Macro Musings Podcast: John Cochrane

My latest Macro Musing podcast is with John Cochrane, a Senior Fellow of the Hoover Institution and former professor of finance at the University of Chicago. In this week's episode I got to sit down and talk the fiscal theory of the price level (FTPL) with John Cochrane. I have been thinking a lot about FTPL lately--thanks in part to John's work on it--so it was a real treat to discuss it with him. We also got to chat about how he got into economics and the benefits of blogging for academics. It was a fascinating conversation throughout. 

Here is a previous post I did on the FTPL that may be helpful in thinking about its implication. I also have a paper on FTPL coming out soon so stay posted. 

You can listen to the podcast via iTunes or Sound Cloud, or through the embedded player above. And remember to subscribe since more guest are coming!

Related Links
John Cochrane's Website
John Cochrane's Blog
John Cochrane's Twitter Account

Macro Musings Podcast: John Taylor

My latest Macro Musing podcast is with John Taylor of Stanford University.  It was an interesting conversation throughout and we covered a lot of ground. We talked about the Taylor Rule, the Great Inflation, the housing boom period, the Great Recession, QE, the failure of the Fed to hit its inflation target, the international dimensions of Fed policy, rules versus discretion, and the latest efforts by Congress to nudge the Fed towards a more rules-based approach to monetary policy. A big thanks to John Taylor for being a part of the show!

You can listen to the podcast via iTunes, Stitcher, Sound Cloud, or the embedded player above. And remember to subscribe since more guest are coming!

Related Links

John Taylor's Website 

John Taylor's Blog

John Taylor's Twitter Account

A New Podcast on Macroeconomics

Today is the launch of a new podcast series on macroeconomics called Macro Musing and I am privileged to be the host. Each week, with the help of a special guest, we will get to explore in depth various macroeconomic topics. If want to go all wonky on macro this is the podcast for you! 

So far I have recorded podcasts with the following guests: Scott Sumner, John Taylor, John Cochrane, Cardiff Garcia, Miles Kimball, Ramesh Ponnuru, and George Selgin. There have been a lot of interesting conversations covering topics such as the origins of the Great Recession, the safe asset shortage problem, negative interest rates, the fiscal theory of the price level, the Eurozone Crisis, Abenomics, the Great Depression, China's economic problems, and alternative monetary regimes. In addition to these interesting topics, I have enjoyed learning how each guest got into macro, either as an academic or as an journalist, and how they see the field changing over time as new ideas and new technology emerge. I think you will find it fascinating too.

More guest are scheduled, including some Fed officials, but I would love to hear from you on what guests and topics you would like to see on the show. My first guest is Scott Sumner with whom I discuss his views on the Great Recession, NGDP targeting, and his new book on the Great Depression, The Midas Paradox.

I hope to make this a long-term project, but it success depends in part on you subscribing. So please subcribe via itunes or your favorite podcast app (update: here is the soundcloud link and here is the Stitcher link) and spread the word. Let's make this podcast a success together and who knows, maybe we can help make the world a better place. 

This podcast is part of the new Program on Monetary Policy (POMP) at the Mercatus Center at George Mason Univeristy. I am grateful for all their support in making the podcast happen.

Related Links for Scott Sumner
Retargeting the Fed
A Market-Driven Nominal GDP Target
The Great Depression
The Money Illusion

The Safe Asset Problem is Back: Negative Interest Rate Edition

The safe asset shortage problem is back. Actually, it never went away but drifted into the background as the symptoms of this problem--sluggish growth and low interest rates--became the norm. As the figure above shows, yields on government bonds considered safe assets have been steadily declining since the crisis broke out. 

This problem is now manifesting itself in a new form: central banks tinkering with negative interest rates. Many view this development as the latest manifestation of central banks running amok. A more nuance read is that central banks are continuing to imperfectly respond to the safe asset shortage problem. The above figure indicates the downward march of global safe yields since 2008 is a global phenomenon. This decline has occurred outside of QE and prior to negative rates. It is a far bigger development than central banks playing with negative rates. 

But many observers miss this point. They confuse the symptom--central bankers tinkering with negative interest rates--for the cause--the safe asset shortage. So I want to revisit the safe asset shortage problem in this post by reviewing what exactly it is, why it has persisted for so long, and what can be done to remedy it. 

So what exactly is the safe asset shortage? It is the shortage of  those assets that are highly liquid, expected to be stable in value, and used to facilitate exchange for institutional investors in the shadow banking system. They effectively function as money for institutional investors and include treasuries, agencies, commercial paper, and repos. During the crisis many of the privately issued safe assets disappeared erasing a large chunk of the shadow banking's money supply. This happened just as the demand for safe assets was increasing because of the panic. As recently shown by Caballero, Farhi, and Gourinchas (2016), if this excess demand for safe assets is big enough it will push down the natural interest rate below zero. Since the central bank cannot push its policy rate very far past 0%, an interest rate gap will emerge and cause output to fall below its potential. That seems to fit post-2008 fairly well. (HT Josh Hendrickson)  

This problem can be illustrated by using a standard supply and demand graph for safe assets, as seen in the two figures below. These graphs are fairly standard except for the second vertical axis which allows me to show that interest rates move inversely with bond prices. The first figure shows the supply and demand of safe asset pre-2008. Note that interest rates are near 5% which is roughly where treasury yields were during that time. 

Now comes the crisis in 2008 and two changes occur, as seen in the next figure. First, the demand for safe assets rises given the fear and uncertainty during the panic. This shifts the demand curve to the right. Second, the the supply of safe assets is reduced as many of the private-label safe assets disappear. This pushes the supply curve to the left.

Given these developments, two rather striking results emerge. First, because of the zero lower bound (ZLB), interest rates remain too high. The ZLB, therefore, acts as price floor that prevents the market from clearing along the interest rate dimension. Second, the ZLB also means safe asset prices are too low. It creates a price ceiling that prevents the market from clearing along the bond price dimension.

This implies treasury prices have been too low since the crisis!

Sometimes I am asked how can there be a safe asset shortage? Shouldn't safe asset prices simply adjust upward to meet the increase demand for them? The above analysis shows why this cannot happen with the ZLB. The safe asset market has been constrained by the ZLB and prevented from working its market-clearing magic.

Why has this problem persisted for so long? Why are safe assets yields still so low? I am not entirely sure. I suspect the demand for safe assets has remained elevated given the ongoing spate of bad news shocks since the crisis: Eurozone crisis, China concerns, fiscal cliff talks, 2016 recessions fears, etc. Also, some of the new banking and finance regulations is probably suppressing the growth of private-label safe assets. That is has taken this long, though, is a bit puzzling.

 So what are the solutions to safe asset shortage problem? One solution is for the government to issue more safe assets. That the 10-year U.S. treasury is now 1.73% seven years after the crisis suggest there is still strong appetite for treasury securities. This is the solution proposed by folks like Stephen Williamson and Paul Krugman. Another solution is for policymakers to 'shock and awe' the public into believing a robust recovery is coming and thereby decrease their demand for safe assets. QE was supposed to do this but was not that effective. Scott Sumner and Michael Woodford's call for NGDP level targeting would also fall under this option. The final option is that policy makers could try to work past the ZLB via negative interest rates. Under this option policymakers would help the safe asset market clear by pushing interest rates and prices to their market-clearing levels.

As  noted by Narayana Kocherlakota, the difficulty of doing the first two options seems to be making negative interest rates the default option.  I am not convinced it will be very effective given how it is being implemented (very different than Miles Kimball's suggested approach). But it is a response--a groping in the dark by central bankers--to the deeper safe asset shortage problem. And that is something we all need to better understand. 

Fed Commentary

I have a a couple of pieces out this week on the Fed. The first is an article in Politico on the Fed's influence on the global economy. Here are some excerpts:

Through both its policy actions and its written words, the Federal Reserve has mistakenly tightened monetary policy in fear of rising inflation. That mistake has not just hurt the U.S. economy, it is reverberating around the globe. 

This week, the Fed has an opportunity to admit its error when the Federal Open Markets Committee meets to set monetary policy. It’s critical that Fed board members understand how their actions are hurting economies around the world, which has a corresponding negative effect on the U.S. Otherwise, the Fed will continue to tighten policy — and the economic recovery will continue to sputter. 

The Fed began tightening policy in 2014 when, despite a slow start, the U.S. economy made significant advances with some observers believing an economic boom was under way. This improved economic outlook and the need for Janet Yellen’s Fed to prove its inflation-fighting credibility led U.S. monetary officials to start talking up future interest rate hikes... 

By talking about future interest rate hike, the Fed was indicating that tighter monetary conditions would exist in the future. That, in turn, worsened the economic outlook and caused companies to cut back on their spending plans. The Fed’s talking up of interest rate hikes, therefore, amounted to an effective tightening of monetary policy long before the actual raising of interest rates in December 2015. It affected not only the U.S. economy but also the many emerging economies whose currencies are pegged to the dollar, colloquially known as the “dollar bloc countries.”

This should be a familiar argument to readers of this blog. The only thing I would add to the Politico piece is that the Fed's slowing down of global aggregate demand since mid-2014 is a non-trivial reason why oil prices have declined so sharply since then. Along these lines, here is the OECD's leading indicator index for China and the United States:

The second piece is an a podcast interview I did with Cardiff Garcia on FT Alphachat. We discuss NGDP level targeting and my call for an automatic treasury backstop to the target. Another way of thinking about this proposal is that an automatic treasury backstop to a NGDPLT is simply an automatic stabilizer tied to a target. It is way of doing 'helicopter drops' in a rule-based manner that actually works. What many people miss is that doing an ad-hoc helicopter drops in inflation-targeting regime will not do much good. It has to be tied to a level target to matter. (See Paul Krugman on this point too). Finally, this proposal adds credibility to the NGDPLT in a manner that Chuck Norris and Jean-Claude Van Damme would appreciate.

Update: the Fed held steady today and signaled there would be fewer rate hikes this year. This was a slight move to easing and good news for China.  Interestingly, the Fed listed "global economic and financial developments" as one reason for its response today. Here is Yellen in her press conference:

"Chinese growth hasn't proven a great surprise.  We have anticipated that it would slow over time, and it seems to be slowing as well.  Japanese growth in the fourth quarter was negative.  That was something of a surprise.  And with respect to the Euro area, recent indicators suggest perhaps slightly weaker growth.  So there's been a number of emerging markets, as you know, where suffering under the weight of declines in oil prices that are affecting their economic activity.  Our neighbors both to the north and south, Canada and Mexico, are feeling the impacts of lower oil prices on their growth.”

Notably absent from her response is the role the strong dollar is playing in these developments. The Fed is almost connecting the dots.

ECB Stimulus in Perspective

Today is a big day for the ECB. Mario Draghi and other monetary officials are expected to add further monetary stimulus via additional interest rate cuts and a possible expansion of the ECB's QE program. Many observers are getting excited and expecting big market moves. 

Here is the thing. Even if the ECB cuts rates and adds more QE and even if there are big positive swings in market prices, these changes will only be tolerated up to the point they push core inflation to between 1.00 and 1.25 percent. That seems to be the ECB's true inflation target range per revealed preferences. Not only is that well below the ECB's stated inflation target of being "below, but close to 2 percent", but it is nowhere near enough to create the kind of catch-up spending growth needed to restore full employment in the Eurozone. 

This is the same problem that plagues the Fed. As I recently noted in my FT Alphaville piece:

The real reason for this failure [to create a robust recovery] is the Fed’s firm commitment to low inflation. Like a governor placed on a truck’s engine to control its speed, a commitment to low inflation helps prevent the economy from growing too fast. Normally, this is a good thing. But sometimes it can backfire. A truck driver may need to temporarily go faster to make up for lost time after being stuck in traffic. Similarly, an economy may need to temporarily speed up to get back to its full potential after a recession. Neither can happen with a rigid adherence to the speed limit. 

Put differently, both the ECB and the Fed are constrained by inflation-targeting straitjackets. These straitjackets are more than the outcome of central banks actions. They are the product of what the body politic expects and so they are tough to remove. But that is exactly what is needed.

To be clear, we want to keep long-run inflation expectations anchored but allow for the temporary deviations in inflation when needed to generate catch-up growth in nominal spending. The best way to do it, in my view, is through level targeting. Here is an earlier post showing a counterfactual where the Fed adopted a NGDP level target in mid-2009. What it reveals is that inflation would have had to temporarily hit between 3 and 4 percent before settling back down to 2 percent in order to stabilize demand. Something similar would be needed in the Eurozone. But this is not going to happen anytime soon.

The world sorely needs predictable, rules-based level targeting. Until it gets some, we should continue to expect weak recoveries from recessions. 

P.S. I made this same point in a BoomBust interview this week. 

Should We Worry About A Global Economic Slowdown?

The International Monetary Fund (IMF) says yes (my bold):

The International Monetary Fund is sounding louder and louder alarms about the state of the global economy. The problem is, few major economies seem to be hearing them.

“The IMF’s latest reading of the global economy shows once again a weakening baseline,” the fund’s No. 2 official, David Lipton, warned Tuesday in a speech to the National Association for Business Economics.

While the world economy is still expanding, he said, “we are clearly at a delicate juncture, where risk of economic derailment has grown.”

On the other hand, the Peterson Institute for International Economics (PIIE) says no (my bold):

After five years of disappointing recovery throughout the major economies, almost everyone is ready to believe the worst. Global markets have displayed the fruits of that pessimism in recent months...

[W]e share a conviction that public discussion of the global economic out-look has run off the rails of late... Global economic fundamentals today are not so grim... and policymakers and the public should base their decisions on fundamentals, not market swings

So the IMF sees declining global aggregate demand growth and worries policy makers in advanced economies are not paying close enough attention to it. PIIE tells us the fundamentals are not so bad and to be more upbeat. Who is right? 

Well, there is this OECD composite leading indicator which suggest a slowdown is ahead for the two largest economies in the world: 

I chose to highlight China and the United States in this graph not just because of their size, but also because they share something in common: the monetary policy of the Fed. It is this common link that explains why both economies have seen increased economic problems within the last year and a half. It may also explain why the OECD leading indicator is turning down for both economies. For Fed policy has been tightening during this time. Here is how.

First, the Fed effectively began tightening monetary policy in mid-2014 by talking up interest rate hikes. That is, monetary policy began tightening well before the actual rate hike of  December 2015. This rate hike talk got priced into the market and (in conjunction with the easing bias at the ECB and BOJ) caused the dollar to soar at one of its fastest paces ever. Between mid-2014 and late-2015 the dollar rose over 20%. This can be seen in the figure below:

Second, this tightening of monetary conditions put the squeeze on the US economy.  A number of indicators--expected inflation, SP500, industrial production, risk premium on corporate debt--began slowing down just as the expected rate hikes began taking off as shown here. More generally, this tightening caused the growth rates of total dollar spending growth and employment growth to slow down. Gavyn Davies correctly called this development the "dollar shock" and warned that a 20% rise in the value of the dollar is enough to hurt even an relatively closed economy like the United States.

Third, this tightening of monetary conditions has also put the squeeze on the dollar block countries. The dollar bloc countries are the ones that peg in some form to the dollar and therefore are subject to Fed policy. They make up around 40% of the world's economy and include China. That dollar bloc countries import Fed policy is not controversial. Even Fed Chair Janet Yellen recognizes this point, as she noted in this 2010 speech:

For all practical purposes, Hong Kong delegated the determination of its monetary policy to the Federal Reserve through its unilateral decision in 1983 to peg the Hong Kong dollar to the U.S. dollar... As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies. Like Hong Kong, China pegs its currency to the U.S. dollar, but the peg is far less rigid.

    [...]

Overall, we encountered concerns about U.S. monetary policy, and considerable interest in understanding the Federal Reserve's exit strategy for removing monetary stimulus. Because both the Chinese and Hong Kong economies are further along in their recovery phases than the U.S. economy, current U.S. monetary policy is likely to be excessively stimulatory for them. However, as both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent extent stuck with the policy the Federal Reserve has chosen to promote recovery.

Back in 2010 the Fed was exporting monetary easing. Today it is exporting monetary tightening. For China this dollar shock has caused the trade-weighted Yuan to rise over 15% between mid-2014 and late-2015 as seen below:

This was bad timing for China which already was experiencing slower growth from its transition to a more developed economy. Moreover, it acquired a lot of debt since 2008 making it more susceptible to economic shocks like a surging dollar. This monetary tightening from the Fed was offset by the Chinese monetary officials easing inside China through interest rate cuts and lower required reserves on bank lending. Between this internal easing and the existing slowdown in China, the Yuan should be falling in value. Instead, it is being propped up by the dollar. This imbalance cannot last forever and investors are racing to get out before the inevitable devaluation occurs. (No, capital controls are not a viable solution to this problem given the size of China's economy and the country's susceptibility to corruption. As an example, Chinese are now using trade invoices to get more capital out of the country.)

The timing of the capital outflows closely matches the Fed rate hike talk and the rise of the dollar so there should be no mystery here as to what is happening. The Fed's tightening that started in 2014 was the catalyst that sparked the capital outflows. All the other developments are of secondary importance.

More importantly, the Fed's tightening is what has tightened the noose around the Chinese economy and put the US economy close to a stall speed. This is the reason for the slowdown in global aggregate demand growth that is now worrying the IMF.¹

While the Fed tightening has not yet pushed the global economy into a recession, imagine what could happen if the Fed goes ahead and raises interest rates several more times this year. Given the easing bias of the BOJ and ECB, it would mean a further appreciation of the dollar that would wreak more harm on the economies of China and the United States. This is the scenario that has the IMF concerned.  So while the PIIE is right to say the fundamentals are okay now, the IMF is also right to be worried they could quickly change.  Let's hope the Fed is paying attention.

¹Note that this slowdown can explain between 40-50% of the decline in oil prices since mid-2014. This undermines the Fed's arguments for tightening since they are premised on the view that the low inflation is only transitory because it is being driven by positive oil supply shocks.A more careful view, then, would be only some of the inflation decline is due to supply shocks. Therefore, the low inflation should be more of a concern to the Fed.