Thursday, December 17, 2009

Monetary Policy Quote of the Day

Scott Sumner on the efficacy of monetary policy even when the policy interest rate hit zero:
Zero rates don’t really make monetary policy more difficult, they make interest rate-oriented monetary policy more difficult... Permanent QE is just as effective as ever. Exchange rate depreciation is just as effective as ever, inflation targeting is just as effective as ever, NGDP targeting is just as effective as ever, commodity price targeting is just as effective as ever.
The strangest thing is that Ben Bernanke agrees with Sumner on this point. Just today we learn of his written reply to a Brad DeLong question on why the Fed has not adopted an explicit 3% inflation target (something that would have done wonders to prevent the great nominal spending crash of late 2008, early 2009):
...The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored. [Emphasis added]
So Bernanke agrees with Sumner in principle but is afraid of inflation expectations becoming unmoored. A look at the average 10-year inflation forecast from the Survey of Professional Forecasters says Bernanke should not be worried about inflation expectations. They have been anchored relatively well since 1997 around 2.5 percent:

Too bad Paul Krugman was not beating his influential drum with a message of inflation targeting--or in my dream world nominal income targeting--over the past year or so. Maybe others would have joined in and forced Bernanke and the Fed to think more about this option. Krugman admitted recently it would have been the first-best economic solution to the current crisis, but avoided doing so because he thought it would be a second-best political solution. (He thought expansionary fiscal policy would be more politically feasible.) Even if Krugman and other observers have been pushing the unconventional monetary policy message more forcefully over the past year, it is still not clear the Fed would have responded. David Wessel in his new book reports that Bernanke came into the Fed wanting to target inflation. He faced, however, strong opposition and (unlike his predecessor) wanted to be a consensus builder at the Fed. He did not want to force his hand on the FOMC.

Update: Scott Sumner, Brad DeLong, Free Exchange, and Will Wilkinson comment on Bernanke's response.

Tuesday, December 15, 2009

Lean Against the Credit Cycle Not Asset Prices

Adam Posen does not think monetary policy should respond to asset price bubbles by adjusting its policy interest rate. He likens this approach to a using a hammer to fix a leaky shower:
[I]f I have a hammer, it can be useful for all sorts of household tasks, but useless for repairing a leaky shower head – in fact, if I take the hammer to the shower head, I will probably make matters worse. I need a wrench to fix a pipe leak, and no amount of wishing will make a hammer a wrench. This is the essential reason why central bankers are now looking around for what has been called a ‘macroprudential instrument’, that is a tool suited to the job – and a tool additional to the one that we already have in our toolkit.
Antonio Fatas weighs in and says not so fast; finding that right tool for the job can be elusive so in the meantime we should not shy from using the tools we have--imperfect as they are--in addressing asset price bubbles (hat tip Mark Thoma). All of this attention on asset prices is a distraction says William White in a recent paper. Asset bubbles are but a symptom of a deeper problem, an unleashed credit cycle:
To favor leaning against the credit cycle is not at all the same thing as advocating “targeting” asset prices. Rather, they wish to take action to restrain the whole nexus of imbalances arising from excessively easy credit conditions. The focus should be on the underlying cause rather than one symptom of accumulating problems. Thus, confronted with a combination of rapid increases in monetary and credit aggregates, increases in a wide range of asset prices, and deviations in spending patterns from traditional norms, the suggestion is that policy would tend to be tighter than otherwise.

From this broader perspective, there is no need to choose which asset price to target. It is a combination of developments that should evoke concern. Nor is there a need to calculate with accuracy the fundamental value of individual assets. Rather, it suffices to be able to say that some developments seem significantly out of line with what the fundamentals might seem to suggest. Finally, there is no need to “prick” the bubble and to do harm to the economy in the process. Rather, the intention is simply to tighten policy in a way to restrain the credit cycle on the upside, with a view to mitigating the magnitude of the subsequent downturn...
White address a number of concerns regarding this leaning against the credit cycle approach. This one in particular caught my attention:
As for the more general concerns about undershooting the inflation target, this could lead to outright deflation, but it need not. In any event, it needs to be stressed that the experience of deflation is not always and everywhere a dangerous development (Borio and Filardo, 2004) The experience of the United States in the 1930’s was certainly horrible, but almost as surely unique (Atkeson and Kehoe, 2004). There have been many other historical episodes of deflation, often associated with bursts of productivity increases, in which falling prices were in fact associated with continuing real growth and increases in living standards. As noted above, there can be little doubt that serious problems can arise from the interaction of falling prices and wages and high levels of nominal debt. But the essential point of leaning against the upswing of the credit cycle is to mitigate the buildup of such debt in order to moderate the severity of the subsequent downturn...[emphasis added]
As readers of this blog know, I made this very point in comparing the deflation threat of 2003 with the deflation threat of 2009. Had the Fed been less fearful of the benign deflationary pressures in 2003 they would not have held the federal funds rate so low for so long and, as a result, there would have been less buildup of debt and thus the potential for the harmful form of debt deflation we face today. (In case there are any doubts as to whether the deflationary pressures of 2003 were truly benign see here and here.)

Read the rest of Williams White's article Should Monetary Policy "Lean or Clean" here.

Monday, December 14, 2009

Taking the Long View

It is easy to get caught up in the issues of the day and lose sight of important long-term structural developments. That is why I appreciate Niall Ferguson's work as it provides a broad, long-term perspective on recent events. Via Joe Wisenthal, here is Ferguson's latest interview where, among other things, he discusses the long-run outlook for the United States in terms of security, finance, and influence:

US vs. Canadian Monetary Policy During the Boom

James MacGee has an interesting article that compares the post-housing boom period in Canada with that of the United States (hat tip James Hamilton). Specifically, he notes that the housing bust that took place in the United States did not occur in Canada and attempts to explain this difference by looking at the two most common reasons given for the housing boom: (1) loose monetary policy and (2) relaxed lending standards. Looking at both factors, MacGee makes the following observations:
The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.
MacGee's claim that monetary policy in the two countries were similar is based on the fact that both policy interest rates followed similar paths during the housing boom (see his central bank target rate figure). Since these indicators of monetary policy did not differ much, he concludes it must be the case that the distinguishing factor between the two countries were the lax lending standards in the United States. I certainly agree that the monetary policy was not the only factor in the housing boom. I hesitate, however, to conclude that because the policy interest rates followed similar paths the stances of monetary policy were also similar. As Nick Rowe points out its not the level of the policy interest rate but where it is relative to the natural interest rate that determines the stance of monetary policy. Consequently, to make a convincing case that monetary policy was similar in Canada and the United States during this time one needs to show the difference between the natural interest rate and the policy interest rate--called the policy rate gap hereafter--for both countries followed similar paths.

So what does the policy rate gap show? It is not easy to answer this question because it requires an estimate of the natural rate of interest for both countries. I am only aware of natural interest rate estimates for the United States covering the housing boom period. Therefore, let me approximate the idea of a natural rate of interest--and will latter corroborate this approach--by looking at the growth rate of labor productivity in both countries relative to the policy interest rate. The natural interest rate, after all, is a function of individuals' time preferences, productivity, and the population growth rate. Of these three components, the one that seems to have changed the most during the housing boom in the United States was productivity. Below is a figure showing the quarterly year-on-year growth rate of labor productivity minus the ex-post real policy interest rate for both countries. (The policy rate in Canada is the overnight rate and in the United States it is the federal funds rate. The ex-post real federal funds rate is used to make a consistent comparison since I could not find quarterly inflation forecasts for Canada.) A positive gap indicates accommodative monetary policy while a negative gaps indicates tightness. (Click on the figure to enlarge it.)

This figure reveals a large policy rate gap for the United States while for Canada it shows one hovering around zero. The figure indicates, then, that monetary policy was not the same in both countries. The Canadian monetary authorities got it about right while the Fed was too accommodating. Now in case you are not convinced that this measure is truly approximating the difference between the natural interest rate and the ex-ante real policy interest rate I have constructed the actual policy rate gap measure for the United States as a comparison. The natural interest rate data comes from this paper by Fed economists John C. Williams and Thomas Laubach while the ex-ante real federal funds rate is constructed by subtracting from the federal funds rate the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters. The figure below graphs the two U.S. policy rate gap measures:

The similarity of these two series indicates the productivity-based approximation of the policy rate gap does a decent job. The low interest rates in the United States, then, appear to have been more distortionary than those in Canada.

So what is the take away from this analysis? For starters, monetary policy was an important part of the U.S. housing boom-bust cycle. Moreover, it is possible that the relaxed lending standards themselves cannot be entirely separated from this loose monetary policy. Over at Econbrowser commentator David Pearson sums it up nicely:
Weak underwriting standards and the "Greenspan Put" were joined at the hips. What you call weak underwriting was actually just collateral-based lending (hence no-doc loans basically eliminated ability to pay as a criterion, and zero-down loans depended entirely on the creation of equity value through appreciation). Where did the confidence come from to adopt widespread collateral-based lending? I believe a great deal of it came from the Fed's asymmetric monetary policy. Remember, the underwriting standards were ultimately set by the volume of demand (from hedge funds and the like) for higher-yielding securitizations, and, in turn, that demand was generated by ultra-low interest rates at the short end...
I would also note that during the housing boom interest rates charged to non-conventional mortgages were closely tied to the federal funds rate as seen in the figure below (see this post for more on this point.)

Source: FHFA

Of course, none of this is new. John Taylor already showed us via his Taylor Rule that those countries that deviated the most from the Taylor Rule's tended to have the greatest housing booms.

Tuesday, December 8, 2009

Monetary Policy and the Pre-Crisis Problems in Financial Institutions

Many observers have made the case that monetary policy was too loose in the early-to-mid 2000s and, as a result, helped fuel the credit and housing boom. Some observers, however, see little role for loose monetary policy in explaining the distortions that arose in the financial system. For example, Arnold Kling's impressive paper on policies that contributed to the financial crisis finds little importance for monetary policy with regard to the bad bets and excessive leverage taken on by financial institutions during this time. While there are a number of factors that contributed to these developments in the financial system, I want to push back on the notion that monetary policy's role was relatively unimportant. There are at least two reasons why monetary policy was important here: (1) it helped create macroeconomic complacency and (2) it created distortions in the financial system via the risk-taking channel. Let's consider each one in turn.

I. Macroeconomic Complacency
The first point is related to the reduction of macroeconomic volatility beginning in the early 1980s that has become known as the Great Moderation. This development can be seen in the figure below which shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983.

Solid line = 10 year rolling average of real GDP growth rate
Dashed line = 1 standard deviation

Now there are many stories for this reduction in macroeconomic volatility and one of the more popular views is that the Federal Reserve (Fed) did a better job running countercyclical monetary policy. In fact, Fed Chairman Ben Bernanke made this very point in a famous 2004 speech. I think there is merit to this view, but not quite in the same way as does Bernanke. During this time one of the key ways through which the Fed was able to reduce macroeconomic volatility was by responding asymmetrically to swings in asset prices. Asset prices were allowed to soar to dizzying heights but cushioned on the way down with an easing of monetary policy (e.g. 1987 stock market crash, 1998 emerging market crisis, 2001 stock market crash). The Fed also used its powerful moral suasion ability to goad creditors into helping the distressed and systemically important LTCM hedge fund. All of these actions served to prevent problems in the financial system from affecting the real economy and thus, were probably a big factor behind the "Great Moderation" in macroeconomic activity. However, they also appear to have caused observers to underestimate aggregate risk and become complacent. This, in turn, likely contributed to the increased appetite for the debt during this time. This interpretation of events was recently alluded to by Fed Vice-Chairman Donald Kohn in a 2007 speech:
In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.
So a macroeconomic complacency created in part by the Federal Reserve set the stage for one of the biggest credit and housing booms in modern history.

II. The Risk-Taking Channel of Monetary Policy
The risk-taking channel of monetary policy is one that looks at the relationship between the Fed's interest rate policy and risk-taking by banks. Leonardo Gambacorta of the BIS summarizes how this link works:
Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.
He goes on to empirically show a strong link between the easy monetary policy and risk-taking by banks during the early-to-mid 2000s using a database of 600 banks in the Europe and the United States. Similar work has been done by Tobias Adrian and Hyun Song Shin as I noted in this previous post. In their paper they find the following:
We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.
I see the macroeconomic complacency idea discussed above as setting the stage for and reinforcing the risk-taking channel of monetary policy. Of course, if so then this undermines the the Sumnerian view that all was well with a 5% trend growth rate for nominal expenditures during the Great Moderation but that is another story.

Monday, December 7, 2009

A 100 Trillion Dollar Zimbabwe Bill

Previously on this blog I have looked at the extent of hyperinflation in Zimbabwe and as well as recent progress (i.e. the defacto dollarization of the economy) the country has made in overcoming this problem. I bring this up because today one of my former students gave me the following Zimbabwe bill dated 2008 (click on pictures to enlarge):

Yes, this a 100 trillion dollar note with fourteen zeros. Note that the bill apparently has several anti-counterfeiting measures like the golden bird statue on the right front. That is surprising; surely the opportunity cost of counterfeiting this bill far exceeded any benefit. Just how worthless is this currency now? Below is a picture that answers this question succinctly (click on picture to enlarge):

Friday, December 4, 2009

The Stance of Monetary Policy Via the "Risk-Taking Channel"

There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of the challenge in measuring the stance of monetary policy is that there are multiple transmission channels through which monetary policy can work: the interest rate channel, the balance sheet channel, the bank lending channel, the wealth effect channel, unanticipated price level channel, the exchange rate channel, and the monetarist channel. (See here and here for a discussion of these channels.) Knowing the true stance of monetary policy depends in part on knowing which monetary transmission channels are most important at a given time.

Tobias Adrian and Hyun Song Shin make the case that one of more important channels in recent years is one that really hasn't been considered yet: the risk-taking channel. This channel measures the stance of monetary policy by looking at balance sheet quantities of financial intermediates:
We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.
While this channel works through balance sheet quantities of financial intermediates, it is important to note that changes in the federal funds rate are important in influencing the size of the balance sheets. This, then, provides another reason why the Fed's low interest rate policy in the early-to-mid 2000s was highly distortionary. The WSJ recently ran a story that highlighted Adrian and Shinn's work. Here are some key excerpts:

Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.

For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms' own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.

The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.

Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."[emphasis added]

His co-author, Mr. Shin, says "clumsy financial regulations" aren't enough to stop boom-bust cycles. "This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes," he says. Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper.

No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian's work closely.

I find this very encouraging. Apparently, Ben Bernanke is taking this risk-taking channel seriously along with its implications: the low federal funds rates in the early-to-mid 2000s was a mistake. Maybe we won't repeat the same mistakes after all.

Scott Sumner's New Best Friend: Joseph Gagnon

Joseph Gagnon is calling for $6 trillion more in global monetary easing. This should not be too hard to implement since the Fed is a monetary superpower.

Update: The Economist's Free Exchange blog comments on Gagnon's "roadmap" to further monetary easing:
I don’t doubt that many of his [Gagnon's] former bosses at the Fed, Mr Bernanke included, agree with his premises; they may even find the specific estimates reasonable. But the barriers to further quantitative easing at the Fed aren’t economic, they’re political. The Fed was taken aback by how critics on Wall Street, in foreign central banks, and in Congress screamed that its modest, $300 billion Treasury purchases were monetising the government deficit and paving the path for future inflation. They have added to the atmosphere of hostility now surrounding the Fed. The Fed has essentially decided to pursue a second-best (i.e. insufficiently aggressive) monetary policy because a first best monetary policy could bring political perdition.
So bad politics trumps good economics. Bill Woolsey notes this proposal would help push nominal spending back toward its long-run trend.

Greenspan's Cult of Personality

Alan Greenspan was a legend in his time and there was no shortage of praise for him back then. For example, who can forget Bob Woodow's 2000 book Maestro: Greenspan's Fed and the American Boom. While I was aware of this Greenspan devotion, I never realized the extent to which it rose until I read David Wessel's In Fed We Trust. In the chapter title "The Age of Delusion", Wessel directs us to a paper delivered at a major economic symposium in 2005 that had this passage in the introduction:
No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although this may come in time as the legend grows. But within the domain of monetary policy, Greenspan has been central to just about everything that has transpired in the practical world since 1987 and to some of the major developments in the academic world as well. This paper seeks to summarize and, more important, to evaluate the significance of Greenspan's impressive reign as Fed Chairman... There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System. (pp. 11-12)
This 86-page paper praising Greenspan's record epitomizes the cult of personality Greenspan had at this time and it is one reason why we got the economic debacle we are in now. Under Greenspan leadership, the Fed asymmetrically responded to swings in asset prices as they were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. While this approach probably contributed to the "Great Moderation" in macroeconomic activity it also appears to have caused observers to underestimate aggregate risk and become complacent. It is likely that it also contributed to the increased appetite for the debt during this time. These developments all helped spawn the current crisis. Greenspan's cult of personality meant little-to-no questioning of his policies.

Now not everyone bowed to emperor Greenspan. There were a few who saw his record differently. Here is one such prominent economist writing also in the year 2005 in the magazine Foreign Policy:
U.S. Federal Reserve Board Chairman Alan Greenspan is credited with simultaneously achieving record-low inflation, spawning the largest economic boom in U.S. history, and saving the world from financial collapse. But, when Greenspan steps down next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Has the world's most revered central banker unwittingly set up the global economy for disaster?
Unfortunately, this view was the exception not the rule. Let us never allow another cult of personality to develop within the Federal Reserve.

Wednesday, December 2, 2009

Charles Plosser and the Burden of Fed Credibility

The Economist's Free Exchange blog is shocked to hear this from Federal Reserve Bank of Philadelphia President Charles Plosser:
"Since expectations play an important role in the dynamics of inflation, it is important that policy act in a manner that keeps expectations well-anchored near the Fed’s inflation objective,” Plosser said in a speech in Rochester. “If expectations do become unanchored, then the Fed will have lost its credibility and either inflation or deflation could arise…So, anticipation and forward-looking policy are essential if the Fed is to achieve its goal of low and stable inflation."
I agree with the Free Exchange blog that inflation becoming unanchored is not an issue now. In fact, Plosser's own bank does the Survey of Professional Forecasters which shows the Fed still has an amazing amount of inflation-fighting credibility. Below is a figure based on this data (click on figure to enlarge):

Note that the 10-year forecast has been and continues to be around 2.5%. Based on Plosser's comments above, one would think it might have been inching up lately, but no it more or less has flat-lined since the late 1990s. I wonder what Plosser thinks of this data; how does he reconcile it with his comments above?

Arnold Kling and Expected Inflation

What do we know about expected inflation? According to Arnold Kling not much if we look to financial markets:
I'm also not convinced that we can read expected inflation in the TIPS market. Take right now, for instance. The TIPS market is saying that inflation is going to be low. But is that what the people who are buying gold believe? I don't think so...I dare you to try to tease inflation expectations out of financial markets right now.
Kling's bigger point here is that Scott Sumner's claim that real interest rates shot up late last year--and hence, monetary policy tightened--cannot be verified since we cannot properly tease out a correct measure of expected inflation from financial markets. In the case of TIPs this is because there was an increased liquidity premium at the time and, as a result, the difference between the treasury nominal yield and the TIPs real yield may have been reflecting more than just expected inflation. I always like an empirical dare so let me respond to Kling's challenge this way: instead of turning to financial markets let's look to the Philadelphia Fed's Survey of Professional Forecasters. This survey of economic forecasters looks at inflation forecasts and should provide a robustness check against the TIPs implied expected inflation. The big drawback to this approach is it only has quarterly data. With that said, below is the average 1-year ahead inflation forecast for the GDP deflator plotted along with the 5-year inflation forecast from TIPs (click on figure to enlarge):

Both series show a sudden change in expected inflation beginning in 2008:Q3. The survey measure of expected inflation, however, drops far less than the TIPs measure. Still, there is (so far) a permanent drop in expected inflation that is hovering around 1.5%. This implies a rise in real rates. How much is not clear. While this leaves some ambiguity as to what happened to real interest rates, I am still convinced that monetary policy was effectively tight late last year based on other measures.

Tuesday, December 1, 2009

A Paper on Stabilizing Nominal Spending

Given the recent discussion on stabilizing nominal spending as a policy goal I found this article by Evan F. Koenig of the Dallas Fed to be interesting:
The article shows that the optimal monetary policy rule in such an economy has the Federal Reserve target a geometric weighted average of output and the price level. In a realistic special case, the monetary authority should target nominal spending. [emphasis added]
This is an accessible article that makes use of standard AD-AS model with sticky wages. It also reaches conclusions about the relationship between nominal spending and deflation similar to the ones I discuss in this paper.

The Future of the Euro (Part VIII)

It seems Martin Feldstein cannot avoid speculating about the demise of the Euro. Since the late 1990s he has been making the case that there are just too many institutional and economic differences in the EU nations for a single currency to work. In short, Feldstein believes the Euro area falls way short of being an optimal currency area. The past decade of relative success for the ECB has done nothing to change his view. In fact, earlier this year he discounted this period as a "lucky time" for ECB policymakers:
Mr. Feldstein pointed out that the past decade has been, until recently, a lucky time in Europe. European country economies weren’t buffeted by severe economic problems, or big unemployment problems, allowing the European Central Bank to focus on price stability. But now, economic conditions are deteriorating rapidly, and some countries are being much harder hit than others...“In my judgment, the next few years will be an important testing time for the EMU and Europe,” Mr. Feldstein said - one in which the possibility of one or more countries choosing to withdraw from the EMU cannot be ruled out.
That was written in January 2009 when Europe seem poised to implode. Now that ECB has weathered that storm Feldstein still questions the Euro's survivability:

The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.

Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).


The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.

Feldstein acknowledges there would be technical and political hurdles to overcome for a country to abandon the Euro. Barry Eichengreen argues these hurdles are probably large enough to prevent a country from leaving the currency union. Obviously, Feldstein is less confident on this point than Eichengreen. Interestingly, Desmond Lachman, who foresaw many of the emerging market crisis of the 1990s, sees a "ticking time bomb" for Spain, Greece, Portugal, and Ireland from the "straightjacket of the Euro-zone membership." He too does not see the hurldes to a breakup of the Eurozone as unsurpassable. As I noted in a previous post, Argentina in the 2001-2002 period provides a good example of a country for which the technical and political hurdles--including a financial crisis, the largest-ever sovereign default, and political chaos--were not enough to prevent it from leaving the dollar zone. Never say never.

Thursday, November 26, 2009

A Must Read on Monetary Economics

The book that played a pivotal role in shaping my understanding of monetary economics is now available online at no cost: Less Than Zero by George Selgin. Among other things, this book will help one (1) appreciate why stabilizing nominal spending should be the ultimate objective of monetary policy and (2) why the deflationary pressures of 2009 were very different than those of 2003.

A Good Time at the SEA Annual Meetings

Earlier this week I attended the Southern Economic Association annual meetings in San Antonio, Texas. Among other things, I was part of a session at the meetings whose participants all happen to agree the Fed let the ball drop in late 2008, early 2009 by effectively--though not intentionally--letting monetary policy tighten: George Selgin, Scott Sumner, Josh Hendrickson, and of course myself. (See here and here for evidence of this tightening.) Our session went well (Larry H. White agrees) and we were able to chat some more over meals along the riverwalk. The conversations were great and covered everything from blogging to nominal income targeting to fiscal policy. I left the meetings more convinced than ever that a nominal income target would have done a lot to prevent the crisis--in terms of minimizing the buildup of economic imbalances during the 2003-2005 nominal spending boom as well as the late 2008, early 2009 nominal spending collapse--and is the best way forward for U.S. monetary policy given the current institutional arrangements in the United States. I want to thank Josh Hendrickson for organizing the session.

Monday, November 16, 2009

Assorted Monetary Musings

Here are some assorted monetary musings:

(1) Paul Krugman comes clean and acknowledges unconventional monetary policy can still pack a punch. In fact, he says the "first-best answer" to our current economic crisis is not expansionary fiscal policy, but a credible commitment by the Federal Reserve to higher inflation. An exasperated Scott Sumner who has been making this case for some time wonders why Krugman has taken so long to acknowledge this point. Krugman replies that he has not pushed this idea because he believes it will not get any traction. As a result he turned to expansionary fiscal policy as a second-best solution. In other words, Krugman believes he faces the following tradeoff regarding aggregate demand-stabilizing policies:

Krugman may be right on this policy tradeoff. But given Krugman's immense political influence, he could have made this issue front and central for policymakers. And with enough exposure unconventional moneary policy could have become a first-best political solution too. In short, had Krugman been pushing this idea some time ago it may have gone a long way in preventing the collapse in nominal spending over the past year. Moving forward, it is good to remember that it was unconventional monetary policy (and not fiscal policy) that ended the Great Contraction of 1929-1933. So too can it now keep the U.S. economy from entering a prolonged slump.

2. Speaking of Scott Sumner, I did a long run yesterday and listened to his podcast with Russ Roberts to pass the time. It was good interview and covered many of the same issues Scott has made on his blog. One of the points he made is that monetary policy could improve its ability to stabilize the macroeconomy by targeting some measure of nominal spending. I too am an advocate of the Federal Reserve stabilizing nominal spending for the same reasons. However, I am a little less confident that it is always a sufficient policy response in terms of stabilizing the macroeconomy. For example, if we look at the period called the "Great Moderation" that occurred during the 25+ years prior to the current crisis, we see the Federal Reserve did a fairly good job on average of stabilizing nominal spending around 5% growth (See this figure). However, this time was also a period of the Fed asymmetrically responding to swings in asset prices. Asset prices were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. This behavior by the Fed appears in retrospect to have caused observers to underestimate aggregate risk and become complacent. It also probably contributed to the increased appetite for the debt during this time. These developments all contributed to current crisis. To the extent, then, that stabilizing nominal spending requires the Fed to respond as it did to swings in asset prices during this time, then it becomes less clear to me that targeting nominal spending is always a sufficient condition for macroeconomic stability. Don't get me wrong, I still believe a nominal spending target would have done much to prevent the collapse in nominal spending over the past year and ultimately it would be an improvement over current Fed policy. The gradual buildup of excesses during the "Great Moderation", though, suggest to me that something more is needed. That is why I see a two part approach to macroeconomic stability: (1) target nominal spending and (2) implement macroprudential regulations.

2. It was a really long run so I also listened to a podcast where Bloomberg's Tom Keene interviewed Bruce Bartlett about his new book The New American Economy. It was an interesting interview, but at one point Bartlett claimed there was nothing more monetary policy could for the economy at this point. Apparently, Bartlett has not been reading Scott Sumner's blog. Bartlett also said of all economists he finds Krugman to make the most sense on the current crisis. If so, then there is hope for Bartlett given Krugman's admission that unconventional monetary policy can still work as noted above.

3. Bill Woolsely has had some great recent posts on monetary economics. First, he reminds us that we should not confuse money with credit. Second, he responds to Bryan Caplan's post on velocity by, among other things, coming to defense of the equation of exchange as being more than a trivial tautology. I agree with him that the equation of exchange is useful in thinking about monetary economics and have used it here before on this blog.

4. Francois R. Velde has a new paper on the recession of 1937. It is probably the best paper I have seen on the on this recession and makes a great policy implication for today: beware of tightening policy too soon in the recovery. Below is a figure from the paper that shows a historical decomposition of the recession. It comes from a vector autoregression that decomposes or attributes the forecast error for industrial production into non-forecasted movements in other series. Here, the other series are monetary policy as measured by M1, fiscal policy as measured by fiscal balance, and labor costs as measured by wages. In this figure, these series contribution to the forecast error--the difference between actual and forecasted (i.e. baseline) values-- of industrial production is shown by their own colored lines. For example, the closer the baseline + M1 line is to the solid black line (i.e. actual industrial production) the more of the forecast error is explained by monetary policy: (Click on figure to enlarge)

This figure makes clear that tight monetary and fiscal policy explain most of the 1937 recession. Read the paper here.

Monday, November 9, 2009

Further Readings on Nominal Spending

Given all the interest my figures generated on stabilizing nominal spending as a policy goal, I thought I would follow up with a collection of links to my posts and others on this topic. Let me note up front that stabilizing nominal spending as goal is nothing new and has been promoted in the past by many prominent economists such as Greg Mankiw, Robert Hall, Bennett McCallum, and others in the form of a nominal income targeting rule. It is just that this current crisis has sparked a renewed interest in the idea, at least among some observers.

Here are some blog posts:
(1) Why Care About Nominal Spending?--David Beckworth
(2) More on the Importance of Nominal Spending Shocks--David Beckworth
(3) Why Nominal GDP Matters--Scott Sumner
(4) Recognizing the Nature of the Macro Problem in My Views on Money/Macro--Scott Sumner
(5) Why Current AD Depends on Expected Future AD--Nick Rowe

And here are some accessible academic articles:
(1) Understanding Nominal GDP Targeting--Michael Bradley and Dennis Jansen
(2) Nominal Income Targeting--Greg Mankiw and Robert Hall

There are many other academic articles on nominal income targeting but most are highly technical. If you know of any more introductory or survey-type articles on this topic please let me know.

Friday, November 6, 2009

My Reply to Krugman

Paul Krugman has chimed in on my figure showing the collapse in nominal spending. He, however, is less enthusiastic about its implications:
[The figure is] certainly suggestive. But I disagree with the interpretation that this shows that the current slump is mainly about insufficiently expansionary monetary policy...


Focusing on nominal spending makes you think that low nominal spending is the problem, a problem with a monetary solution; but actually it’s the symptom, and monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).
Note that the part about changing expectations of future inflation in parentheses is actually an admission that monetary policy can do something about the current slump. Krugman, however, does not explore this point anywhere else in his post. That is unfortunate because it is the very argument advocates like Scott Sumner have been making in their case that monetary policy could have done more to prevent the nominal spending crash of 2008-2009. One way to think about this is to imagine what would have happened had the Fed set an explicit inflation target of say 3% in mid-2008 and promised it would do whatever was needed to keep actual inflation there. If such a policy had been adopted it is unlikely inflation expectations would have collapsed liked they did in late 2008, early 2009 as seen in the figure below (click on figure to enlarge):

And if inflationary expectations had not collapse then current nominal spending would have been far more stable. This is because if folks think that inflation will be permanently higher going forward they are more likely to spend their money today. That is, money demand will fall and velocity will pick up.

This is a point I empirically tested in a recent post. There I took the monthly expected inflation series implied by the difference between the nominal 10-year Treasury yield and the 10-year TIPs yield and put it in a vector autoregression (VAR) along with the monthly GDP series from macroeconomic advisers. Nominal GDP was turned into an annualized monthly growth rate and the data used runs from 1999:1 through 2007:9. More data would have been helpful, but TIPs only start in the late 1990s.* The two figures below show what the typical responses of expected inflation and nominal GDP to the typical sudden change or shock to expected inflation over the sample. The solid line shows the point estimate while the dashed lines show two standard deviations around the point estimate. Upon impact, the shock causes expected inflation to jump 16 basis points and occurs as the level of nominal GDP increases by 1.16 percent. In other words, a sudden positive change in expected inflation is associated with an increase in current nominal spending. Both effects persist but eventually become insignificant about 14-15 months later. (Click on figures to enlarge.)

So contrary to Krugman's claim, there is reason to believe the Fed could have prevented the great nominal spending crash of 2008-2009. The real question for me is why did the Fed allow inflationary expectations to fall so dramatically in late 2008, early 2009. My guess is they simply dropped the ball or there was too much pressure from inflationary hawks.

Update I: The Economist blog Free Exchange responds to Krugman's post by arguing that monetary policy is not out of gas.

Update II: Scott Sumner also shoots down Krugman's nominal nonsense.

*(Technical note: both series were in rates so no unit root problems, 13 lags were used to eliminate serial correlation, and corporate bond spreads were included as a control variable for the financial crisis).

Why Care About Nominal Spending?

Thanks to Alex Tabarrok, The Economist's Free Exchange blog, Ezra Klein, and Bruce Bartlett my last post on the history of U.S. nominal spending received a lot of attention. It also raised the important question of why we should care about nominal spending. Before I answer this question let me first define nominal spending: it is the current dollar value of total spending in an economy. More simply, it is total demand in an economy. Technically, what I showed in the last post was the growth rate of final sales to domestic purchasers or U.S. domestic demand. One could also look at final sales of domestic product--which includes foreign purchases of U.S. made goods and services--which is aggregate demand for the U.S. economy. Either way, both series show a large collapse in nominal spending late 2008, early 2009 as seen in this figure.

Now on to the importance of nominal spending. I have asserted that the best way for the Fed to reduce macroeconomic volatility is to stabilize nominal spending rather than inflation. Here is why. If an economy is running at full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that are not sustainable. This is because there are numerous rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending (i.e. create a nominal spending shock) and not have real economic activity move as well.

Note that the key here is not to aim for inflation stability, but to aim for nominal spending stability. This is because inflation is merely a symptom of nominal spending shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high (low) inflation due to positive (negative) aggregate demand (AD) shocks or negative (positive) aggregate supply shocks (AS)?--and as a result monetary policy that targets inflation rather than nominal spending may make the wrong call. To illustrate this point, consider the following two cases*:
(1) A central bank has a 2% inflation target and the economy's sustainable (i.e. natural) rate of growth is 3%. Here we have nominal spending growing at 5%. Now imagine that fiscal policy generates a positive AD shock that increases nominal spending and pushes inflation temporarily to 4%. Now nominal spending is growing at 7% and if there are any nominal rigidities (i.e. upward slopping SRAS curve) this increase in nominal spending (or AD) should also push real economic activity beyond its natural rate. Hence, a positive output gap is created and there is an uptick in inflation. In this scenario--where a positive AD shock is the issue--a policy aiming to stabilize nominal spending would have prevented the output gap from emerging. An inflation target regime would have also addressed the output gap, but since inflation is a symptom of the nominal spending shock it only would have done so after the horse was out of the barn, so to speak. Still, in this case inflation targeting would have made the right call.

(2) A central bank has a 2% inflation target and the economy's natural rate of growth is 3%. Once again, nominal spending is growing at 5%. Now assume a permanent productivity innovation pushes the natural rate of real economic growth to 5%. Assume also that the surge in productivity in the absence of any new accommodation or changes in monetary policy--that is, the central bank is still increasing money supply at rate that would have created a 2% inflation target under the old steady state of 3% real growth--would have pushed inflation down to 0%. If the central bank adopts this approach and does not accommodate the increase in productivity, nominal spending will still be at 5% (0% inflation + 5% real growth). Note, there has been no change in AD (still growing at 5%) and thus no movements against the SRAS by which to create an output gap.

Now assume the central doesn't sit idly by but accommodates the productivity shock so that its inflation target is maintained. It will have to stimulate nominal spending such that the potential 2% drop in inflation is avoided. Now nominal spending jumps to 7% from its previous value of 5%. Here, we have a sudden increase in nominal spending (or AD) that in the face of an upward-slopping SRAS will temporarily push output beyond its natural rate. In other words, an positive output gap will emerge. But here there is no observed change in inflation or the inflation target! Had the central bank targeted a 5% nominal spending growth rate this output gap would not have emerged. Instead, its rigid focus on inflation caused it to be too accommodative.
There are other scenarios one could consider, but any way you slice it what becomes apparent is that monetary policy that targets nominal spending can handle both AD and AS supply shocks, while monetary policy that targets inflation can only handle AD shocks. I believe one example of this was the 2003-2004 period when the U.S. economy was buffeted with rapid productivity gains (i.e. positive AS shocks) that led to low inflation. The Fed interpreted this low inflation as indicating weak AD and kept monetary policy extremely loose. They were wrong, nominal spending was soaring by 2003 and thus, monetary policy was too accommodative. I also believe that had the Fed been targeting nominal spending it would been easier for them to avoid the collapse in nominal spending that occurred in late 2008, early 2009. Of course, an explicit inflation target would have helped too but why not go for root of the problem rather than its symptom?

For more on the importance of stabilizing nominal spending I would recommend you take a look at Scott Sumner's blog. Also, here is an article from the St. Louis Fed that provides a more thorough but gentle introduction to the importance of nominal spending and how monetary policy might target it.

* These are variations of scenarios I first posted over at Worthwhile Canadian Initiative.

Tuesday, November 3, 2009

Global Nominal Spending History

As someone who believes that stabilizing nominal spending rather than inflation is key to macroeconomic stability, I have taken the liberty in the past to reframe U.S. macroeconomic history according to this perspective. Thus, I renamed (1) the "Great Inflation" that started in the mid-1960s and ended in the early-1980s as the "Great Nominal Spending Spree" and (2) the "Great Moderation" of 25 years or so preceding the current crisis the "Great Moderation in Nominal Spending." I also labeled the late-2008, early 2009 period as the "Great Nominal Spending Crash". Below was the figure I used to summarize this reframing of U.S. macroeconomic history (Click on figure to enlarge):

Recently, I learned the OECD has a quarterly nominal GDP measure (PPP-adjusted basis) aggregated across 25 of its member countries going back to 1960:Q1. The countries are as follows: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States. The combined economies of these counties make up over half the world economy and thus, provide some sense of global nominal spending. So in the spirit of reframing global macroeconomic history according to a nominal spending perspective I created the following figure (click on figure to enlarge):

I suspect the similarities between these two figures speak to the size and influence of the U.S. economy. I think it also speaks to the influence of U.S. monetary policy on global liquidity conditions and, thus, it influence on global nominal spending.

Monday, November 2, 2009

Pick Your Poison

After reading Nouriel Roubini's latest article in the FT I feel less certain about what the Fed should be doing going forward. On one hand I see figures like the one below from the IMF's World Economic Outlook (p. 32) that point to excess global capacity and the ongoing threat of global deflation (the bad kind) and come to same conclusion as Scott Sumner:
If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.
In short, the Fed should use its monetary superpower status to ensure there is ample global liquidity and in so doing stabilize global nominal spending.

On the other hand, Nouriel Roubini claims the current Fed policies in conjunction with a large dollar carry trade is creating a new set of asset bubbles:
Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals... So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fueling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time.Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

Roubini is not optimistic about what this means for the future:
[O]ne day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
So what is the bigger threat: global deflation or asset bubbles driven by Fed policy and "the mother of all carry trades"? Tim Lee via Buttonwood also sees potential problems to the unwinding of this dollar carry trade. I hope there is another way out for the Fed.

Friday, October 30, 2009

More Takes on the Fed's Monetary Superpower Status

As a follow up to my previous post, here are some more articles that point to the Federal Reserve (Fed) as a monetary superpower. Before I get to them I want to be clear why this discussion is important: if the Fed is a monetary superpower then it was more than a passive player during the global liquidity glut of the early-to-mid 2000s--it was an enabler. Moreover, the monetary superpower status means the Fed will continue to shape global liquidity conditions for some time to come. Until the Fed takes this role and the responsibilities that come with it seriously, it is likely to create more distortions in the global economy.

Now on to the articles. First up is Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:
A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.2 I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.
Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary policy and was more the cause rather than the consequence of the funding coming from Asia.

Along these same lines Sebastian Becker of Deutsche Banks makes the following case:
[I]t might well be the case that excess savings in emerging markets and the resulting re-investment pressure on developed economies’ asset markets contributed to the pronounced fall in US long-term interest rates between 2000 and 2004. Nevertheless, a simple graphical depiction of the US Fed funds rate and selected US long-term market interest rates (as e.g. 15-year and 30-year fixed mortgage rates) rather suggests that the Federal Reserve’s monetary policy stance was the major driver behind low US market interest rates. [See the figure below-DB] Correlation analysis confirms that US mortgage rates and US Treasury yields have both been strongly positively correlated with the official policy rate since the early 1990s. Although global imbalances and the corresponding rise in world FX reserves are likely to have contributed to very favourable liquidity conditions prior to the crisis, the savings-glut hypothesis does not seem to tell the full story. Instead, what really caused global excess liquidity might have been the combination of very accommodative monetary policies in advanced economies between 2002-2005 coupled with fixed or managed floating exchange rate regimes in major emerging market economies such as China or Russia. Consequently, emerging markets implicitly imported at that time the very accommodative MP stance of the advanced economies. (Click on Figure to Enlarge):

The entire Becker piece is worth reading and is a follow-up to another interesting article he did on global liquidity in 2007.

Finally, let's turn to Scott Sumner for how the Fed could use its monetary superpower status in a productive manner going forward:
If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.
The Fed abused its monetary superpower status in the past by creating a global liquidity glut that in turn fueled a global nominal spending spree. Now the Fed has a chance to redeem itself by stabilizing global nominal spending and preventing the emergence of global deflationary forces.

Friday, October 23, 2009

More Evidence the Fed is a Monetary Superpower

I have the made the case many times that the Fed is a monetary superpower. Recent developments seem to confirm this view: the Fed's low interest rate policy is making it difficult for other countries to raise their interest rates lest their currencies strengthen and they lose external competitiveness to the United States. Here is Vincent Fernando:

There's a huge problem with the entire world trying to have weaker currencies relative to the dollar right now.

It's that they've all become slaves to U.S. interest rate policy, even more so than they already may have been.

Right now, raising interest rates in any country before the U.S. does so is likely to strengthen that country's currency against the dollar, all else being equal.


For countries with a strong desire to keep exports competitive, that's a big problem.

Thus the Eurozone, the U.K., and most international countries have to decide whether their own fear of currency strength is worth the collateral damage it causes at home.

And you thought the ECB was a truly independent central bank? The Economist also has an article that touches on this issue:

The ECB will eventually face a problem that some central banks are already encountering. As long as America keeps its interest rates low, attempts by others to tighten policy (even stealthy ones that leave benchmark rates unchanged) are likely to mean a stronger currency. That is a price that Australia’s central bank seems prepared to pay. The minutes of its policy meeting on October 6th, at which it raised its main interest rate, revealed the exchange rate was not a consideration. The bank’s rate-setters ascribed the Australian dollar’s rise to the economy’s resilience and strong commodity prices. In New Zealand, similarly, the central-bank governor, Alan Bollard, told politicians that the kiwi dollar’s strength would not stand in the way of higher rates.

Note that this means the Fed is setting global liquidity conditions, just as it did during the early-to-mid 2000s. The Fed's official mandate is the U.S. economy, but its reach is global.

More on the Dollar

From Barry Eichengreen:
[T]he dollar isn’t going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial centre. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.
From David Lynch:

In the short run, the only currency that could challenge the dollar is the euro... But for all its attractions, the euro lacks some essential attributes. Although the European Union has a central bank, comparable to the Federal Reserve, there is no European treasury. Instead, there are 27 European treasuries. Investors can't easily track or influence fiscal policy on the continent.

The dollar is also buoyed by the existence of a massive government bond market. There's roughly $4 trillion worth of U.S. Treasuries floating around, and almost $100 billion changes hands each day, according to investment management firm Pimco. Trading that's carried on almost 24 hours a day, rolling east to west from Tokyo to London to New York, makes it easy to move into and out of dollar positions in a hurry.

Europe, by contrast, has no analogue to the U.S. Treasury market. Instead there is a fragmented scene with individual sovereign debt from Germany, Italy, France and other EU members. No individual market enjoys anything like Treasuries' liquidity and size.


There's another potential dollar rival on the horizon, though its day likely lies a decade or more in the future... But before it does, China will have to thoroughly overhaul its existing financial system. Today, the yuan isn't freely convertible into other currencies, and there are strict limits on the cross-border movement of the Chinese currency. Chinese officials publicly have committed themselves to freeing the yuan to float alongside the dollar, euro, yen and other major currencies. That change, however, won't happen overnight.

Thursday, October 22, 2009

Much Ado About Nothing: the Dollar's Decline

There has been much angst by observers over the dollar's decline from the conspiracy laden to the serious and somber. Other observers say this discussion is pointless; the weakened U.S. economy needs some dollar depreciation so get over it. A quick look at the dollar's value in the figure below shows the dollar's decline is (1) only returning it to where it was 2007 and (2) pales in comparison to its slide between 2002-2007. (Click on figure to enlarge.)

Daniel Drezner provides great perspective on this development:
OK, let's be as plain as possible about this - as a reserve currency, the dollar is not going anywhere. Really.

The dollar's slide in value has been predictable, as the need for a financial safe haven has abated. By and large, a depreciating dollar helps the U.S. trade balance (though it would help much more if the Chinese renminbi got in on the appreciation).

Even the Chinese, who have spoken like they want an alternative to the dollar as a reserve currency, are in point of fact not doing much to alter the status quo. Why? To paraphrase Winston Churchill, the dollar is a lousy, rotten reserve currency - until one contemplates the alternatives.

Because all of the alternatives have serious problems. The euro, the only truly viable substitute for the dollar, is not located in the region responsible for the largest surge of growth. It would be unlikely for the ASEAN +3 countries to agree to switch from the dollar to a new currency over which regional actors have no influence (the Europeans wouldn't be thrilled either, as it would lead to an even greater appreciation of the currency). Oh, and the European Union has no consolidated sovereign debt market. The euro is worth watching, but it's not going to replace the dollar anytime soon.

The other alternatives are even less attractive. Most other national currencies beyond the euro - the yen, pound, Swiss franc, Australian dollar - are based in markets too small to sustain the inflows that would come from reserve currency status. The renminbi remains inconvertible. A return to the gold standard in this day and age would be infeasible - the liquidity constraints and vagaries of supply would be too powerful. There's the using-the-Special-Drawing-Right-as-a-template-for-a-super-sovereign currency idea, but this is an implausible solution. As it currently stands, the SDR is not a currency so much as a unit of account. Even after the recent IMF authorizations, there are less than $400 billion SDR-denominated assets in the world, which is far too small for a proper reserve currency.

So, what's really going on here with the dollar obsession? I suspect that with the Dow Jones going back over 10,000, Republicans are looking for some other Very Simple Metric that shows Obama Stinks. The dollar looks like it's going to be declining for a while, so why not that? Never mind that the dollar was even weaker during the George W. Bush era -- they want people to focus on the here and now.

The thing is, I'm not sure this gambit is going to work. People who already think Obama is a socialist will go for it, sure, but that's only rallying the base. I'm not sure how much fence-sitters care about a strong dollar, however. If anything, populist movements tend to favor a debasing of the currency rather than a strengthening of it.
Read the rest of Drezner's article here.

Update: Martin Wolf has a great column on this issue titled "the rumours of the dollar's death are much exagerated."