Michael Woodford Endorses A Tax-Cuts-And-QE-Regime

A Benjamin Cole post

Since becoming a devout Market Monetarist, I have pondered not the goal but the how—how does the U.S. Federal Reserve and federal government meaningfully target nominal growth in GDP at an appropriate level, i.e. NGDPLT?

It may be that plain-vanilla QE, without the straitjacket of interest on excess reserves, would be effective. It appears QE was effective in the United States, especially the open-ended QE 3, even when hamstrung by interest on excess reserves.

But I have also been curious about marrying QE to tax cuts, such as a tax holiday on Social Security and Medicare taxes (the FICA taxes), with the lost revenues supplanted by the bonds obtained through QE. The FICA tax cut scheme has the additional benefit of lowering the cost of employment (remember, employers pay half of FICA taxes) at the very time that unemployment is a problem.

Michael Woodford

I had assumed my tax cuts+QE scheme would never appeal to serious economists, as it is suspiciously close to monetizing the debt, if not outright money-printing to run the federal budget.

But it turns out the highly regarded and deferred to Michael Woodford, the Colombia University professor, also backs tax cuts+QE!  Woodford has accolades too numerous to mention, and gets invited to the Kansas City Fed’s annual Jackson Hole confab as a speaker.

In a 2013 interview for VOX, the policy portal for the Center for Economic Policy Research, Woodford said of a QE-and-tax-cuts regime:

“I believe that one could achieve a similar effect, with equally little need to rely upon people having sophisticated expectations, through a bond-financed fiscal transfer, combined with a commitment by the central bank to a nominal GDP target path (the one that would involve the same long-run path for base money as the other two policies).

The perfect foresight equilibrium would be exactly the same in this case as well; and as in the case of helicopter money, the fact that people get an immediate transfer would make the policy simulative even if many households fail to understand the consequences of the policy for future conditions, or are financially constrained. Yet this alternative would not involve the central bank in making transfers to private parties, and so would preserve the traditional separation between monetary and fiscal policy.”

True, Woodford leaves open whether the “fiscal transfer” is tax cuts or direct spending. But I think most economists would concur that leaving money in the private sector is better than public spending, and so we can say, ceteris paribus, Woodford endorses tax-cuts+QE.

Conclusion

Back when the U.S. space program was in the early and televised days, NASA did not refer to the Atlas or Gemini or Mercury rockets as “blasting off.” Too cartoon-y. So, NASA used the words “lift off” to describe a launch, even though “blast off” is more correct.

Woodford appears the very epitome on erudition and intellect, deeply committed to his craft. But obscurantism is everywhere.

What Woodford is saying is, “Print money and finance federal deficits with it.”

He also says no promise should be made to unprint the money.

So…why is Michael Woodford not the Chairman of Federal Reserve?

Zombie Economics Will Never Die

A Benjamin Cole post

The tight-money crowd is dominant in central-bank staffs, and so firmly (and self-perpetuatingly?) ensconced in such independent government sinecures that they look likely to outlast all rivals. That tight-money enthusiasts preach an increasingly dubious religion or ideology—I have dubbed it Theomonetarism—is unimportant. They have allies in media and academia, curiously always on the right-wing side of things (with some exceptions, such as Ramesh Ponnuru at National Review, James Pethokoukis at AEI, and Scott Sumner, of the Mercatus Center at George Mason University).

The latest tight-money sermon comes from Daniel Thornton, an excellent writer and former veep at the St. Louis branch of the U.S. Federal Reserve, who damns the Fed for quantitative easing (QE) and low interest rates, in Requiem For QE, written for Cato Institute.

The Thornton Allegations

Thornton says not only did QE accomplish almost nothing in terms of stimulus, it resulted in “unintended consequences.” From Thornton, “[T]he intention of the (Fed’s) policy is to distort asset prices in an attempt to reduce long-term yields. But such actions produce unintended distortions: a strong and persistent rise in equity prices, a marked change in the behavior of commodity prices, a resurgence in house prices and residential construction beyond what is warranted by economic fundamentals, and excessive risk taking, even by those who are least well situated to take it. These are the unintended consequences of QE and the FOMC’s zero-interest-rate policy.”

Thornton also reiterates that the Fed was kicking Grandma; poor and elderly savers get hurt by low yields. And, of course, Thornton sermonizes that QE and low interest rates threaten injurious inflation down the road.

Where To Start

Like wrestling with a criminal octopus in Sodom and Gomorrah, it is difficult to know where to begin with Thornton. Wrong is everywhere. But let’s just hack away.

  1. Thornton avers QE and low interest rates cause “a strong and persistent rise in equity prices.” Given where stock prices were in 2009, one is tempted to answer, “And?”

But beyond that, Thornton overlooks what stocks did in the 1990s, long before QE and zero bound. Today’s stock market (which anyway has been flat for the last year, and not “persistently rising”) is far more sober than that of 1999, when the average Nasdaq p-e was at 100x earnings, and the S&P 500 at 44.2x earnings. The fed funds rate in August 1999 was 5.25%, and no QE.  The p-e’s on Wall Street today are slightly above long-term averages (now about 20 times earnings), even while corporate profits are at all-time record highs, absolutely and relatively. (QE evidently only has bad unintended consequences; Thornton does not say that QE caused corporate profits to soar to the moon.)

  1. Thornton also complains that QE-zero bound causes a “marked change in the behavior of commodity prices.” Well, one has to smile at this one. There were no commodity boom-busts before QE? BTW, gold hit $887.50 an ounce in 1980, before hitting $273.00 in 2000. Oil has been everywhere and done everything since the 1970s. I think what Thornton wants more than anything is to say, “higher commodity prices signal too-easy money.” That has been the standard refrain from the Theomonetarists since the 1970s, when the U.S. had double-digit inflation and OPEC was jacking up oil prices. In ensuing decades, we had the Chinese industrialization and full-throttle demand for all industrial commodities, while the U.S. ethanol program boosted corn prices, a basic agriculture good (they feed corn to pigs and cows, btw). Global oil was controlled by uncertain thug states. The last three decades have been a great run for commodities, and for inflation-hysterics who could endlessly siren about commodities prices.

But since QE started in 2009, commodity prices have been zooming—downhill. Copper has been cut in half, and gold is way off. Oil is cut in half too, and still going down. Thornton is reduced to saying QE results in a “marked change” in commodities prices. Yes, a “marked” reduction, so far.  Frankly, there are global markets for commodities, and global supply. The Fed went to QE and a nominally low federal funds rate, and commodities prices subsequently tanked. What is the connection?

  1. Thornton credits a “resurgence in house prices and residential construction beyond what is warranted by economic fundamentals” to QE and low interest rates.

Here Thornton seems unaware the basic facts. Housing starts are in the toilet.

BC Thornton

Actually, based on demographics, the U.S. has been under-building housing for years. As for house prices, noose-tight city zoning regulations prevent much new housing stock, and that plays a key role in national housing costs. Does Thornton mean to say U.S. apartments rents are rising (as they are), as there is too much residential construction? How does that work? The unfortunate truth is that even a merely mediocre economy in much of the U.S. will result in higher housing costs. It is a gigantic structural impediment. The solution to rising housing costs is much more liberal city zoning, or even no zoning. Thornton’s solution, on contrast, is to suffocate the economy enough that we obtain house price stability, despite regional housing shortages. Good luck with that—it is called 2008.

  1. Then we have Thornton’s assertion the Fed has caused “excessive risk-taking.” This reprises the “Fed as Mommy” role. You see, in free markets investors and business managers go bananas when interest rates are low. The free-market system is an inherently unstable platform on straw-like stilts, one that collapses whenever investors and business managers are not kept in check by an ever-vigilant Fed. Anyway, American corporations are actually sitting on huge piles of cash and not taking risks. There is not enough demand to warrant expansionist behavior by those who produce goods and services.
  2. I could go on, but another oddity is Thornton’s contention the Fed is too long in hugging the zero-bound tree. Yet, most economists would say the Fed cannot control long-term rates—that is, institutional investors will lend on 10-year Treasuries and other sovereign debt based on their gimlet-eyed assessments of yields, present value and the long-run economic landscape, not Fed antics. Okay, so the 10-year Treasury rate today, set by institutional investors, is 2% and pennies. If I quizzed a college class, “If in Free-Market Utopia Nation the 10-year sovereign-bonds sell at 2.00%, then what would you say the overnight federal funds rate should be?” I would answer, “Really, really low, as low as a morsel of snow.” That may explain why I did not get into Harvard, but the real answer would seem to be “somewhere near zero.”
  3. “Income was redistributed away from people on fixed incomes and toward better-off investors, “ avers Thornton, a reprise of the “Fed is bashing Grandma” argument. One wonders how to respond at less than encyclopedic length to this assertion. Interest rates have been falling globally for decades, and are negative now in many nations, including the famously tight Switzerland. Low rates are a sign that money has been tight, as Milton Friedman said. Monetary policy must be made for the general good, not any particular group or region. Raising rates hurts investors of all stripes—including those who risk equity to start businesses or invest in real estate. In fact, the Fed must be callous about poor people invested only in short-term risk-free assets. Helping the poor is the job of government and charity, not central bankers.
  4. Thornton adds, the “huge increase in the monetary base that QE entailed could cause inflation if the Fed loses control of excess bank reserves.” Again, one must suppress a smile here. Since 1980, has the tight-money crowd ever written a monetary paper that did not warn of the perils of pending inflation, due to Fed laxity? We have lived through five of the last zero hyperinflations, about 23 runaway inflations, and 71 double-digit inflations. Oddly, after decades of wanton laxity by our central bank, we are now paying the price—core PCE inflation is drifting down towards 1%, or perhaps lower if the Fed induces another recession.

In many regards, I have not been fair to Thornton in this brief blog. Thornton does ponder why the Fed is paying interest on excess reserves, thus suffocating some of QE’s stimulus effect. Thornton also criticizes the Fed for not expanding its balance sheet pre-2008, in the early days of failures by financial institutions.

Conclusion

As I have said before, the tight-money crowd has been increasingly erratic since 2009, and the failure for inflation to erupt following QE, or for there to be any detectable consequences for the Fed’s balance sheet (other than taxpayer relief, and some stimulus), let alone catastrophic results. The Theomonetarists are reduced to flying their tattered, sun-bleached storm flags for inflation (as does Thornton), and attributing all present-day economic ills to QE or low interest rates.

In fact, the Fed is too tight. We see weak demand, but global supply lines are thick and unused. We see that PCE core inflation is sinking below even the Fed’s niggardly 2% target. We see unit labor costs nearly dead-flat for years on end, a rising dollar, up 20% in last 18 months.

The Fed should target a robust growth rate via nominal GDP level targeting, and heavily use all tools at its disposal to get there, including QE and even negative interest rates.

QE and Business Investment: The VAR Evidence: Part 3

A Mark Sadowski post

What we are 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 inflation expectations, stock prices and the value of the US dollar leads to in terms of business investment. As mentioned in Part 2, all four of our series (T5YIEM, DJIA, TWEXBPA and ANXAVS) have unit roots. With unit roots in our models, 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).

Since there is no evidence of cointegration between investment in equipment and stock prices or the value of the US dollar, we are really only faced with a choice between a VARD and a VARL in these two cases. And although the existence of cointegration between investment in equipment and inflation expectations means that a VECM is an option in the third case, given the pros and cons of doing so, I am not going to estimate a VECM. For a detailed discussion of what these pros and cons are, see this post.

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. As we shall soon see, this is not at all an issue, so in the interests of brevity, I am only going to estimate three VARLs.

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 (Cholesky decomposition). Such a strategy means that the order of the variables affects the results. I will follow the traditional practice of ordering the goods and services market variables before the financial market variables in each vector. The response standard errors I will show are analytic, as Monte Carlo standard errors change each time an IRF is generated. In order to render the IRFs easier to interpret, for the rest of this analysis, with the exception of T5YIEM (which is already in percent) I have multiplied the log level of each series by 100.

Let’s look at the effect of a positive shock to inflation expectations first.

Most information criteria suggest a maximum lag length of two in the VAR involving inflation expectations. The LM test suggests that there is no problem with serial correlation at this lag length. The AR roots tables suggest that the VAR is dynamically stable at this lag length. Here are the responses to a shock to inflation expectations.

MS Investment3_1

A positive shock to inflation expectations leads to a statistically significant positive response to investment in equipment in months two through 31, or a period lasting nearly two and a half years. The IRFs show that a 13 basis point shock to inflation expectation in month one leads to a peak increase in investment in equipment of 1.04% in month 11. Recall that we previously showed that a positive 2.6% shock to the monetary base (QE) leads to an increase in inflation expectations of 4.8 basis points.

Now let’s look at the effect of a positive shock to stock prices.

Most information criteria suggest a maximum lag length of one in the VAR involving stock prices. The LM test suggests that there is no problem with serial correlation at this lag length. The AR roots tables suggest that the VAR is dynamically stable at this lag length. Here are the responses to a shock to stock prices.

MS Investment3_2

A positive shock to stock prices leads to a statistically significant positive response to investment in equipment in months two through 40, or a period lasting over three years. The IRFs show that a 3.1% shock to stock prices in month one leads to a peak increase in investment in equipment of 1.10% in month 15. Recall that we previously showed that a positive 2.3% shock to the monetary base (QE) leads to an increase in stock prices (DJIA) of 1.6%.

Finally let’s look at the effect of a negative shock to the value of the US dollar.

Most information criteria suggest a maximum lag length of four in the VAR involving the US dollar. The LM test suggests that there is no problem with serial correlation at this lag length. The AR roots tables suggest that the VAR is dynamically stable at this lag length. Instead of estimating the model with LTWEXBPA, I am multiplying LTWEXBPA by negative one and terming the result LRERROWUS, which stands for “real exchange rate of the rest of world in terms of the US dollar”. In other words this represents the real value of the rest of the world’s currency in terms of US dollars. This will make the IRFs easier to interpret. Here are the responses to a shock to the value of the US dollar.

MS Investment3_3

A positive shock to the value of foreign currency in month one leads (with the sole exception of month 5) to a statistically significant positive response in investment in equipment in months three through 27, or a period lasting over two years. The IRFs show that a 0.90% shock to the value of foreign currency in month one leads to a peak increase in investment in equipment of 1.16% in month 25. Recall that we previously showed here and here that a positive 1.9-2.5% shock to the monetary base (QE) leads to an increase in the value of the euro (1.5%), the Canadian dollar (1.4%), the Mexican peso (1.1%) and the Japanese yen (1.1%) in terms of the US dollar.

Now that we’ve established the empirical facts concerning QE and investment in equipment, let’s discuss the monetary theory that explains these facts.

As we have previously discussed, a positive shock to the US monetary base increases expected Nominal GDP (NGDP), or expected aggregate demand (AD). Higher expected AD means higher inflation expectations, ceteris paribus. Higher expected AD also leads to higher nominal stock prices. And higher expected inflation leads to an increase in the expected real exchange rates of foreign currencies in terms of the US dollar.

So why do higher inflation expectations, higher stock prices and a lower US dollar lead to increased investment in equipment?

Inflation expectations are the closest proxy we have for expected NGDP as an increase in expected NGDP should lead to an increase in inflation expectations, ceteris paribus. An increase in expected NGDP should lead to an increase in investment in equipment as businesses anticipate rising sales and increased profit making opportunities.

James Tobin’s q theory provides a mechanism through which increased NGDP expectations lead to increased investment in equipment through its effects on the prices of stocks. Tobin defines q as the market value of corporations divided by the replacement cost of their physical capital. If q is high the market price of corporations is high relative to the replacement cost of their physical capital, and new equipment is cheap relative to the market value of corporations. Corporations can then issue stock and get a high price for it relative to the cost of the equipment they are buying. Thus investment spending will rise because corporations can purchase new equipment with only a small issue of stock.

An increase in the real exchange rate of foreign currency in terms of the US dollar can make US goods and services more competitive with goods and services priced in that currency, both here and in that currency area. And if US goods and services become more competitive with goods and services priced in foreign currencies, this provides an incentive for US businesses to increase their investment in equipment.

And what of Robert Waldmann’s theoretical argument that QE leads to less business investment by raising the price of long term Treasuries (lowering their yields)?

The biggest problem with this theory is the empirical fact, despite the widely accepted myth otherwise, that QE leads to higher bond yields.

In Waldmann’s defense, he states that he is sure that Michael Spence and Kevin Warsh are wrong, and that he is simply making a theoretical argument for their conclusion, something which DeLong and Krugman argued Spence and Warsh had failed to do.

And, something which I hitherto have not discussed, just how important is the equipment component of business investment?

The three main components of private nonresidential fixed investment (PNFI) are 1) equipment, 2) intellectual property rights, and 3) structures. In the US in 2014 PNFI totaled $2,233.7 billion. Equipment represented $1036.7 billion of that total or 46.4%. Intellectual property rights (software, R&D and artistic rights) represented $690 billion of that total or 30.9%.  Structures represented $507 billion of that total or 22.7%.

Thus equipment is by far the most important component of business investment, and I find it remarkably difficult to believe, given QE’s demonstrably positive effect on investment in equipment (as well as its demonstrably positive effect on the output and price level), that it might have a negative effect on business investment overall.

QE and Business Investment: The VAR Evidence: Part 2

A Mark Sadowski post

In Part 1 we demonstrated that Value of Manufacturers’ Shipments for Capital Goods: Nondefense Capital Goods Excluding Aircraft Industries (ANXAVS) is a monthly frequency proxy for private nonresidential investment in equipment.

In Part 2 we are going to check if inflation expectations, stock prices and the value of the US dollar are correlated with private nonresidential investment in equipment in the Age of Zero Interest Rate Policy (ZIRP). Specifically we’re going to check if the 5-Year Breakeven Inflation Rate (T5YIEM), Dow Jones Industrial Average (DJIA) and the Real Trade Weighted U.S. Dollar Index: Broad (TWEXBPA) each Granger cause ANXAVS. This analysis is performed using a technique developed by Toda and Yamamoto (1995).

First let’s consider inflation expectations. Here is T5YIEM and the natural log of ANXAVS from December 2008 through September 2015.

MS Investment2_1

Using the Augmented Dickey-Fuller (ADF) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests I find that the order of integration is one for T5YIEM and two for LANXAVS. I set up a two-equation Vector Auto-Regression (VAR) in the levels of the data including an intercept for each equation.

Most information criteria suggest a maximum lag length of two. The LM test suggests that there is no problem with serial correlation at this lag length. The AR roots tables suggest that the VAR is dynamically stable at this lag length, and Johansen’s Trace Test and Maximum Eigenvalue Test both indicate the series are cointegrated at this lag length. This suggests that there must be Granger causality in at least one direction between T5YIEM and ANXAVS.

Then I re-estimated the level VAR with two extra lags of each variable in each equation. But rather than declare the lag interval for the two endogenous variables to be from 1 to 4, I left the intervals at 1 to 2, and declared the extra two lags of each variable to be exogenous variables. Here are the Granger causality test results.

MS Investment2_2

Thus, I fail to reject the null hypothesis that private nonresidential investment in equipment does not Granger cause inflation expectations, but I reject the null hypothesis that inflation expectations does not Granger cause private nonresidential investment in equipment at the 5% significance level. In other words there is evidence that inflation expectations Granger causes private nonresidential investment in equipment from December 2008 through September 2015, but not the other way around.

Next let’s consider stock prices. Here is the natural log of DJIA and ANXAVS from December 2008 through September 2015.

MS Investment2_3

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

Most information criteria suggest a maximum lag length of one for the VAR. The LM test suggests that there is no problem with serial correlation at this lag length. 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 not cointegrated at this lag length.

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

MS Investment2_4

Thus, I fail to reject the null hypothesis that private nonresidential investment in equipment does not Granger cause stock prices, but I reject the null hypothesis that stock prices does not Granger cause private nonresidential investment in equipment at the 10% significance level. In other words there is evidence that stock prices Granger causes private nonresidential investment in equipment from December 2008 through September 2015, but not the other way around.

Finally let’s consider the value of the US dollar. Here is the natural log of TWEXBPA and ANXAVS from December 2008 through September 2015.

MS Investment2_5

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

Most information criteria suggest a maximum lag length of four for the VAR. The LM test suggests that there is no problem with serial correlation at this lag length. 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 not cointegrated at this lag length.

Then I re-estimated the level VAR with two extra lags of each variable in each equation. But rather than declare the lag interval for the two endogenous variables to be from 1 to 6, I left the intervals at 1 to 4, and declared the extra two lags of each variable to be exogenous variables. Here are the Granger causality test results.

MS Investment2_6

Thus, I fail to reject the null hypothesis that private nonresidential investment in equipment does not Granger cause the value of the US dollar, but I reject the null hypothesis that the value of the US dollar does not Granger cause private nonresidential investment in equipment at the 1% significance level. In other words there is evidence that the value of the US dollar Granger causes private nonresidential investment in equipment from December 2008 through September 2015, but not the other way around.

The next step in this process is to determine the nature of these “correlations”. What do positive shocks to inflation expectations, positive shocks to stock prices, and negative shocks to the value of the US dollar lead to in terms of private nonresidential investment in equipment? Do they lead to a decline in investment as Mike Spence and Kevin Warsh are implicitly claiming?

Or might they cause investment to increase (counterfactually) as Monetarists claim? In order to determine this we will estimate properly specified bivariate VARs and generate appropriate Impulse Response Functions (IRFs).

For that, tune in next time.

QE and Business Investment: The VAR Evidence: Part 1

A Mark Sadowski post

Mike Spence and Kevin Warsh, writing in the Wall Street Journal on Wednesday said:

 “We believe that QE [Quantitative Easing] has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose “shareholder friendly” share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.”

To which Brad DeLong responded by saying:

“As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high? No. The U.S. looks to have an elevated level of exports, and depressed levels of government purchases and residential investment. Given that background, one would not be surprised that business investment is merely normal–and one would not go looking for causes of a weak economy in structural factors retarding business investment. One would say, in fact, that business investment is a relatively bright spot.”

And Paul Krugman, who said:

“It is, indeed, kind of amazing. In the eyes of critics, QE is the anti-Veg-O-Matic: it does everything bad, slicing and dicing and pureeing all good things. It’s inflationary; well, maybe not, but it undermines credibility; well, maybe not but it it causes excessive risk-taking; well, maybe not but it discourages business investment, which I think is a new one.”

And Larry Summers, who said:

“Perhaps Spence and Warsh are on to something that I am missing. I’m curious whether they can point to any peer reviewed economic research, or indeed any statistical work, that backs up their views.”

And Joseph Gagnon, who said:

“…economies in which central banks were most aggressive in conducting QE early in the recovery (the United Kingdom and the United States) have been growing more strongly than economies that were slow to adopt QE (the euro area and Japan)…. Indeed, to the extent that QE has raised stock prices, it discourages businesses from buying back stock because it makes that stock more costly to buy.”

About the only economist who rose to Spence and Warsh’s defense was Robert Waldmann, who said:

“The argument is that the duration risk in long term Treasuries is negatively correlated with the risk in fixed capital. I think this is clearly true. The risk of long term Treasuries is that future short term rates will be high. This can be because of high inflation or because the FED considers high real rates required to cool off an overheated economy. Both of these are correlated with high returns on fixed capital (someone somewhere keeps arguing that what the economy needs is higher inflation).

This means that a higher price for long term treasuries should make fixed capital less attractive — the cost of insuring against the risk in fixed capital is greater.”

It just so happens that there is Vector Auto-Regression (VAR) evidence on the relationship between QE and business investment.

This summer we showed that, in the age of zero interest rate policy (ZIRP), from December 2008 to present, the monetary base Granger causes inflation expectations, stock prices and the value of the US dollar, and that positive shocks to the monetary base (QE) lead to

statistically significant increases in inflation expectations,

statistically significant increases in stock prices,

and statistically significant decreases in the value of the US dollar.

In this series of posts we are going to show that in the Age of ZIRP, inflation expectations, stock prices and the US dollar all have an effect on investment in equipment, a component of business investment.

Private nonresidential investment in equipment is only available at a quarterly frequency. So since this analysis requires data at a monthly frequency, it is necessary to find a proxy variable for investment in equipment.

In applied macroeconomics, proxy variables typically satisfy two main requirements. First, the proxy variable should measure the equivalent characteristic of a reasonable subset of the variable being proxied. Secondly, the contemporaneous growth rates of the proxy variable and the variable being proxied should be correlated (i.e. have a relatively high Pearson’s r value).

Value of Manufacturers’ Shipments for Capital Goods: Nondefense Capital Goods Excluding Aircraft Industries (ANXAVS) overlaps in content considerably with US private nonresidential investment in equipment, and is available at a monthly frequency back to January 1992. Here is a graph of the natural log of ANXAVS and the natural log of Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment (Y033RC1Q027SBEA) since 1992Q1.

MS Investment_1

ANXAVS overlaps in content with private nonresidential investment in equipment, and it ranges from 77.4% to 116.2% of Y033RC1Q027SBEA from 1992Q1 through 2015Q3. So it would appear that the first proxy variable requirement is well satisfied.

Now we must check to see if the two variables are correlated. Here are the results of regressing the logged difference (i.e. the growth rate) of Y033RC1Q027SBEA on the logged difference of ANXAVS and the corresponding scatterplot with the Ordinary Least Squares (OLS) regression line.

MS Investment_2

MS Investment_3

The R-squared value is approximately 0.633. Since the growth rates are positively correlated, the Pearson’s r value is +0.796, which is above average for a macroeconomic proxy variable. So it would appear that the second proxy variable requirement is well satisfied. Thus we conclude that ANXAVS is a suitable monthly frequency proxy for private nonresidential investment in equipment.

In Part 2 we’ll check to see if inflation expectations, stock prices or the value of the US dollar are “correlated” with private nonresidential investment in equipment in the age of ZIRP.

The Verboten Topic? Central Bank Monetizing Of Debt Works? QE: The Rodney Dangerfield Of Macroeconomic Policies

A Benjamin Cole post

The central bank strategy of buying bonds, usually government issue, is known as “quantitative easing.” As practiced, QE appears stimulative, while paying off bondholders with cash, and essentially eliminating national debt. Nowhere has QE—in Europe, Japan, or the United States—resulted in much inflation. But one must scour the Internet in search of a favorable word on behalf of QE.

Oddly Enough

If you burrow deeply enough, you can find a paper written in September 2006 by right-wing iconic scholar John Taylor, who gushed about the positive results of QE, then undertaken by the Bank of Japan to flog some life into their deflation-slow growth economy.

“In the last three years, the Japanese economy has improved greatly compared to the decade-long period of near zero economic growth and deflation that began in the early 1990s. Once again Japanese economic growth is contributing to world economic growth as the expansion in Japan begins to set records for its durability.

What has been responsible for this recovery? The key to the recovery, in my view, has been the quantitative easing of monetary policy….”

Unfortunately, the Bank of Japan backed away from QE, and Japan went right back to the economic freezer. Evidently, the topic of QE thereafter became politicized.

Last Time

Taylor’s soliloquy to the triumph of QE might be the last time any U.S. economist said something nice about central bank monetizing, or paying off, of national debt to stimulate growth. From what I can gather, it is not PC in right-wing circles to like QE, as it is damned as either inert or hyperinflationary or maybe immoral, or in left-wing circles, who want piles of social welfare spending instead.

Moreover, there is a tangle of competing explanations why QE may or may not work, with a favorite dismissal in right-wing circles (since QE did not result in hyperinflation) that “QE is just a swap of bonds for reserves.”

Of course, this dismissal ignores the fact the Treasury bond-owners who sold into QE received cash, and also bank reserves swelled by an amount equivalent to the amount of QE. That is because when the Fed buys bonds, it does so only from the 22 primary dealers. The 22 primary dealers get reserves equal to Fed bond purchases, placed into their commercial bank accounts.

Consumption

In academia there is little discussion that QE might stimulate consumption directly. That is, bond-sellers can place an immediate claim on goods and services, once they have sold their bonds. Before QE, a bond-seller would have to sell, say, a $100,000 Treasury bond to another private-sector buyer, and that buyer would have to give up $100,000 in cool cash. No new Jaguar in the garage for the bond-buyer. But, post-QE, the seller instead sells to the Fed, no one in the private sector gives up anything.

There is, post QE, $4 trillion in digital and paper cash out in the economy that can place immediate claim on goods, services or assets.

Of course, the Fed website talks obliquely about portfolio rebalancing, that is people who sell bonds move into other assets, pushing up prices. A rally in stock and property prices gets the economy going too. And interest rates (ceteris paribus) fall, and that is good too. But the direct consumption angle is not mentioned.

I also wonder about the positive effects of paying off the national debt with cash.  This topic is evidently verboten, and never discussed. But debt reduction it is going on in Japan, and without inflationary impact.

For decades, U.S. doomsayers have screamed about mounting national debt, and grandchildren in debt bondage to Chinese or Japanese overlords, or Wall Street rentier-barons. I do not like mounting national debt, btw.

But the Fed can print up money, pay off the national debt, and spur the economy. Inflation does nothing, at least so far.

What is it that economists don’t like about QE?

PS Rodney Dangerfield?  An American comedian, and very American at that.  Sadly, since passed away. “I tell you, I get no respect, no respect at all,” was his signature line. I liked his joke, told in the crime-ridden 1980s, “I tell you I get no respect. I go down to the grocers, and some guy holds me up with knife. It still has peanut-butter on it. No respect at all.” And QE gets no respect.

China, Hong Kong and Singapore Sliding—Japan Not So Much. Beckworth and the Fed Export Of Recession

A Benjamin Cole post

China in recent years has kept its slowly rising yuan more or less pegged to the U.S. dollar, while Hong Kong has been explicitly pegged to greenbacks, and Singapore pegged its dollar to a mix of trading currencies, including prominently the greenback.

There is problem with this pegging—the U. S. Federal Reserve has been running a tight money policy since tapering down its successful open-ended quantitative easing (QE) program last year.

Now we see China desperately trying to un-peg its yuan, but awkwardly (fearful of dollar-denominated debts), and the Hong Kong stock market as of August 21 is off 7.47% YOY. Singapore in Q2 reported deflation and recession.

David Beckworth, cartoonist and University of Western Kentucky scholar, has called the above process the export of U.S. monetary policy.

PBOC, HKMA and MAS

Of course, the relevant central banks—the People’s Bank of China, the Hong Kong Monetary Authority and the Monetary Authority of Singapore—should immediately move to expansionary pro-growth stances until their economies are open full-throttle.

With pegged exchange rates, the policymakers at the three central banks have essentially defaulted on their obligations, and let the Fed dictate monetary policy, leading to a regional weakling economy blue in the face for lack of money. BTW, recent history suggests the Far East does not do recession well.

Indeed, if sanity prevailed, Far East central bankers would hold a confab to make Donald Trump blush, and gaily declare they will gun the money presses until the plates melt.

After all, moderate inflation will be small price to pay to avoid recession, or for robust economic growth, of which the region is fully capable.

Japan

Japan, of course, is trying to recover from 20 years of deflationary tight money, starting 1992. The Bank of Japan is now pursuing a steady QE program, perhaps too timidly.

Nevertheless, despite last week’s reverses, the Japan Nikkei 225 is up 12.34% year-to-date and up 26.78% year-over-year. Tourism to Japan leapt nearly 50% YOY in H1, thanks to a yen that depreciated from 80 to 124 or so to the U.S. dollar. Japanese corporate profits have been very healthy. There is so much paper cash sloshing around the Japanese economy ($6000 per resident, dollar equivalent) that official GDP figures, or even employment stats, may be suspect. But certainly the relative success of Japan suggests that persistent QE is a valuable tool in promoting economic revival and growth, and other Far East central banks should quickly adopt the same.

Conclusion

As usual, I support NGDPLT, with the proviso that central banks shoot higher rather than lower, as in 7% or so. To my fellow Market Monetarists, I ask, “Why be so prissy about inflation?”

In 1992 Milton Friedman told the Fed to gun the presses when inflation was at 3%. Fed Chairman Paul Volcker ended his war on inflation in 1981 when the CPI dipped below 5%. Why the present-day fey squeamishness about inflation?

Modern economies appear to suffocate at inflation below 3%.  I suspect it has to do with robust growth creating bottlenecks that are addressed by higher prices; sticky wages; criminalized housing production; and other friction and structural impediments.

The good news is that inflation is not that important. Economies have flourished for decades with moderate inflation—see the United States 1982 to 2007.

I prefer prosperity and some inflation to stagnation in real growth and prices. I will never be a central banker.

The IMF Tells the Bank Of Japan To Hit The Gas? What About The U.S. Federal Reserve?

A Benjamin Cole post

The International Monetary Fund on May 22 badgered the Bank of Japan to adopt a more-aggressive growth stance, even though the island nation posted Q1 real GDP growth of 2.4%, and an annual inflation rate of 2.3%—along with an unemployment rate of 3.4%.

Moreover, under the leadership of Governor Haruhiko Kuroda, the BoJ is buying about $83 billion in bonds a month, a quantitative easing program equal in size to that of the U.S. Federal Reserves’ Q3 at its peak—except that Japan has an economy one-half the size of the United States.

Nevertheless, the IMF warned the “BOJ needs to stand ready for further easing, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2% inflation target.”

Fair enough. Maybe the BoJ needs to really pour it on.

Um. What About the Fed?

So, the United States’ posted Q1 real GDP dead in the water, and many are forecasting Q2 not much better. The core PCE deflator is now running at 1.3% YOY, with headline deflation, and the Fed has not reached its 2% inflation target for seven years, except once, and that fleetingly. The U.S. producer price index has been in deflation for several months. The U.S. unemployment rate is 5.4%, and a squishy figure at that.

Yet Fed Chair Janet Yellen never misses a chance to rhapsodize about raising interest rates, and on May 21 warned that Fed cannot wait too long before tightening the monetary noose or it will “risk overheating the economy.”

BTW, also from the Fed: “Industrial production decreased 0.3% in April for its fifth consecutive monthly loss.” Capacity utilization is at 78.2%, below the long-term average.

Conclusion

Yellen has new definition of “overheat,” and that is any room temperature warm enough to melt ice cream. And the IMF…well, what can you say. They appear seriously confused.

The Japan Story

A Benjamin Cole post

If you don’t like quantitative easing, then consider this: The Nikkei 225, a broad measure of Japan’s stock market, is up 45.9% in the last 52 weeks.

On May 20, official Japan reported that Q1 GDP was up 2.4% YOY.

This is good news for Japan, a nation nearly moribund from 1992 through 2012, when so encrusted in deflation it managed but scant growth of 1 percent annually. In that pair of lost decades, the Japan stock market lost about 80% of its nominal value, as did property values. The nation became deeply indebted, as it tried fiscal stimulus to revive. The yen soared in value against the U.S. dollar.

The twenty years after 1992 were a debacle for Japan, a long real-world experiment that savages the folly that deflation and a strong currency are economic cure-alls.

Congratulations are in order to the current Bank of Japan, led by the courageous Governor Haruhiko Kuroda, who has shown resolve, so unlike the indecisive, feeble troupe who gaggle together at the Federal Open Market Committee, the lugubrious policy-making board of the U.S. Federal Reserve.

In contrast to the stop-and-go FOMC, BoJ’er Kuroda has been buying $80 billion in bonds a month since 2013, and has said he would do more if necessary to hit his 2% inflation target.

And yes, ordinary Japanese are benefitting too: “Wage growth is now positive, ending years of wage deflation,” Christopher Mahon, of Baring Asset Management recently told Barron’s. Mahon says buy Japan.

If I have criticism for the BoJ, it is that they should have a nominal GDP target, not an IT—more on that later.

QE in the U.S.

When finally the Fed did try to right kind of QE—QE3, which was open ended, results dependent—QE worked in the United States too. After peek-a-boo with QE 1 and QE2, the Fed in September of 2012 said it would buy $40 billion a month, and later upped that to $85 billion a month, until conditions improved. That policy roughly worked (although note that BoJ is buying $80 billion of bonds a month in an economy half the size of the U.S. economy).

Yet unlike the BoJ stalwarts, the FOMC folded up their QE tents when inflation was still below target, ending QE3 in October, 2014. Thus, the FOMC sent a signal to Wall Street and markets everywhere: seeking robust economic growth is not worth risking inflation even close to 2%.

Since the Fed quit QE, the DJIA has drifted sideways for fleeting gains, while the first half 2015 may be flat in terms of GDP growth, with just a little bad luck.

The U.S. is in the same “stall speed” that defined Japan for two decades.

And For What?

The Fed is obsessed with a nominal index of prices, the PCE deflator.

But as Martin Feldstein pointed out recently in the The Wall Street Journal, government indices of inflation are imprecise, and may read a few percent high. The Fed may have the nation in Japan-style deflation now.

Feldstein then lectured that government policies should be growth-oriented, more so than today.

Amen—I hope the Fed is listening. And watching. Watching Japan, that is.

And the IT? Well, Marcus Nunes is right, as he recently blogged: The Fed should actually target nominal GDP. But if they would even have the resolve to hit the IT they have, or preferably one a bit higher, that would be an improvement.

BNY Mellon Suggests A Brighter Future—And Why Not? Because of the Fed and Anti-Business Cranks?

A Benjamin Cole post

Of the many lamentable aspects of modern macroeconomics is the cowardly defeatism, that only slow growth is possible, and if not that, then advisable.

So welcome is a recent white paper issued by banker BNY Mellon, which ponders a future in which the U.S., China, Japan, and India (the “G4”) come close to fulfilling economic growth potential—and not through heroics, but just by rising to past growth trends.

The return to mediocre G4 growth would add $10 trillion to their projected GDPs by 2020, and another $8 trillion in related growth outside those four nations.

One key paragraph in the BNY Mellon report catches the eye:

Under Shinzo Abe, Japan now has its most stable government in almost a decade and a central bank that has twice surprised the markets with its determination to defeat deflation.”

Finally?

I have agonized in this space a few times how long the “right-wing” or business class would abjectly genuflect to gold and tight money. This self-destructive monetary peevishness must certainly appeal only to ideologues, theoretical academics, pundits and traders who have shorted markets—and to no one in the real business world.

I have found in interviews with economists in institutional real estate circles that the worship of tight money is absent. And now banker BNY Mellon says that the Bank of Japan’s aggressive QE program is a good thing. How long until the tight-money fanatics are seen for what they are: anti-business cranks.

The Fed Is The Monkey Wrench?

So, we read that the People’s Bank of China has been practicing a type of QE all along and is now lowering rates and considering more QE, and of course the Bank of Japan is in the QE camp. After foot-dragging and destroying the economies of a few nations, the ECB is in QE too.

That leaves the Fed, which has quit QE and blindly painted itself into a corner by endlessly rhapsodizing about raising rates. So now a Fed return to QE would look like a “flip-flop” or institutional ineptitude or uncertainty.

Would you like another $18 trillion in global GDP?

Tell the ECB, the PBoC and the BoJ to pour it on, to go to QE hard and heavy, print way more money.

But mostly tell the Fed.