Needed: Nonpartisan witnesses

In a tweet, John Taylor draws attention to this:

FEDERAL RESERVE ACCOUNTABILITY AND REFORM

Tuesday, March 3, 2015
02:30 PM – 04:30 PM
538 Dirksen Senate Office Building

The COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS will meet in OPEN SESSION to conduct a hearing on the “Federal Reserve Accountability and Reform.” The witnesses will be: Dr. John B. Taylor, Mary and Robert Raymond Professor of Economics, Stanford University; Dr. Paul H. Kupiec, Resident Scholar, American Enterprise Institute; Dr. Allan H. Meltzer, The Allan H. Meltzer University Professor of Political Economy, Tepper School of Business, Carnegie Mellon University; and Mr. Peter Conti-Brown, Academic Fellow, Stanford Law School’s Rock Center for Corporate Governance. Additional witnesses may be announced at a later date.

You can guess what the two highlighted names will say. Taylor will talk about the need for the Fed to follow Taylor-type rules. Meltzer will testify that “as I said 4,3,2 and again last year, the Fed is leading us down the hyperinflation road”.

They should call nonpartisan Canadian economist Nick Rowe to testify!

Inflation target no more!

Why Isn’t the Fed More Worried About Inflation Expectations?

Expected inflation, as measured by financial markets, has fallen sharply since last summer in both the eurozone and the U.S. The response of their central banks couldn’t be more different. The European Central Bank reacted with alarm and soon decided to launch quantitative easing. By contrast, the Federal Reserve has shown a puzzling insouciance.

Back in 2008, as attested by the Meetings Transcripts, quite the opposite was happening!

Expectations unhinged

Because we have the likes of John Williams, SF Fed president saying inane things like: “Door Open for Interest-Rate Increases Starting in June

NEW YORK–Federal Reserve Bank of San Francisco President John Williams said the door is open to central bank interest rate increases any time from mid-June onward.
In an interview with The Wall Street Journal, Mr. Williams expressed a good deal of confidence in the U.S. outlook, especially on hiring. He said the jobless rate could fall to 5% by the end of the year, which means the central bank is getting closer to boosting its benchmark short-term interest rate from near zero, where it has been since the end of 2008.
“We are coming at this from a position of strength,” Mr. Williams said. “As we collect more data through this spring, as we get to June or later, I think in my own view we’ll be coming closer to saying there are a constellation of factors in place” to make a call on rate increases, he said.

An inflation target no more!

Brazil: Not (yet) sinking, but “bogged down”

As usual the Economist has a defining picture:

Dilmas Woes

CAMPAIGNING for a second term as Brazil’s president in an election last October, Dilma Rousseff painted a rosy picture of the world’s seventh-biggest economy. Full employment, rising wages and social benefits were threatened only by the nefarious neoliberal plans of her opponents, she claimed. Just two months into her new term, Brazilians are realising that they were sold a false prospectus.

Brazil’s economy is in a mess, with far bigger problems than the government will admit or investors seem to register. The torpid stagnation into which it fell in 2013 is becoming a full-blown—and probably prolonged—recession, as high inflation squeezes wages and consumers’ debt payments rise (see page 71). Investment, already down by 8% from a year ago, could fall much further. A vast corruption scandal at Petrobras, the state-controlled oil giant, has ensnared several of the country’s biggest construction firms and paralysed capital spending in swathes of the economy, at least until the prosecutors and auditors have done their work. The real has fallen by 30% against the dollar since May 2013: a necessary shift, but one that adds to the burden of the $40 billion in foreign debt owed by Brazilian companies that falls due this year.

During her first term, the damage done is well summarized by the chart below. And to reverse those trends will not be an easy matter. If he tries too hard, Mr. Levy risks becoming the “neoliberal scapegoat”!

Dilmas Woes_1

Updating Scott Sumner´s chart

In discussing claims by Tyler Cowen, Scott Sumner writes:

However I take issue with this claim:

  1. During the upward phase of the recovery, monetary policy just doesn’t matter that much.

I can’t even imagine what a model would look like where that claim was true.  To see why it is not true, compare the post mid-2009 recoveries in the US and Europe. If monetary policy in the US and Europe did not matter very much during the recovery, then the tightening of monetary policy in mid-2011 in the eurozone ought to have had little effect.  What does it look like to you?

(The updated chart follows.) It is very compelling evidence against Tyler´s claim:

SS-Eur-US

Austerity only explains outcomes when monetary policy is absent

In “Explaining Recovery Performance in Europe”, Krugman writes:

I was very interested by the new paper by Claeys and Walsh on “plucking” as an explanation of differential performance in Europe; basically, they’re saying that fast growth has come in countries that previously had deep slumps. But how does that result interact with the result many of us have found, which is that differences in austerity seem to explain a lot?

……………………………………………………………………….

What happens if you throw both variables in? With standard errors in parentheses, I get Growth in GDP 2009-14 = 7.91 – .26(.28)*Change in GDP 2007-9 – 1.41(.27)*Change in structural balance as % of potential GDP. Plucking might be important, but it’s hard to tell given the lack of data. Austerity, on the other hand, comes in very clear.

Maybe the point is that there aren’t any deep mysteries that need explaining. You can point to individual countries and say that they did better than you might have expected, but any kind of non-cherry-picked analysis of the data really, really wants to tell you not just that austerity hurts growth but that it’s the major factor causing some European countries to do worse than others.

That´s the correct conclusion when comparing countries that do not have an independent monetary policy.

But what happens when you compare with countries that do have control of their monetary policy? Does austerity still stand out?

The charts compare Spain (no monetary policy) with Poland (own monetary policy). Curiously, austerity (measured by the reduction in the structural balance) was even stronger in Poland. Nevertheless, the Polish economy has done much better in terms of real output growth.

Austerity_1

Austerity_2

Why is that?

The next charts show that monetary policy is much tighter in Spain, dependent on the ECB, than in Poland, with its own central bank!

Austerity_3

Austerity_4Update: In “Eurozone Counterfactual” David Beckworth has a detailed take:

So once again, the evidence points to something unique to the Eurozone that affects both the economy and  fiscal policy. The Eurozone’s tight monetary policy over this period fits the billing.
It is reasonable to conclude, then, that had the ECB had not raised its interest rate target in 2008 and 2011, but lowered it and had it started its open-ended QE program back in 2009 there would now be a much brighter future for the Eurozone. Instead, we now face the prospect of a Grexit for which the ECB has only itself to blame.

The discussion should be about “instrument rules” vs “target rules”

In “A Feature Not a Bug in the Policy Rules Bill” John Taylor writes:

In his opening line of questions for Janet Yellen at the Senate Banking Committee today, Senator Richard Shelby asked about the use of monetary policy rules and the Taylor Rule, apparently referring to the recent policy rules bill (Section 2 of HR 5018) that would require the Fed to report its strategy or rule for policy. The headline-grabbing first sentence of Janet Yellen’s  response was about not wanting to “chain” the FOMC to a rule, and it did get a lot of attention (including many real time tweets). But it was the rest of her response that really focused on the Senator’s question. Here is a transcript from C-Span (minute 28:39).

SENATOR SHELBY: YOU HAVE OPINED ON THE USE OF MONETARY POLICY RULES SUCH AS THE TAYLOR RULE, WHICH WOULD PROVIDE THE FED WITH A SYSTEMATIC WAY TO CONDUCT POLICY IN RESPONSE TO CHANGES IN ECONOMIC CONDITIONS. I BELIEVE IT WOULD ALSO GIVE YOU — GIVE THE PUBLIC A GREATER UNDERSTANDING OF, AND PERHAPS CONFIDENCE IN, THE FED’S STRATEGY. YOU’VE STATED, AND I’LL QUOTE, RULES OF THE GENERAL SORT PROPOSED BY TAYLOR CAPTURE WELL OUR STATUTORY MANDATE TO PROMOTE MAXIMUM EMPLOYMENT AND PRICE STABILITY. YOU HAVE EXPRESSED CONCERNS, HOWEVER, OVER THE EFFECTIVENESS OF SUCH RULES IN TIMES OF ECONOMIC STRESS. WOULD YOU SUPPORT THE USE OF A MONETARY POLICY RULE OF THE FED’S CHOOSING IF THE FED HAD DISCRETION TO MODIFY IT IN TIMES OF ECONOMIC DISRUPTION? >>

CHAIR YELLEN: I’M NOT A PROPONENT OF CHAINING THE FEDERAL OPEN MARKET COMMITTEE IN ITS DECISION MAKING TO ANY RULE WHATSOEVER. BUT MONETARY POLICY NEEDS TO TAKE ACCOUNT OF A WIDE RANGE OF FACTORS SOME OF WHICH ARE UNUSUAL AND REQUIRE SPECIAL ATTENTION, AND THAT’S TRUE EVEN OUTSIDE TIMES OF FINANCIAL CRISIS. IN HIS ORIGINAL PAPER ON THIS TOPIC, JOHN TAYLOR HIMSELF POINTED TO CONDITIONS SUCH AS THE 1987 STOCK MARKET CRASH THAT WOULD HAVE REQUIRED A DIFFERENT RESPONSE. I WOULD SAY THAT IT IS USEFUL FOR US TO CONSULT THE RECOMMENDATIONS OF RULES OF THE TAYLOR TYPE, AND OTHERS, AND WE DO SO ROUTINELY, AND THEY ARE AN IMPORTANT INPUT INTO WHAT ULTIMATELY IS A DECISION THAT REQUIRES SOUND JUDGMENT

Back to Taylor:

Note how Janet Yellen refers to my 1993 paper where I pointed to the 1987 stock market break as a case where there was a deviation from the Taylor rule. However, this example is really a illustration of how the policy rule legislation would work effectively rather than a critique of the legislation. To see this, take a look at this chart from my original paper:

Notice how the funds rate was cut in 1987 while the policy rule setting kept rising.  This is the deviation that Janet Yellen was referring to.  It is actually quite small and temporary, but in any case the Fed could easily take such an action and stay within the terms of the policy rules bill.  The Fed chair would simply explain the explicit reason for the deviation as required in the legislation. I can’t imagine the case would be difficult to make given the size of the shock unless for some reason the deviation continued long after the shock.

This example illustrates a feature not a bug in the bill.

Understandably, John Taylor is an unconditional fan of his namesake rule. Interestingly Yellen says that the Fed shouldn´t “be chained to any rule whatsoever”. Why? Because monetary policy requires “sound judgment”? And rules won´t provide that?

Maybe that´s a problem associated with “instrument rules” like Taylor-type rules, which give out the “desired” setting for the interest rate instrument (the FF target rate in the case of the US). What if the central bank, instead of an “instrument rule” adopted a “target rule”?  For concreteness, let´s assume the Fed had adopted (maybe implicitly) a NGDP level target as it´s rule for monetary policy.

The charts compare and contrast the interest rate “policy rule” and the NGDP level target rule (where the “target (trend) level” is the “Great Moderation” (1987-05) trend). In this comparison, the actual setting of the Federal Funds (FF) rate is “right or wrong” depending on, not if it agrees with the setting “suggested” by the instrument rule, but if it is the rate that keeps NGDP close to the target path; and in case there is a deviation from the path, if the (re)setting drives NGDP back to the target.

For the “instrument rule”, I use the Mankiw version of the Taylor rule. The Mankiw version is simpler because it doesn´t require the estimation of an output gap and doesn´t state an inflation target rate (which the Fed didn´t have any way until January 2012).

The first chart shows John Taylor´s chart from his original 1993 paper. Note that it is qualitative (even if not exactly quantitative) similar to the “policy rule” obtained with the Mankiw rule.

During this period (1987 – 1992) monetary policy was “quite good”, in the sense of keeping NGDP close to the “target path”. Actually, when the Fed reduced the FF rate at the time of the stock market crash, it turned monetary policy a bit too expansionary, given NGDP went a bit above trend.

Target Rule_1

The next period covers 1993 – 1997. This is the core period of the “Great Moderation”. At the end of 1992, the FF rate had been reduced to 3%, a level which was maintained throughout 1993. According to the “policy rule” this was “too low”. With respect to the “target rule”, the FF rate was “just right”.

Target Rule_2

All through those years, NGDP remained very close to the “target path”, although the FF rate at times differed significantly from the “policy rule”.

The next period, 1998 – 2003.II is pretty damaging to the “policy rule” advocates. Taylor likes to say that the 2002 – 2005 period was one of “rates too low for too long” (having responsibility for the crash that came later).

What the chart tells us, however, is very different. The FF rate was too low in 1998 – 99. At this time, the Fed reacted to the Russia crisis (and the LTCM affair). Monetary policy loosened up at the same time that the economy was being buffeted by a positive productivity shock.

The monetary tightening that followed was a bit too strong because NGDP dropped below trend. The downward adjustment of the FF rate was correct in the sense that it stopped NGDP from falling lower, and by mid-2002 it began to recover. I wonder how much more grief the economy would have been subjected to if the “policy rule” had been followed.

Target Rule_3

The 2003.III – 2005 period is the second half of Taylor´s “too low for too long”. In the FOMC meeting of August 2003, the Fed adopted “forward guidance” (FG) (first it was “rates will remain low for a considerable period” followed by “will be patient to reduce accommodation, and finally “rates will rise at a measured pace”).  The fact is that FG helped push NGDP back to trend. Maybe the “pace was too measured”, but the fact is that by the time he handed the Fed to Bernanke, NGDP was square back on trend.

Target Rule_4

If the “policy rule” had been closely adhered to, the “Great Recession” would likely have happened sooner!

And now (“the end is near…”) we come to see how the Fed botched monetary policy (likely due to Bernanke´s preferred inflation targeting monetary policy regime).

The FF rate remained at the high level it had reached at the end of the “measured pace story”. At the end of 2006, aggregate demand (NGDP) began to deviate, at first slowly, below the trend level. The FF rate remained put (notice that although too high, the “rule rate” changed direction). The FOMC was not comfortable with the “elevated” price of oil and kept hammering on the risks of inflation expectations becoming un-anchored (see the late 2007-08 FOMC transcripts).

Target Rule_5

Despite the reduction in the FF rate, monetary policy was being tightened! And the “Great Recession” was invited in! Maybe there would have been a “Second Great Depression” if the “policy rate” had been followed closely.

Moral of the story. Yellen and the Fed do not have “infinite degrees of freedom”, hidden under the umbrella of “sound judgment”. They would do well to set a “target rule”

 

The Record On U.S. Commercial Bank Deposits and QE Strongly Suggests Freshly Printed Cash Did Enter Economy, Was Stimulative and Worked As It Should.

A Benjamin Cole post

Okay, in my last post we saw that “QE only ends up as bank excess reserves, and is thus a largely inert Treasuries-for-bank-reserves asset-swap” narrative get crushed.

We showed how the Fed printed (digitized) cash and bought $4 trillion in Treasuries and MBS bonds from the 22 authorized primary bond dealers (Cantor Fitzgerald, Nomura Securities et al), who in turn bought bonds on the open market. Primary dealers are mere intermediaries.

After re-selling the bonds to the Fed, the primary dealers get credited with $4 trillion in reserves at depositary institutions (commercial banks)–not the real sellers of the bonds. See this from NY Fed: “So when the Fed sends and receives funds from the [primary] dealer’s account at its clearing bank [depositary institution, or commercial bank], this action adds or drains reserves to the banking system.”

During QE, the Fed credited the primary bond dealers with $4 trillion in reserves. So what? It is unimportant.

The $64K Q

The $64,000 Question: What did the actual bond sellers—those who sold their bonds to the primary dealers, who are mere intermediaries—do with their money?

Some say the real bond sellers only put their $4 trillion in freshly printed cash into commercial bank deposits, where it is inert, as banks are not lending out enough.

But the record suggests otherwise. See chart below.

Deposits

Obviously, commercial bank deposits stayed on their growth path, no $4 trillion bulge in the QE years. And just as obviously, anybody can make deposits in U.S. commercial banks, from cash-hoarding corporations, to households tightening belts, to foreign flight-capital refugees. So, not just bond sellers but others are making bank deposits through the QE years.

It is worth nothing that since the Fed adopted QE in 2008 (running on and off through 2014), the Dow Jones Industrial Average has risen from about 8,800 to about 18,100, or more than doubled. Property values recovered as well. The economy has grown, if slowly. All that suggests QE freshly printed cash went…into other asset classes, or was spent. Which makes a lot of common sense.

To be sure, much of the recent feeble recovery was normal economic forces at work. And the Krugmanites must be writhing at the fact the annual U.S. annual federal deficits shrank through the period, while the recovery gained speed.

Equally baseless are the right-wing nostrums that QQ would cause hyperinflation, and if not that, it must be inert, locked up in bank reserves.

It sure looks like QE worked, monetary expansionism worked, and just should have been bigger, harder and longer. Like the new Bank of Japan Governor Yutaka Harada says, “We have to print more money.” We can make the language fancy, cloth ourselves in sophisticated obscurantisms, but it comes down to the Fed printing money.

Put the money-printing (digitizing) presses on “Red Hot High” and take a long, long vacation.

 

In Greenspan, Rubin had his “wizard”!

In “The Search for a Monetary-Policy Wizard and Political Moral Hazard”, Rubin downplays monetary policy:

In the eurozone, leaders of key troubled countries—including Italy, Spain, France and, most immediately, Greece—need to undertake structural reforms, further strengthen banking systems, and strike a fiscal balance between sufficient discipline to win market and business confidence and adequate fiscal room for growth. As to Japan, the fundamental requisite is structural reform.

In all three major advanced economies, there should be a clear-eyed view of the moral hazard created by disproportionate focus on central banks. Monetary policy should be treated with a pragmatic analysis of all its attendant risks and rewards. Instead of looking for a wizard at the end of a yellow-brick road, we should demand that elected officials take the difficult fiscal, public-investment and structural actions that could do so much good now and that are imperative for the longer term.

Does he really think he could have accomplished the “difficult fiscal actions” in his time with the low quality monetary policy of today and at the same time keep the economy growing vibrantly?

Rubins Wizard_1


Rubins Wizard_2

 

Rubins Wizard_3

A “price” is never “guilty” of anything. It´s just a variable that reflects its fundamental determinants!

Matt O´Brien does a long and convoluted analysis on the dollar in “The strong dollar is the biggest threat to the economic recovery

So the dollar, in other words, is strong because the U.S. economy is strong, and it is about to get even stronger because the Fed is about to start tightening even more. Well, that and the fact that the rest of the world is slowing down.

He could have been more simple and explicit. Saying the strong dollar reflects the (relatively) strong economy is fine. Saying at the same time that it is the biggest threat to the economic recovery is just the common mistake of reasoning from a price change.

What is clear, however, is that it´s not the strong dollar that´s the big threat to recovery. It´s the fact that the Fed is “about to start tightening even more”. Among other things, that would cause a shift in the demand curve for dollars, strengthening it. In that case, both the strengthening of the dollar and the fall in the pace of the recovery would be the consequence of monetary policy tightening.

Is John Cochrane’s “The Banks Just Swapped Treasuries For Reserves—QE Was Mostly Inert” Narrative A Little Glib? Do Right-Wingers Confuse Financial Intermediaries With Ultimate Bond Buyers And Sellers?

A Benjamin Cole post

Many right-wingers predicted the Hyper-Inflationary Doomsday when the U.S. Federal Reserve undertook quantitative easing back in 2009. The Fed ultimately bought about $4 trillion in Treasuries and mortgage-backed securities, and we now see near-deflation on the horizon.

Meanwhile, economic growth in the U.S. picked up after QE, particularly when the Fed finally went to open-ended results-dependent QE3 in 2012. It sure looks like central bank QE and printing (digitizing) money works, at least when you have an underutilized modern-day economy near deflation (duh). My guess is the Fed should have done QE bigger, harder and longer.

Never to be chastened, the right-wing had to develop a new counter-argument to this heresy of a central bank printing money with good results. But the standard-issue right-wing hyperinflation-scare stories were in tatters.

Thus, the “banks just swapped Treasuries for reserves” argument was fashioned, with a side-dollop story that QE was mostly inert. The “economy recovered through natural forces, and see the 1921 recession” story line emerged.

Some right-wingers even say, “The Fed did not print money.”

Really?

But let’s examine the “with Fed QE, banks just swapped Treasuries-for-reserves” narrative. Does it hold water?

Well, no.

The Federal Reserve did buy $3 trillion in Treasuries—but not from commercial banks. The Fed buys their Treasuries from “primary dealers.” That is a list of 21 firms that includes Cantor Fitzgerald, Goldman Sachs, Jefferies, Nomura Securities, etc. These are government bond-dealers. Not commercial banks. Even with Glass-Steagall in ruin, these old business lines broadly hold up.

The primary dealers did not have $3 trillion in Treasuries in their own accounts or inventories, so they had to go into bond markets and buy $3 trillion in Treasuries, and sell those to the Fed.

The Fed, in fact, printed (digitized) $3 trillion and bought the Treasuries from the primary dealers. The primary dealers bought the Treasuries from the real sellers, who were people and companies. The primary dealers were intermediaries.

So where swelling commercial bank reserves come from? From the NY Fed: “So when the Fed sends and receives funds from the [primary] dealer’s account at its clearing bank [depositary institution, or commercial bank], this action adds or drains reserves to the banking system.”

Sellers

Now, after QE, the real or ultimate sellers of the Treasuries —not the primary dealers—had the freshly printed (digitized) Fed cash in their hands.

The real, or ultimate, private-sector bond sellers could then buy other bonds, or equities, or property, or spend the money, or bank it.

Now, it happens at the time the Fed was conducting QE that commercial bank deposits in the U.S. also swelled.

To be sure, some of the people and companies selling Treasuries to the primary dealers simply banked the freshly printed money, causing commercial bank deposits and related reserves to swell. And such deposits could be said to be “inert.”

But the swelling in bank deposits had many fathers. Households were also paying down debts and saving more in bank accounts. Corporations were and are sitting on growing cash hoards. Then, there is an undetermined amount of global flight capital deposited and parked into U.S. banks, from the Mideast and Far East.

In short, the people selling Treasuries to the primary dealers put some of the freshly printed money into banks, but they also then bought equities or property or bonds or spent the loot. All good, all expected—and all stimulative to the economy. And as the economy had plenty of slack, stimulative but not inflationary.

John Cochrane

John Cochrane, the brilliant University of Chicago econ prof, has long touted the desirability of commercial banks with trillions of dollars of excess reserves, and he may have a point.

But Cochrane also reprises that “banks just swapped Treasuries for reserves” theme. But he never explains where primary dealers obtained the bonds they sold to the Fed, or that primary dealers have accounts at depositary institutions.

It strikes me that Cochrane is providing a glib explanation, and obscures some very important facts on the ground: Like who are the ultimate sellers of the bonds purchased by the Fed, and what do they really do with the freshly printed cash they have in their pockets?