Tag Archive for 'Brad DeLong'

Calm down people. Kocherlakota is still a hawk.

A certain kind of nerd is excited about this recent speech by Narayana Kocherlakota, the president of the Minneapolis arm of the Federal Reserve.  Watching him speak, some people think they saw a leopard not only change its spots, but but paint stripes on as well.

The reason?  Well, Kocherlakota is famously an inflation hawk (we do like our animal analogies, don’t we?), but in the speech he argued that the Fed should commit to keeping interest rates at “exceptionally low levels” until unemployment in America falls to 5.5% (it’s currently 8.3% and was last at 5.5% around May 2008) and, as a general rule, inflation hawks are not meant to care about unemployment.  They’re meant to focus, like a hawk, on inflation.  Here are Bloomberg, Joe Weisenthal, Neil Irwin, FT Alphaville, Felix Salmon, Tim Duy, Scott Sumner, Aki Ito and Brad DeLong (I don’t mean to suggest that these guys are all suggesting that Kocherlakota has become a dove — they’re just all worth reading).

Let’s look at his speech (I’m mixing his words up a little, but the words and their meaning are the same):

As long as longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent, [the FMOC] should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

This is not the statement that a dove would make.  A dove would be speaking about giving weight to both unemployment and inflation in any decision rule.  A NGDP-targetter, if forced against their will to speak in this language, would speak of something close to a 50-50 weighting, for example.  But that’s not what Kocherlakota is saying here.  He is instead saying that the Fed should keep long-term expectations of inflation stable (presumably at 2%) and, in any event, freak out if inflation over the coming year is likely to be any higher than 2.25% and only then, when as an inflation hawk he has nothing to worry about, should the Fed be willing to look at unemployment.

These are still lexicographic preferences.  “Fight inflation first and ignore unemployment while you’re doing it,” he is saying.  “Then look at unemployment (but be prepared to ditch it if inflation so much as twitches).”

As I say, these are not the ideas of an inflation dove.

It does represent at least a slight shift, though.  As Tim Duy makes clear, last year he thought a core PCE inflation rate of 1.5% would be enough to trigger an increase in interest rates, whereas now he appears to be focusing on 2.25% in headline CPI inflation.  Those are different objects, though, so it’s not always apples-to-apples.

Instead, I perceive two main shifts in Kocherlakota’s viewpoint:

First, and most importantly, he has been convinced that much of America’s currently-high unemployment is because of deficient demand and not, as he used to hold, because of structural (i.e. supply-side) factors.  Here is a snippet from an interview he did with the FT:

“I’m putting less weight on the structural damage story,” said Mr Kocherlakota, arguing that recent research on unemployment pointed more towards “persistent demand shortfalls”. Either way, he said, “the inflation outlook is going to be pretty crucial in telling the difference between the two”.

The recent research he mentions, at least in part, will be this paper by Edward Lazear and James Spletzer presented recently at Jackson Hole.  Here’s the abstract:

The recession of 2007-09 witnessed high rates of unemployment that have been slow to recede. This has led many to conclude that structural changes have occurred in the labor market and that the economy will not return to the low rates of unemployment that prevailed in the recent past. Is this true? The question is important because central banks may be able to reduce unemployment that is cyclic in nature, but not that which is structural. An analysis of labor market data suggests that there are no structural changes that can explain movements in unemployment rates over recent years. Neither industrial nor demographic shifts nor a mismatch of skills with job vacancies is behind the increased rates of unemployment. Although mismatch increased during the recession, it retreated at the same rate. The patterns observed are consistent with unemployment being caused by cyclic phenomena that are more pronounced during the current recession than in prior recessions.

Second (and to some extent, this is just a corollary of the first), Kocherlakota is now emphasising that conditional on inflation being tightly restrained, he is happy to deploy (almost) any amount of stimulus to help improve the employment situation, whereas previously his emphasis was on how additional stimulus would lead to more inflation.

In other words, I read this speech as evidence that Kocherlakota’s underlying philosophy remains unchanged, but his perception of the problems to which he needs to apply that philosophy has changed.  That doesn’t make him a leopard changing it’s spots, that makes him principled, intelligent and open minded.

Naturally, Mark Thoma said all of this before me, and better than I could have.


Ryan Advent, over at the Economist’s Free Exchange, also has a comment worth reading. He expands a little on the two points I mention:

As Mr Kocherlakota points out, one advantage of the threshold approach (an advantage shared by NGDP targeting) is that it allows members to remain agnostic about the extent of structural unemployment in the economy. If unemployment is mostly structural, the inflation threshold will be crossed first; if not, the unemployment threshold will. Either way, the Fed has set its tolerances and adopted a policy to get there.

… which is something that I had originally meant to highlight in this post (honest!). Ryan continues:

(I will point out, however, that the threshold approach implies contracting in the fact of negative structural shocks and easing in the face of positive productivity shocks while NGDP targeting will generally pull in the opposite direction, more sensibly in my view.)

That’s the real debate, right there. Generally everyone agrees on what to do when faced with a demand shock, but how to deal with supply shocks continues to be a matter of considerable disagreement, no doubt to the frustration of both sides. That and how best to disentangle the data to identify whether a shock, or more correctly an assortment of shocks is, on net, mostly supply or mostly demand.

Seasonal adjustments to unemployment in the USA

I might as well put this here.  Brad DeLong writes:

Microsoft Excel.png

Put me down as somebody who does not believe that the seasonal factor in the unemployment rate is twice as big today as it was four short years ago, or was half as big four short years ago as it was in the early 1990s…

Not that I am complaining about the BLS, you understand. If I could do better, they would already have done better. Nevertheless this is a source of nervousness…

My first thoughts:

At a first glance, the size of the seasonal adjustment factor looks like it is countercyclical to the business cycle, which immediately raises the question: Why would seasonality-based volatility in unemployment increase during a recession?

Could it just be that seasonal employment is less susceptible to business cycle movements than regular employment, so that during a recession the (relatively constant) seasonal movements look larger relative to the smaller total employment number?

Some brief thoughts on QE2

  • Instead of speaking about “the interest rate” or even “the yield curve”, I wish people would speak more frequently about the yield surface:  put duration on the x-axis, per-period default risk on the y-axis and the yield on the z-axis.  Banks do not just borrow short and lend long; they also borrow safe and lend risky.
  • Liquidity is not uniform over the duration-instantaneous-default-risk space.   Liquidity is not even monotonic over the duration-instantaneous-default-risk space.
  • There is still a trade-off for the Fed in wanting lower interest rates for long-duration, medium-to-high-risk borrowers to spur the economy and wanting a steep yield surface to help banks with weak balance sheets improve their standing.
  • By keeping IOR above the overnight rate, the Fed is sterilising their own QE (the newly-injected cash will stay parked in reserve accounts) and the sole remaining effect, as pointed out by Brad DeLong, is through a “correction” for any premiums demanded for duration risk.
  • Nevertheless, packaging the new QE as a collection of monthly purchases grants the Fed future policy flexibility, as they can always declare that it will be cut off after only X months or will be extended to Y months.
  • It seems fairly clear to me that the announcement was by-and-large expected and so “priced in” (e.g. James Hamilton), but there was still something of a surprise (it was somewhat greater easing than was expected) (e.g. Scott Sumner).
  • Menzie Chinn thinks there is a bit of a puzzle in that while bond markets had almost entirely priced it in, fx-rate markets (particularly USD-EUR) seemed to move a lot.  I’m not entirely sure that I buy his argument, as I’m not entirely sure why we should expect the size of the response to a monetary surprise to be the same in each market.

US treasury interest rates and (disin|de)flation

This Bloomberg piece from a few days ago caught my eye.  Let me quote a few hefty chunks from the article (highlighting is mine):

Bond investors seeking top-rated securities face fewer alternatives to Treasuries, allowing President Barack Obama to sell unprecedented sums of debt at ever lower rates to finance a $1.47 trillion deficit.

While net issuance of Treasuries will rise by $1.2 trillion this year, the net supply of corporate bonds, mortgage-backed securities and debt tied to consumer loans may recede by $1.3 trillion, according to Jeffrey Rosenberg, a fixed-income strategist at Bank of America Merrill Lynch in New York.

Shrinking credit markets help explain why some Treasury yields are at record lows even after the amount of marketable government debt outstanding increased by 21 percent from a year earlier to $8.18 trillion. Last week, the U.S. government auctioned $34 billion of three-year notes at a yield of 0.844 percent, the lowest ever for that maturity.
Global demand for long-term U.S. financial assets rose in June from a month earlier as investors abroad bought Treasuries and agency debt and sold stocks, the Treasury Department reported today in Washington. Net buying of long-term equities, notes and bonds totaled $44.4 billion for the month, compared with net purchases of $35.3 billion in May. Foreign holdings of Treasuries rose to $33.3 billion.
A decline in issuance is expected in other sectors of the fixed-income market. Net issuance of asset-backed securities, after taking into account reinvested coupons, will decline by $684 billion this year, according to Bank of America’s Rosenberg. The supply of residential mortgage-backed securities issued by government-sponsored companies such as Fannie Mae and Freddie Mac is projected to be negative $320 billion, while the debt they sell directly will shrink by $164 billion. Investment- grade corporate bonds will decrease $132 billion.

“The constriction in supply is all about deleveraging,” Rosenberg said.
“There’s been a collapse in both consumer and business credit demand,” said James Kochan, the chief fixed-income strategist at Menomonee Falls, Wisconsin-based Wells Fargo Fund Management, which oversees $179 billion. “To see both categories so weak for such an extended period of time, you’d probably have to go back to the Depression.”

Greg Mankiw is clearly right to say:

“I am neither a supply-side economist nor a demand-side economist. I am a supply-and-demand economist.”

(although I’m not entirely sure about the ideas of Casey Mulligan that he endorses in that post — I do think that there are supply-side issues at work in the economy at large, but that doesn’t necessarily imply that they are the greater fraction of America’s macroeconomic problems, or that demand-side stimulus wouldn’t help even if they were).

When it comes to US treasuries, it’s clear that shifts in both demand and supply are at play.  Treasuries are just one of the investment-grade securities on the market that are, as a first approximation, close substitutes for each other.  While the supply of treasuries is increasing, the supply of investment-grade securities as a whole is shrinking (a sure sign that demand is falling in the broader economy) and the demand curve for those same securities is shifting out (if the quantity is rising and the price is going up and supply is shifting back, then demand must also be shifting out).

Paul Krugman and Brad DeLong have been going on for a while about invisible bond market vigilantes, criticising the critics of US fiscal stimulus by pointing out that if there were genuine fears in the market over government debt, then interest rates on the same (which move inversely to bond prices) should be rising, not falling as they have been.  Why the increased demand for treasuries if everyone’s meant to be so afraid of them?

They’re right, of course (as they so often are), but that’s not the whole picture.  In the narrowly-defined treasuries market, the increasing demand for US treasuries is driven not only by the increasing demand in the broader market for investment-grade securities, but also by the contraction of supply in the broader market.

It’s all, in slow motion, the very thing many people were predicting a couple of years ago — the gradual nationalisation of hither-to private debt.  Disinflation (or even deflation) is essentially occurring because the government is not replacing all of the contraction in private credit.

Double-yolk eggs, clustering and the financial crisis

I happened to be listening when Radio 4’s “Today Show” had a little debate about the probability of getting a pack of six double-yolk eggs.  Tim Harford, who they called to help them sort it out, relates the story here.

So there are two thinking styles here. One is to solve the probability problem as posed. The other is to apply some common sense to figure out whether the probability problem makes any sense. We need both. Common sense can be misleading, but so can precise-sounding misspecifications of real world problems.

There are lessons here for the credit crunch. When the quants calculate that Goldman Sachs had seen 25 standard deviation events, several days in a row, we must conclude not that Goldman Sachs was unlucky, but that the models weren’t accurate depictions of reality.

One listener later solved the two-yolk problem. Apparently workers in egg-packing plants sort out twin-yolk eggs for themselves. If there are too many, they pack the leftovers into cartons. In other words, twin-yolk eggs cluster together. No wonder so many Today listeners have experienced bountiful cartons.

Mortgage backed securities experienced clustered losses in much the same unexpected way. If only more bankers had pondered the fable of the eggs.

The link Tim gives in the middle of my quote is to this piece, also by Tim, at the FT.  Here’s the bit that Tim is referring to (emphasis at the end is mine):

What really screws up a forecast is a “structural break”, which means that some underlying parameter has changed in a way that wasn’t anticipated in the forecaster’s model.

These breaks happen with alarming frequency, but the real problem is that conventional forecasting approaches do not recognise them even after they have happened. [Snip some examples]

In all these cases, the forecasts were wrong because they had an inbuilt view of the “equilibrium” … In each case, the equilibrium changed to something new, and in each case, the forecasters wrongly predicted a return to business as usual, again and again. The lesson is that a forecasting technique that cannot deal with structural breaks is a forecasting technique that can misfire almost indefinitely.

Hendry’s ultimate goal is to forecast structural breaks. That is almost impossible: it requires a parallel model (or models) of external forces – anything from a technological breakthrough to a legislative change to a war.

Some of these structural breaks will never be predictable, although Hendry believes forecasters can and should do more to try to anticipate them.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

That might sound pointless.

In fact, given that traditional economic forecasts miss structural breaks all the time, it is both difficult to achieve and useful.

Talking to Hendry, I was reminded of one of the most famous laments to be heard when the credit crisis broke in the summer. “We were seeing things that were 25-standard deviation moves, several days in a row,” said Goldman Sachs’ chief financial officer. One day should have been enough to realise that the world had changed.

That’s pretty hard-core.  Imagine if under your maintained hypothesis, what just happened was a 25-standard deviation event.  That’s a “holy fuck” moment.  David Viniar, the GS CFO, then suggests that they occurred for several days in a row.  A variety of people (for example, Brad DeLong, Felix Salmon and Chris Dillow) have pointed out that a 25-standard deviation event is so staggeringly unlikely that the universe isn’t old enough for us to seriously believe that one has ever occurred.  It is therefore absurd to propose that even a single such event occurred.   The idea that several of them happened in the space of a few days is beyond imagining.

Which is why Tim Harford pointed out that even after the first day where, according to their models, it appeared as though a 25-standard deviation event had just occurred, it should have been obvious to anyone with the slightest understanding of probability and statistics that they were staring at a structural break.

In particular, as we now know, asset returns have thicker tails than previously thought and, possibly more importantly, the correlation of asset returns varies with the magnitude of that return.  For exceptionally bad outcomes, asset returns are significantly correlated.