed with him on this issue, he was so much more than that one issue. So I hope readers will look at his entire life's work when judging him.

My appreciation for him grew over the past few years for several reasons. First, I got to the chance to interview him before a live audience for my podcast. It was a great interview. He was incredibly sharp, witty, and funny. I can only hope I am that lucid and spry when I hit my late 80s. 

Second, I came to appreciate his work with Karl Brunner on the monetary transmission mechanism as I was working a recent paper. As an example, below is an excerpt from a 1987 article. Read it and see if you can find any relevance for Fed's QE programs (my bold):
The adjustment of reserve positions to transitory change by buying and selling Federal funds (or by borrowing or repaying loans at the central bank) has negligible effects on the interest rates and asset prices relevant for household and business decisions.  A perceived permanent change in the monetary base initiates very different responses and has different costs.  The banks' balance sheet adjustments involve all portfolio items.  The responses by the banks change the money stock, affect interest rates on a variety of assets and the prices of real assets.  The public responds to changing relative costs and returns between loan liabilities and real assets.  The adjustment to a perceived permanent change is reinforced by changes in price expectations or adjustment of the current expected return to capital whenever permanent increase in the base are sufficiently large or persistent.
Meltzer and Brunner, in short, are saying that expected changes in the monetary base have to be permanent to have any meaningful effect.  This is a widely understood point now, one that if ignored leads to the QE "irrelevance results" of Krugman (1998) and Eggertson and Woodford (2003). This understanding explains why the Fed's QE programs failed to generate a robust recovery.  The monetary base injections under them were always meant to be temporary and this limited how much kick they could generate. Put differently, the Fed's temporary monetary injections were never going to create a fast escape from a ZLB environment. (For those interested, I further explain this point in a recent working paper.)

What is remarkable to me is that Meltzer and Brunner understood this principle long before QE was tried in Japan, the United States, the United Kingdom, the Eurozone, and Japan again. His work continues to shed light on current policy debates.

Examples like this one is why Allan Meltzer's life work deserves to be remembered. He is a giant and will be missed. Rest in Peace Allan.   

Friday, April 28, 2017

Macro Musings Podcast: Josh Zumbrum

My latest Macro Musing podcast is with Josh Zumbrum. Josh is a national economics correspondent for the Wall Street Journal. He joined me to talk about the angst facing the economics profession in this current environment. We also talked about the future of economic journalism, economic facts, and what really drives inflation.

It was fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Josh Zumbrum's web page at the Wall Street Journal
Josh Zumbrum's twitter account

Friday, April 21, 2017

Macro Musings Podcast: James Bullard

 
My latest Macro Musings podcast is with James Bullard. James is the President of the St. Louis Federal Reserve Bank and an accomplished economic scholar. He joined me for a great conversation on macroeconomics that covered everything from the determinants of inflation to the Fed's balance to the future path of monetary policy. We also discussed Jame's work on imperfect credit markets and how it provides a another justification for NGDP level targeting. 

This was a fascinating conversation throughout and the transcripts for the show are here. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
James Bullard's page at the St. Louis Federal Reserve

Friday, April 14, 2017

Macro Musings Podcast: Tyler Cowen

My latest Macro Musings podcast is with Tyler Cowen. Tyler is a professor of economics at George Mason University. He joined me to discuss his new book, The Complacent Class: The Self-Defeating Quest for the American Dream. In it, Tyler argues that the restlessness and willingness to take risks have been key traits throughout American history has been waning. In the last few decades, American society has become more risk-averse and this has led to less innovation and dynamism in the economy. 

Tyler notes that this risk aversion has bled over into macroeconomic policy and may be a contributor to the slow recovery following the 2008 crisis.

This was a fun and fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Tuesday, April 11, 2017

Macro Musings Podcast: George Selgin



My latest Macro Musings podcast is with George Selgin. George the director of the Cato’s Institute for Monetary and Financial Alternatives and is a former professor of economics at the University of Georgia. 

 George joined me to talk about the normalization of Fed policy and his new proposal to reform open market operations.  It was interesting conversation throughout. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Monday, April 3, 2017

A Challenge to the Fed's Normalization Plans: the IOER-Treasury Yield Spread

Over at U.S. News and World Report, I have a new article up on the next big challenge facing the Fed: normalizing its balance sheet. Some excerpts:
This path to monetary policy normalization.... may be fraught with surprises and setbacks. Not only must the Fed avoid getting ahead of the recovery with its interest rate hikes, but it must delicately navigate the shrinking of a balance sheet that has grown fourfold since 2008. This latter task may prove to be especially daunting since it puts the Fed in unchartered waters. Never before has the Fed had to shrink its balance sheet...
I go on to discuss some of the many challenges the Fed may face in attempting to shrink its balance sheet. One of them is dealing with the potential stresses caused by the new regulatory demands of the liquidity coverage ratio running up against the spread between IOER and treasury bills:
The second reason the scaling back of the Fed's balance sheet may be challenging is that post-2008 regulation now requires banks to hold more liquid assets. Specifically, banks now have to hold enough high-quality liquid assets to withstand 30 days of cash outflow. This liquidity coverage ratio has increased demand for such assets of which bank reserves and treasury securities are considered the safest. So, in theory, as the Fed shrank its balance sheet, the banks could simply swap their excess reserves (that the Fed was pulling out of circulation) for treasury bills (that the Fed was putting into circulation). The challenge, as observed by George Selgin, is that the Fed's interest on excess reserves has been higher than the interest rate on treasury bills. This creates relatively higher demand for bank reserves. 
Banks would not want to give up the higher-earning bank reserves at the very moment the Fed was trying to pull them out of circulation. This tension could create an effective shortage of bank reserves and be disruptive to financial markets. The solution here would be for the Fed to lower the interest on excess reserves to the level of treasury bill interest rates.
The figure below illustrates this potential problem. It shows the Fed's upper and lower bounds on the federal funds, the effective federal funds rate, and the 4-week treasury bill interest rate. These upper and lower bounds have created a successful corridor system for the federal funds rate, but they have not been very good at bounding the 4-week treasury bill yield. Moreover, the spread between the IOER--the upper bound--and the 4-week treasury bill has persistently been sizable and gotten larger on average since the first interest rate hike in December 2015. It is hard to see why banks would want to swap their excess reserves for treasury bills given this spread. 


This is just one of the challenges the Fed faces in shrinking its balance sheet. Read the rest of the piece for the others I outline.

P.S. While it is easy to understand why the effective federal fund rates falls within the corridor, it is not clear why the 4-week treasury bill interest rate has not conformed to it. Arbitrage should push them closer together, so there must be some friction. One obvious one is the limited access to the Fed's balance sheet. Even with RRP, there are still only so many firms that can effectively tap into the Fed's balance sheet. I suspect that if the Fed further opened up its balance sheet some of this spread would disappear. Whether that is a desirable objective, however, is an altogether different question (though it is discussed in this weeks Macro Musings podcast).

Friday, March 31, 2017

Macro Musings Podcast: Steve Hanke



My latest Macro Musings podcast is with Steve Hanke. Steve is s a professor of applied economics at the Johns Hopkins University in Baltimore. He has advised many governments on economic policy, including helping the establishment of new currency regimes in Argentina, Estonia, Bulgaria, Bosnia-Herzegovina, Ecuador, Lithuania, and Montenegro.

Steve also is the director of the troubled currency project at the Cato Institute and is the author of the  Hanke-Bushnell hyperinflation table.

Steve joined me to talk about his work on hyperinflation. It was interesting conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.


Sunday, March 26, 2017

Macro Musings Podcasts: Jeffrey Frankel


My latest Macro Musings podcast is with Jeffrey Frankel. Jeff is a professor and economist at Harvard University and directs the program on international finance and macroeconomics at the National Bureau of Economic Research.

Jeff joined me to talk about the future of globalization, the dollar, the Plaza Accord, and more. It was a fascinating conversation throughout. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.


Friday, March 17, 2017

Macro Musings Podcast: Jason Furman


My latest Macro Musings podcast is with Jason Furman. Jason is currently a Senior Fellow at the Peterson Institute for International Economics. Previously, Jason spent eight years serving on President Obama’s Council of Economic Advisers, including the chair position from 2013-2017. Jason also worked on the Council of Economic Advisers under President Clinton.

Jason joined me to talk about his time at the CEA. Among other things, we talk about fiscal policy, the fiscal multiplier, monetary policy offset, and the platinum coin. This was a super fun talk throughout. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Jason Furman's Twitter Account
Jason Furman's Webpage

Monetary Policy Analysis is Hard: Inflation Edition

I have a new article at The Hill that responds to some of the buzz created  by the Cecchetti et al. (2017) paper that was delivered at the U.S. Monetary Policy Forum:
What causes inflation? Most people believe inflation is caused by central banks adjusting monetary conditions... But is this right? A recent study by some top economists has raised questions about this conventional wisdom.  
The study found that the standard indicators... [like] economic slack, inflation expectations, and money growth were, in fact, unrelated to inflation. These findings caused quite a stir and even led the Wall Street Journal to declare that “everything markets think they know about inflation might be wrong”. 
This understanding misses, in my view, the deeper and more important point of the Cecchetti et al. paper. As the authors note in a separate blog post, the lack of a relationship between the standard indicators and inflation is actually an indication that the Fed has done a good job in managing inflation:
While the USMPF report is titled Deflating Inflation Expectations, we do not conclude that expectations are unimportant. In fact, quite the opposite: the failure of measured inflation expectations to help forecast changes in inflation is probably a side effect of monetary policy’s success in stabilizing them. 
This point, though, is a subtle one that is often missed by observers and that is why I wrote my piece for The Hill. Drawing upon Nick Rowe's work, I used the following example to illustrate the idea:
Imagine that the Fed is a driver, the economy is a car, the gas pedal is monetary policy and the car's speed is the inflation rate. The Fed’s objective here is to keep the car moving steadily along at 65 miles per hour.  
When the car starts climbing hills, the Fed pushes further down on the gas pedal. When the car starts descending from the hills, the Fed lays off the gas pedal. Over many hills and miles, the Fed is able to maintain 65 MPH by making these adjustments to the gas pedal.  
 A child sitting in the backseat of the car who was oblivious to the hills but saw the many changes to the gas pedal would probably conclude the gas pedal has no bearing on the speed of the car. After all, no matter what happened to the gas pedal the car’s speed never changed.  
 As outside observers, we know better. We know the driver was adjusting the gas pedal just enough to offset the ups and downs of the hills so that a constant speed was maintained. In terms of our Fed analogy, monetary policy was adjusted just enough to offset the ups and downs of the economy so that a stable inflation rate was maintained.
So many people have failed to grasp this point, especially over the past eight years. The Fed got the inflation it wanted over this period by pushing the gas pedal--QE and low rates--just enough to offset the drag of the Great Recession on the price level. Although the Fed wanted a quick recovery, it wanted even more to maintain stable and low inflation. This is evident in their core inflation projections in the FOMC's Summary of Economic Projections (which always saw 2% as ceiling) and in the FOMC's revealed preferences.

This meant the FOMC was not willing to allow an inflation overshoot which, in addition to making their inflation target symmetric, would have allowed more rapid catch-up growth in aggregate demand. As I have said elsewhere, this was the Fed's Dirty Little Secret: its policies were never going to create a robust recovery given the Fed's asymmetric approach to inflation targeting.

But I digress, the point of this post is to remind us that analyzing monetary policy is hard. One cannot simply draw conclusions by looking at interest rates, output gaps, money growth and comparing them to inflation Depending on how the Fed is conducting monetary policy, these indicators should be uncorrelated with inflation if the Fed is doing its job.

Given the importance of this idea, I have excerpted an earlier post on this topic below the fold.

Friday, March 10, 2017

Macro Musings Podcast: Larry White

My latest Macro Musings podcast is with Larry White. Larry is a professor of economics at George Mason University where he specializes in monetary economics and monetary history.

Larry joined me to talk about India's demonetization's efforts and Austrian macroeconomics. This was fun and fascinating conversation throughout.You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Larry White's Homepage

Friday, March 3, 2017

Macro Musings Podcast: Tim Duy


My latest Macro Musing podcast is with Tim Duy. Tim is a professor of economics at the University of Oregon, a columnist for Bloomberg, and a former economist at the U.S. Department of Treasury. 

Tim is also a widely read Fed-watcher and he joined me to talk about Fed watching and the future of U.S. monetary policy. If you want to get into Fed watching this podcast is just for you. Tim shares his approach and what defines a successful Fed watcher. 

We also discussed some of Tim's recent comments about the normalization of Fed monetary policy. The FOMC plans to return to normal monetary policy by first raising it interest rate target and then by reducing the size of its balance sheet. Tim thinks this is a bad idea, as he has written in several Bloomberg articles. He would like to see a simultaneous raising of interest rates and shrinking of the Fed balance sheet as the Fed returns to normalcy. We discuss why he favors this approach.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Tim Duy Homepage

Friday, February 24, 2017

Macro Musings Podcast: Hester Peirce


My latest Macro Musings podcast is with Hester Peirce. Hestor is a Senior Research Fellow and director of the Financial Markets Working Group at the Mercatus Center. She previously served on Senator Richard Shelby’s staff on the Senate Committee on Banking, Housing, and Urban Affairs. In that position, she worked on financial regulatory reform following the financial crisis of 2008 as well as oversight of the regulatory implementation of the Dodd-Frank Act. Hester also served at the Securities and Exchange Commission as a staff attorney and as counsel to Commissioner Paul S. Atkins.  Hester was also nominated by President Obama to be an SEC Commisioner.

Hester joined me to discuss a new book she co-edited with Ben Klutsey titled “Reframing Financial Regulation: Enhancing Stability and Protecting Consumers” This book covers a lot of topics on how to better regulate the financial system. 

We spent most of our time talking about how to improve the stability of the financial system. The laws and regulations emanating from Dodd-Frank (DF) were supposed to make the financial system safer, but a number of recent papers--Nissim and Calormiris (2014)Sarin and Summers (2016)Chousaks and Gorton (2017)--find the banking system weaker now and not meaningfully safer than pre-2008. Others, like Minneapolis Fed President Neel Kashkari, are worried about financial institution that remain too big to fail (TBTF) since they still fund with too much debt. Moreover, it is not clear if the reforms made in DF, like living wills and the Financial Stability Oversight Council, will actually make much difference should the TBTF institutions get in trouble again. President Kashkari, consequently, has proposed a number of reforms to end TBTF.

Hester and I discussed these concerns as well as the possibility that DF has actually increased the fragility of the financial system. One area, in particular, that is creating new potential problems for financial stability is the new DF central clearinghouse utility for derivatives. These central clearinghouses or CCPs were created as a way to improve transparency about derivatives so that regulators and other observer would know what is happening in this part of the financial system. Ironically, however, they appear to be making the financial system more fragile. This is because the CCPs concentrate all the risk from formerly bilateral relationships into one financial firm, making it another TBTF institution. Put differently, DF has inadvertently created more Lehmans or AIGs. 

Now some of the clearinghouse existed before DF, but they have grown and absorbed more risk since DF. In fact, the Financial Stability Oversight Board has designated some of the CCPs as TBTF institutions that need to be monitored. Other reports have come out saying "clearing house push has created unforeseen systemic risk" or "U.S. Treasury warns clearinghouses could spread risk". So it is not clear whether DF on balance has increased the safety of the financial system.

Hester and I do discuss other issues that are covered in the book, but I wanted to highlight here what I see as one of the bigger issues still facing us eight years after the crisis.

If you are interested in the book, you can download it or individual chapters from here. This is a great resource to have as the new President and Congress consider revamping financial regulation.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Macro Musings podcast with Anat Admati (similar these covered).

Friday, February 17, 2017

Macro Musings Podcast: Sebastian Mallaby



My latest Macro Musings podcast is with Sebastian Mallaby. Sebastian is a senior fellow at the Council on Foreign Relations and a contributing columnist to the Washington Post. Previously, he worked with the Financial Times and the Economist magazine and is the author of several books. He joined me to talk about his latest book “The Man Who Knew: The Life and Times of Alan Greenspan”.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Monday, February 13, 2017

The Monetary Superpower: As Strong As Ever

In a forthcoming paper, Chris Crowe and I argue the Fed is a monetary superpower:
[A] defining feature of the US financial system is that its central bank, the Federal Reserve, has inordinate influence over global monetary conditions. Because of this influence, it shapes the growth path of global aggregate demand more than any other central bank does. This global reach of the Federal Reserve arises for three reasons. 
First, many emerging and some advanced economies either explicitly or implicitly peg their currency to the US dollar given its reserve currency status. Doing so, as first noted by Mundell (1963), implies these countries have delegated their monetary policy to the Federal Reserve as they have moved towards open capital markets over the past few decades. 
These “dollar bloc” countries, in other words, have effectively set their monetary policies on autopilot, exposed to the machinations of US monetary policy. Consequently, when the Federal Reserve adjusts its target interest rate or engages in quantitative easing, the periphery economies pegging to the dollar mostly follow suit with similar adjustments to their own monetary conditions.  
[...] 
The second reason for the global reach of US monetary policy is that a large and growing share of global credit is denominated in dollars. That means the Federal Reserve’s influence over the dollar’s value gives it influence over the external debt burdens of many countries.  
[...] 
The third reason for the extended reach of US monetary policy is that other  advanced- economy central banks are likely to be mindful of, and respond to, Federal Reserve policy given the large size of the dollar bloc...  These  findings imply that even  inflation- targeting central banks in advanced economies with developed financial markets are not immune from the influence of Federal Reserve policy. This has led Rey (2013, 2015) to argue that the standard macroeconomic trilemma view is incomplete. 
There is more in our article, but I wanted to share this excerpt because a new working paper from Ethan Ilzetzki, Carmen Reinhart, and Kenneth Rogoff sheds light on our claim that Fed is a monetary superpower. 

Specifically, this new paper shows that contrary to conventional wisdom exchange rate regimes across the world have not become significantly more flexible since the end of the Bretton Woods System. This surprising finding is backed up by a large cross-country data set that spans the period 1946-2015. Moreover, they show that the limited exchange rate flexibility has coincided with an expanding reach of the dollar. From their abstract:
Our central finding is that the US dollar scores (by a wide margin) as the world’s dominant anchor currency and, by some metrics, its use is far wider today than 70 years ago. 
Here is the key chart from their paper as it relates the monetary superpower argument. It shows the share of world GDP that has the dollar as its anchor currency:


What this graph implies is that about 70 percent of world GDP has its monetary policy effectively set by the FOMC! Given the size of the dollar bloc and its spillover effects, it is likely the Fed's total influence on global monetary conditions is even larger. 

This is staggering. It means that twelve Fed officials that meet in Washington D.C. largely determine global monetary conditions. The Fed is truly a monetary superpower. 

Related Links

Friday, February 10, 2017

Macro Musings Podcast: Eswar Prasad

 
My latest Macro Musings podcast is with Eswar Prasad. Eswar is a professor of economics at Cornell University and a senior fellow at Brookings Institution. He joined me to talk about his new book, Gaining Currency: the Rise of the Renminbi

We began by reviewing the history of money in China. Many people know that China had the first paper currency, but few appreciate that China had the first debates over monetary theory and role of the state in money creation. China also had the first currency war--literally a physical war between two competing central banks in China--as well as its own interesting monetary history during the Great Depression of the 1930s. 

We then moved to China's exchange rate regime and the thorny question of whether China's currency being undervalued in the past and whether it was now overvalued. We also discussed how consequential was the past undervaluation of China's currency to the huge trade surplus it ran with the United States. Our conversation also covered the role the Fed played in setting monetary conditions in China via its currency peg to the dollar. 

The interview wrapped up by considering the prospects of the Renminbi becoming a truly important currency. This was a fascinating conversation throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Friday, February 3, 2017

Macro Musings Podcast: Jesus Fernandez-Villaverde

 
My latest Macro Musing podcast is with Jesus Fernandez-Villaverde.  Jesus is a professor of economics the University of Pennsylvania, a research associate with the National Bureau of Economic Research, and a research affiliate with the Centre for Economic Policy Research. 

Jesus does theoretical macroeconomic modeling, econometrics, and economic history. He has several books coming out on those topics and recently coauthored a chapter in the Handbook of Macroeconomics titled "Solution and Estimation Methods for DSGE Models". He joined me to talk about European economic history and macroeconomic modeling on the show. 

Most of our conversation focused on German monetary history in the 20th century since it has been so consequential for the rest of the Europe. We began by discussing the Weimar hyperinflation of the early-to-mid 1920s and the Great Depression of the late 1920s-early 1930s. It is hard to appreciate the fact that Germany went from hyperinflation to painful deflation in a decade. Several interesting questions come out this experience. First, which is worse: hyperinflation or depression? Second, why do the Germans seem to remember the former more than the later? Third, is it true that the Great Depression brought the Nazis to power? Jesus provides good answers to these in the interview. We also touch on Bretton Woods, the EMS crisis in 1992, the advent of the Eurozone, and the best path forward for this currency union.

Jesus and I then turn to the current debate over DSGE  modeling in macroeconomics. He responds to recent criticism of this approach and also considers the the future of monetary search models in this field.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Update: Since we talked about it in the podcast, here is a chart I created some time ago on the EMS crisis in 1992 . It shows Germany's tightening of monetary policy pulling down (via the peg) nominal demand in other European countries.  It is also shows a recovery in UK nominal spending once the peg was broken.



Related Links
Jesus Fernandez-Villaverde's home page

Tuesday, January 24, 2017

Macro Musings Podcast: Gauti Eggertsson



My latest Macro Musings is with Gauti Eggertson. Gauti is a professor of economics at Brown University and formerly worked in the research departments of the International Monetary Fund and the Federal Reserve Bank of New York. He has written widely on liquidity traps, deflation, and the zero lower bound (ZLB) and joined me to talk about these issues.

This was a fun conversation and a good look back at the challenges and shortcomings of macroeconomic policy since the crisis in 2008. One of the big takeaways from our conversation, at least for me, is that central banks during this time ignored many of the key findings in the literature when it comes to best practices at the ZLB.

Before getting to these missed opportunities, it is worth recalling the nature of the ZLB problem. It emerges when there has been a severe recession that forces down the 'natural' or market-clearing level of short-term interest rates to a level well below 0%. The Fed's normal response, lowering interest rates to the level of the natural interest rate, does not work here because the Fed will run up against a lower bound where people would rather hold cash than earn a negative interest rate on their deposits. This lower bound is effectively a price floor that prevents the economy from properly healing and quickly returning to full employment. 

So what can policymakers do? Gauti's work gives an answer. Specifically, his 2003 paper with Michael Woodford (which builds upon Paul Krugman's 1998 paper) shows that policymakers need to credibly commit to an expected path of interest rates that will restore the pre-crisis path of the price level. Put differently, Gauti's work implies the best defense against and escape from a depressed economy is some kind of level targeting. Gauti favors an output-gap adjusted price level target. As Michael Woodford noted in his 2011 talk, this effectively amounts to a nominal GDP level target or restoring the growth path of nominal spending. 

One implication of this understanding is that if there is any disinflation or deflation from a collapse in aggregate demand during a recession there needs to be an offsetting period of reflation to restore the aggregate demand growth path. This did not happen after 2008 and implies aggregate demand growth was persistently weak. This was a missed opportunity by the Fed.

The Fed, instead, tried various rounds of QE. And it did so in exactly the manner that Eggertson and Woodford (2003) and Krugman (1998) said would lead to the famous  'irrelevance results'. That is, the Fed did these programs using temporary monetary base injections, whereas only permanent injections matter. 

What is truly surprising about this observation is that the permanent injections point is widely understood. For example,  here is a list of prominent New Keynesians who acknowledge it (including former Fed chair Ben Bernanke). And here is a list of quantity theory advocates making the same point.

To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment. 

So why did the Fed ignore the literature and fall right into the irrelevance results trap? I have a working paper that takes a stab at this question. I argue there were both external forces (public's fear of inflation vented via Congress) as well as internal ones (Fed still fighting the last battle and suffering from loss aversion) that kept the Fed timid. In our interview, Gauti made an interesting observation related to this point. The Fed seemed okay being aggressive with QE, but not with reflation. It is a bit of puzzle why it was so bold in the former but timid in the later. 

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

P.S.
Gauti and I also touched on how best to sell level targeting to policymakers and the public. Here is a recent Bloomberg article that looks at Gauti's innovative attempt to do so at the New York Fed in 2010 using 'Inflation Budget Accounting". Below is an excerpt:
We suggest that the FOMC keeps track of the extent to which it has "missed" its inflation target. Let us call these accumulated misses "inflation debt". Hence if the inflation target is 2 percent, and inflation is at 1 percent for two years in a row, then the accumulated "inflation debt" is 2 percent. 
The FOMC would then announce an "easing bias" until the inflation debt accumulated in the current recession has been extinguished. If this is credible, a deflationary reading of the data would signal a larger "easing bias" going forward.
P.P.S.
As I note in my working paper mentioned above, the Fed has been explicit about its plan to eventually shrink its balance sheet. It said so in its exit strategy plans reported in the June 2011 and September 2014 FOMC meetings. Janet Yellen recently reiterated those plans in her August 2016 Jackson Hole speech (see footnote 13). More recently, the Federal Reserve updated its basic guidebook to monetary policy in October 2016. Here too it stresses the balance sheet will be reduced:
As the policy normalization process proceeds, the Federal Reserve’s securities holdings—and the supply of reserve balances—will be reduced in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the portfolio...
The FOMC intends that the Federal Reserve will, over the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities (p.52)
And if there were any questions about what this means, the Fed later notes that "no more securities than necessary" means doing away with the overnight  reverse repurchase facility:
During normalization, the Committee is using an overnight reverse repurchase (ON RRP) facility as a supplementary tool as needed to help control the federal funds rate... The FOMC plans to use the ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate (p.51).
I would also add from a political economy perspective that the balance sheet will have to be reduced given IOR. The increasingly bad optics of the Fed paying banks larger interest payments as interest rates go up  will force the Fed's hands on reducing its balance sheet.

Sunday, January 22, 2017

Note to President Trump: It's Policy Divergence, Not China, Driving the Dollar

President Trump is worried about the strong dollar:
In his interview with the Journal on Friday, Mr. Trump said the U.S. dollar was already “too strong” in part because China holds down its currency, the yuan. “Our companies can’t compete with them now because our currency is too strong. And it’s killing us.”
The real issue is not China but the diverging of the current and expected paths of monetary policy among the major advanced economies, particularly the United States and Europe. The Fed has been tightening and is expected to continue do so with further rate hikes in 2017. The ECB, on the other hand, is still running its QE program and is keeping it short-term policy rates pegged close to zero. 

This policy divergence can be seen in the figure below. It shows the 6-month interest rate, 6 months ahead for the United States minus the same measure for the Eurozone (blue line).1 Ever since mid-2014 this spread has been rising--with a brief plateauing in 2016--and the trade weighted dollar (red line) has closely followed it.



Part of the divergence between the expected paths of monetary policy comes from the belief that Trump's policies will spur robust growth. This belief may prove premature, but if it does come to fruition it will only reinforce the policy divergence by pushing interest rates higher.  Going after China will not change this policy divergence. 

The surging dollar, if anything, creates more problems for the rest of the world than for the U.S. economy.  It is something to worry about, as I have noted before, because there is a lot of foreign debt denominated in dollars and because other currencies tied to the dollar will also strengthen.  But this is a very different problem than the one President Trump sees with the strong dollar. 

1 I calculate this 6 month interest rate, 6 months ahead as follows.

Friday, January 20, 2017

Macro Musings Podcast: Anat Admati


My latest Macro Musing podcast is with Anat Admati. Anat is a professor of finance and economics at Stanford University. Since the crisis in 2008, she has also been a fervent advocate of banks using more equity and less debt to fund their investments. As part of this effort, Anat coauthored the book "Bankers' New Clothes: What's Wrong with Banking and What to Do About it". She joined me to talk about these and other issues related to the stability of the U.S. banking system.

It was a fun and interesting conversation throughout. We covered everything from the distortions created by the Basel bank regulations to the still inordinate amount of bank leverage to the prospects for a safer financial system. One of the more sobering implications of our discussion is that the U.S. banking system is not much safer today than it was in 2008. This is a point also made by Larry Summers in a recent Brookings Paper

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Anat Admati Homepage
Anat Admati Twitter Account
Paper - It Takes a Village to Maintain a Dangerous Financial System
Paper - Contingent Liability, Capital Requirements, and Financial Reform

Friday, January 13, 2017

Macro Musings Podcast: Allan Meltzer


My latest Macro Musing podcast is with Allan Meltzer. Allan is a professor of economics at Carnegie Mellon University and a visiting fellow at the Hoover Institution. He is also a well-known monetarist and author of the authoritative multi-volume history of the Fed

We had a wide-ranging conversation on everything from Allan's role in the Monetarist's Counterrevolution to his reinterpretation of Keyne's General Theory to his take on current Fed policies. Among other things, I learned that Allan formerly worked under Paul Volker in the Kennedy Administration.  

This was a fun interview and Allan showed he still has a lot of spunk in him. The interview taped live in front of audience at the Southern Economic Association meetings last November. 

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Friday, January 6, 2017

Macro Musings Podcast: Ylan Mui


My latest Macro Musings podcast is with Ylan Muy of the Washington Post. She was the Fed beat reporter for several years and now covers economic policy at the White House. She joined me to discuss what it was like covering the Fed and what we might expect going forward from President Trump's economic policies.

This was a fascinating conversation throughout and we covered everything from the tight security of FOMC press meetings to the future of the Fed's balance sheet to whether the Fed will ever have a truly symmetric 2% inflation target. We also considered whether Trump's economic policies will truly live up to the market's expectations for them. One thing we do know for sure is that 2017 will be an interesting year for U.S. economic policy and Ylan will have much to cover for the Washington Post.

Ylan also shared that she is working with the Brookings Institute on a book about negative interest rates as a tool for monetary policy. It sounds interesting and I look forward to reading it.

Finally, Ylan and I discussed the lack of women in macroeconomics. A recent article in the Journal of Economic Perspectives reminded us that a disproportionately small share of women are in the economics profession. This problem seems to be even more pronounced in macroeconomics. Ylan shared her observation on this challenge and talked about her related work on Janet Yellen breaking barriers in macroeconomics.

This was great episode to start the new year. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Ylan Muy's articles at the Washington Post
Ylan Muy's Twitter Account