Inflation Targeting When the Natural Interest Rate is Negative

Over a century ago, in a theory that is still influential today, Swedish economist Knut Wicksell argued that, at any particular time, there is a certain “natural rate of interest” that is consistent with price stability. If the actual rate of interest falls below the natural rate, there is an incentive for entrepreneurs to borrow aggressively and demand more goods and more labor, driving prices up. If the actual rate rises above the natural rate, the incentive to borrow disappears, leading entrepreneurs to demand less goods and labor, driving prices down. Since the opportunities available to entrepreneurs are always changing, the natural rate is always changing, sometimes rising dramatically and at other times falling dramatically. Thus Wicksell argued that, relative to the natural rate, “the interest on money is, in reality, very often low when it seems to be high, and high when it seems to be low.”

As applied to the world we live in today, Wicksell’s original theory has several shortcomings, all widely recognized now. First, it doesn’t account for stickiness in wages and prices: as we observe, the short-run effect of a drop in demand is not so much a fall in wages and prices as a fall in employment. Second, it doesn’t account for the role of expectations in determining the price level and thus, the possibility of “inertial” inflation: it is now generally understood that (under a fiat money regime) a steadily rising price level, rather than a necessarily constant price level, is consistent with the equilibrium “natural” interest rate that Wicksell hypothesized. Third, it doesn’t fully account for the role of inflation expectations in defining the “real” interest rate: for example, a 2% nominal interest rate when prices are expected to be constant is equivalent to a 4% nominal interest rate when prices are expected to rise at a 2% rate. Finally, as I discuss below, it doesn’t account for the role of risk aversion in determining the behavior of entrepreneurs and those who finance them.

Wicksell argued that the natural interest rate was determined by the rate of return on capital. But in practice, the rate of return on capital is never known exactly in advance. Entrepreneurs require a compensation for the risk involved, and lenders (and buyers of stock and other forms of financing) require a compensation for the risk involved in financing them. As a result, particularly in times which are uncertain and when people are particularly risk-averse, there can be a very large wedge between the natural “risk-free” rate of interest and the rate of return on capital. One consequence of having such a large wedge is that, even if the return on capital is necessarily expected to be positive, the natural interest rate can be negative.

When the natural interest rate is negative, since it’s impossible to cut nominal interest rates much below zero, the only way to get back to normal is to create an expectation of inflation. If the nominal interest rate is zero and the inflation rate is positive, then the real interest rate is negative; thus it is possible, with a sufficient amount of expected inflation, to set the real interest rate down to the negative natural rate. But how can that inflation be achieved? Wicksell argues that prices rise when the actual interest rate falls below the natural rate, but in order for that to happen, prices must already be expected to rise. Can a central bank pull itself up by its own bootstraps?

The answer is almost certainly yes, since nearly everyone agrees that a sufficiently reckless central bank will always be able to produce a high inflation rate. (Imagine the Fed buying up the entire national debt, along with all the private sector’s offerings of commercial paper, mortgages, corporate bonds, and so on. Eventually, there will be inflation.) The problem is that it is hard to estimate in advance how aggressive monetary policy needs to be in order to produce the needed expectation of inflation. Not only doesn’t the central bank know what actions would produce a given “happy medium” target between too-low and too-high inflation expectations; it never really even knows what the natural interest rate is, so it doesn’t know how much inflation would be enough to get the real rate down to the natural rate.

If the central bank estimates wrong and overshoots, it risks a period of very high, and unnecessarily high, inflation. If (as seems infinitely more likely to me) it estimates wrong and undershoots, it risks reducing its credibility, so that it becomes more difficult, subsequently, to achieve the necessary inflation rate. (Note BTW that if you take the Mankiw Rule as an estimate of the natural interest rate, then the Fed’s current 2% inflation target is not high enough: the Fed is on a course to fail and thereby reduce its subsequent credibility.)

The solution is to aim not for an inflation rate but for a price level (or, as I suggested in my previous post, a level of nominal GDP). A series of price level targets that rises over time, but that does not get revised when the central bank undershoots or overshoots, allows for policy that automatically becomes more aggressive (or less aggressive) as necessary. If the central bank undershoots the first price level target, the second target is still in place, and this means it must aim for a higher inflation rate. If it undershoots the second target, the third is still in place, and it must aim for yet a higher inflation rate. And so on. Eventually, it will (automatically) find the inflation rate that works.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Nominal GDP Targeting: the 24-7 Solution

Though I’m skeptical of some of his specific proposals, Scott Sumner has convinced me that nominal GDP targeting is the way to go. I’d like to propose the following law:

The Board of Governors of the Federal Reserve System shall conduct monetary policy in such a way as to increase the nominal gross domestic product to approximately $24 trillion in the year 2017.

I choose 2017 because it’s 10 years after the end of the last growth cycle, and I choose $24 trillion based on an approximate extrapolation of the growth rate from 1997 to 2007. (You get why I like the numbers 7 and 24, right?) This is essentially a retroactive 10-year plan for monetary policy, but it leaves all the details up to the Fed.

I’m proposing this as a law to be passed by Congress, because it’s a little bit easier for me to imagine Congress passing such a law than the Fed making such a radical change on its own. Moreover, it would have more credibility if it were written into law rather than merely an announced policy of the Fed. It does take away a little bit of the Fed’s independence, but, as Dr. Phil might say, “How’s that independent central bank thing workin’ out for ya?” It fully retains the Fed’s operational independence, and it mandates an objective based on what the Fed was already achieving over the 10 years up to 2007 (and very roughly for the prior 10 years as well).

The law would need some sort of enforcement provisions, too, but these need not constrain any specific Fed actions. The Chairman would simply have to explain to Congress, on a regular basis, how the Fed plans to get from here to there. If the plan misses in the early years, it obviously has to become more aggressive in the later years – which is the whole point: the worse things get, the more dangerous it should become for banks, businesses, and individuals to keep sitting on cash instead of investing it. (If you want to give the Fed governors a bonus based on how close they come to the target, I’m down with that, too.)

After 2017, the Fed would be free to go back to its discretion in setting long-range policy goals. But it will have an incentive to continue nominal GDP targeting. It may even ask Congress to pass another law. What incentive? To make up for the abysmal performance of 2008-2010, the 2017 goal will almost certainly require the Fed to allow an inflation rate greater than 2% – possibly much greater than 2% – as 2017 approaches. The Fed will then need a credible way to bring the inflation rate back down. What could be more credible than a promise to continue the nominal GDP pattern of the past 20 years? (Remember, the $24 trillion goal for 2017 was based on an extrapolation of the 1997-2007 trend..)

I would hope that the Fed would then elect to continue with nominal GDP targeting. In the longer run, it’s a policy that solves the problem I discussed when I wrote about inflation targets and financial crises. A financial crisis will (if history is any guide) reduce expectations of real growth. If the Fed is targeting nominal GDP, then inflation expectations should automatically increase when real growth expectations decline. This automatically gives the Fed more room to cut the real interest rate so as to clean up the economic fallout from the financial crisis. And nominal GDP targets should also help prevent such crises by reining in real growth that is driven by speculation rather than actual improvements in productivity. In such cases, inflation may not accelerate, but nominal GDP will, and this will automatically lead to an expectation of Fed tightening. Aside from the arbitrary connection with the numbers 24 and 7, nominal GDP targeting is a 24-7 solution in the sense that it reliably provides help in a variety of circumstances.

I’m hoping my law will receive bipartisan – or even tetrapartisan – support. Progressives can see it as a way to make up for the inadequacy of fiscal policy initiatives. Mainstream Democrats can see it as way to consolidate the gains of fiscal policy. Republicans can see it as an acknowledgment that Democratic fiscal policy initiatives were the wrong solution in the first place. And Tea Partiers can see it as a way to get the Fed out of the business of micromanaging the economy. I don’t really care how you sell it; it’s just a good idea. And since all but about 535 of the members of Congress read my blog...

Yes, I’m hoping that Congress will pick up ideas like this from people like Scott Sumner and me, but I’m not expecting it. I’m still long the bond market in my personal accounts. For the sake of the country, though, I’m begging Congress and the Fed. Take my capital gains. Please.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

Stop Worrying About Structural Unemployment

The economic blogosphere has suddenly become very concerned about the possibility that structural unemployment – resulting from a mismatch between the needs of employers and the capabilities of available job-seekers – has increased in the US. Paul Krugman is worried; Brad Delong is convinced; it’s obvious to Tyler Cowen; The Economist presents a variety of opinions; and any number of other bloggers and fora have been discussing the topic.

One major source of this newfound concern is a post by Dave Altig of the Atlanta Fed, who has detected a shift in the relationship between job openings and unemployment – the Beveridge curve. While the shift is unmistakable in his chart (see below), I have looked more closely at the data, and I have come to the conclusion that it does not represent a major increase in structural unemployment. Rather, I believe it represents the normal dynamics of the business cycle in the context of an incipient recovery from a historically severe recession that, in some ways, has not quite ended.

First, let’s get a clear idea of what’s going on in the chart:


Consistent with a common practice by people (including me) who plot economic data, Dave Altig has drawn a linear regression line to represent the general relationship between job openings and unemployment. But we should not therefore assume that the true relationship is a linear one. If you ignore the regression line, you can see a distinctly curved pattern to the points. We should expect a curved pattern: a strictly linear relationship wouldn’t make sense, because it would mean that, if there were enough job openings, unemployment could go below zero, and if there were enough unemployment, job openings could go below zero. In practice, when one of the series gets very low, it becomes less responsive to the other series. Thus the pattern in 2009, where the unemployment rate keeps rising while job openings become nearly flat at a very low level, is exactly what one might expect. It’s certainly what I expected, having plotted curves like this before.

But the point labeled “2010 Q2” breaks the pattern. It appears that we’ve suddenly moved off the old Beveridge curve onto a new one that has yet to be traced and that promises to associate a significantly greater amount of unemployment with any given number of job openings. But have we, really?

To answer this question, we need to think about how job openings (as well as other factors) affect the number of unemployed workers. Take a look at the actual numbers: in 2010 Q2 there were about 15 million unemployed workers and just over 3 million job openings. If all 3 million job openings were filled, it would (other things equal) reduce unemployment to about 12 million. But if you were to plot that hypothetical point on the chart, it would still be above the old Beveridge curve. So even with what seems a rather optimistic assumption about the matching process, it was inevitable, given the appearance of a comparatively large number of job openings in Q2, that they produced a point that was off the old curve. That result has nothing to do with structural unemployment; it’s just because there are many more available workers than openings.

My assumption is not really as optimistic as it seems, though, because in fact job openings fill very quickly. The May (most recent) JOLTS report, for example, shows 3.2 million job openings but 4.5 million new hires – which implies that the average job opening gets filled in less than a month. What about all those employers complaining that they can’t find people with the right qualifications? Apparently they are a minority – or else they end up settling.

If we’re looking for evidence of an increase in structural unemployment, we need to compare the rate at which openings fill today to the rate at which they filled in the past. When was the last time that there were this many job openings? In November 2008, there were 3.2 million openings but only 4.1 million hires. So job openings are filling faster now than then. You might expect them to fill faster, since there are more unemployed people with whom to fill them (15 million vs. 11 million). Indeed, the fact that they fill only a little bit faster could be taken as evidence that some of the additional unemployment is structural. But these data don’t support the idea that there has been a dramatic shift, that the pool of the unemployed is a significantly worse match for the available job opportunities than it was a few years ago. To find a point where actual hiring was happening as quickly as it is today, you have to go back to August 2008, before the fall of Lehman, when there were 3.7 million job openings.

So if 4.5 million people (equivalent to 30% of the unemployed) find jobs in a given month, how come so many people are still unemployed? Because people are losing jobs almost as quickly. That’s what I meant when I said that the recession, in some ways, has not quite ended. While the average rate of job losses during the recent recession was not particularly severe, those job losses continued for a long time (as it was a long recession) and pushed more and more people into unemployment, while there was an unusual lack of new jobs to get them out of unemployment. The new jobs are finally starting to appear, but the job losses are continuing. When I declared last year that “job losses are not the problem,” it hadn’t occurred to me how long the job losses might last. By the standards of a recovery, job losses are the problem today.

Well, part of the problem. Notice that even after the recent jump, there are fewer job openings than there were at any time during the 2001 recession, and only about as many as there were at the depth of the 2003 “job recession” that lingered after the official recession had ended. Whether you measure in terms of job losses or job openings, the job market is still depressed. There’s plenty of reason to expect persistent cyclical unemployment. Structural unemployment, not so much.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

The Opposite of Monetization

One objection to the Fed’s erstwhile policy of purchasing longer maturity Treasury securities was that the Fed was “monetizing the debt.” I find this objection odd. The Fed had set a near-zero target for the federal funds rate, and it was already committed, if necessary, to maintain this target by purchasing an indefinite quantity of Treasury bills. In practice it hasn’t had to do many such purchases, because there are plenty of private sector buyers willing to “monetize the debt” on their own, and when the Fed purchases other assets, the sellers of those assets go ahead and buy T-bills with the proceeds. But generally, open market operations – consisting primarily of purchases and sales of T-bills – are the normal method by which the Fed enforces its interest rate policy, and accordingly, “monetization” of some sort is inherent in the zero interest rate policy that was already in place when the Fed began its longer-maturity Treasury purchases (and that remains in place today).

It will be objected that T-bill purchases – even if they were actually happening – are temporary. T-bills mature quickly, and if the Fed buys T-bills today, it is not obliging itself to roll over those purchases when the bills mature. Thus it is only temporarily monetizing the debt, for such a short period of time that it hardly matters. By contrast, when the Fed purchases longer maturity Treasuries, it is paying for government expenditures without requiring to Treasury to repay any time soon.

But this view is deceptive. Assuming that the Fed maintains its resolve to prevent the inflation rate from rising significantly above 2%, and assuming that the economy does recover before the aforementioned securities mature (because otherwise the question is moot anyhow), the Treasury will have to repay the money. How will it have to repay the money, if the securities are still outstanding? Since the Fed’s profits go into the Treasury, any reduction in the Fed’s profits is equivalent to a payment by the Treasury. And if the economy does recover, the Fed will, to prevent that recovery from overheating, either raise the interest rate it pays on excess reserves or liquidate the Treasury securities at a loss. Either way, its profits go down, and the Treasury loses, just as if the Treasury had had to repay the money directly.

The real issue is whether the Fed will be tempted to abandon its inflation target. So let’s imagine the Fed, say, 5 years from now, under two different scenarios where the Fed faces a dramatic increase in the velocity of money and has to choose whether to allow inflation. In the first scenario, the Fed’s portfolio is full of long-term Treasury bonds. In the second, it’s full of short-term bills. Under which scenario will the Fed be tempted to allow inflation?

Under the first scenario, the Fed would have to choose whether to liquidate its Treasury bonds at a loss. If the Fed were simple-minded, it would be tempted to avoid the loss by holding on to the bonds and allowing the economy to overheat. But the Fed isn’t so simple-minded: Fed officials will be well aware of the effect that inflation would have on the value of their bond portfolio. If they don’t liquidate, they will face the same decision a year later under worse conditions. And if they don’t liquidate then, they will face the same decision a year after that under yet worse conditions. In all likelihood, they will follow the logic through to its conclusion and realize that they have little choice: holding the bonds to maturity is not really an option (unless they want to risk hyperinflation, which we can presume they won’t), and the best alternative is to liquidate the bonds before inflation becomes an issue, because waiting would only increase their losses. So a Fed with a portfolio of long-term bonds is not one that is likely to tolerate inflation.

Now look at the other scenario. With a portfolio of short-term Treasury bills, the Fed faces the decision whether to allow the economy to overheat and produce inflation. There are no losses to worry about, so you might think the decision would be easy: just sell some of the T-bills, contract the money supply, and avoid inflation. But there’s another consideration. If the Fed didn’t buy bonds in the first place, then those bonds remained in the hands of the public. This means the government will have to repay those bonds, which means that it may have to raise taxes or cut public services. Inflation is one form of tax, and when the public debt is large, inflation is a tax that can generate considerable revenue while arguably producing only a minimal amount of distortion in the economy. With no losses of its own to worry about, the Fed may quite rationally decide that an inflation tax is better than the alternatives. So, if anything, the temptation to allow inflation is higher when the Fed’s portfolio doesn’t include long-term bonds.

In terms of its likely implications for future inflation, buying longer-term Treasury securities is not monetization; it is the very opposite of monetization. This conclusion is actually a little bit disturbing, because it means that asset purchases by the Fed may have just the wrong effect on the real interest rate. Rational markets will anticipate less, not more, inflation when the Fed purchases long-term bonds, and this will only serve to make real investment less attractive – just the opposite of the intended effect. On the other hand, Fed bond purchases would have a direct effect on the real interest rate by reducing the available supply of bonds, and my guess is that this effect would outweigh any adverse effect via inflation expectations.

In any case, the implications for bond investors are unambiguous: Fed asset purchases are good for you. Some caveats are needed, though. The likelihood of additional asset purchases (if you believe there is such a likelihood) does not necessarily imply a buying opportunity, since the rest of the market may also be anticipating it. And one has to take into account a couple of important risks. The Fed could come to its senses and announce higher inflation targets, which would clearly be bad for bond investors (at least at a certain horizon, though the dynamics could be complicated). And Fed asset purchases (indeed, even those that have already taken place) may end up having the intended effect by getting a more solid recovery going. The big risk is that things will go back to normal.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

The Phillips Curve Today: Beware the White Swan

The theory, at its core, is pretty straightforward: businesses compete with one another, and they’re constantly looking for ways to cut costs so they can increase – or maintain – their market share. The bulk of their costs are labor costs – wages and benefits. When the unemployment rate is low, it’s hard to reduce labor costs. Businesses are constantly finding ways to make workers more productive, but during good times, those increases in productivity are eaten up by increases in wages and benefits, which are necessary to retain workers who face relatively abundant alternative opportunities and relatively little competition. When the unemployment rate is high, businesses continue to compete by increasing productivity, but they can also compete by keeping wages down. Under those circumstances, they undercut one another’s prices, and the general price level tends downward.

It gets more complicated, of course. The largest complication is that businesses have relationships – and often contracts – with both customers and employees, and unanticipated changes in prices and wages can disturb those relationships. Consequently, businesses anticipate changes in prices, wages, and market conditions, and they set their own prices accordingly, in the hope of minimizing future surprises. As a result, inflation tends to have momentum. If prices have been rising by 2 percent per year, businesses anticipate that price growth, and the actual inflation rate – under idealized “normal” conditions – comes out close to 2 percent per year. But if the unemployment rate is very low, competition for workers forces businesses to raise prices more quickly, and the inflation rate rises. And if the unemployment rate is very high, competition for customers forces business to raise prices more slowly, and the inflation rate falls.

So much for the theory. I could add a lot more complications – the supply and demand for money, the difference between flexible and sticky prices, the impact of different degrees of competition, the various ways businesses might form expectations about prices, the relationship between unemployment and job vacancies, the possibility of structural changes in the economy over time, and so on – but let’s just stop here and take a look at the evidence in its simplest form. (To produce the chart below, I first took the rate of change in the core CPI from December to December for each year. Then I subtracted the previous year’s rate of change from the current year’s rate of change, for each year in the sample, and I plotted the result against the average unemployment rate for the current year. The core CPI series starts in 1957, so the first observation for which I could compute the change in the inflation rate is 1959. All the underlying data are from the Bureau of Labor Statistics.)



The correlation isn’t perfect – and we wouldn’t expect it to be, since there are other factors that affect the inflation rate in the short run. But it’s strong enough to be quite statistically significant.

And under today’s circumstances, it’s strong enough to be disturbing. The core inflation rate for 2009 was 1.8 percent. If you take the regression line at face value and plug in an average unemployment rate of 9.6 percent – a little toward the low end of what most economists expect for the year – it implies a 1.8 percentage point decline in the core inflation rate. And if you look at the actual data for January through April 2010, we are right on target for a zero percent core inflation rate. I probably don’t have to point out that the unemployment rate will almost certainly still be quite high in 2011, and it won’t be low in 2012.

The May CPI comes out tomorrow morning. It’s expected to show a very slight increase in core consumer prices. If it does show only a very slight increase, or no increase at all, how many will report that “inflation is still under control” and describe it as good news? If you’re worried about the black swan of inflation, I guess it is good news each month that the black swan doesn’t appear. But under today’s circumstances, the white swan – the common species that past experience would lead us to expect – is deflation.



DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Second Dip?

As you might surmise from the conclusion of my previous post, I have been worried about the possibility of a second dip, a new recession beginning sometime in the next year or so, before the current recovery has had a chance to produce much improvement. I was surprised to read (hat tip to Mark Thoma’s twitter feed) that Macroeconomic Advisors is suggesting that there is no chance of a second dip. (I was particularly surprised because MA’s own estimates of the growth impact of the waning fiscal stimulus were one of the reasons I was worried.) After reading their case for zero chance, I have to say that I am still worried. Verbally-intuitively, the case for a second dip still seems pretty overwhelming to me. I take comfort in the knowledge that I tend to have a pessimistic bias, and in the fact that sophisticated quantitative models are generally putting the odds of a second dip quite low. On the other hand, successfully forecasting recessions has not been a strong point of quantitative models.

Here is what I see as the case for and against a second dip. As you will see, I am more skeptical about the case against. Maybe someone can tell me what I have overlooked or how I am being too pessimistic.

The Case for a Second Dip

1. The Fed’s policy of quantitative easing, which was temporarily buttressing demand, is over, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.
   
   
2. This fiscal stimulus, which was temporarily buttressing demand, has been largely exhausted and has likely reached its point of peak impact (even if additional fiscal measures are taken), so that its impact will be declining in the coming quarters, imparting a downward bias to growth.
   
   
3. Pent-up demand from consumers (many of whom were worried about the losing their jobs last year but no longer are) has been largely exhausted, and its impact will likely decline over time, imparting a downward bias to growth in the coming quarters.
   
   
4. The process of inventory adjustment has run its course, and firms have been able to increase production again to maintain inventories at the new, lower level and to begin slightly increasing inventories in anticipation of a recovery. Significant increases in production are no longer necessary to maintain inventories, so that an upward bias that has been imparted to growth in recent quarters will no longer be present in future quarters.
   
   
5. With the dollar relatively strong again and the pace of world recovery expected to slow, export growth, which had offered the possibility of a robust recovery, no longer seems to offer that possibility.
   
   
6. Normally, the surge in productivity at the beginning of a recovery is followed by a surge in employment. They typical lag is about two quarters. Last year’s surge in productivity took place over the last three quarters of the year, which suggests that a surge in employment should have taken place beginning in the last quarter of last year and continuing through the current quarter. Aside from temporary census employment, the anticipated surge does not appear to be taking place. Meanwhile, productivity growth has settled back into the normal range, which dampens hope for a future surge in employment.
   
   
7. The Bush tax cuts expire at the end of 2010, creating an incentive for high-income individuals (and their corporate agents) to shift income out of 2011 into 2010. To the extent that they are successful in doing so, and to the extent that the shifted income is associated with actual economic activity taking place during the period in which it is declared, we should expect a downward bias to growth between 2010 and 2011. (This point comes from a recent Wall Street Journal op-ed by Arthur Laffer, to which a colleague referred me. People who know my work well know that I have had my quarrels with Arthur Laffer in the past, but in this case, I don’t see any fundamental flaw in his argument.)
   
   
8. Given all these negatives, there is no evidence of any positive stimulus to growth that would offset them. The financial panic of late 2008 subsided long ago, and the residual financial weakness is lifting very slowly, with no suggestion that the pace of improvement will accelerate, especially in the light of potential fallout from financial difficulties in Europe. With capital ratios still an issue, the current regulatory environment is not conducive to rapid increases in bank lending.
   

The Case Against a Second Dip

1. In the years since the Great Depression, there is no precedent for a long recession (longer than 8 months, in this case about 18 months) followed by a short recovery (shorter than 35 months). The two closest “double dip” examples (both with first dips lasting 8 months or less) are 1980 – when the second dip was essentially intentional on the part of the Fed – and 1960 – when the economy had already made nearly a full recovery by the time the new dip happened. On the other hand, double dips appear to have been fairly common in the years before the Great Depression, so the validity of this piece of evidence depends on the premise that something (the fixed gold standard?) fundamentally changed in the 1930’s and has not since reverted.
   
   
2. Recessions seldom begin when the unemployment rate is already high. In particular, since the end of the Great Depression, we have not seen a recession begin with an unemployment rate greater than 7.5 percent. (Today it is 9.7 percent.) Having said that, though, I should note that the second dip of the Great Depression began with an unemployment rate of over 14 percent. (Presumably the reason this happened in the 1930’s is that fiscal and monetary policy were tightened, whereas in subsequent cycles fiscal and monetary policy have generally been loosened when the unemployment rate remained very high. Unfortunately, in the light of the first two points adduced in favor of a second dip, this contrast doesn’t bode well for the immediate future.)
   
   
3. Recessions are normally preceded by stock market declines of greater severity than what we have seen recently. (Of course, if your concern is whether to own stock, the fact that the stock market has not yet had a large decline isn’t much of a comfort.)
   
   
4. Credit spreads do not suggest a high risk of recession. (Again, if your concern is whether to own bonds, this is not much comfort. But perhaps the stock and bond markets should find each other’s lack of severe concern reassuring.)
   
   
5. The price of oil has been reasonably stable, not exhibiting the sort of spike that has helped induce most of the post-WWII recessions. (However, since the second dip, if it happens, is likely to have deflationary characteristics, we need to be concerned that any lack of strength in commodities such as oil could be in anticipation of a second dip.)
   
   
6. The yield curve (difference between long-term and short-term interest rates) is unusually steep. Recessions normally begin with a flat yield curve. Short-term interest rates normally fall during a recession, whereas a steep yield curve suggests rather that short-term rates are expected to rise. However, as Paul Krugman points out, this usual interpretation doesn’t apply now. If there is a second dip, short-term rates will not fall, because there is nowhere down for them to go. Under these circumstances, the steep yield curve likely only indicates the possibility of a rise in short-term rates (without the offsetting possibility of a fall), not the likelihood of a rise. In fact, it could be argued that the steep yield curve is reason to worry more about a second dip: in linear models, a false signal from the unusually steep yield curve could easily outweigh other indicators that are showing valid, but less intense, signs of trouble. (For example, the stock market hasn’t declined dramatically, but it has declined. Should we be worried? Ordinarily, with such a steep yield curve, the answer would be an unambiguous “no.” Today, we’re likely to hear that “no” from linear models, but it could well be based on a single indicator giving a flawed signal.)
   

It’s possible that the case for a second dip is basically right but that we still don’t technically get one. With normal productivity growth and population growth, we could have a severe slowdown, involving maybe one quarter of negative growth, or two quarters of very slightly negative growth, or three quarters of very slightly positive growth, and it might not qualify as a recession. Obviously, it would still suck.

What worries me particularly is that, even if the case for a second dip is completely wrong, the employment picture going forward is still dismal, and there is still a case for deflation. Am I wrong in understanding that this is standard textbook macroeconomics? There is a non-accelerating inflation rate of unemployment (NAIRU). When the actual unemployment rate is above the NAIRU, the inflation rate declines. The further the unemployment rate is above the NAIRU, the more quickly the inflation rate declines. The unemployment rate is currently 9.7% and is not expected to fall rapidly, even under optimistic scenarios. Recent estimates put the NAIRU at about 5%. The current core CPI inflation rate is about 1%. You do the math.



FOOTNOTE: Well, OK, technically you can’t do the math, since I didn’t give you a Phillips curve coefficient. From what I can tell, Phillips curve coefficients are all over the map these days, with some people arguing that the coefficient is zero as long as monetary policy is credible. (But is monetary policy really credible?) At the other end of the spectrum, coefficients with magnitude as high as 0.5 (implying a half percentage point decline in the inflation rate each year for every percentage point that the unemployment rate is above the NAIRU) seem to be well within the mainstream. I recommend against doing the math with that coefficient if you have a heart condition.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

The Mankiw Rule with Quantitative Easing: Why is the Fed So Tight?

In my last post, I suggested that the Fed – at least if it behaves in a reasonable manner consistent with its past practices – is not likely to raise its federal funds rate target any time soon. I argued that the Mankiw Rule (a.k.a. Greg Mankiw’s version of the Taylor Rule) has done a good job of tracking Fed policy in the Greenspan-Bernanke era and that it has now fallen well into negative territory, out of which it will take some time to climb. Some commenters pointed out that, while the Fed obviously can’t make interest rates go negative, it did continue to loosen during the period of zero interest rates, by means of “quantitative easing” or “credit easing” – attempting to pull down the level of riskier or higher maturity interest rates by acquiring unconventional assets. I don’t think this observation really affects the main point of my previous post, but it it’s interesting to take a closer look.

So I tried to come up with a simple measure of monetary policy stance that incorporates both the federal funds rate and quantitative easing. My first thought was to look at the growth of unconventional assets on the Fed’s balance sheet, but as it turns out, it’s not really necessary to specify “unconventional” assets, since the Fed had already reduced holdings of its conventional asset – Treasury bills – to near zero by the time Lehman Brothers failed. We can therefore measure the subsequent quantitative easing as an unusually rapid growth in the Fed’s total assets – or equivalently total liabilities, which is to say, the monetary base. To get a composite measure, we need to somehow graft a measure of this monetary base growth onto the federal funds rate. The simplest way is to subtract the monetary base growth rate from the federal funds rate. Here I have chosen to use the average monthly growth rate over 12 months, because it was a simple specification that gave vaguely reasonable results. Those results are summarized in the chart below.



If you take this chart at face value, it looks like the Fed initially far overshot the level of easing prescribed by the Mankiw Rule, but remember that my choice of equivalence between interest rate percentage points and monthly growth rate percentage points was arbitrary. I could have used a weekly growth rate, and the picture would look quite different. Moreover, I could have used a 3-month or 6-month average instead of 12 months, though I think such choices would only have made the picture look even more strange. The one conclusion that is robust to reasonable changes in specification is that the composite measure is now moving close to zero again, even as the Mankiw Rule interest rate remains well below negative 3 percent. (It will likely rise slightly above negative 4 percent based on the May data, but I’m waiting for the CPI report before I update.) Quantitative easing is over, but the economic conditions that justified it are still with us – at least if we measure retrospectively.

Basically, once we recognize that quantitative easing is an option – and one that is no longer being pursued – we can draw the conclusion that the Fed is much tighter today than what the Mankiw Rule would suggest. Indeed, relative to the Mankiw Rule, the Fed is much tighter than at any time during the Greenspan-Bernanke years. Since 1957, when the core CPI data series begins, there have only been two times when the Fed was as tight as it is today relative to the Mankiw Rule. One was in 1973, when the effect of Nixon’s price controls was artificially reducing the retrospective inflation rate used in the Mankiw Rule. The other was during the early 1980’s, when the Fed was targeting monetary aggregates rather than interest rates and attempting (with great success) to reduce the inflation rate dramatically.

So why is the Fed so tight? Here are some possibilities:

1. Fed policy is better described by a rule that is non-linear in unemployment. With the unemployment rate so tremendously high, perhaps marginal increases in the unemployment rate affect the Fed less than they would if the rate were closer to normal. But given the Fed’s mandate to pursue high employment, wouldn’t the need for more aggressive monetary policy in response to higher unemployment rates be even more acute when the employment situation is already so obviously out of whack? And wouldn’t the unusually high unemployment rate, in and of itself, tend to eliminate the risk of pushing the unemployment rate too low and thereby free the Fed to pursue more aggressive policies than it otherwise would?
   
   
2. The Fed is anticipating dramatic declines in the unemployment rate and/or increases in the inflation rate. Except that we don’t see those in the Fed’s forecasts.
   
   
3. The Fed is correcting for its earlier overshoot, for being too loose in 2009. Except we’re not seeing much evidence that the overshoot (if there was one) needs to be corrected. There is no economic boom. The inflation rate has continued to fall. If the Fed did overshoot on the ease side, recent economic data suggest that, in retrospect, the overshoot was a good idea and not one that should be corrected by a reversal in subsequent policy.
   
   
4. The Fed is passing the buck to fiscal policy. But fiscal policy is tightening too now, in relative terms. It doesn’t seem likely that the Fed is irresponsible enough to base its policy on hypothetical fiscal policies that aren’t actually happening.
   
   
5. The Fed has “abandoned the Mankiw rule” and is now setting its policy stance according to very different criteria than it has used over the past 23 years. But is there any evidence that Ben Bernanke has had some sort of conversion experience? And is there any reason why the Fed would be interpreting its mandate differently than it has in the past?
   
   
6. The Fed has dramatically altered the parameters of its “Taylor Rule.” But why?
   
   
7. The Fed is uncomfortable with quantitative easing and would like to minimize its use and reverse it as soon as possible, irrespective of Taylor Rule considerations. I think we have a winner. The long term effects of quantitative easing are uncertain and could be seen as potentially dangerous. (What will happen if, at some point in the future, the Fed has to choose between liquidating its unconventional assets at a loss, exacerbating an inflationary environment, or raising interest rates high enough to risk a fiscal crisis?) So there is arguably reason for the Fed to be uncomfortable with it. But the implications are disturbing, if you believe in a Philips curve or anything like it. Faced with an excessively high unemployment rate and an excessively low inflation rate, the Fed is choosing to risk exacerbating the situation (i.e., to take the intermediate-term risk of deflation) rather than to risk a very different type of difficult situation in the distant future. Maybe it’s the right decision, but it’s an awfully scary one.
   

Here’s one way to think about the situation. Fed policy typically affects output and employment with a lag of less than a year. Over the past year, the Fed has tightened dramatically. The super-duper-easy aggressive quantitative easing policy of 2009 (especially early 2009) has given the US economy enough monetary fuel to get it almost to an employment growth rate (exclusive of the Census) that could stabilize, but not significantly reduce, the unemployment rate. That policy is gone. In order to believe that the economy is going to strengthen from here, you have to believe either (1) that the lag associated with monetary policy is longer than usual or (2) that the underlying strength of the economy, holding monetary policy constant, has improved dramatically. Maybe one (or both) of those things is true. Or maybe not.






DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.