Finance Basic To Advance Level Knowledge

Martin Wolf says its time to unload both barrels of the gun and resort to true helicopter drop-types stimulus.  He has the right idea, but it could be better implemented through an explicit price level or nominal GDP level target.  Doing so is important because as Josh Hendrickson notes no one at the Fed or the ECB knows exactly how much to print. What the central banks can do, though, is properly shape expectations about future nominal spending and price growth.  Doing so would cause the markets themselves to do much of the heavy lifting (through expectation-induced portfolio rebalancings) and in the process ensure the Fed's goals are realized. Josh Hendrickson sums it up this point nicely: The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the ma...

Following a speech on Wednesday, Fed Chairman Ben Bernanke had this to say in a Q&A: "If inflation itself falls too low or inflation expectations fall too low, that would be something we'd have to respond to because we don't want deflation[.]" At first glance this statement seems reasonable, but upon further reflection there is something troubling about it.  It is the monetary policy equivalent of locking the barn door after the horse is already out.  Bernanke is saying here the Fed will respond after inflation falls too low.  Why not lock the barn door up front by explicitly targeting inflation expectations so that the public's expectations about future spending and price growth are anchored and not likely fall in the first place?   If this were the way monetary policy were conducted the Fed would be a little more concerned right now about the now 6-month downward trend in inflation expectations.   If there is one lesson the Fed sho...

I have mentioned many times here how the decision of FDR and his Treasury to devalue the dollar and not sterilize gold inflows sparked a robust recovery from 1933-1936.  This development can be called the original QE program and it worked wonders despite the fact that the private sector was still deleveraging through at least 1935.   The recovery fell apart when the recession of 1937-1936 hit.  The standard story for this recession has been that some fiscal policy tightening and a lot of monetary policy tightening caused it.  On the latter point, the conventional view is that monetary policy tightened when the Fed raised reserve requirements on banks.  Douglass Irwin, however, has a new paper that calls into question this conventional wisdom.  He says it was largely a tightening of monetary policy that caused the recession, but it was not because the Fed raised reserve requirements.  Rather, it was because the Treasury started sterilizing gol...

Yesterday we learned that despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now.  In the Eurozone, ECB president Jean acknowledged the Eurozone economy faces "particularly high uncertainty and intensified downside risks" yet chose, along with the rest of the ECB authorities, not to further loosen monetary policy.  Across the Atlantic, Fed Chairman Ben Benarnke gave a speech where he too acknowledged the economy was surprisingly weak. He then noted that the "Federal Reserve has a range of tools that could be used to provide additional monetary stimulus" that he and other Fed offiicials "will continue to consider... at our meeting in September..."  In short, both central banks have decided to sit on the sidelines for now despite the ability and need to do more. There is a term for this. It is called a passive tightening of monetary policy. ...

I have continually stressed the need for the Fed to (1) publicly and forcefully announce a level target and to (2) back up such an announcement with a commitment to buy up as many assets as needed so that the target is hit.  Well, the Swiss National Bank has amazingly just done that in a way that would make Lars E. O. Svensson proud .  Below is the press release (my bold): The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities. Even at a rate of CHF 1.20 per euro, the Swiss franc is still high and should continue to weaken o...

Via the FT's Alphaville we learn that Goldman Sachs is discussing some "radical" options the Fed could use if economic conditions deteriorate further. One of the options discussed is a nominal GDP level target. It would be a radical change from way the Fed currently operates, but such a shock is exactly what the public now needs.  For the past few years the economic outlook of households and firms has been dismal and consequently they have had been accumulating a large stock of money assets .  If the Fed were to announce a nominal GDP level target it would provide a big expectation shock that would reverse much of this buildup.   One of the ways this shock would play out is through the many more observers who would be wailing about the reckless course of monetary policy, the horrors of debasing the dollar, the end of Western Civilization, and other hard money concerns.  Similar concerns were raised when FDR effectively did the same thing in 1933 with his own Q...

Here is the article .  It does a fair job discussing the pros and cons of such a rule.  Among the advantages for NGDP level targeting is that it better handles supply shocks: They could also react more appropriately to supply shocks. Take the example of an economy that is hit by a negative supply shock through high oil prices depressing output and raising inflation. An inflation-targeting central bank may feel compelled to tighten policy, worsening the slump in output, whereas one mandated to hit NGDP could be more flexible. There could be advantages, too, in the opposite case where a positive supply shock through productivity-enhancing new technology boosts real GDP growth while lowering inflation. An inflation-targeting central bank would respond by easing monetary policy, which could produce asset bubbles, whereas an NGDP-targeting central bank would hold steady. Certainly inflation would be more volatile, but the overall economy would not be. One of the disadvan...

I will let the data answer the question.  To do that, I took the Cleveland Fed's monthly 10-year expected inflation rate series and plotted it against the subsequen t growth in nominal consumer expenditures.  I looked at a one, two, and three-year horizons for subsequent consumer spending growth.  Below are the scatterplots created from this exercise. (The data starts in 1982:1 since that is the beginning of the Cleveland Fed's expected inflation series.)  Not only is there a strong relationship, but it gets stronger at longer horizons for consumer expenditures.  So changes in expected inflation do affect nominal spending.  This is nothing new and is a central tenet of modern macroeconomics.  I only bring it up now because some observers have questioned whether there really is this relationship.  Reviewing this relationship also reminds us why it is important for the Fed to be clearer about the future path of monetary policy. Update: I...

Michael Woodford, one of the top monetary theorist in the world, has an Op-Ed today that does a great job explaining why the Fed's policies have failed to gain traction in the economy.  His key point is that the Fed has failed to clearly communicate the path of future monetary policy.  In so doing, the Fed has failed to shape expectations forcefully enough to make a dent in nominal spending.  In other words, the problem is not that the Fed cannot do anything, but that the Fed has failed to act properly.  Woodford says a price level target would solve the problem (and by implication so would a nominal GDP level target) of properly shaping nominal expectations.  Here is Michael Woodford making his point by showing the flaws with the Fed's QE programs: The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan’s experiment with QE, t...

A popular explanation for the ongoing economic slump is that the United States is in the midst of a balance sheet recession.  This view holds that the vast amount of household debt built up during the housing boom is now being unwound and that this deleveraging is creating a drag on the economy.  Though intuitive, this balance sheet recession view is inadequate because one, it ignores the potential offset in spending by creditors and two, it misses a more fundamental problem: the elevated demand for liquidity.  I believe one of the reasons for this confusion is that advocates of the balance sheet recession view tend to focus on the liability side of household balance sheets while ignoring the details of the asset side.  A close look at the asset side reveals that despite the collapse in overall household assets, there has been a inordinately large buildup of liquid assets.  It is this accumulation of money and money-like assets rather than the delevera...

Ambrose Evans-Pritchard writes there is still much monetary policy can do to support the economy: [W]ith fiscal policy exhausted, the burden must fall on monetary policy. Here we have barely begun to use our atomic arsenal even at zero rates. As Milton Friedman taught us – though nobody in Frankfurt -- it is a fallacy to think that low rates are loose. Zero can be extremely tight.  That may be the case now with US Treasury yields signalling deflation and M2 velocity collapsing as it did pre-Lehman.  To those who argue that the Fed is pushing on the proverbial string, David Beckworth from the University of Texas replies that the Fed showed between 1933 and 1936 that it could deliver blistering growth of 8pc a year despite debt deleveraging in the rest of the economy. He is referring to this post where I noted the following: [H]ouseholds were also significantly deleveraging during the Great Depression.  This experience would fit the standard definition of a ba...

Michael Darda sees trouble in the decline of long-term yields and attributes it to a negative velocity shock: The U.S. 30-year “long bond” yield has collapsed below the 2010 lows, an ominous sign, in our view. Although some (mistakenly, in our opinion) associate low rates with easy money, we view the collapse in yields across the Treasury term structure as an unambiguous sign of weaker nominal growth expectations. In technical terms, it would appear that a negative velocity shock is under way... Broad money velocity in the U.S. is collapsing at the fastest rate since the end of the 2007-2009 recession. In other words, the recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets, which also occurred in 2008 and 2001 as velocity collapsed. Widening credit spreads, a collapsing term structure and flat bank credit also are consistent with low/falling velocity. In more graphic terms, the recent spate of bad economics news coming from the U.S. and Europe is ...

There are many things I like about Governor Rick Perry, but his remarks on monetary policy make me what to cringe.  He had this to say in Iowa about Ben Bernanke and the possibility of QE3: “If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost … treasonous in my opinion.” Governor Perry may have scored some points in the primary race with this comment, but the implication of the Fed doing nothing--a passive tightening of monetary policy--or even actively tightening would be very unpleasant for him.  Not only does tightening make it likely the U.S. economy will continue to weaken, it also makes it much harder to balance the federal budget.  As I have noted before, successful fiscal consolidation requires monetary easing. Doing so raises aggregate demand which, in turn, rai...

Except when it was done in Sweden over the past few years or when it was done between 1933 and 1936 in the U.S. economy.  In both cases short-term interest rates were at 0% and almost all the other characteristics of what a New Keynesian like Matt Rognlie would call a liquidity trap were present.  Monetary policy stimulus, however, proved to be very effective in both economies. In Sweden, monetary authorities were aggressive with quantitative easing--their central bank's balance sheet rose to 25% of the GDP versus the Fed's 15%--and had an explicit inflation target.  This was enough to push nominal spending back to its pre-crisis, long-run growth path.  FDR also used aggressive monetary stimulus--arguably the original QE program --in conjunction with a price level target to spark a robust recovery that saw real GDP growth average around 8% per annum between 1933 and 1936. And it occurred despite a massive deleveraging by an indebted household sector. Unfortunat...

The Financial Times (FT) is the one newspaper that has columnists who understand the virtues of nominal GDP targeting.  Samuel Brittan has been making the case for it over many years on the pages of the FT.  He did it most recently last year when he called for a rebranding of nominal GDP targeting so that it would be more easily understood by the public.  He suggested calling it something along the lines of  a total money spending objective.  Martin Wolf has also implicitly endorsed something like a nominal GDP target in his columns and has told me in an email exchange that he thinks it is a good idea.  Finally, Clive Crook has come out with a strong endorsement of nominal GDP targeting in his most recent column .  Here is an excerpt: To make the case for new stimulus, the Fed needs better arguments. The past few weeks have settled, to my satisfaction at least, a long-running debate on this very topic. Rather than targeting inflation, central ban...

My initial reaction to the FOMC decision this week was disappointment.  That has not changed, but after reading other observations and thinking about it some more I am now disappointed for other reasons.  For the FOMC decision can be interpreted as adding monetary stimulus, but only in a way that creates further uncertainty and problems for the Fed.  Let me explain why. The FOMC's new declaration that it will likely hold its target interest rate at 0.25 percent until mid-2013 can be viewed as creating new monetary stimulus.  As Matt Rognlie notes , the Fed through this policy has changed the expected path of future short-term interest rates to a lower level, one that implies greater monetary stimulus and thus higher economic activity in the future.  This future expansion, in turn, makes households and firms more likely to spend today because one, it improves their economic outlook and two, it lowers the real interest they face via higher expected inflation. A...

Needless to say I am disappointed with yesterday's FOMC decision.  Since I am currently afflicted with FDFS*, I will outsource discussion of my disappointment to Ryan Avent and Scott Summer .  *FDFS = Fed Disappointment Fatigue Syndrome.

I hope not.  As you may recall , the FOMC met a day after Lehman collapsed on September 16, 2008 and decided against lowering the federal funds rates.  Yes, the Fed decided to keep its targeted interest rate unchanged at 2% just as the financial crisis was reaching its peak.  Amazingly, the reason the FOMC acted this way was its concerns about inflation , which at the time were driven by commodity prices and reflected a backward-looking view of inflation.  Had the Fed given more weight to forward-looking indicators like the expected inflation rate coming from TIPS and a host of other market indicators, the Fed would have realized the market was pricing in a sharp recession.  Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level.  The Fed, therefore, effectively tightened monetary policy at that time.  Though the circumstances are somewh...

The market meltdown yesterday and the cumulative market losses of the past few weeks have showcased two important failures of the Fed.  First, the Fed has yet to seriously anchor short-to-medium term nominal spending expectations.  This is not particularly surprising since at best the Fed has an implicit and fuzzy inflation target.  It is bad enough that the inflation target is vague, but being a growth rate target also means it also has no memory.  That is, any deviation from the inflation target is allowed to persist.  Consequently, the price level and nominal spending become a random walk, creating more long-term uncertainty than if the Fed had a level target.  Now the market meltdown seems to have started in Europe yesterday, but it really was a culmination of a number of bad economic news releases over the past few weeks and more importantly over the past few years.  Ultimately, these developments can arguably be traced to a U.S. monetary policy ...

Ken Rogoff is one smart guy and his writings are typically fun to read.  His latest piece , however, left me feeling a little disappointed.  It concedes too much to the "balance sheet" view of recessions which for reasons spelled out here and here is an inadequate view of the crisis.  Moreover, his analysis ignores what monetary policy is really capable of doing for the U.S. economy: increasing nominal spending and nominal incomes.  Ramesh Ponnuru, the resident quasi-monetarist and Senior Editor at the National Review, makes this point: Kenneth Rogoff writes that “the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years.” It certainly would be a way to reduce the real burden of debt, but is it the only or the best way? The Federal Reserve has more direct control over nominal spending/nominal income than it has over inflation, and higher nominal income...