A Simple Baseline VAR for Studying the US Monetary Base and the Channels of Monetary Transmission in the Age of ZIRP: Part 3

A Mark Sadowski post

In Part 1 we established that there is bidirectional Granger causality between the monetary base and CPI, PCEPI and industrial production. In Part 2, using bivariate Vector Auto-Regression (VAR) models to generate Impulse Response Functions (IRFs), we showed that a shock to the monetary base leads to an increase in the price and output level. In Part 3 we are going to estimate a trivariate VAR model to verify that the relationships we observed in Part 2 are robust to the inclusion of all three types of variables.

The first thing we have to do is to put all three types of variables into VARs in levels (VARLs) and test for cointegration.

Most information criteria suggest a maximum lag length of four for both the VARL that includes CPI as the measure of the price level, and the VARL that includes PCEPI as the measure of the price level. An LM test suggests that there is no problem with serial correlation in either VARL at this lag length. The AR roots tables suggest that the VARLs are dynamically stable, and the Johansen’s Trace Test and Maximum  Eigenvalue Test both indicate that there exists one cointegrating equation in each VARL at this lag length. This probably shouldn’t be too surprising since we already have evidence that the monetary base and industrial production are cointegrated.

So, to reiterate what I argued in Part 2, although the order of integration for the log levels of all four of our series (SBASENS, CPI, PCEPI and INDPRO) is one, the fact that there is a cointegrating relationship between the three types of variables means that only estimating a VAR in first differences (a VARD) would discard the information contained in the levels and lead to model misspecification. Furthermore, since there is cointegration, we should probably estimate a Vector Error Correction Model (a VECM), since it can generate statistically efficient estimates without losing long-run relationships among the variables, as a VARL might. However, in cases where there is no theory which can suggest the true cointegrating relationship or how it should be interpreted, it is probably better not to estimate a VECM.

However, in the interests of thoroughness, I am going to estimate a VARD, a VARL and a VECM. And since we have two measures of the price level that means we will be estimating six models. But after we have done that, and have noted the results, the choice, at least for the moment, will come down to one between the two VARLs.

First, let’s estimate the VARDs. Most information criteria suggest a maximum lag length of three in both VARDs. The LM tests suggest that there is no problem with serial correlation at this lag length. And the AR roots tables suggest that both VARDs are dynamically stable at this lag length.

As I did in Part 2, I am going to use a recursive identification strategy (Choleskey decomposition), which is the dominant practice in the empirical literature on the transmission of monetary policy shocks. Such a strategy means that the order of the variables affects the results. I will follow the traditional practice of ordering output level first, the price level second, and the monetary policy instrument third in each vector. Changing the ordering of the variables would change the results (in this case there are six permutations), but since order doesn’t matter in the other impulse definitions I am mentioning (Residual and Generalized Impulses), we should be able to detect if this would have a significant effect. As before, the response standard errors I will show are analytic, since Monte Carlo standard errors change each time an IRF is generated.

Here are the responses to a shock to the monetary base in the trivariate VARD using CPI as the measure of the price level. I’ll restrict the time period to 10 months as it isn’t of interest after that point.

Sadowski GC3_1

And here are responses to a shock to the monetary base in the trivariate VARD using PCEPI as the measure of the price level.

Sadowski GC3_2

In each case a positive shock to the rate of change in the monetary base generates a statistically significant negative response to the rate of change in industrial production in the third month, followed by a statistically significant positive response in the fourth month as well as a statistically significant positive response to the rate of change in the price level (i.e. the inflation rate) in the third month. Changing the impulse definition to Residual or Generalized Impulse doesn’t change the results much, if at all.

Now let’s look at the IRFs for the VARLs. As I already noted, most information criteria suggest a maximum lag length of four in both VARLs, the LM tests suggest that there is no problem with serial correlation at this lag length in either of these VARLs and the AR roots tables suggest that both VARLs are dynamically stable at this lag length.

Here are the responses to a shock to the monetary base in the trivariate VARL using CPI as the measure of the price level. In this case I’ll extend the time period to 48 months.

Sadowski GC3_3

And here are responses to a shock to the monetary base in the trivariate VARL using PCEPI as the measure of the price level.

Sadowski GC3_4

In both cases a positive shock to the rate of change in the monetary base generates a statistically significant negative response to the rate of change in industrial production in the third month. With PCEPI as the measure of the price level this is followed by a statistically significant positive response in the tenth month. In both cases a positive shock to the monetary base generates a statistically significant positive response to the price level in months three and four.

Changing the impulse definition to Residual doesn’t change the results much, if at all. However changing the impulse definition to Generalized Impulse results in a statistically significant positive response in only month four in the VARL with CPI as the measure of the price level, and results in the loss of the statistically significant positive response to industrial production in the VARL with PCEPI as the measure of the price level. Note that we’ve already established that the monetary base has a statistically significant positive effect on industrial production with the VARDs. As I said in Part 2, there is loss in statistical efficiency when estimating a VARL with unit roots.

The IRFs show that a positive 2.3% shock to the monetary base in month one leads to a peak increase in industrial production of 0.26% in month 11 in the VARL that uses CPI as the measure of the price level, and that a positive 2.4% shock to the monetary base in month one leads to a peak increase in industrial production of 0.27% in month 11 in the VARL that uses PCEPI as the measure of the price level. The IRFs also show that a 2.3% and 2.4% shock to the monetary base in month one leads to a peak increase in the CPI level of 0.10% and in the PCEPI level of 0.077% in month four respectively.

Now let’s estimate the VECMs. The following IRFs are generated assuming a linear trend in the data and an intercept but no trend in the cointegrating vector. Here are responses to a shock to the monetary base in the trivariate VECM using CPI as the measure of the price level. (As I noted in Part 2, unfortunately VECM standard errors are not available in EViews.).

Sadowski GC3_5

Here are responses to a shock to the monetary base in the trivariate VECM using CPI as the measure of the price level.

Sadowski GC3_6

In both cases a positive shock to the monetary base generates a negative response to level of industrial production in the second through fourth month, followed by a positive response thereafter. In both cases a 2.3% positive shock to the monetary base in month one leads to a peak increase in industrial production of 0.36% in month 14. In the first VECM, CPI has a peak increase of 0.092% in month four and then falls to a maximum decrease of 0.042% in month 16. In the second VECM, PCEPI has a peak increase of 0.069% in month four and then falls to a maximum decrease of 0.014% in month 17. In both cases changing the impulse definition to either Residual or Generalized Impulse doesn’t change the results much, if at all. But as I’ve already said, there is good reason to be skeptical of these VECMs.

Now the time has come to pick between the two VARLs.

First, the VARL that uses PCEPI as the measure of the price level has a statistically significant positive increase in the level of industrial production unlike the VARL that uses CPI as the measure of the price level. This makes the PCEPI VARL more consistent with the evidence from the more statistically efficient VARDs.

Second, since PCEPI is the deflator of the Personal Consumption Expenditure component of GDP it is arguably a better measure of the price level than the much more ad hoc CPI.

Third, and perhaps most importantly, the Federal Open Market Committee (FOMC) has used the PCEPI to frame its inflation forecasts since February 2000 (Page 4, Footnote 1) and since January 2012 the FOMC has explicitly targeted the inflation rate of PCEPI.

Thus PCEPI very likely represents a better measure of the preferences of the monetary authority as it sets the policy variable (i.e. the monetary base).

So the PCEPI VARL is the Simple Baseline VAR for Studying the US Monetary Base and the Channels of Monetary Transmission in the Age of ZIRP.

In upcoming posts I shall add other variables to the VAR that the monetary base Granger causes in the age of ZIRP, such as domestic stock indices, nominal Treasury yields, inflation expectations, the value of the dollar, and commercial bank credit and deposits.

Recasting views

Robert Mundell

The Euro

Friedman-Mundell“This is in my view a great step forward, because it will bring forth new and for once meaningful ideas about reform of the international financial architecture. The euro promises to be a catalyst for international monetary reform.” 

“At the close of the “American century,” the euro has appeared as a potential rival, the countervailing power, to the dollar. The advent of the euro may turn out to be the most important development in international monetary arrangements since the emergence of the dollar as the dominant currency shortly after the creation of the US central bank, the Federal Reserve System, in 1913.”

Milton Friedman

“The drive for the Euro has been motivated by politics not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.”

The Beatles sing about Greece & the Troika: “You say yes, I say no. You say stop but I say go, go, go. Oh no. You say goodbye and I say hello. Hello, hello. I don’t know why you say goodbye. I say hello …”

Just one example from each side of the aisle:

Yes:

A No vote would bring a new economic darkness. There is widespread agreement that the initial period would be characterised by default on Greece’s obligations to creditors, a chronic liquidity contraction and a solvency crisis in the banking sector, which would keep the banks shut. It would see a sclerotic blockage of most forms of economic activity. A further sharp GDP contraction would ensue. Whether or not the government chose to introduce a parallel currency to pay wages, pensions and other bills in the interim, a “new drachma” would be introduced. The currency would almost certainly drop sharply, most likely by about 50 per cent at first. Behind the wall of capital controls, the Bank of Greece would then print money. The risk of Greek deflation would disappear at a stroke. Banks would re-open, supported by the central bank and by a government programme to recapitalise them.

So Syriza would finally have re-taken control of Greece’s economic destiny. But it is unlikely to be successful in delivering a bright economic future, without help, for at least three reasons.

No:

This Sunday, the Greek people will finally face a decisive choice, yay or nay, to stay in the eurozone. In the humble opinion of this writer, the Greeks should reject Europe’s terms, ditch the euro, and take their chances restarting their own currency.

I’m certainly not the first or the smartest person to recommend this course. But there’s an extra wrinkle to add: Along with its own self-preservation, Greece should do it for the sake of its fellow European nations, since a Grexit might just shock Europe out of its crazed economic murder-suicide pact.

Images of Greece & Others

Contrast this chart

Beatles-Greece_1

With this

Beatles-Greece_2

Here Greece doesn´t standout at all, it´s super boom Ireland!

But Greece notches the biggest drop from the peak

Beatles-Greece_3

Dives just as deep but stays there for longer than the US during the Great Depression

Beatles-Greece_4

Comparing the “heathens” along “sacred” dimensions

Beatles-Greece_5

Beatles-Greece_6

Beatles-Greece_7

Except for the pre-crisis debt level, no great (and unsurmountable) differences

Which leads me to endorse David Beckworth´s argument in The Monetary Origins of the Eurozone Crisis;

The Eurozone crisis is one of the greatest economic tragedies of the past century. It has caused immense human suffering and continues to this day. The standard view attributes it to a pre-crisis buildup of public and private debt augmented by the imposition of austerity during the crisis. While there is evidence of a relationship between these developments and economic growth during the crisis, this evidence upon closer examination points to the common monetary policy shared by these countries as the real culprit for the sharp decline in economic activity. In particular, the ECB’s tightening of monetary policy in 2008 and 2010-2011 seem to have not only caused two recessions but sparked the sovereign debt crisis and gave teeth to the austerity programs. This finding points to the need for a new monetary policy regime in the Eurozone. The case is made that the new regime should be a growth path target for total money spending.

The illustrative pictures

Beatles-Greece_8

Bottom Line: Greece, more than the rest had (has) enormous structural issues, but the Gordian knot of monetary policy only helped strangle it!

Martin Feldstein Drags Out The Inflation Bogeyman One More Time Again

A Benjamin Cole post

The Federal Reserve must end its “excessively easy monetary policy [that] can no longer achieve a sustained increase in employment.”

So says (again) Martin Feldstein, renowned Harvard econ prof, old Reaganaut, writing on June 29 for the Project Syndicate.

Of course, Feldstein has been soap-boxing an inflationary doomsday since at least April 19 of 2009. Writing for the Financial Times, under the banner Inflation Is Looming On America’s Horizon, Feldstein said then only lower commodity prices were keeping inflation at bay, and stripping food and energy, that the CPI was already at 1.8%. “That is the good news: the outlook for the longer term is more ominous,” warned Feldstein.

The Fed was monetizing federal deficits, observed Feldstein, who literally concluded, “It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.”

We can hope Feldstein did not follow his own investment advice. In 2009, or all the subsequent years in which he has constantly rung the inflation klaxons.

And Now?

Evidently having given up on the QE-scaremongering, Feldstein now is running with a tight-labor markets argument. Rising wages will mean higher prices.

And indeed, average hourly earnings in May were up 2.3% YOY, and productivity has been weak. However, Feldstein ignores that for seven years, unit labor costs have been nearly dead in the water. From 2007 to 2015, unit labor costs are up about 7%, or less than 1% a year.

So, any increase in productivity going forward will tend to counteract higher wages, as has happened in the past. Really, a 2.3% annual wage increase is a reason for the monetary noose?

An Interesting Question

Suppose that the United States develops tighter labor markets, and official unemployment rates shrink.

In the 1990s, inflation ran between 4% and 1.5%, generally sinking as the decade went on. The unemployment rate shrank also, finishing the decade at 4.2%, well below the current 5.5% rate. So, based on recent history, the U.S. may not see that much of a budge in inflation.

But even if the U.S. did see some inflation—would it be a calamity to have tight labor markets and, say, steady 4% inflation? I mean, to anyone except central bankers and inflation-mongers?

How would the voters feel about free markets and capitalism if the U.S. had sustained tight labor markets and constant real wage growth? Or, conversely, lots of unemployment and wage stagnation?

Dudes, like I always say, print more money. When it is boom times in Fat City, voters will love making money the American way.

Feldstein made good, if right-wing PC, suggestions for structural reforms of labor markets. Sure, bring ‘em on. But the Fed should print lots of money too.

 

 

 

 

A Simple Baseline VAR for Studying the US Monetary Base and the Channels of Monetary Transmission in the Age of ZIRP: Part 2

A Mark Sadowski post

What I am going to do next is to construct three bivariate Vector Auto-Regression (VAR) models to generate Impulse Response Functions (IRFs) in order to show what a shock to the monetary base leads to in terms of the price level and output. As mentioned in Part 1, the order of integration for the log levels of all four of our series (SBASENS, CPI, PCEPI and INDPRO) is one. With two unit roots per model, we are faced with a procedure that could lead to a VAR model in differences (a VARD), a VAR model in levels (a VARL), or a Vector Error Correction Model (a VECM).

Using the Augmented Dickey-Fuller (ADF) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests I find that the order of integration is zero for all four series after they are differenced (as expected). In order to render the IRFs easier to interpret, for the rest of this analysis I have multiplied the natural log of each series by 100.

Since there is no evidence of cointegration between the monetary base and CPI or PCEPI, we are really only faced with a choice between a VARD and a VARL in these two cases. This means we are confronted with a tradeoff between statistical efficiency and the potential loss of information that takes place when time series are differenced. In the interests of thoroughness, I am going to do it both ways.

First, let’s estimate the VARDs. Most information criteria suggest a maximum lag length of one in both VARDs. The LM test suggests that there is a problem with serial correlation at this lag length, but this problem disappears when the lag length is increased to three in both of these VARDs. The AR roots tables suggest that both VARDs are dynamically stable at this lag length.

Motivated by the dominant practice in the empirical literature on the transmission of monetary policy shocks, I am going to use a recursive identification strategy (Choleskey decomposition). Such a strategy means that the order of the variables affects the results. I will follow the traditional practice of ordering output and the price level before the monetary policy instrument in each vector. The response standard errors I will show are analytic, as Monte Carlo standard errors change each time an IRF is generated.

Here are the responses to a shock to the monetary base in the VARD including CPI as a variable. I’ll restrict the time period to 10 months as it isn’t of interest after that point.

Sadowski GC2_1

And here are responses to a shock to the monetary base in the VARD including PCEPI as a variable.

Sadowski GC2_2

In each case a positive shock to the rate of change in the monetary base generates a statistically significant positive response to the rate of change in the price level (i.e. the inflation rate) in the third month. Changing the impulse definition to Residual or Generalized Impulse doesn’t change the results much, if at all.

Now, let’s estimate the VARLs. Most information criteria suggest a maximum lag length of two in both VARLs. The LM test suggests that there is a problem with serial correlation at this lag length, but this problem disappears when the lag length is increased to three in both of these VARLs. The AR roots tables suggest that both VARLs are dynamically stable at this lag length.

Here are the responses to a shock to the monetary base in the VARL including CPI as a variable. In this case I’ll extent the time period to 48 months.

Sadowski GC2_3

And here are responses to a shock to the monetary base in the VARL including PCEPI as a variable.

Sadowski GC2_4

A positive shock to the monetary base generates a statistically significant positive response to the CPI in months three and four. A positive shock to the monetary base generates a statistically significant positive response to the PCEPI in months two through five. Changing the impulse definition to Generalized Impulse renders the responses statistically insignificant (there is little difference using Residual impulses), but we’ve already established that the monetary base has a statistically significant positive effect on CPI and PCEPI with the VARDs. And, as I said earlier, there is loss in statistical efficiency when estimating a VARL with unit roots.

The IRFs show that a 2.5% and 2.6% shock to the monetary base in month one leads to a peak increase in the CPI level of 0.12% and in the PCEPI level of 0.085% in month four respectively. In short, the empirical evidence does not seem to be very supportive of the Neo-Fisherite hypothesis.

Now let us turn our attention to industrial production.

In Part 1 we showed that there is evidence of cointegration between the monetary base and industrial production. This means, in addition to the option of estimating a VARD or a VARL, we may also estimate a VECM. But before discussing the pros and cons of doing this, let us estimate a VARD and VARL first. I should also mention at this point that, in a book edited by David Glasner, “Business Cycles and Depressions: An Encyclopedia”, Neil Ericsson (in an article entitled “Distributed Lags”) argues that estimating a model in first differences alone when cointegration exists discards the information contained in the levels and leads to model misspecification. Consequently a VARL is probably preferred to a VARD in this case, but it may still be useful to estimate both.

First let’s estimate the VARD. Most information criteria suggest a maximum lag length of three in the VARD. The LM test suggests that there is no problem with serial correlation at this lag length. The AR roots table suggests that the VARD is dynamically stable at this lag length. Here is the IRF for the VARD.

Sadowski GC2_5

A positive shock to the rate of change in the monetary base generates a statistically significant negative response to the rate of change in industrial production in the third month, followed by a statistically significant positive response in the fourth month. Changing the impulse definition to Residual or Generalized Impulse doesn’t change the results much, if at all.

Now, let’s estimate the VARL. Most information criteria suggest a maximum lag length of four in the VARL. The LM test suggests that there is no problem with serial correlation at this lag length. The AR roots tables suggests that the VARL is dynamically stable at this lag length. Here is the IRF for the VARL.

Sadowski GC2_6

A positive shock to the monetary base generates a statistically significant negative response to level of industrial production in the third month, followed by a statistically significant positive response in months eight through 17. Changing the impulse definition to Residual doesn’t change the results much, if at all. Changing the impulse definition to Generalized Impulse eliminates the statistically negative response in the third month.

The IRF shows that a 2.5% shock to the monetary base in month one leads to a peak increase in industrial production of 0.43% in month 13.

Now, let’s talk about the pros and cons of estimating a VECM. The advantage of a VECM is that it can generate statistically efficient estimates without losing long-run relationships among the variables. Thus, if cointegration exists, and the true cointegrating relationship is known and can be given a theoretical interpretation, it’s generally acknowledged that a VECM should be estimated in the manner suggested by Johansen (1995).

On the other hand, if the true integrating relationship is unknown, imposing cointegration may not be appropriate. Imposing incorrect cointegrating relationships can lead to biased estimates and hence bias the IRFs derived from the VARL. In cases where there is no theory which can suggest the true cointegrating relationship or how it should be interpreted, it is probably better not to estimate a VECM. Moreover, Sims et al. (1990) show that when a cointegrating relationship exists, the systems dynamics can be estimated consistently with a VARL, and James Hamilton (1994) appears to agree (pp. 651-653). As a final note on the pros and cons of VARDS, VARLS and VECMs when modeling and forecasting with cointegrated variables, I highly recommend this “hands-on” paper by Tim Duy and Mark Thoma.

Nevertheless, I think it will still be interesting to estimate a VECM for industrial production. The following IRF is generated assuming a linear trend in the data and an intercept but no trend in the cointegrating vector. (Unfortunately VECM standard errors are not available in EViews.).

Sadowski GC2_7

A positive shock to the monetary base generates a negative response to level of industrial production in the second and third month, followed by a positive response thereafter. A 2.4% shock to the monetary base in month one leads to a peak increase in industrial production of 0.51% in month 15. In this model the response of industrial production is remarkably persistent with the level of industrial production still up by 0.43% nearly four years later. Changing the impulse definition (to either Residual or Generalized Impulse) slightly increases the response. In any case, as I’ve already implied, I don’t put much stock in this VECM.

Here are a couple of preliminary observations. The price level responses seem less persistent than what multivariable VARs estimated in “normal” times with short term interest rates as the instrument of monetary policy show. On the other hand, the output response seems somewhat more persistent.

In Part 3 I shall finally put output, the price level and the monetary base together in our baseline trivariate VAR model.

A Simple Baseline VAR for Studying the US Monetary Base and the Channels of Monetary Transmission in the Age of ZIRP: Part 1

A Mark Sadowski post

Most highly publicized academic studies on quantitative easing (QE) seem to come in one of four flavors: 1) event studies on changes in security yields on the days of announcement (e.g. Krishnamurthy and Vissing-Jorgensen, 2011), 2) panel data studies on flow and stock effects of QE on daily security yields during the programs (e.g. D’Amico and King, 2010) , 3) times series studies on the effect of open market operations on security yields during normal times (e.g. Hamilton and Wu, 2011) and 4) studies on the macroeconomic effects of QE using major models calibrated to normal times (e.g. Fuhrer and Olivei 2011). The underlying assumption of nearly all these studies is that the primary channel of the Monetary Transmission Mechanism (MTM) is the Traditional Real Interest Rate Channel, which is almost certainly not the case at the zero lower bound (ZLB) in interest rates.

Notably, there are very few empirical studies on the macroeconomic effects of QE during QE. Indeed, to my knowledge, there are only four: Honda et al. (2007), Girardin and Moussa (2010), Gambacorta et al. (2012) and Behrendt (2013).

What these four studies have in common is that they focus on periods of zero interest rate policy (ZIRP) employing Vector Auto-Regression (VAR) methodology with the monetary base, or bank reserves, as the instrument of monetary policy. The convention in the empirical literature on the transmission of monetary policy is to estimate a VAR with a measure of output, the price level and a short term interest rate (along with other variables). Thus, the principal difference between these four studies, and what is the usual practice, is to substitute the monetary base (or bank reserves) in place of the short term interest rate as the instrument of monetary policy.

Focusing on periods of ZIRP also presents some additional challenges. In particular, instead of having decades of data permitting the use of real GDP (RGDP) and the GDP deflator as the measure of output and price level, there is only a period of years usually necessitating the use of data at monthly frequency, meaning (for example) that the industrial production index may have to be substituted for RGDP, and that a measure of the consumer price level may have to be substituted for the GDP deflator, if a sufficient number of observations is to be available in order for it to be possible to generate statistically significant results.

When constructing a macroeconomic VAR model (as I am about to do), it is especially desirable for the policy variable to Granger cause another variable (or variables) in the model. This is because, if the policy variable Granger causes another variable, then it provides statistically significant information about future values of the other variable. Under those circumstances we might expect shocks to the policy variable in the VAR model to lead to statistically significant changes in the other variable.

To that end, let us consider the relationship between the St. Louis Source Base (SBASENS) and the Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the Industrial Production Index (INDPRO). Here is the natural log of SBASENS and CPI:

Sadowski GC_1

the natural log of SBASENS and PCEPI:

Sadowski GC_2

and the natural log of SBASENS and INDPRO from December 2008 through May 2015:

Sadowski GC_3

The following analysis is performed using a techniques developed by Toda and Yamamato (1995).

Using the Augmented Dickey-Fuller (ADF) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests I find that the order of integration is one for all four series. I set up three two-equation VARs in the log levels of the data including an intercept for each equation.

Most information criteria suggest a maximum lag length of two for the pair of VARs that include the price level as a variable. The LM test suggests that there is a problem with serial correlation at this lag length, but this problem disappears when the lag length is increased to three in both of these VARs. The AR roots tables suggest that both VARs are dynamically stable at this lag length, and Johansen’s Trace Test and Maximum Eigenvalue Test both indicate the two pairs of series are not cointegrated at this lag length.

Most information criteria suggest a maximum lag length of four for the VAR that includes the industrial production index as a variable. The LM test suggests that there is no problem with serial correlation. The AR roots table suggests that the VAR is dynamically stable, and the Johansen’s Trace Test and Maximum Eigenvalue Test both indicate that the two series are cointegrated at this lag length. This suggests that there must be Granger causality in at least one direction between the monetary base and industrial production.

Then I re-estimated the three level VARs with one extra lag of each variable in each equation. But rather than declare the lag interval for the two endogenous variables to be from 1 to 3, 1 to 4, and 1 to 5 respectively, I left the intervals at 1 to 3, 1 to 3, and 1 to 4, and declared the lag of each variable to be exogenous variables. Here are the Granger causality test results.

Sadowski GC_4

Sadowski GC_5

Sadowski GC_6

Thus, the results are as follows:

  • I reject the null that CPI does not Granger cause the monetary base at the 5% significance level, and I reject the null that monetary base does not Granger cause CPI at the 1% significance level.
  • I reject the null that PCEPI does not Granger cause monetary base at the 5% significance level, and I reject the null that monetary base does not Granger cause PCEPI at the 1% significance level.
  • I reject the null that industrial production does not Granger cause the monetary base at the 5% significance level, and I reject the null that monetary base does not Granger cause industrial production at the 1% significance level.

In other words, there is strong evidence of bidirectional Granger causality between the monetary base and CPI, PCEPI and industrial production from December 2008 through May 2015. Moreover the evidence for Granger causality from the monetary base to CPI, PCEPI and industrial production is slightly stronger than the evidence for Granger causality from CPI, PCEPI and Industrial production to the monetary base.

The next step in this process is to determine the nature of this “correlation”. What does a shock to the monetary base lead to in terms of the price level and output? For example, does a positive shock to the monetary base cause the price level to decline (counterfactually) as the Neo-Fisherites seem to be claiming?

Or might it cause the price level to increase (counterfactually) as Monetarists claim? And what happens to output?  In order to determine this we need to estimate properly specified VARs, and then to generate the appropriate Impulse Response Functions (IRFs).

For that, tune in next time.

New “con game” in town: Naming dots!

Here’s How Quickly Yellen Wants to Raise Interest Rates, According to a Former Fed Policy Maker:

In what’s become known as the “dot plot,” Fed officials earlier this month showed the public their best estimates for where the central bank’s policy rate will be over the next few years. It’s valuable information for investors who are desperate to know how quickly borrowing costs will rise in the U.S. What makes things tricky is that these dots are anonymous, and no one’s views matter more than the chair’s.

Enter Meyer, who was a Fed governor from  1996 to 2002 and is now senior managing director at Macroeconomic Advisers. He’s taken a stab at guessing which dots belong to whom (scroll down for the chart). He estimates that Yellen in June foresaw a single rate hike this year. That would make her dot one of five at 0.375 percent, which is below the median of her fellow Federal Open Market Committee participants.

Meyer also expects her to change her view by September, by which point he expects to see an economy on stabler footing.

Con Game

In Does the Fed finally realize forward guidance is folly? Caroline Baum thinks this is a waste of time:

In the last two weeks, three Federal Reserve officials have said or implied that the first rate increase could take place in September. The reaction? The September federal funds futures FFU5, +0.01%   set a new contract high of 99.83, an implied yield of 0.17%.

Just imagine what Fed officials must be thinking…

Fed Chairman Janet Yellen: “What part of September don’t they understand? In the old days, the Fed said almost nothing, or leaked it to The Wall Street Journal. Fed watchers had to deduce our stance from open-market operations. Yet traders were quick to tell their underlings: Don’t fight the Fed. Now we basically tell everyone what we are going to do and when, and the response is: So what?”

Fed Vice Chairman Stanley Fischer: “Perhaps it’s because we keep moving the goal posts. Sometimes we use a date for guidance. Other times it’s a threshold. Once our thresholds are breached, we have to hide behind a mish-mash of indefinite words, such as “considerable time” or “patient.” What exactly does that mean?”

Yellen: I think it’s very clear what we mean.

Fischer: Yes, it’s clear that we don’t know when we are going to raise rates, by how much and at what intervals. That’s what is clear. How could we be expected to know that given the nature of a rapidly changing global economy? As I said before I joined the Fed, and refrained from public comments to that effect since: ‘You can’t expect the Fed to spell out what it’s going to do. Why? Because it doesn’t know.’”

And concludes:

If policy makers want to understand why markets are ignoring the likelihood of an imminent increase in interest rates, look to the ever-changing nature of the guidance. Say what you mean, mean what you say, and realize that some things are best left unsaid.

The Bank for International Settlements Proposes Sadomonetarism To Promote Recovery, Higher Inflation What Greek Crisis?

A Benjamin Cole post

The central banker’s club known as the Bank of International Settlements (BIS), suitably HQ’ed in Basel, Switzerland, this past weekend released its annual report, and advocated the globe’s major central banks raise interest rates to combat the chronic lack of aggregate demand and low inflation-deflation dogging the world’s developed economies.

Greece may be melting down under relentless tight-money policies of the European Central Bank (ECB), but no worries.

“Rather than promoting sustainable and balanced global growth, the system risks undermining it,” Mr. Claudio Borio, head of the monetary and economic department said. “It has spread exceptionally easy monetary and financial conditions to countries that did not need them, exacerbating vulnerabilities there.”

That must explain the global double-digit inflation we see emerging. So much easy money!

Seriously, the Cleveland Federal Reserve Bank says inflation expectations are below 2% for the next 10 years—this is “easy money”? Greece is scant mentioned in the BIS annual report, except to be damned for pushing the ECB to an “easier” stance.  I wish I was making this up.

Democracy And Central Banks

The old saw is that democracy is a lousy way to run a country, until you try any other way. One can certainly rue the economic structural impediments that become permanent fixtures in democracies, what with voting blocs and accommodating office holders.

But the incredible arrogance, ineptitude and theo-monetaristic certitude of central bankers certainly tops any stupidity foisted by voters upon themselves. Voters can and have voted in tax and regulatory platforms that slow down economic growth—but the tight-money lunatics at BIS and the ECB have devised schemes that obtain actual, sustained contractions of economies.

Western central bankers, unmoored from reality or any connection to actual economies—they get their salaries no matter what is the real economic growth rate—have become economic ISIS-men, genuflecting to and implementing an ascetic ideology even as it wreaks destruction.

Remembering Milton Friedman

It is difficult to believe that less than 23 years ago, in Oct. 1992, Milton Friedman bashed the U.S. Federal Reserve in The Wall Street Journal op-ed pages for being too tight—and that, when the Fed had just cut the federal funds rate from 10% to 3%, and CPI-inflation was 3.2%! In 1992 Q4 real growth clocked in north of 4.0%.

Friedman rebuked those who erroneously connected low rates to “easy money”—just the opposite is true, he pointed out. Years of “easy money” do not result in ZLB and deflation. Except perhaps, to demented BIS gnomes.

The slavish zeal for microscopic inflation rates or even deflation at any cost is a new and dangerous affectation among the money-obsessed, especially central bankers. And tight money has not worked! Look at Japan, Europe, or the U.S. in 2008.

Indeed, when did monetary suffocation end up in the nirvana of rapid real growth and but zero inflation?

Never and nowhere.

Bad News

I see no optimistic economic outlook for Europe.

The annual report from the BIS suggests a depth of monetary-policy depravity to rival the Mariana Trench. Europe has an un-democratic central bank that will suffocate parts of Europe for decades, and pompously pettifog the whole time.

The Federal Reserve may be a bit better. One can at least hope the GOP will win in 2016, and like President Nixon, or the Reaganauts, the installed GOP go after the Fed to print more money. Remember, hounded by Reagan’s minions, Fed Chairman Paul Volcker in 1981 declared victory on rising prices—when inflation was at 4%. Today 4% inflation would be presented economic bubonic plague. Funny thing, America prospered in the 1980s with moderate rates of inflation, and then again in the 1990s.

The Bank of Japan and the People’s Bank of China may be the best of the central banking lot today.

Invest accordingly.

What the Fed wants, the Fed gets!

With the GDP revision today:

Broadly, economists expect the economy will strengthen later in the year, but it remains to be seen if growth can breakout of its about 2% pattern recorded for most of the economic expansion that began in mid-2009. Even a rebound to a 3% growth rate in the second quarter would still result in a sluggish expansion for the first half of the year.

The concept of “strengthen” is vague in the context. And there´s nothing to indicate that “growth will breakout of the close to 2% recorded pattern”.

The charts give a good visual.

In the first, I blocked out the (extended) Great Recession period. Note how nominal and real growth have come back at reduced speeds, which I named “Depressed” Moderation to contrast with the “Great” Moderation that took place from 1987 to 2007.

What the Fed wants_1

In the levels chart below, you can see how the economy has been “downgraded” to the “Depressed” Moderation. The important thing to note is that that´s exactly where the Fed wants it to be. If that´s true, there´s no chance the economy will brakeout of the “recorded pattern”.

What the Fed wants_2

Maybe that´s optimistic, because it appears the Fed has set its sights lower:

Federal Reserve officials forecast the economy to grow between 1.8% to 2.0% all this year, according to projections released earlier this month. That would represent a slowdown from the 2014 rate.

Note: The Fed knows what it wants!

Brad DeLong misses the “put”

In “Why Small Booms Cause Big Busts”, DeLong writes:

As bubbles go, it was not a very big one. From 2002 to 2006, the share of the American economy devoted to residential construction rose by 1.2 percentage points of GDP above its previous trend value, before plunging as the United States entered the greatest economic crisis in nearly a century. According to my rough calculations, the excess investment in the housing sector during this period totaled some $500 billion – by any measure a tiny fraction of the world economy at the time of the crash.

The resulting damage, however, has been enormous. The economies of Europe and North America are roughly 6% smaller than we would have expected them to be had there been no crisis. In other words, a relatively small amount of overinvestment is responsible for some $1.8 trillion in lost production every year. Given that the gap shows no signs of closing, and accounting for expected growth rates and equity returns, I estimate that the total loss to production will eventually reach nearly $3 quadrillion. For each dollar of overinvestment in the housing market, the world economy will have suffered $6,000 in losses. How can this be?

………………………………………………………………………………………………………………………………………

Today, we recognize that clogged credit channels can cause an economic downturn. There are three commonly proposed responses. The first is expansionary fiscal policies, with governments taking up the slack in the face of weak private investment. The second is a higher inflation target, giving central banks more room to respond to financial shocks. And the third is tight restrictions on debt and leverage, especially in the housing market, in order to prevent a credit-fueled price bubble from forming. To these solutions, Keynes would have added a fourth, one known to us today as the “Greenspan put” – using monetary policy to validate the asset prices reached at the height of the bubble.

Just rewrite the underlined sentence as “keeping nominal spending on a stable level path” (a.k.a. NGDP-LT)!

So, it appears even Keynes knew that to be the best option!

Keynes Put