A limited central bank

Philadelphia Fed president Charles Plosser gave a noteworthy speech, "A limited central bank." It's especially noteworthy in the context of Janet Yellen's nomination, discussion between Congress and Fed about how the Fed should be run, the Fed's focus on unemployment, and the current state of the hawks vs. doves debate.

We find out what he thinks of micromanaging the taper based on monthly employment reports:

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment....

When I talk to Fed types about this, the usual answer is a version of "well, yes, we don't really have that much effect on employment, but employment is in the toilet, we have to do what we can, no?"

Charlie has a good answer to that, along the way blasting his colleagues who want the Fed to continue to fiddle with long term bond markets, mortgage rates, credit spreads, credit "availability" and perceived bubbles:

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. ...

...We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

...Even though the [Fed's] 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.

What should the Fed do?

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability.

The speech is very thoughtful about independence. In a democracy, an agency can only be independent if it has limited powers. An agency that writes checks to voters, allocates credit to favored businesses and industries, cannot be politically independent.

The current deal for independence is written in part in the Federal Reserve act which sets up the current "dual mandate," but

The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

You're getting a sense of what genies Charlie would like to put back in their bottles. It's a bit remarkable for a Fed president to essentially say that Fed policy is not only unwise, but stretching the Fed's legal authority.  Yet independence is a good thing:

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. 

... in exchange for such independence, the central bank should be constrained from conducting fiscal policy... [yet] the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms.

What would Charlie do to draw some lines in the sand? One, by reinstating traditional limits on what assets the Fed can buy:

One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries.

Rules are important,

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner. It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority.  

And for more reasons than usual: if the bank is following a rule, it's much less open to political criticism and able to preserve its independence:

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals

...assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

Charlie agrees: you can't have effective forward guidance without precommitment, and you can't have precommitment and discretion. Here is the slam at how taper talk roiled bond markets

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.

In some sense, arguing about the dual mandate is the last war. The Fed is now the Gargantuan Financial Regulator, and the "mandate" includes "financial stability," and detailed discretionary direction of credit flows. Charlie:

Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort.... the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. .. by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

In fact, the bigger the fire house, the more the chance of fires:

I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

I would add, if you prop up prices in bad times, you kill the incentive for people to keep some cash around to buy in the next "fire sale."

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

"You can keep your bonds if you like them?"

The whole speech is good, I hope my excerpts get you to go to the real thing.

Miron and Rigol go after a classic

Jeff Miron and Natalia Rigol have a provocative working paper, "Bank Failures and Output During the Great Depression." They take on one of Ben Bernanke's most famous papers.

Bernanke concluded that the great depression was severe not because of a lack of money-- medium of exchange -- but because of the credit effects of so many bank failures.

You may say, "duh," but it's not so easy. If bank A fails, what stops you from going and getting a loan from bank B? Well, if your ability to get a loan is wrapped up in the knowledge that employees of bank A have about you. And if, as a result of some sort of friction, Bank B doesn't hire those people for their knowledge. And if, as a result of another friction, someone can't come buy the assets of Bank A, including people and knowledge, and continue to operate the bank. In the great depression, restrictions on branches and interstate banking did that. The process is, fortunately, much swifter now that the assets of a small local bank can be swiftly bought up by other banks even out of state.

Bernanke's paper was - and is -- enormously influential. It was part of a movement to put credit rather than money at the heart of monetary economics and understanding of Fed policy.

But, as Jeff and Natalia point out, what if the banks fell because output was going down, not the other way around? How strong was Bernanke's actual evidence?

Source: Jeff Miron and Natalia Rigol

The graph, from the paper, makes the basic point. We can argue about the "bank holiday" but you see that even the other failures came rather late in the game. It's not at all obvious that bank failures cause output declines and not the other way around.

And of course, "the economy will tank if banks go under" is the mantra that produced the bailouts. Jeff and Natalia's closing words:

To the extent U.S. experience during the Great Depression – and especially the view that bank  failures played a significant, independent role during that period – formed the intellectual foundation for  Treasury and Fed actions, however, our results suggest a hint of caution. If the Great Depression does not constitute evidence for Too-Big-to-Fail, then what historical episodes do provide that evidence? We leave  that question for another day

There are lots of important unsettled issues, justifying Jeff and Natlia's cautious tone in the paper.  How about regional evidence -- didn't  towns whose banks failed suffer more than others, and had lower loan volumes? (I vaguely remember seeing that.  I don't pretend to be an expert on empirical great depression work. If someone has the cross-sectional evidence, add a comment.)

Still, given how the "credit channel" view underlies most of Fed thinking, even though inequalities by definition don't always bind, and how deeply the "we can't let banks fail or there won't be any new lending" view underlies so much crisis policy, I salute a careful reexamination of even classic "facts."

Update:

On the cross-sectional point, Hanno Lustig found Hal Cole and Lee Ohanian's "Reexamining the contributions of money and banking shocks to the U.S. great depression" and suggests this graph as a summary. Not even in the cross section. Thanks Hanno!

Source Hal Cole and Lee Ohanian

Is QE contractionary?

I ran across a fascinating blog post by Peter Stella at Vox-Eu on exit strategies and QE. 

Peter points out that only banks can hold reserves, while anyone can hold short term Treasuries. And you can easily use Treasuries for collateral.  That means that short term Treasuries are in some sense more liquid than reserves, and that by buying huge amounts of Treasuries and issuing reserves, the Fed may be actually contracting. 


In Peter's words:

Large Scale Asset Purchases (LSAPs) have inadvertently caused a significant change in the composition of assets available in the open market.

• The stock of marketable, highly liquid, AA+ collateral fell by trillions (disappearing into the Fed’s portfolio, i.e. System Open Market Account).
• The stock of assets available only for interbank trade (bank reserve deposits at the Fed) rose by trillions.

..Treasuries and Fed deposits are equally safe. But they differ significantly in their marketability. Anyone can trade Treasury securities; only banks can exchange Fed deposits. ... 

• Banking and money creation has not worked for at least two decades in the way that most people learned in school.

The old system was rather simple in the textbooks. The basic assumptions were (i) all credit was provided by banks; (ii) all bank credit (assets) were funded by the issuance, or creation, of depository liabilities (money) subject to a reserve requirement; and (iii) central banks controlled credit/money/inflation by rationing bank reserves. A stable 'money multiplier' was hypothesised to allow central banks to accurately predict the eventual impact of changes in bank reserves on money and credit. 

The problem with the old theory of monetary operations is that none of the three assumptions has been true for at least a generation. 

Most credit in the US is created by nonbanks; virtually all bank lending is funded by the creation of liabilities that are not subject to reserve requirements,3 and central banks do not ration reserves. In fact they take great pains to provide banks with the amount of reserves they desire. Central banks influence credit not by rationing the quantity of reserves but by altering the interest rate that banks must pay to obtain the quantity of reserves they desire.

• Today, credit creation in general and money creation in particular are no longer tied to the stock of reserves (i.e. the stock of banks’ deposits at the Fed).

Today, bank deposits at the Fed have only one real role – to facilitate management of the payments system. They are used to settle transactions among banks. Thus:

• The old notion that the quantity of bank reserves constrains lending in a fiat money world is completely erroneous.
• Traditional monetary policy has virtually nothing to do with money.4

....Plainly the stock of reserves is no longer connected to credit or meaningful measures of “money” via the old-notion of a reserve-ratio-based money multiplier. 

I don't buy it all, and I think some of the magic properties of treasuries as collateral and money are a bit overstated. But I'm collecting interesting stories by which it might be the case that current monetary policy has the opposite of the intended sign or other unexpected effects.  Peter certainly offers an interesting example.

He also points out that simply raising interest paid on vast reserves may have different effects than conventional policy which rations reserves. At a minimum he corrects my frequent assertion that reserves and Treasuries are perfect substitutes. No, Treasuries might be more "liquid''!

(Thanks to Thorvald Moe for pointing me to this interesting post.)

 

The New-Keynesian Liquidity Trap

I just finished a draft of an academic article, "The New-Keynesian Liquidity Trap"  that might be of interest to blog readers, especially those of you who follow the stimulus wars. 

New-Keynesian models produce some stunning predictions of what happens in a "liquidity trap" when interest rates are stuck at zero.  They predict a deep recession. They predict that promises work: "forward guidance," and commitments to keep interest rates low for long periods, with no current action, stimulate the current level of consumption.  Fully-expected future inflation is a good thing. Growth is bad. Deliberate destruction of output, capital, and productivity raise GDP. Throw away the bulldozers, let them use shovels. Or, better, spoons. Hurricanes are good. Government spending, even if financed by current taxation, and even if completely wasted, of the digging ditches and filling them up type, can have huge output multipliers.

Even more puzzling, new-Keynesian models predict that all of this gets worse as prices become more flexible.  Thus, although price stickiness is the central friction keeping the economy from achieving its optimal output, policies that reduce price stickiness would make matters worse.

In short, every law of economics seems to change sign at the zero bound. If gravity itself changed sign and we all started floating away, it would be no less surprising.

And of course, if you read the New York Times, people like me who have any doubts about all this are morons, evil, corrupt, and paid off by some vast right-wing conspiracy to transfer wealth from the poor to the secret conspiracy of hedge fund billionaires.

So I spent some time looking at all this.

It's true, the models do make these predictions. However, there is a crucial step along the way, where they choose one particular equilibrium. There is another equilibirum choice, where all of normal economics works again: no huge recession, no huge deflation, and policies work just as they ought to.

I took a setup from Ivan Werning's really nice 2012 paper: There is a negative "natural rate" from time 0 to time T, and the interest rate is stuck at zero. After that, the natural rate becomes positive again, and everyone expects the actual interest rate to follow. I solved the standard new-Keynesian model in this circumstance -- forward-looking "IS" and Phillips curves.

This is Werning's "standard" equilibrium choice, which shows all the new-Keynesian predictions. The liquidity trap lasts until T=5, shown as the vertical line in the middle of the graph.

The thick red line is inflation. As you see, there is huge deflation during the liquidity trap, though deflation is steadily decreasing.

The dashed blue line is output (deviation from  "potential".) As you see, there is a huge output gap, though strong expected output growth as it comes back to "trend" at the end of the trap. This is why growth is bad -- in these models you always come back to trend, so if you can lower growth, that raises today's level.

The thin red dashed lines marching toward the vertical axis show what happens as you reduce price stickiness. (I only showed inflation, output does the same thing.) As you reduce price stickiness, it all gets worse -- output at any given date falls dramatically. For price stickiness epsilon away from a frictionless market, output falls to zero and inflation to negative infinity.

I verify in the paper that all the claimed policy magic works in this equilibrium.  Even a small amount of "forward guidance" can dramatically raise output, wasted-spending multipliers can be as large as you like, and those policies get more effective as price stickiness gets smaller.

However, for the same interest rate path, there are lots and lots of equilibria.

This graph shows a different equilibrium. I call it the "local-to-frictionless" equilibrium. Again, the thick  red line is inflation. Now, during the liquidity trap, there is steady, mild inflation. The inflation pretty much matches the negative natural rate, so the zero interest rate during the trap (from t=0 to t=T=5) produces a the real interest rate near the natural rate.

As the trap ends, inflation slowly declines and then takes a "glide path" to zero -- i.e. zero deviation from trend, or back to the Fed's long-run target.

In this equilibrium, there is a small increase in potential output, shown in the dashed blue output line. The new-Keynesian Phillips curve says that when inflation today is higher than inflation tomorrow, output is above potential.

As we turn down price stickiness, the thin red lines show that inflation smoothly approaches the totally frictionless case, positive inflation from 0 to T and zero inflation immediately thereafter. I didn't have room to show it, but  output smoothly approaches a flat line as well.

The paper shows that all the magical policies are absent in this equilibrium: The multiplier is always negative, announcements about the far off future do no good, and deliberately making prices sticker doesn't help.

These are not different models. These are not different policies or different expected policies. Interest rates follow exactly the same path in each case, zero from t until T=5, and following the natural rate thereafter. These are different equilibrium choices of the same model. Each choice is completely valid by the rules of new-Keynesian models. I don't here challenge any of the assumptions, any of the model ingredients, any of the rules of the game for computation. Which outcome you choose is completely arbitrary.

The difference between the calamitous equilibrium and the mild local-to-frictionless equilibirum, in this model, is just expectational mulitple equilibria (with an implicit Ricardian regime.) If people expect the inflation glide path, we get the benign equilibrium. If they expect inflation to be zero the minute the trap ends, we get the disaster.

The paper goes on to compute all the magical policies, consider Taylor rules, and every other objection I can think of. So far.

What do I make of all this? Well obviously, maybe one isn't so dumb, evil, or corrupt for having doubts about changing the sign of all economic principles when interest rates hit zero.

Let me just quote from the conclusion

At a minimum, this analysis shows that equilibrium selection, rather than just interest rate policy, is vitally important for understanding these models' predictions for a liquidity trap and the effectiveness of stimulative policies. In usual interpretations of new-Keynesian model results, authors feel that interest rate policy is central, and equilibrium-selection policy by the Fed, or equilibrium-selection criteria, are details relegated to technical footnotes (as in Werning 2012), game-theoretic foundations, or philosophical debates, which can all safely be ignored in applied research. These results deny that interpretation.

....there really are multiple equilibria and choosing one vs. another is simply an arbitrary choice. Since there is an equilibrium with no depression and deflation, and no magical policy predictions, one cannot say that the new-Keynesian model makes a definite prediction of depression and policy impact.

I have not advocated a specific alternative equilibrium selection criterion. Obviously, the local-to-frictionless equilibrium has some points to commend it: It is bounded in both directions, it produces normal policy predictions, it has a smooth limit as price stickiness is reduced, and it does not presume an enormous fiscal support for deflation. But this is not yet economic proof that it is the "right" equilibrium choice.

We might consider which equilibrium choice is more consistent with the data. The US economy 2009-2013 features steady but slow growth, a level of output stuck about 6-7% below the previous trendline and the CBO's assessment of "potential," a stagnant employment-population ratio, and steady positive 2-2.5% inflation.

The local-to-frictionless equilibrium as shown in my second Figure can produce this stagnant outcome, but only if one thinks that current output is about equal to potential, i.e. that the problem is "supply" rather than "demand," and that the CBO and other calculations of "potential" or non-inflationary output and employment are optimistic, as they were in the 1970s, and do not reflect new structural impediments to output.

The standard equilibrium choice as shown in my first Figure cannot produce stagnation. It counterfactually predicts deflation, and it counterfactually predicts strong growth. One would have imagine a steady stream of unexpected negative shocks -- that each year, the expected duration of the negative natural rate increases unexpectedly by one more year -- to rescue the model. But five tails in a row is pretty unlikely.

The problem in generating stagnation is central to the new-Keynesian model. The "IS" curve and the assumption that we return to trend means that we can only have a low level of output and consumption if we expect strong growth. The Phillips curve says that to have a large output gap, we must have inflation today much below expected inflation tomorrow and thus growing inflation (or declining deflation). Thus if we are to return to a low-inflation steady state, we must experience sharp deflation today.  If one wants a model with stagnation resulting from perpetual lack of "demand," this model isn't it. Static old-Keynesian models produce slumps, but dynamic intertemporal new-Keynesian models do not.
....
I close with a few kinds words for the new-Keynesian model. This paper is really an argument to save the core of the new-Keynesian model -- proper, forward-looking intertemporal behavior in its IS and price-setting equations -- rather than to attack it. Inaccurate predictions for data (deflation, depression, strong growth), crazy-sounding policy predictions, a paradoxical limit as price stickiness declines, and explosive off-equilibrium expectations, are not essential results of the model's core ingredients.  A model with the core ingredients can give a very conventional view of the world, if one only picks the local-to-frictionless equilibrium. That model will build neatly on a stochastic growth model, represented here in part by the forward-looking "IS" equation and changes in "potential." Its price stickiness will modify dynamics in small but sensible ways and allow a description of the effects of monetary policy. This was the initial vision for new-Keynesian models, and it remains true.

Really, the fault is not in the core of the new-Keynesian model. The fault is in its application, which failed to take seriously the fundamental problem of nominal indeterminacy.... Interest rate targets, even those that vary with output and inflation, or money supply control with interest-elastic demand, simply do not determine the price level or inflation.  In a model with price stickiness, nominal indeterminacy spills over in to real indeterminacy.

In that context, this paper shows there is an equilibrium choice that leads to sensible results. Alas, those sensible results are non-intoxicating. In that equilibrium, our present (2013) economic troubles cannot be chalked up to one big simple story, a "negative natural rate" (whatever that means) facing a lower bound on short term nominal rates; and our economic troubles cannot be solved by promises, or a sign reversal of all the dismal parts of our dismal science. Technical regress, wasted government spending, and deliberate capital destruction do not work. Growth is good, not bad. That outcome is bad news for those who found magical policies an intoxicating possibility, but good news for a realistic and sober macroeconomics.
    

If all this just whets your appetite, I hope you will read the paper. Similarly, if you're brimming with objections, take a look at my attempts to anticipate most objections -- what about the Taylor rule, etc. -- in the paper.

(This follows an earlier paper in the JPE (online appendix) looking deeply at multiple equilibria in new-Keynesian models. In that paper, I questioned whether ruling out multiple explosive equilibria made sense. In this paper, I accept that part of the rules of the game, and think about the mulitple non-explosive equilibria.)

A Chicago economist runs a central bank

Raghu Rajan celebrated his first day on the job running India's central bank. Coverage from Financial Times and Wall Street Journal.

Did he.. Find the coffee machine? Test the sofas in his office? Dust off his desk? Tour the printing press? Or...

Raghuram Rajan unveiled moves to liberalise banking and spread services across the nation of 1.3bn people... 

“There are so many low-hanging fruit in the economy that if we only pluck them we can accelerate growth substantially"...

The measures announced by Mr Rajan...are aimed at freeing India’s banks from the web of state controls that have stifled the sector since independence in 1947. ...

Indian banks will no longer have to receive RBI permission for each branch they want to open, though they will still be obliged to open branches in underserved rural areas in proportion to their expansion in the cities, Mr Rajan said....

He also suggested an easing of “priority sector lending requirements” that oblige banks to lend to farmers and small businesses, and said there was a need to reduce the requirement for banks to invest in government bonds so as to free credit for productive parts of the economy.

To say nothing of the wisdom of  forcing banks to buy shady sovereign debt, which turns sovereign troubles into banking crises, but he can't say that...

...foreign banks would be encouraged to operate in India as wholly owned subsidiaries that would enjoy “near national” treatment on a reciprocal basis.

“The Indian public would benefit from more competition between banks, and banks would benefit from more freedom in decision-making,” he said.

Competition a good thing in the financial sector? Heresy!

Other planned measures included the easing of restrictions on overseas borrowing by banks and on position-taking in financial markets, the introduction of new interest rate futures contracts, and the establishment of new mobile payments systems and “mini-ATMs” run by non-bank financial companies.

Indians who have traditionally turned to gold imports as a hedge against inflation will from the end of November be able to buy government savings certificates linked to a consumer price index, Mr Rajan said.

What will he do on his second day on the job? FT says he "will make his first substantial statement on monetary policy in two weeks." I'm looking forward to it.

Fed Chair

My pick for Fed chair below. I don't have much to say on the choice between Janet Yellen and Larry Summers. Both are worthy economists, with well-discussed pluses and minuses on which I have no particular insight.

So, this post is about who else one might want to look at, and much more importantly the broader question about what makes a good Fed chair.

The press mostly  wants a soothsayer, who will foresee events the market does not see and calm the waters -- in practice,  basically operating the worlds largest contrarian hedge fund, or the commissariat of macroeconomic central planning. Such people don't exist, so that's a self-defeating job description. Let's talk about reality.

The Fed chair will not just have to pick the right course, but will also have to wade through the cacophony of advice and pressure he or she will receive, from politicians, powerful banks and businesses, outside critics – people like me – and the crosswinds of contradictory advice from Fed board members, staff and regions. And then guide a headstrong committee and a ponderous bureaucracy to those ends.

To do that, a chair needs a clear intellectual framework and a core set of principles.

He or she must deeply understand modern macroeconomics, finance, and banking. Too many policy-oriented people are mired in simpleminded 1970-era Keynesian story-telling that they learned as undergraduates, and a similarly simplistic understanding of finance. Too many academic economists are too deep into modern work, take equations at face value and do not know how to distill and apply their essential lessons, and what lessons are robust from the inevitable simplifcations of all formal models. Too many bankers have little understanding at all of cause and effect. Long practical experience in a system produces little experience of how to guide that system.

The FOMC (Federal Open Market Committee) of bank presidents and governors is now as high-powered a group as you could imagine. The academics have taken over. They know their stuff, and so does their staff. When the staff brings in or a governor cites “unique locally bounded equilibria” of the latest "new-Keynesian DSGE model," or distills the tea leaves of interest rates in “three factor affine models,” a chair must find the nuggets of gold, the grains of salt, and the remains of horses. All three are present.

There is a tendency in many quarters, reflected well in the New York Times opinion pages, to dismiss modern macro as hogwash. (Except, of course, when particular equilibria of particular new-Keynesian models produce pleasing multipliers.) Dismissing all modern thinking is as dangerous as accepting it all uncritically. If for no other reason, this is the language the FOMC and its staff speak, so a chair who doesn't understand it will simply be bamboozled.

We are at a crossroads in monetary policy,  with deeply different intellectual frameworks bounding the discussion, from monetarists, old-fashioned IS-LM Keynesians, Minnesota/Chicago dynamic equilibrium, new-Keynesian DSGE all talking past each other in essentially different languages. And I haven't started on financial views, even more disparate. The chair must be literate! And this stuff is hard. Well, I think it's hard. It's going to be hard to find someone who has not been actively contributing to this thinking who really understands what's going on.

An ideal chair has the universal admiration and respect of all in the room -- they may disagree, but everyone knows the chair deeply understands all the modeling points of view. An ideal chair also has the rare talent to explain and apply modern macroeconomics, not just push the equations around correctly.

More deeply, the fundamentals of modern macro -- thinking intertemporally, thinking about expectations, rules, institutions, moral hazards, precommitment vs. discretion, not in static terms of this year's stimulus and this year's GDP, really are important guides to a successful central bank.

That intellectual framework should be broad as well as deep. Some people have one great idea and to Washington to  implement their pet idea. Such people do not often do well when asked to guide a large institution through, inevitably, uncharted waters. Great military theorists do not make great battlefield generals.

A great Fed chair also understands history, and the legal and institutional structure of the Federal Reserve and previous central banks. Too many academics, (I include myself, though I'm trying to repair the damage)  are steeped in theory and quantitative evidence, but pretty light on the simple facts of what happened in past crises.

Nobody can know everything, however, so the Fed chair needs a few core principles. Paul Volcker had them, when the cacophony of experts said we couldn’t stop inflation. Ronald Reagan had them, when he said “tear down this wall” over the cacophony of experts. And those principles need to be right.

So, a great Fed chair is not so much smart as wise. There is a big difference. Humility is a bedrock of wisdom. The chair needs clearly to understand the limits of our knowledge, how imperfectly we understand cause and effect of the Fed’s policy tools.  A wise chair remembers how much consensus views on those matters have changed in the past, and knows how much they will change in the future.  If the Chair does a good job, ideas will change in response to the slow accumulation of experience and not in the wake of some new disaster borne of overconfidence in wrong ideas.

Above all, a successful chair will avoid screwing up! The Fed is a defensive institution. Like oil in the car, you don't notice it when it's doing its job well, and it mainly is in the news when it fails. It is not an institution that succeeds by leading great charges to direct the economy.

The big past screwups came when old ideas met new events, as they did in the banking crises of the great depression and the unleashing of the great inflation of the 1970s, just as on the 1914 western front and Maginot line.

An ideal chair has thought a lot about issues which are likely to be the next great crisis. Ben Bernanke was one of the great scholars of the bank runs of the Great Depression, and in part as a result the Fed did not repeat many of the mistakes of that event.

But we never fight the last war, at least right away. The chance of us having another real estate boom, a huge increase in shadow banking, a run in short term debt linked to mortgages in the next 10 years is next to zero.  So what are the challenges going forward, and what special expertise would one want in a Fed chair?

It seems obvious to me that sovereign debt, sovereign promises, an emerging period of sclerotic growth (rather than "lack of demand" recession) and how monetary policy is fundamentally affected by this set of circumstances is going to be a big issue for the Fed going forward. A chair who relies only on rules of thumb or correlations that held in a time of high trend growth and small sovereign debts is going to be taken by surprise.

An ideal Fed chair has spent a lot of time thinking about, and surveying the wide historical and cross-country experience on, the link between monetary policy, sovereign finances, and large-scale economic fluctuations. When California and Illinois default, Spain can't roll its debts, Germany refuses to recapitalize the ECB, and US long rates spike, a chair armed only with shifting around IS and LM curves and bailing out creditors will fall flat.

It also seems obvious to me that financial regulation, the temptations to financial micromanagement, and the forces of capture by the financial industry, are going to fill the Fed's plate as much or more than the mundane question of whether to raise or lower short term interest rates by a few basis points.

Financial regulation is even more about moral hazard, rules, institutions and perceptions than regular monetary policy. Chair William McChesney Martin, referring to rising interest rates, once sad the job of the Federal Reserve was to take away the punch bowl just as the party gets going. Now that the Fed is managing "financial stability,"  the chair’s job is to more to stop putting out fires soon enough that the underbrush burns out, people don’t build their houses too close to trees, and keep their own fire extinguishers loaded. At some point, you  let Bear Stearns go to send a message to Lehman Brothers.  A Fed chair that spends a lot of his time clarifying what the Fed's role will be in the next crisis rather than one who just ammasses larger and larger discretionary power, will weather that crisis much better.

Resisting capture will be a full time job. When billions of dollars are on the line for powerful Wall Street firms, the chair needs to be someone who can say no -- and who everyone knows will say no. From before the Fed’s inception, people have wanted to manipulate monetary policy and financial regulation to their ends.  They will steer subsidies and protection their way, they will use regulation to block competition, and they will steer credit their way.

We didn't have a central bank for a century, mostly because of this fear. The argument over having a central bank at all focused on the concentration of financial power and its marriage to political power, not inflation and unemployment. Now that the Fed is squarely running the financial system, and not just setting interest rates, we will start that discussion again.

Ideally it would not matter at all who the Fed chair is. Our government works well when the institutions work, not when we await the right benevolent aristocrat to run things with great power and no accountability. So a wise central banker is not one in the news every day, spouting a frenzy of new ideas. The wise central banker works within and buttresses well codified rules of behavior, thinks hard about what those rules should be, and slowly moves them over time.

Oh, and politics matter. Pick a Democrat.

So who fills that bill? I've pretty much described Tom Sargent. If you want a taste, go to his website. His latest paper "Fiscal discrimination in three wars" with George Hall is just what I would want a Fed Chair to be thinking about with state and local defaults looming. His Nobel Prize speech "US Then, Europe now" is one of the wisest set of thoughts on the Euro crisis I've seen. Some of my favorite classics: "The macroeconomics of the French Revolution" with Francois Velde. There you see how Tom can put modern macro into action, to understand real-world events. Of course his studies of the fiscal roots of hyperinflations are fundamental. He knows macroeconomic theory of all stripes inside and out. He knows the history and institutions inside and out.  He is one guy who could command hushed awe in the FOMC.

There are a few other candidates who fit the bill similarly. I don't want to get too deep in to personalities, it's the job posting that counts. You could make a similar case for, among others Ken Rogoff, David Romer, John Taylor, Mike Woodford, Greg Mankiw, and many others. (Just examples; I don't mean to insult anyone by omission). The interesting observation is that none of these are on the agenda reported in the papers.

There is perhaps two good reasons why such candidates are not on the table. First,  the Fed chair runs a large organization. The talents of corralling a bureaucracy, herding the opinionated cats on the board of governors, keeping the staff in line, working within the legal and institutional structure of the Fed, keeping one’s mouth shut so as not to roil markets and cause scandals, (or perhaps talking so much that markets stop paying attention? That's what would happen if I were Fed chair!) while furthering the Fed’s admirable quest of transparency are crucial.

Second, the chair has to make hard decisions in real time. This is incredibly hard.

Most academics don't have these skills. I don't know if Tom does. Perhaps some trial of running a large organization is a needed requirement.

And of course, the chair needs to persuade one person he or she will be good at the job, the president. Ben Bernanke served on George Bush's council of economic advisers, and undoubtedly impressed Bush. Tom impresses me, but I'm not in charge.

You may object that I'm thinking too narrowly. I'm a university academic, so I'm pushing other university academics. But in this case, I think that's warranted. The academics really have thought long and hard about central banking, and they have taken over from the bankers. The FOMC is a great debating club of monetary and financial policy. An industry economist or banker will get eaten alive.

By the way, I think when the dust has settled, history will be kind to Ben Bernanke. He fits most of my job description. Inflation is stuck at 2%, the world did not melt down, and we’re all gradually coming to the realization that if $2 trillion bucks of stimulus and zero interest rates didn’t bring our economy out of the doldrums, there really is nothing more that a central bank could do. The Phillips curve has been screaming "this is supply, not demand" for a few years now. Like any great general, we can argue with specific decisions, and much of the direction of Fed policy, and I have. But we have not lost the war.

Yet. The next chair could easily make Mr. Bernanke’s term look even better.

Macro-prudential policy

Source: Wall Street Journal

Not a fan. A Wall Street Journal Op-Ed. Link to WSJ. Link to pdf on my website. Director's cut follows:

Interest rates make the headlines, but the Federal Reserve's most important role is going to be the gargantuan systemic financial regulator. The really big question is whether and how the Fed will pursue a "macroprudential" policy. This is the emerging notion that central banks should intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability.

For example, the Fed is urged to spot developing "bubbles," "speculative excesses" and "overheated" markets, and then stop them—as Fed Governor Sarah Bloom Raskin explained in a speech last month, by "restraining financial institutions from excessively extending credit." How? "Some of the significant regulatory tools for addressing asset bubbles—both those in widespread use and those on the frontier of regulatory thought—are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting."

This is not traditional regulation—stable, predictable rules that financial institutions live by to reduce the chance and severity of financial crises. It is active, discretionary micromanagement of the whole financial system. A firm's managers may follow all the rules but still be told how to conduct their business, whenever the Fed thinks the firm's customers are contributing to booms or busts the Fed disapproves of.

Macroprudential policy explicitly mixes the Fed's macroeconomic and financial stability roles. Interest-rate policy will be used to manipulate a broad array of asset prices, and financial regulation will be used to stimulate or cool the economy.

Foreign central banks are at it already, and a growing consensus among international policy types has left the Fed's relatively muted discussions behind. The sweeping agenda laid out in "Macroprudential Policy: An Organizing Framework," a March 2011 International Monetary Fund paper, is a case in point.

"The monitoring of systemic risks by macroprudential policy should be comprehensive," the IMF paper explains. "It should cover all potential sources of such risk no matter where they reside." Chillingly, policy "should be able to encompass all important providers of credit, liquidity, and maturity transformation regardless of their legal form, as well as individual systemically important institutions and financial market infrastructures."

What could possibly go wrong?

It's easy enough to point out that central banks don't have a great track record of diagnosing what they later considered "bubbles" and "systemic" risks. The Fed didn't act on the tech bubble of the 1990s or the real-estate bubble of the last decade. European bank regulators didn't notice that sovereign debts might pose a problem. Also, during the housing boom, regulators pressured banks to lend in depressed areas and to less creditworthy customers. That didn't pan out so well.

More deeply, the hard-won lessons of monetary policy apply with even greater force to the "macroprudential" project.

First lesson: Humility. Fine-tuning a poorly understood system goes quickly awry. The science of "bubble" management is, so far, imaginary.

Consider the idea that low interest rates spark asset-price "bubbles." Standard economics denies this connection; the level of interest rates and risk premiums are separate phenomena. Historically, risk premiums have been high in recessions, when interest rates have been low.

One needs to imagine a litany of "frictions," induced by institutional imperfections or current regulations, to connect the two. Fed Governor Jeremy Stein gave a thoughtful speech in February about how such frictions might work, but admitting our lack of real knowledge deeper than academic cocktail-party speculation.

Based on this much understanding, is the Fed ready to manage bubbles by varying interest rates? Mr. Stein thinks so, arguing that "in an environment of significant uncertainty . . . standards of evidence should be calibrated accordingly," i.e., down. The Fed, he says, "should not wait for "decisive proof of market overheating." He wants "greater overlap in the goals of monetary policy and regulation." The history of fine-tuning disagrees. And once the Fed understands market imperfections, perhaps it should work to remove them, not exploit them for price manipulation.

Second lesson: Follow rules. Monetary policy works a lot better when it is transparent, predictable and keeps to well-established traditions and limitations, than if the Fed shoots from the hip following the passions of the day. The economy does not react mechanically to policy but feeds on expectations and moral hazards. The Fed sneezed that bond buying might not last forever and markets swooned. As it comes to examine every market and targets every single asset price, the Fed can induce wild instability as markets guess the next anti-bubble decree.

Third lesson: Limited power is the price of political independence. Once the Fed manipulates prices and credit flows throughout the financial system, it will be whipsawed by interest groups and their representatives.

How will home builders react if the Fed decides their investments are bubbly and restricts their credit? How will bankers who followed all the rules feel when the Fed decrees their actions a "systemic" threat? How will financial entrepreneurs in the shadow banking system, peer-to-peer lending innovators, etc., feel when the Fed quashes their efforts to compete with banks?

Will not all of these people call their lobbyists, congressmen and administration contacts, and demand change? Will not people who profit from Fed interventions do the same? Willy-nilly financial dirigisme will inevitably lead to politicization, cronyism, a sclerotic, uncompetitive financial system and political oversight. Meanwhile, increasing moral hazard and a greater conflagration are sure to follow when the Fed misdiagnoses the next crisis.

The U.S. experienced a financial crisis just a few years ago. Doesn't the country need the Fed to stop another one? Yes, but not this way. Instead, we need a robust financial system that can tolerate "bubbles" without causing "systemic" crises. Sharply limiting run-prone, short-term debt is a much easier project than defining, diagnosing and stopping "bubbles." [For more, see this previous post] That project is a hopeless quest, dripping with the unanticipated consequences of all grandiose planning schemes.

In the current debate over who will be the next Fed chair, we should not look for a soothsayer who will clairvoyantly spot trouble brewing, and then direct the tiniest details of financial flows. Rather, we need a human who can foresee the future no better than you and I, who will build a robust financial system as a regulator with predictable and limited powers.

*****
Bonus extras. A few of many delicious paragraphs cut for space.

Do not count on the Fed to voluntarily limit its bubble-popping, crisis management, or regulator discretion. Vast new powers come at an institutionally convenient moment. It’s increasingly obvious how powerless conventional monetary policy is. Four and a half percent of the population stopped working between 2008 and 2010, and the ratio has not budged since. GDP fell seven and a half percent below “potential,” in 2009 and is still six points below. Two trillion didn’t dent the thing, and surely another two wouldn’t make a difference either. How delicious, in the name of “systemic stability,” to just step in and tell the darn banks what to do, and be important again!

Ben Bernanke on macroprudential policy:

For example, a traditional microprudential examination might find that an individual financial institution is relying heavily on short-term wholesale funding, which may or may not induce a supervisory response. The implications of that finding for the stability of the broader system, however, cannot be determined without knowing what is happening outside that particular firm. Are other, similar financial firms also highly reliant on short-term funding? If so, are the sources of short-term funding heavily concentrated? Is the market for short-term funding likely to be stable in a period of high uncertainty, or is it vulnerable to runs? If short-term funding were suddenly to become unavailable, how would the borrowing firms react--for example, would they be forced into a fire sale of assets, which itself could be destabilizing, or would they cease to provide funding or critical services for other financial actors? Finally, what implications would these developments have for the broader economy? ...

As if in our lifetimes anyone will have precise answers to questions like these. In case you didn't get the warning,

... And the remedies that might emerge from such an analysis could well be more far-reaching and more structural in nature than simply requiring a few firms to modify their funding patterns.

A big thank you to my editor at WSJ, Howard Dickman, who did more than the usual pruning of prose and asking tough questions.

Taylor Jackson Hole Blog

John Taylor is blogging from Jackson Hole

Day 1: Skepticism of unconventional policy  Academics say quantitative easing does't do much. I happen to agree

Forward guidance Is "forward guidance" clarification of a rule, i.e. here is what we think we'll feel like doing in the future, or a precommitment? To the Bank of England and ECB, the former.

This looks like an interesting series to watch.

Rajan to run the central bank of India

My colleague Raghu Rajan has just been appointed governor of the central bank of India. See Financial Times and Reuters. Congratulations Raghu!

Let me add two little notes to the songs of praise for this decision.

Traditionally, academic central bank governors come from the world of monetary policy, people who think about interest rates and inflation and all that. Raghu comes from the academic world that studies finance and banking. Look at his vita and you'll see great article after great article thinking about how banks work.

Just in time. Central banks are now all scrambling to understand banking and financial markets, regulating the financial system, avoiding crises, and so on. This is their central new task. (Or you might say, a return to their age-old task after a short interlude.) You can't ask for a person on the planet who has thought more clearly and productively about these issues.

His popular book “Saving capitalism from the capitalists” with Luigi Zingales is also revealing. Yes, he sees how over regulation and corruption are at the heart of India’s problems (and many of our own). But he also sees the strong political forces that keep the dysfunctional system in place. If anyone can understand and resist the political pressures that central bank governors face, it will be Raghu. And he won’t be tempted to think that any monetary magic or financial dirigisme from a central bank can fix all of India's problems.

He is also about the most polite person I know, while never shying away from standing for what's right. That means he will be far more effective than typical bull-in-a-china-shop academics like myself would ever be in steering a ponderous bureacracy.

Good luck, Raghu. I think you'll need it.

Reuters already expreses the view that it's too bad he's out of the running for the US Fed job.

Job market doldrums

Three recent views on the dismal labor market pose an interesting contrast.

Alan Blinder wrote a provocative WSJ piece on 6/11, Fiscal Fixes for the Jobless Recovery. A week prviously, 6/5, Ed Lazear wrote about The Hidden Jobless Disaster. And John Taylor has a good short blog post Job Growth–Barely Keeping Pace with Population

All three authors emphasize that the unemployment rate is a poor measure of the labor market. Unemployment counts people who don't have a job but are actively looking for one. People who give up and leave the labor force don't count. Employment is a more interesting number, and the employment-population ratio a better summary statistic than the unemployment rate. After all, if unemployment falls because everyone who is looking for a job gives up, I don't think we'd see that as a good sign.

Source: Wall Street Journal

Ed Lazear made this interesting chart. As he explains,

Every time the unemployment rate changes, analysts and reporters try to determine whether unemployment changed because more people were actually working or because people simply dropped out of the labor market entirely... The employment rate—that is, the employment-to-population ratio—eliminates this issue by going straight to the bottom line, measuring the proportion of potential workers who are actually working.

While the unemployment rate has fallen over the past 3½ years, the employment-to-population ratio has stayed almost constant at about 58.5%, well below the prerecession peak. Jobs are always being created and destroyed, and the net number of jobs over the last 3½ years has increased. But so too has the size of the working-age population. Job growth has been just slightly better than what it takes to keep the employed proportion of the working-age population constant. That's why jobs still seem so scarce.

The U.S. is not getting back many of the jobs that were lost during the recession. At the present slow pace of job growth, it will require more than a decade to get back to full employment defined by prerecession standards....

Why have so many workers dropped out of the labor force and stopped actively seeking work? Partly this is due to sluggish economic growth. But research by the University of Chicago's Casey Mulligan has suggested that because government benefits are lost when income rises, some people forgo poor jobs in lieu of government benefits—unemployment insurance, food stamps and disability benefits among the most obvious. The disability rolls have grown by 13% and the number receiving food stamps by 39% since 2009.
....

John Taylor makes the point nicely with another graph, which contrasts the labor force participation rate to the BLS' forecast of what should have happened from demographic effects.

The graph comes from a recent paper Chris Erceg and Andrew Levin.

I part company a bit with Lazear on his conclusions

... the various programs of quantitative easing (and other fiscal and monetary policies) have not been particularly effective at stimulating job growth. Consequently, the Fed may want to reconsider its decision to maintain a loose-money policy until the unemployment rate dips to 6.5%.

If low employment is "structural," resulting from the worker-side disincentives as well as employer-side disincentives -- policy uncertainty, regulatory threats, NLRB, Obamacare, Dodd-Frank, EPA, and so on -- then the problem isn't lack of "demand" in the first place. If the problem has nothing to do with the Fed, and if $2 trillion of QE didn't do anything to help it, why does the solution have anything to do with the Fed?

The greater surprise is to hear so much agreement from Alan Blinder:

The Brookings Institution's Hamilton Project, with which I am associated, estimates each month what it calls the "jobs gap," defined as the number of jobs needed to return employment to its prerecession levels and also absorb new entrants to the labor force. The project's latest jobs-gap estimate is 9.9 million jobs. At a rate of 194,000 a month, it would take almost eight more years to eliminate that gap.

.... policy makers should be running around like their hair is on fire.

Lazear said "a decade."  More suprising agreement on the impotence of monetary policy:

The Federal Reserve has worked overtime to spur job creation, and there is not much more it can do.

As you might imagine, I'm not such a fan of Blinder's suggested fixes. He starts with traditional simple Keynesian recommendations that  the government should hire people and "spend" more. No need to refight that here. The more interesting recommendations follow as he warms up to his latest clever scheme.

... the basic idea is straightforward: Offer tax breaks to firms that boost their payrolls.

For example, companies might be offered a tax credit equal to 10% of the increase in their wage bills over the previous year. ...

Another sort of business tax cut may hold more political promise....Suppose Congress enacted a partial tax holiday that allowed companies to repatriate profits held abroad at some bargain-basement tax rate like 10%. The catch: The maximum amount each company could bring home at that low tax rate would equal the increase in its wage payments as measured by Social Security records.

For example, if XYZ Corporation paid wages covered by Social Security of $1 billion in 2012 and $1.1 billion in 2013, it would be allowed to repatriate $100 million at the superlow tax rate. The reward for boosting its payroll by $100 million would thus be a $25 million tax saving. That looks like a powerful incentive.

...companies could claim the tax benefit only for individual earnings below the Social Security maximum ($113,700 in 2013). No subsidies for raising executive pay.

I find this most interesting at the level of basic philosophy; how we think about economic policy.

There are huge, longstanding, tax and regulatory disincentives to hiring people. Income tax, payroll taxes, health care and other mandates, and NLRB, OSHA, and so on. There are the high marginal taxes to labor implied by social insurance programs, as Mulligan points out.  If we want to increase the incentive for companies to hire people and people to take the jobs, why add another tax break to an obscenely complex tax code, rather than fix some of the existing disincentives? 

Is this really the right way to run a country? When "policy makers" want more employment, they slap on a complex, tax break on top of a mountain of disncentives. Presumably they then will remove this tax break, and pages 536,721 to 621,843 of the tax code describing it, despite the lobbying by large corporations who have figured out how to exploit it for billions of dollars, once the Brookings Institution decides that there is "enough" employment (!), and "policy-makers" no longer need to encourage it? 

How are the existing hundreds of bits of social engineering in the tax code working out? Do we really need more of this?  Isn't it time to return to a tax code that raises money for the government at minimal distortion?

The contrast between the benevolent "policy-maker" (no dictator ever had such power) and the reality of how the tax code in this country is actually enacted is pretty striking.

I have to say, I'm a bit disappointed in the end by both. They agree that the US economy is about 10 million jobs short. Something big is in the way. Lazear at least mentions some candidates, though many are long-standing. But the stirring conclusion from Lazear is only to continue a loose monetary policy that he says has been ineffective so far, and the conclusion from Blinder is the sort of clever scheme that economists cook up in late-night cocktail parties piling one more quickly-exploitable bit of social engineering on top of a tax code rife with them. Neither recommendation comes close to 10 million jobs, or addressing any sort of clear story why those jobs have vanished.

Bipartisan Mercantilism

From the press release here and here

Wednesday, June 5, 2013 WASHINGTON, D.C. — Following new figures that show a 34 percent jump over last month’s [my emphasis] U.S.-China trade deficit, U.S. Sens. Sherrod Brown (D-OH), Jeff Sessions (R-AL), Chuck Schumer (D-NY), Lindsey Graham (R-SC), Debbie Stabenow (D-MI), Richard Burr (R-NC), Susan Collins (R-ME), and Robert Casey (D-PA), today introduced the Currency Exchange Rate Oversight Reform Act of 2013... 

 ...the bill would use U.S. trade law to counter the economic harm to U.S. manufacturers caused by currency manipulation, and provide consequences for countries that fail to adopt appropriate policies to eliminate currency misalignment. The senators’ introduction comes in advance of upcoming talks between President Obama and Chinese President Xi.

Obviously, this is a political shot across the bow to the Obama Administration to press mercantilist trade restrictions in the upcoming discussions with China. Still, why cloak it in such nonsense as

“It is universally accepted that China and other major countries intentionally manipulate their currency to create an advantage for themselves in the marketplace” [Senator] Graham said.

Well, not "universally."

The "complete summary" continues,

"the bill specifies the applicable investigation initiation standard, which will require Commerce to investigate whether currency undervaluation by a government provides a countervailable subsidy if a U.S. industry requests investigation... 

I'm glad to see that industries which don't like to compete with Chinese manufacturers will become experts in monetary policy.

The legislation requires Treasury to develop a biannual report to Congress that identifies... "fundamentally misaligned currencies" based on observed objective criteria...

I cannot find what those "objective criteria are." Let us know, guys and gals, a Nobel Prize in economics awaits you.

If they don't like the Chinese peg, maybe next they can target Texas for its 1-1 peg to the Ohio dollar, which is obviously sucking business to Texas.

When they're done with "currency manipulation" perhaps they can get to the serious business of impeaching the Easter Bunny.


(Thanks to Alex Walsh at the Birmingham News for pointing me to the link.)

Monetary Policy Puzzle

Might raising interest rates, but not paying interest on reserves, actually be "stimulative," inducing banks to lend out reserves?

Last week, I gave a talk on monetary policy at a forum organized by the Becker-Friedman institute.  I explained my view, that as long as reserves pay the same interest rate as very short-term Treasuries, and as long as banks are holding huge amounts of excess reserves, that monetary policy and pure quantitative easing -- buy short-term treasuries, give the banks more reserves -- has absolutely no effect on anything. Interest-paying excess reserves are exactly the same thing as short-term treasuries.

When the time comes to tighten, I said, I hope dearly that the Fed continues to pay a market interest rate on reserves and allow huge amounts of excess reserves to continue. (I had lots of financial-stability reasons, which will wait for another day here.)   But that means that conventional open market operations and quantitative easing -- more reserves, less Treasuries -- will continue to have no effect whatsoever.

An audience member asked a very sharp question: Suppose the Fed raises interest rates but does not raise the rate on reserves? Now, banks do have an incentive to lend them out instead of sitting on them. Wouldn't velocity pick up, MV=PY start to work again, and the Fed get all the "stimulus" it wants and then some?

It's a particularly sharp question, because it gives sensible-sounding mechanism why the conventional sign might be wrong: why raising rates now might give monetary "stimulus" that is otherwise so conspicuously lacking. There are a few other of these stories wandering around. One: Low rates are said to discourage retirees and other savers, who now "can't afford to spend."  (Quotes around things that don't make much economic sense.)   John Taylor, wrote a very provocative WSJ oped, (too subtle to summarize in one sentence here) and also came close to saying the sign is wrong and higher rates would be more stimulative.

But is the suggestion right? I sort of stammered, and needed the weekend to think it through. (Giving talks like this is a great way to clarify one's ideas. Or maybe this just reveals my shocking ignorance. In any case, it makes a good exam question.) Think about it, and then click the "read more."

The answer is no, I think, but revealing about what the Fed can and cannot do.

How exactly would the Fed raise interest rates?

In the new interest-on-reserves regime (the one I hope will continue) the Fed simply announces, "we borrow and lend reserves at 3%." Interest rates go up to 3%. But so do interest rates on reserves.

The standard mechanism, which allows reserves not to pay interest,  would be for the open-market desk to sell securities in exchange for reserves, in order to drive down the supply of reserves until interest rates rise on the inter-bank (federal funds) market. Banks who need reserves then are willing to pay interest to borrow non-interest-paying reserves overnight to satisfy reserve requirements on their checking accounts.

You see the trouble. Rather than "get banks to lend out the reserves,"  the Fed has to soak up all those reserves in order to raise interest rates in the first place.

Like other central banks, the Fed could offer prices rather than control quantities. Other central banks set rates in the interbank market, by simply saying "we borrow and lend at 3%. Come and get it." (They may leave a window, borrow at 2.9%, lend at 3%, to keep a private market going.)

If the Fed were to do this, banks would simply take all the reserves --  money lent to the Fed overnight -- and... lend it to the Fed overnight at the higher interest rate. This is interest on reserves by another name, no more no less. To the extent that the Fed ties up the money -- borrows at term, or otherwise makes its offer more "bond" like -- this action just synthesizes the huge open market operation that drains reserves from the system. (It's not a bad idea, though, if the Fed wants to shrink reserves without selling assets!) Again, the desired incentive to get banks to "lend out" the reserves vanishes.

What if the Fed offers a price target for Treasuries, and also refuses to pay interest on reserves? Could the Fed offer to buy and sell 3 month Treasuries at 3%, but insist on no interest on reserves and no open market operations to soak up reserves? No, because offering to buy and sell Treasuries means offer to take reserves and give out treasuries, which ipso facto soaks up the reserves again.

The Treasury could (and arguably should) take over interest-rate policy. After all, in the interest-on-reserves regime, when the Fed says "3%, come and get it," short-term Treasury rates will also jump to 3%. (Banks dump Treasuries and give the proceeds to the Fed, driving up Treasury rates.)  It is exactly as if the Treasury said, "Rather than auction 3 month debt, we'll set the rate at 3%, and the market sets the quantity." If you think the quantity reaction might be large, you've figured out some usually unspoken limits on the Fed's interest-rate setting abilities.

But reserves are our numeraire. Pegging interest rates at 3% means the Treasury rather than the Fed takes in reserves in exchange for debt, and parks it in the Treasury account rather than bank's accounts at the Fed. The banks will  again drain reserves rather than "lend them out."

The Treasury could commit to immediately spend the money... But now we're in the land of fiscal, not monetary stimulus, and a reminder that the two always come together.

I'll be interested to hear comments on this one.  The standard stories by which interest rate increases are contractionary are very weak and full of holes. The idea that perhaps raising interest rates is "stimulative" is fun to think about. And a number of schemes around to get banks to "lend out the reserves" are also fun to think about. I don't think this one works, but maybe one of you can get it to work.

Forward Guidance vs. Commitment

He: "Honey, I'm getting tickets for Sunday's football game. Do you want to come?"

Forward guidance.  She: "As things look now, I think I'll feel like coming when Sunday rolls around. Of course that might change. If my mother calls and wants to go shopping I might well feel differently."

Commitment. She: "Sure, honey, that sounds like fun. Get the tickets. I know my mom might call, and I'll regret it later, but we have to get the tickets now, so count me in."

 Commitment means declaring a plan, even a contingent plan, that you will follow, even if you will regret it later. Forward guidance means announcing now what you think you will feel like doing in the future, but not giving up any discretion to change your mind later. Obviously, to someone who has to plunk down money for tickets, commitment is useful.

These issues came up in the last year's fascinating discussions about monetary policy, and brought to the forefront again by Fed Chairman  Ben Bernanke's testimony on May 22, the subsequent question and answers, the FOMC meeting, and market gyrations and controversy surrounding these events.

The words that roiled the markets were, most briefly, "in considering whether a recalibration of the pace of its purchases is warranted, the Committee will continue to assess the degree of progress made toward its objectives in light of incoming information."  Recalibration? Says the  market.

Perceptions matter as much or more than actual statements here (this is the "managing expectations" game). The Wall street journal wrote

Wednesday's flurry of new information jostled markets, which moved up when Mr. Bernanke's congressional testimony was released in the morning, then pared triple-digit gains when he began taking questions and turned negative when the minutes were released in the afternoon....Taken together, the chairman's testimony before the Joint Economic Committee and the minutes suggested that Fed officials aren't yet near consensus on when to begin to wind down the bond buying but that a decision appears to be approaching in the months ahead. ...

"Rather we would be looking beyond that to seeing how the economy evolves and we could either raise or lower our pace of purchases going forward. Again that is dependent on the data," he [Mr. Bernanke] said.

The minutes of the most recent policy meeting said "a number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth."

But, the minutes added, "many [officials] indicated that continued progress, more confidence in the outlook, or diminished downside risks would be required before slowing the pace of purchases would become appropriate." 

The Economist wrote (my emphasis)  

One of the main points Mr Bernanke tried to make was that if QE slows, it will "not be an automatic mechanistic process." For example, if it drops from $85 billion to $65 billion, it need not drop to $45 billion at the next meeting. It could stay at $65 billion or if the data worsen, go back to $85 billion. This isn’t that surprising; the Fed always reserves the freedom to respond to the data and hates feeling boxed in by market expectations.

This all scores somewhere between total discretion (we'll do whatever we think is right given the data at the time) to a degree of forward guidance (here is an outline of what we think now we'll feel like doing, but of course we might change our minds.)

Why does this matter? It's an interesting denoument to a big discussion in academia, the Fed, and the broader evolution of central banking doctrine (I hate to say "theory" as it's all pretty loosey-goosey).

The idea was that the Fed can stimulate the economy by committing now to keep policy expansionary for longer than it will want to do ex-post.  I last wrote about this in "managing a liquidity trap." For the previous year, highlighted by a stellar speech by Mike Woodford at Jackson hole (see previous post), this idea was all the rage.

In the standard new-Keynesian model, consumption is low today because its future level is anchored, and a too-high path of real interest rates makes consumption grow too fast. Hence the current level of consumption is too low. That level can be raised by lowering expected future interest rates and hence expected future consumption growth just as effectively as by lowering today's interest rates and today's consumption growth. (If this all seems insane, read here.) So, goes the story, the key to stimulus when interest rates are zero is for the Fed to commit to keeping interest rates low, lower than than we and the Fed know it will want them to be when the time comes. 

 I expressed some doubts that the Fed would ever make such a commitment, or that people would believe it if it tried to do so. (I also expressed some doubts at the whole modeling approach, but that's not important now.)  These events seem to prove that conjecture in spades.

The vast market gyrations, and the Economist's trenchant quote are especially interesting. If the Fed had been committed to a path, or even to a rule (no change until unemployment falls below 6.5%), and most of all if people thought it had such a commitment,  then Mr. Bernanke's answers to questions from congressmen should have no effect.

If only commitment now to do things you will regret later were so easy as it is in our models. This is not a criticism of the Fed. Imagine the Fed chair explaining to Congress that he is keeping rates lower than everybody thinks they should be, with unemployment down to 5% and inflation heating up at 4%, because he made that commitment in order to stimulate the economy back in 2012. Commitments need more than words. It's easy in a model to write "the Fed commits to x," like a new inflation target or interest rate path. It's easy to write opeds that "the Fed should commit to x." Generating such a commitment -- which means, by definition, something that constrains your actions in the future -- is not so easy.

Benn Steil has a nice blog post and more media links.  

The Fed and Shadow Banking

The WSJ has a fascinating Op-Ed by Andy Kessler, "The Fed Squeezes the Shadow-Banking System" Andy thinks that Quantiative Easing has the opposite, contractionary effect.

QE is just a huge open market operation. The Fed buys Treasury securities and issues bank reserves instead. Why does this do anything? Why isn't this like trading some red M&Ms for some green M&Ms and expecting it to affect your weight?  (M&M of course stands for "Modigliani Miller" if you didn't get the joke.)

The usual thinking is that bank reserves are "special." They are connected to GDP in a way that Treasuries are not.  In the conventional monetary view, MV = PY.  Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.

In Andy's view (my interpretation), that is turned around now. Now, Treasuries supply more "liquidity" needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.

Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don't do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don't make a difference to anything. More treasuries, according to Andy, we can do something with.

More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can't push on a string, as the saying goes. Much "constraint" economics forgets that once the constraint is off, the relationship doesn't hold any more.

Andy describes the repo market and the sense in which Treasuries are "special" in providing low-haircut collateral. Lots of academic research is now viewing Treasuries as special or liquidity-providing in the shadow banking system.

So, this is at least a gorgeous possibility: In a frictionless world, open-market operations, buying one kind of government debt (Treasuries) and issuing another (reserves)  have zero effect on anything, by the M&M theorem. Monetary economics thinks the M&M theorem is violated, because one kind of government debt (M) is connected to nominal GDP and the other is not.

But financial systems change. When the textbooks were written, banks mattered a lot, so bank reserves, leveraged to loans and checking accounts, were the "special" asset. In today's market, and given today's glut of reserves, Treasuries, leveraged to mortgage backed securities and money market funds through the repo market and "shadow banking system,"  might be the "special" asset connected to nominal GDP. In that case, the effects of open market operations might have the opposite sign. As Andy says,

... the Federal Reserve's policy—to stimulate lending and the economy by buying Treasurys..—is creating a shortage of safe collateral, the very thing needed to create credit in the shadow banking system for the private economy. The quantitative easing policy appears self-defeating, perversely keeping economic growth slower and jobs scarcer.

I'm not totally convinced, though this story and the alleged enormous demand for Treasuries is being bandied around as established fact. I'm also not convinced that this is all a good idea. Maybe the Fed should starve the shadow banking system.

You repo a security so that you can borrow against it. For example, you might buy a mortgage-backed security, then leave (repo, really) that security as collateral for a loan, which you used to buy the security in the first place. But what sense does it make to repo-finance a Treasury? You can't borrow at lower interest rate to make money on a Treasury! You could, possibly, if it's a long term Treasury and you're borrowing short, betting that interest rates don't rise. But I would think an interest rate swap or future would be a cheaper way to make that bet, and anyway betting on the slope of Treasury yield curve doesn't add up to the necessary GDP-linked lending that Andy has in mind.

In short, if you have money to buy a Treasury, why do you need to borrow? For any of this to get off the ground, you have to have some other, not totally rational,  reason for buying the Treasury, and then you want to borrow against the Treasury  so you can buy the risky asset that you really wanted all along. Who is that? Why is this such a necessary part of our financial system? Can't we fix things so they just buy the MBS with their initial cash?

Andy points out that repos are re-hypothecated. You use your Treasury as collateral against a loan, then the guy you gave it to uses it again as collateral to get the money to give to you. So one Treasury is used as collateral against two or three loans. Hmm. As the money multiplier creates run-prone structures, so using the same thing as collateral two or three times is a lot of what makes banks "too big to fail." If we all go down, who has the collateral?

A system awash in all kinds of liquidity, following the Freidman optimal quantity of money, seems a lot safer to me. I'd rather we expand the "bank reserve" concept -- fixed-value, floating-rate, electronically-transferable Treasury debt, and lots of it, washing the shadow banking system in liquidity and putting the run-prone structures out of business. Of course, open market operations would then have no effect in my world either, as I have removed the liquidity constraint in the shadow banking system just as Mr. Bernanke has removed it in the conventional banking system. But violations of M&M always mean the system can be made better.

If you want to comment and explain shadow banking, please use little words that the rest of us can understand.

The Role of Monetary Policy, Revisited

I am giving a talk Thursday May 30, titled  "The Role of Monetary Policy, Revisited."  The event is at Booth's Gleacher Center in downtown Chicago, reception 4:30 and talk 5:15. It's part of a series of talks sponsored by the Becker-Friedman Institute.

The talk is based on  an essay I'm working on, and will be presenting at a few central banks this summer. Once per generation we re-think what central banks do, can't do, should do, and shouldn't do. Milton Friedman's famous 1968 address marked the last big transition. I think, we are in a similar moment. I will look at the big picture in the same spirit. I'm aiming at a serious talk, grounded in academic research, but accessible.

Blog followers, students, colleagues, friends, and even glider pilots are most welcome. Please rsvp so they know how many people to plan for.

The event announcement invitation and rsvp links are here on the BFI webpage

There is also an event announcement and rsvp link on the Booth Alumni events webpage here.

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The Becker Friedman Institute for Research in Economics of the University of Chicago cordially invites you to The Role of Monetary Policy Revisited A talk by John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance at the University of Chicago Booth School of Business Thursday, May 30, 2013 4:30 p.m. Reception 5:15 p.m. Talk and Q&A Executive Dining Room, Sixth Floor University of Chicago Gleacher Center 450 North Cityfront Plaza Drive Chicago, Illinois (map and directions) Please join us as University of Chicago Booth School of Business Professor John Cochrane reexamines Milton Friedman's 1968 presidential address to the American Economic Association. In this famous speech on the role of monetary policy, Friedman argued, "There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off." Starting from this perspective, Cochrane will reevaluate the role of monetary policy 45 years later. Is it effective? Can it fill all the roles people expect of it? How should monetary policy be conducted going forward? RSVP Please respond online by May 23. Please extend this invitation to others who might find the program of particular interest. Complimentary valet parking will be available at the Gleacher Center entrance. QUESTIONS If you have questions or require advance assistance, please contact Maria Bardo-Colon at 773.834.1898 or bfi@uchicago.edu. John H. Cochrane The AQR Capital Management distinguished service professor of finance at the University of Chicago Booth School of Business, Cochrane's scholarly work focuses on finance, monetary economics, macroeconomics, health insurance, time-series econometrics, and other topics. He is the author of Asset Pricing, a coauthor of The Squam Lake Report, a research associate of the National Bureau of Economic Research, a senior fellow of the Hoover Institution at Stanford University, and an adjunct scholar of the CATO Institute. He blogs as The Grumpy Economist. Cochrane earned a bachelor's degree in physics at Massachusetts Institute of Technology and PhD in economics at the University of California, Berkeley. He was a member of the University of Chicago Department of Economics before joining Chicago Booth.

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