What's the Fed doing? One view

Torsten Slok of Deutsche Bank Research, showed me a slide deck he prepared for evaluating the US economy. Here are a few fascinating graphs. Sorry, the slide deck isn’t public – you have to pay DB for this kind of art!

Most hilariously, “forward guidance” seems to be getting harder.

Torsten also makes the case that interest rates are much below the Fed’s usual “Taylor rule.” Implicitly, it’s supply now not “demand.” The market of people who are working looks recovered, the large number of people out of the labor force is the problem, and addressing that is, at least, a deviation from usual policy.

The rest of Torsten’s slide deck makes a persuasive case that strong growth may finally be just around the corner, a warning to anyone spending a lot of time on “secular stagnation” models!

No editorial here, I just thought the graphs were really interesting. Thanks to Torsten for allowing me to post them.

Richmond Fed Interview

The Richmond Fed published a long interview with me in their Econ Focus, shorter pdf (print) version here and longer web version here. Some of the questions:

• Does the 2010 Dodd-Frank regulatory reform act meaningfully address runs on shadow banking?
• So what do you think is the most promising way to meaningfully end “too big to fail”?
• Do you think there’s any reason to believe recessions following financial crises should necessarily be longer and more severe, as Carmen Reinhart and Kenneth Rogoff have famously suggested?
• Many people have asked whether the finance industry has gotten too big. How should we think about that?
• What are your thoughts on quantitative easing (QE) — the Fed’s massive purchases of Treasuries and other assets to push down long-term interest rates — both on its effectiveness and on the fear that it’s going to lead to hyperinflation?
• Both fiscal and monetary policies have been on extreme courses recently. What are your thoughts on how they might affect each other as they move back to normal levels?
• Switching gears to finance specifically, what do you think are some of the big unanswered questions for research?
• You wrote an op-ed on an “alternative maximum tax.” What’s the idea there?
• Can transfers really help the bottom half of the income distribution?
• Which economists have influenced you the most?

You’ll have to click to the interview for answers!

Thanks to Aaron Steelman, Lisa Kenney and especially  Renee Haltom, who helped a lot with the editing. I’m a lot less coherent in person!

Dupor and Li on the Missing Inflation in the New-Keynesian Stimulus

Bill Dupor and Rong Li have a very nice new paper on fiscal stimulus: “The 2009 Recovery Act and the Expected Inflation Channel of Government Spending” available here.

New-Keynesian models are really utterly different from Old-Keynesian stories. In the old-Keynesian account, more government spending raises income directly (Y=C+I+G); income Y then raises consumption, so you get a second round of income increases.

New-Keynesian models act entirely through the real interest rate.  Higher government spending means more inflation. More inflation reduces real interest rates when the nominal rate is stuck at zero, or when the Fed chooses not to respond with higher nominal rates. A higher real interest rate depresses consumption and output today relative to the future, when they are expected to return to trend. Making the economy deliberately more inefficient also raises inflation, lowers the real rate and stimulates output today. (Bill and Rong’s introduction gives a better explanation, recommended.)

So, the key proposition of new-Keynesian multipliers is that they work by increasing expected inflation. Bill and Rong look at that mechanism: did the ARRA stimulus in 2009 increase inflation or expected inflation?  Their answer: No.


This is a quantitative question. How much do the large-multiplier models say the ARRA should have increased inflation? Their answer: 4.6%. Where is it?

We know, of course, that inflation (especially core inflation) basically did nothing during the period of the ARRA, and Bill and Rong have some nice graphs. Defenders might say, aha, but except for the stimulus, we would have had a catastrophic deflation spiral. Critics might reply, that’s what George Washington’s doctors said while they were bleeding him. As always, teasing out cause and effect is hard.

Bill and Rong have a range of interesting facts that address this question. Here are two that I thought particularly clever. First, they look at the survey of professional forecasters, and examined how the forecasters changed inflation forecasts along with their changes in government spending forecasts, i.e. when they figured out a big stimulus is coming. I plotted the data from Bill and Rong’s Table 2

Dupor and Li Table 2

As you can see, in 2008Q4 and 2009Q1, many forecasters updated their views on government spending, a few by a lot.  However, there is next to no correlation between learning of a big stimulus and increases in expected inflation, especially among the forecasters who strongly update their stimulus forecasts.

Bill and Rong’s interpretation is that the stimulus failed to increase expected inflation. The main defense I can think of is to say that this evidence tells us about professional forecaster’s model, not about true inflation expectations. Professional forecasters are a bunch of old-Keynesians, not properly enlightened new-Keynesians; they don’t realize that stimulus works through inflation, they’re still thinking about a pre-Friedman consumption function. That’s probably true. But if so, it’s hard to think that everyone else in the economy does understand the new truth, and changed their inflation forecasts dramatically when they learned of the stimulus.

Another nice piece of evidence: The US had much bigger government spending stimulus than the UK. The behavior of expected inflation revealed in the real vs. nominal treasury spread was almost exactly the same. (Yes, Bill and Rong delve into the TIPS pricing in the crisis.)

Source: Dupor and Li

Finally, a key point missing in most of the stimulus debate. These models predict big multipliers not just at the zero bound, but anytime that interest rates don’t respond to inflation. We don’t have to just rely on theory, there is some experience. New-Keynesians since at least Clarida Gali and Gertler’s famous regressions have said that the Fed was not increasing interest rates fast enough in the 1970s, and the 1930s and interest-rate peg of the late 40s and early 50s are another testing ground. Using standard measures of exogenous spending increases, Bill and Rong find no impact of government spending on inflation in any of these periods.

New Keynesian stimulus analysis has been particularly slippery, on the difference between the models and the words, and on advocating the policy answers without checking or believing the mechanisms. The models are Ricardian: the same stimulus happens whether paid for by taxes or borrowing. The opeds scream that the government must borrow. The models say totally useless spending stimulates. The opeds are full of infrastructure, and roads and bridges. (At least, the “sprawl”  complaint is temporarily quiet.) The models say that spending works by creating inflation, not through a consumption function. Inflation being totally flat, and the counterfactual argument weak, you don’t hear much about that in the opeds.  The models say we should be in a huge deflation with strong expected output growth. The facts are protracted stagnation. (More in my last stimulus post.) The models are models, worthy of careful examination and empirical testing. All I ask is that their proponents take them seriously, and not as holy water for a completely different old-Keynesian agenda.

Rogoff on UK Defaults

Ken Rogoff wrote a very interesting FT oped on UK finances (FT original, Rogoff webpage if you can’t see FT.)

The issue: Should we worry about huge sovereign debts of advanced countries? Or was the only problem with fiscal stimulus that it was not big enough?


A little history:

Yes, from the 1800s until the first world war, the UK was a global superpower that commanded vast colonial resources and investments. Over long periods, these foreign assets yielded returns well in excess of interest on debt. But comparing government debt ratios back then, when the UK was a massive net creditor, to debt ratios today, when British foreign liabilities exceed foreign assets, is utterly misleading. Moreover, back in the 1820s, the UK was pioneering the industrial revolution; things are not quite the same today. Back then, the UK did not have to worry about pension liabilities or existential threats to the banking system that could require massive injections of cash to fix. …

During the 1930s, Britain defaulted on debt to the US accumulated during the first world war and its aftermath. …

It is often stated that after the second world war the UK debt reached almost 250 per cent of gross domestic product and was brought down merely through growth and inflation. This is a myth …

Then there is the high-inflation era of the 1970s – another de facto default. Last but not least, what about the UK’s serial dependence on International Monetary Fund bailouts from the mid-1950s until the mid-1970s? This is hardly a country with an indestructible credit status. …

Being a UK bondholder has had its ups and downs.

Looking forward, an important point: a country needs to be substantially below its ultimate borrowing limit, or it loses its ability to fight crises going ahead.

..a euro collapse would have triggered a stampede out once investors realised that the UK banks and trade would be savaged, a flexible currency notwithstanding. In that scenario, UK leaders would have been forced to close massive budget deficits almost overnight. That would have been truly catastrophic austerity. …

We now know the euro did not collapse. [yet – JC] With 20-20 hindsight, yes, the UK could have borrowed more. But we do not have hindsight at the moment decisions have to be taken. 

Kan and Carmen Reinhart have been at the receiving end of Paul Krugman’s tender commentaries lately, and I’m interested to see Ken taking up the issue. Krugman likes to lambaste people for “predictions” that he imagines they made which didn’t come out. On the euro blowing up, Ken seems to be offering a taste of his own medicine, made more bitter by the fact that Krugman actually did say what Ken says he said:

…This was the big call – the one that everyone was focusing on. To state that credit risk was gone by 2010 is ludicrous. None other than The New York Times columnist Paul Krugman prognosticated the euro’s early demise regularly from April 2010 to July 2012. His big call has turned out – so far – to be dead wrong.

I will be curious if we see more of that from Ken. Stay tuned.

Miron and Rigol go after a classic

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

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

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

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

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

Source: Jeff Miron and Natalia Rigol

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

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

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

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

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

Update:

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

Source Hal Cole and Lee Ohanian

The New-Keynesian Liquidity Trap

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

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

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

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

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

So I spent some time looking at all this.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let me just quote from the conclusion

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

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

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

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

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

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

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

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

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

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

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