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.

Update:

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.

Monetary policy, fear of commitment and the power of infinity

This is a fascinating time to be thinking about monetary policy…

Like everybody else, central banks can do two things:  they can talk, or they can act.

Some people say that talk is cheap and, in any event, discretion implies bias.

Other people point out that things like central bankers’ concern for their reputation mean that it’s perfectly possible to promise today to implement history-dependent policy tomorrow. Some cheeky people like to point out that this amounts to saying that, when in a slump, a central bank should “credibly commit to being irresponsible” in the future.

In fact, some people argue (pdf) that, in my words, “all monetary policy is, fundamentally, about expectations of the future.”  But if that’s the case, why act at all? Why not just talk and stay away from being a distorting influence in the markets?

There are two reasons: First, since since talk is cheap, credibility requires that people know that you can and, if necessary, will act to back it up (talk softly and carry a big stick). Second, because if you can convince people with actions today, you don’t need to explicitly tell them what your policy rule will be tomorrow and central bankers love discretion because no rule can ever capture what to do in every situation and well, hey … a sense of mystery is sexy.

OMO stands for “Open Market Operation”. It’s how a central bank acts.  Some scallywags like to say that when a central bank talks, it’s an “Open Mouth Operation.” Where it gets fun (i.e. complicated) is that often a central bank’s action can be just a statement if the stick they’re carrying to back it up is big enough.

In regular times, a typical central bank action will be to announce an interest rate and a narrow band on either side of it. In theory, it could be any interest rate at all, but in practice they choose the interest rate for overnight loans between banks. They then commit to accepting in or lending out infinite amounts of money if the interest rate leaves that narrow band. Infinity is a very big stick indeed, so people go along with them.

So what should a central bank do when overnight interest rates are at (or close to) zero and the central bank doesn’t want to take them lower, but more stimulus is needed?

Woodford-ites say that you’ve got to commit, baby. Drop down to one knee, look up into the economy’s eye and give the speech of your life. Tell ’em what you promise to do tomorrow. Tell ’em that you’ll never cheat.  Pinky-swear it … and pray that they believe you.

Monetarists, on the other hand, cough politely and point out that the interest rate on overnight inter-bank loans is just a price and there are plenty of other prices out there. The choice of the overnight rate was an arbitrary one to start with, so arbitrarily pick another one!

Of course, the overnight rate wasn’t chosen arbitrarily. It was chosen because it’s the price that is the furthest away from the real economy and, generally speaking, central bankers hate the idea of being involved in the real economy almost as much as they love discretion. They watch it, of course. They’re obsessed by it. They’re guided by it and, by definition, they’re trying to influence it, but they don’t want to be directly involved. A cynic might say that they just don’t want to get their hands dirty, but a realist would point out that no matter the pain and joy involved in individual decisions in the economy, a cool head and an air of abstraction are needed for policy work and, in any event, a central banker is hardly an industrialist and is therefore entirely unqualified to make decisions at the coalface.

But as every single person knows, commitment is scary, even when you want it, so the whole monetarist thing is tempting. Quantitative Easing (QE) is a step along that monetarist approach, but the way it’s been done is different to the way that OMOs usually work. There has been no target price announced and while the quantities involved have been big (even huge), they have most definitely been finite. The result? Well, it’s impossible to really tell because we don’t know how bad things would have been without the QE. But it certainly doesn’t feel like a recovery.

Some transmission-mechanism plumbers think that the pipes are clogged (see also me).

Woodford-ites say that it’s because there’s no love, baby. Where’s the commitment?

Monetarists say that infinity is fundamentally different to just a really big number.

Market monetarists, on the other hand (yes, I’m sure you were wondering when I’d get to them), like to argue that the truth lies in between those last two. They say that it’s all about commitment (and without commitment it’s all worthless), but sometimes you need an infinitely big stick to convince people. They generally don’t get worked up about how close the central bank’s actions are to the real economy and they’re not particularly bothered with concrete steps.

So now we’ve got some really interesting stuff going on:

The Swiss National Bank (a year ago) announced a price and is continuing to deploy the power of infinity.

The European Central Bank has switched to infinity, but is not giving a price and is not giving any forward guidance.

The Federal Reserve has switched to infinity and is giving some forward guidance on their policy decision rule.

The Bank of England is trying to fix the plumbing.

It really is a fascinating time to be thinking about this stuff.

More on Woodford and QE

Continuing on from my previous post, I note that James Hamilton has also written a piece on Woodford’s paper [pdf here].  He expands on another way in which QE in the form of long-dated asset purchases could have an effect on the real economy:  the pricing kernel is almost certainly not constant.  Before I get to him, though, recall Woodford’s argument:

But it is important to note that such “portfolio-balance effects” do not exist in a modern, general-equilibrium theory of asset prices — in which assets are assumed to be valued for their state-contingent payoffs in different states of the world, and investors are assumed to correctly anticipate the consequences of their portfolio choices for their wealth in different future states — at least to the extent that financial markets are modeled as frictionless. It is clearly inconsistent with a representative-household asset pricing theory (even though the argument sketched above, and many classic expositions of portfolio-balance theory, make no reference to any heterogeneity on the part of private investors). In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, where the present value is calculated using an asset pricing kernel (stochastic discount factor) derived from the representative household’s marginal utility of income in different future states of the world. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, the representative household’s marginal utility of income in different states of the world should not change. Hence the pricing kernel should not change, and the market price of one unit of a given asset should not change, either, assuming that the risky returns to which the asset represents a claim have not changed.

Given that context, here’s Hamilton:

In a recent paper with University of Chicago Professor Cynthia Wu, I discussed this theory. We noted that 3-month and 10-year Treasury securities are treated by the private market as very different investments. Based on a very long historical record we can say with some confidence that, if the U.S. Treasury were to borrow $10 B in the form of 3-month T-bills and roll these over each quarter for a decade, it would end up on average paying a substantially lower total borrowing cost than if it were to issue $10 B in 10-year bonds. If it’s really true that nothing in the world would change if the Treasury did more of its borrowing short-term, the natural question is why does the Treasury issue any 10-year bonds at all?

I think if you ask that question at a practical, institutional level, the answer is pretty obvious– the Treasury believes that if all of its debt were in the form of 3-month T-bills, then in some states of the world it would end up being exposed to a risk that it would rather not face. And what is the nature of that risk? I think again the obvious answer is that, with exclusive reliance on short-term debt, there would be some circumstances in which the government would be forced to raise taxes or cut spending at a time when it would rather not, and at a time that it would not be forced to act if it instead owed long-term debt with a known coupon payment due.

The implication of that answer is that the assumption underlying Woodford’s analysis — that changing the maturity structure would not change the real quantity of resources available for private consumption in any state of the world — is not correct.

Hamilton goes on to point out that a similar risk-aversion story may be at play at the Federal Reserve:

I think the Fed’s reluctance to do more has to do with the same kind of risk aversion exhibited by the Treasury, namely, large-scale asset purchases tie the Fed into a situation in which, under some possible future scenarios, the Fed would be forced to allow a larger amount of cash in circulation than it would otherwise have chosen.

Which is funny, if only for a specialised sub-set of humanity, because it translates into the Fed being worried that by engaging in stimulus whose effect ranges from weak to uncertain, they may be forced to engage in stimulus that will absolutely work.

Woodford, QE and the BoE’s FLS

I’ve been thinking a bit about the efficacy of QE, the potential benefits of the Bank of England’s Funding for Lending Scheme (FLS) [BoE, HM Treasury] and the new paper Michael Woodfoord presented at Jackson Hole [pdf here] (it’s a classic Woodford paper, by the way, even if it is is almost entirely equation free: a little difficult to wrap your head around, but ultimately very, very insightful).  Woodford’s conclusion starts with an excellent statement of the problem:

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit.

The interest-rate lower bound here is not necessarily zero, but rather whatever rate is paid on excess reserves, which may indeed be equal to zero, but need not be.  In the US, interest on reserves for depository institutions has been 0.25% since Oct 2008; in the UK it has been Bank Rate, currently 0.5%, since Mar 2009.  In principle, one might push the interest rate paid on reserves into negative territory, but such an action would come at the cost of destroying a subset of the money market and with a very real risk that economic agents (banks or, worse, businesses and households) would instead choose to hold their money in the form of physical currency.

Woodford advocates a strong form of forward guidance — that is, the abandonment of restriction (i) — as the optimal policy at the present time, on the basis that all monetary policy is, fundamentally, about expectations of the future.  In particular, he uses the paper to make an argument for nominal GDP level targeting.

This is vitally important stuff, but in this post I want to talk about quantitative easing, in the general sense of the phrase, or what Woodford far more accurately refers to as “balance sheet policies.”

First up is the purchase of short-dated safe assets, paid for with the creation of new reserves.  For the financial sector, this means giving up a safe, liquid asset with a steady revenue stream in return for money.  In normal times, the financial sector might then seek to increase their lending, providing a multiplier effect, but with interest rates on short-dated safe assets at the same level as interest paid on reserves, the financial position of the bank does not change with the purchase, so their incentive to lend can’t increase.  In this case, the short-dated safe asset has become a perfect substitute for money and, absent any forward guidance, such a policy can have no effect on the real economy.  Krugman (1998) and Eggertson and Woodford (2003) provide two-period and infinite-horizon treatments respectively.  Forward guidance in this setting might be anything from the private sector observing the purchases and inferring a more accommodative policy stance in the future (and the central bank doing nothing to disabuse them of that belief) to an outright statement from the central bank that the increase in reserves will be permanent.

Next up is the idea of purchasing long-dated safe assets, or even long-dated risky assets.  Woodford stresses that this can be decomposed into two distinct parts:  An initial expansion of the central bank’s balance sheet via the purchase of short-dated, safe assets and then an adjustment of the composition of the balance sheet by selling short-dated safe assets and buying long-dated assets.  Since the first step is thought to be ineffective (by non-Monetarists, at least), any traction should be obtained in the second step.

But because the second step represents either an adjustment in the relative supply of short- and long-dated government debt (in the case of limiting oneself to safe assets) or an allocation of capital directly to the real economy (in the case of purchasing risky assets), this is arguably fiscal policy rather than monetary and should perhaps be better done by the Treasury department.  Putting that concern to one side, I want to consider why it might, or might not, work.

The standard argument in favour is that of portfolio rebalancing: now holding extra cash and facing low yields on long-dated safe assets, a financial actor seeking to equate their risk-adjusted returns across assets should choose to invest at least some of the extra cash in risky assets (i.e. lending to the real economy).  Woodford emphasises that this story implicitly requires heterogeneity across market participants:

But it is important to note that such “portfolio-balance effects” do not exist in a modern, general-equilibrium theory of asset prices — in which assets are assumed to be valued for their state-contingent payoffs in different states of the world, and investors are assumed to correctly anticipate the consequences of their portfolio choices for their wealth in different future states — at least to the extent that financial markets are modeled as frictionless. It is clearly inconsistent with a representative-household asset pricing theory (even though the argument sketched above, and many classic expositions of portfolio-balance theory, make no reference to any heterogeneity on the part of private investors). In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, where the present value is calculated using an asset pricing kernel (stochastic discount factor) derived from the representative household’s marginal utility of income in different future states of the world. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, the representative household’s marginal utility of income in different states of the world should not change. Hence the pricing kernel should not change, and the market price of one unit of a given asset should not change, either, assuming that the risky returns to which the asset represents a claim have not changed.

He goes on to stress that if the central bank were to take some risk off the private sector, the risk still remains and, in the event of a loss, the reduction in central bank profits to the treasury would require a subsequent increase in taxes. Consequently, a representative household would experience the loss no matter whether it was formally held by itself or the central bank.  Crucially, too …

The irrelevance result is easiest to derive in the context of a representative-household model, but in fact it does not depend on the existence of a representative household, nor upon the existence of a complete set of financial markets. All that one needs for the argument are the assumptions that (i) the assets in question are valued only for their pecuniary returns [John here: i.e. their flow of revenue and their expected future resale value] — they may not be perfect substitutes from the standpoint of investors, owing to different risk characteristics, but not for any other reason — and that (ii) all investors can purchase arbitrary quantities of the same assets at the same (market) prices, with no binding constraints on the positions that any investor can take, other than her overall budget constraint. Under these assumptions, the irrelevance of central-bank open-market operations is essentially a Modigliani-Miller result.

[…]

Summing over all households, the private sector chooses trades that in aggregate precisely cancel the central bank’s trade. The result obtains even if different households have very different attitudes toward risk, different time profiles of income, different types of non-tradeable income risk that they need to hedge, and so on, and regardless of how large or small the set of marketed securities may be. One can easily introduce heterogeneity of the kind that is often invoked as an explanation of time-varying risk premia without this implying that any “portfolio-balance” effects of central-bank transactions should exist.

Of the two requirements for this irrelevance result, the second is clearly not true in practice, so large-scale asset purchases should, in principle, work even in the absence of any forward guidance, although the magnitude of the efficacy would be in doubt.

On the first, Woodford does acknowledge some work by Krishnamurthy and Vissing-Jorgensen (2012) which shows that US government debt possesses non-pecuniary qualities that are valued by the financial sector.  In particular, safe government debt is often required as collateral in repo transactions and this requirement should give such assets value above that implied by their pure pecuniary returns.  However, as pointed out by Krishnamurthy and Vissing-Jorgensen in a discussion note (pdf), to the extent that this channel is important, it implies that central bank purchases of long-dated safe assets can even be welfare reducing.

To see why this is so, I think it best to divide the universe of financial intermediaries into two groups:  regular banks and pure investment shops.  Pure investment shops have, collectively, particularly stable funding (think pension funds) although the funds might swoosh around between individual investment shops.  Regular banks have some stable funding (from retail deposits), but also rely on wholesale funding.

Up until the financial crisis of 2008, regular banks’ wholesale funding was done on an unsecured basis.  There was no collateral required.  There was very little asset encumbrance.  But since the crisis (and, indeed, arguably because of it), regular banks have had essentially no access to unsecured lending.  Instead, banks have been forced to rely almost entirely on secured borrowing (e.g. through covered bonds at the long end or repos at the short end) for their wholesale funding.  In addition to this, new regulations have been (or are being) put in place that increase their need to hold safe assets (i.e. government debt) even if unsecured borrowing is available.

QE has therefore acted through two, broad channels.  In the first, portfolio rebalancing may still have worked through the pure investment shops.  Having sold their government bonds and now holding cash, they reinvested the money but since the yields on government bonds were now lower relative to other asset classes, they put a larger fraction of that money into equity and corporate bond markets.  To the extent that such investment shops are not able to perfectly offset the central bank’s trade, or are unable to full recognise their need to bear any potential losses from any risk the central bank takes on, large non-financial companies (NFCs) with access to stock and bond markets should therefore have seen a reduction in the price of credit and, in principle, should have been more willing to undertake investment.

On the other hand, QE has also served to lower the supply of eligible collateral at precisely the time when demand for it among regular banks has shot up.  The banks have then been faced with an awful choice:  either pay the extra high cost to get the required collateral (buying it off the pure investment shops), or deleverage so that they don’t need the funding any more.  As a result, their funding costs will have gone up as a direct result of QE and if they have any pricing power at all (and they do), then interest rates available to households and small-to-medium sized enterprises (SMEs) will be forced to be higher than they would otherwise have been.  No matter which option banks choose (and most likely they would choose a combination of the two), a negative supply (of credit) shock to the real economy would occur as a result.

If this second broad channel (through regular banks) were to outweigh the first (through pure investment shops), then QE focused on the purchase of long-dated safe assets would, in aggregate, have a negative effect on the economy.  I believe it is this very possibility that has given both the Federal Reserve and the Bank of England pause in their consideration of additional asset purchases.

Of course, if the central bank were not to buy long-dated safe assets but were instead to purchase long-dated risky assets (bundles of corporate bonds, MBS, etc), the supply of safe assets needed for collateral purposes would not be artificially reduced and, to the extent that portfolio rebalancing helps at all, the full efficacy would be obtained.   However, such a strategy would go against the principle that central banks ought to stay away from the decisions regarding the allocation of credit.

All of which is why, I suspect, that the Bank of England has decided to go for their Funding for Lending Scheme.  At it’s heart, the FLS is a collateral swap.  The BoE gives banks gilts and the banks give the BoE bundles of their mortgages and SME loans, plus interest.  The banks can then use the gilts to obtain funding on the wholesale market, while the interest that banks pay the BoE is a decreasing function of how much additional lending the banks make to the real economy.  The mortgages and SME loans that the banks give the BoE will have a haircut applied for safety.  It’ll be pretty tricky to get just right, but in principle it should be able to offset any increase in funding costs that QE may have imposed.

A clear majority of credit creation in Britain takes place via regular banks, so this has the potential to have quite a dramatic effect.  We’ll just have to wait and see …

Output gaps, inflation and totally awesome blogosphere debates

I love the blogosphere.  It lets all sorts of debates happen that just can’t happen face to face in the real world.  Here’s one that happened lately:

James Bullard, of the St. Louis Fed, gave a speech in which (I believe) he argued that wealth effects meant that potential output was discretely lower now after the crash of 2006-2008.  David Andolfato and Tyler Cowen both liked his argument.

Scott Sumner, Noah Smith, Paul Krugman, Matt Yglesias, Mark Thoma and Tim Duy (apologies if I missed anyone) all disagreed with it for largely the same reason:  A bubble is a price movement and prices don’t affect potential output, if for no other reason then because potential output is defined as the output that would occur if prices didn’t matter.

Brad DeLong also disagreed on the same grounds, but was willing to grant that a second-order effect through labour-force participation may be occurring, although that was not the argument that Bullard appeared to be making.

In response, Bullard wrote a letter to Tim Duy, in which he revised his argument slightly, saying that it’s not that potential output suddenly fell, but that it was never so high to start with.  We were overestimating potential output during the bubble period and are now estimating it more accurately.

The standard reply to this, as provided by by Scott SumnerTim DuyMark Thoma and Paul Krugman, takes the form of:  If actual output was above potential during the bubble, then where was the resulting inflation?  What is so wrong with the CBO’s estimate of potential output (which shows very little output gap during the bubble period)?

Putting to one side discussions of what the output gap really is and how to properly estimate it (see, for example, Menzie Chinn here, here and here), I’ve always felt a sympathy with the idea that Bullard is advocating here.  Although I do not have a formal model to back it up, here is how I’ve generally thought of it:

  • Positive output gaps (i.e. actual output above potential) do not directly cause final-good inflation.  Instead, they cause wage inflation, which raises firms’ marginal costs, which causes final-good inflation.
  • Globalisation in general, and the rise of China in particular, meant that there was — and remains — strong, competition-induced downward pressure on the price of internationally tradable goods.
  • That competition would induce domestic producers of tradable goods to either refuse wage increases or go out of business.
  • Labour is not (or at least is very poorly) substitutable.  Somebody trained as a mechanic cannot do the work of an accountant.
  • Therefore, the wages of workers in industries producing tradable goods stayed down, while the wages of workers in industries producing non-tradable goods were able to rise.
  • Indeed, we see in the data that both price and wage inflation in non-tradable industries have been consistently higher than those in tradable sectors over the last decade and, in some cases, very much higher.

The inflation was there.  It was just limited to a subset of industries … like the financial sector.

(Note that I’m implicitly assuming fixed, or at least sticky, exchange rates)

As it happens, I also — like Tyler Cowen — have a sneaking suspicion that temporary (nominal) demand shocks can indeed have effects that are observationally equivalent to (highly) persistent (real) supply shocks.  That’s a fairly controversial statement, but backing it up will have to wait for another post …

Terrible news from Apple (AAPL)

Apple just reported their profits for 2011Q4.  It turns out that they made rather a lot of money.  So much, in fact, that they blew past/crushed/smashed expectations as their profit more than doubled on the back of tremendous growth in sales of iPhones and iPads.  [snark] I’ll bet nobody’s talking about Tim Cook being gay now. [/snark]

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative.  Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits.  The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost.  So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio.  Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now — but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me?  Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK.  I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar.  The report it’s from can be found here (it was published only a few days ago).  The Economist’s Free Exchange has some commentary on it here (summary:  we’re still in trouble).

So what is happening to all that money?  Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral.  They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE.  As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

 

 

 

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

For the first time since 2004q4, US household debt is less than 100% of disposable income

In today’s story of household “deleveraging” in America (okay, so this is very, very late since the data were released in August. Still … ):

2011q2 was the first time since 2004q4 that U.S. Household debt was less than 100% of Disposable Personal Income (click on the image for a less squished version):

2005q1 and 2011q1 were both at 100% exactly, or close enough.

In the period 1999q2 to 2006q3, distressed household debt averaged 4.35% and was never higher than 5.06%. Distressed household debt was at 9.86% in 2011q2, having peaked at 11.98% in 2009q4.  As the Fed’s credit conditions report highlights, that was the 6th straight quarter of improvement.  However, the quarter-to-quarter falls have been quite low:  0.04 percentage points (2009q4 to 2010q1), 0.58 p.p., 0.26 p.p., 0.31 p.p., 0.31 p.p. and 0.62 p.p. (2011q1 to 2011q2).  If we assume a continuing fall of 0.4 percentage points per quarter, it’ll take another 14 quarters – that’s 2014q4 – to return to the pre-crisis average.

Of course, a resumption of growth in consumption is not contingent on that happening (maybe we’ll see a jump in incomes for some reason – I’m looking at you, policy makers), but it’s still pretty depressing.

Crucially, too, everything here only looks at aggregate, or average, numbers and if you think the balance-sheet recession story carries any weight at all, you should be very, very interested in the distributional effects.

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.

Paying interest on (excess) reserves (Updated)

The U.S. Federal Reserve is currently paying 0.25% interest on the reserve accounts of depository institutions.  This is therefore, at present, the primary rate of policy concern (as opposed to the Fed Funds rate):  if a bank can’t get a rate of return that, when adjusted for risk, is greater than 0.25%, they will stick their money in their reserve account at the Fed.  Among others, Scott Sumner [blog] has called this policy a mistake.

There is an economic cost to the policy.  0.25% isn’t much, but it’s the risk-free aspect that complicates things.  If banks’ risk aversion or their perception of the risks associated with investments are high, then a truely risk-free 0.25% could look quite attractive.  With the interest rates on US treasuries so low, there’s certainly reason to believe that risk aversion is still abnormally high at the moment.  Whether the demand for loans is coming from particularly risky projects, or is perceived to be, I don’t know (is there any way of knowing?).

So why have it at all?  I suppose I support the paying of interest on required reserves.  The banks don’t get a choice with them, so it seems only fair that they be compensated.  But for excess reserves, there would need to be an offsetting benefit to justify the policy.  One benefit will be that the interest is paid with new money, so it’s a way of quietly helping banks improve their balance sheets.  There’s currently about US$1 trillion in excess reserves, so that’s about US$2.5 billion per year.  That may be a lot of money to you and me, but it’s not much more than a rounding error to the US banking system as a whole.  Still, it’s something.  Another benefit, depending on your point of view, is that by attracting all that money into excess reserves, the Fed sterilised the QE they engaged in last year.  If you feel that the sterilised QE has caused lower long-term interest rates and hold that those rates are the ones that most significantly drive the economy and distinctly dislike inflation, then you’d probably judge the affair to have been a success [I include the weasel words because I am no longer certain].  A third benefit, which is really a further justification of the second, is that there is evidence that the Fed’s QE appears to have lowered not just US rates, but foreign rates as well.  In that case, then you probably want to sterilise the fraction going to other countries (bad enough, one might think, that America is fixing the rest of the world; it would be unthinkable if America also had to suffer inflation by doing so).

Anyway, all of that is by way of getting around to this point:  via Bruce Bartlett, I’ve just discovered that Sweden also pays interest on reserve deposits, normally 0.75 percentage points lower than their repo rate.  But, crucially, their repo rate is currently only 0.50%, which means that their deposit rate is negative, at -0.25%.

For myself, I tend to think that the interest rate on excess reserves should be lowered.  My argument is similar to what I imagine Scott Sumner would say, so I should also explain his view a little, to the extent that I understand him.  With nominal GDP at US$14 trillion, the US$1 trillion sitting in excess reserves is a very, very large amount of money.  If it were released into the economy, it would be a huge stimulus (even if the money multiplier/velocity of money is temporarily low).  By choosing to sterilise their QE (presumably out of fear of inflation), the Fed has turned what could have been a tremendously effective stimulus into a mediocre one at best.  Scott is rather more sanguine about inflation in general than I am (he favours targeting NGDP; I suspect that this graph would make him want to tear his hair out), but even if the Fed wishes to target inflation of, say, the near-universally accepted benchmark of 2%, then with actual current inflation down at 0.5% and expected future inflation below 1.5% for most of the next 10 years and falling, the sterilisation has been excessive.

Update 6 Aug 2010:

The FT’s Alphaville has gathered the arguments for and against.  Here are three arguments (and their counter-arguments) for keeping the Interest on Reserves (IoR) unchanged:

First, from Ben Bernanke himself, made in recent congressional testimony:

The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down … it’ll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there’s really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.

I think this is silly. It’ll be more difficult to manage short-term interest rates in the future only if, following an effective shut-down of the federal funds market, it becomes costly to start it back up again. I seriously doubt that the banks are going to take their existing staff, processes and infrastructure dedicated to this and throw them out the window. Heck, in a Q&A session after his testimony, Mr Bernanke stated that lowering the interest rate on reserves is a (serious) option in the event that the FMOC decides that further stimulus is warranted:

But broadly speaking, there are a number of things we could consider and look at; one would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time — giving more information about that, that’s certainly one approach. We could lower the interest rate we pay on reserves, which is currently one-fourth of 1%.

A second viewpoint, put forward by Dave Altig (of the Atlanta Fed) and Joseph Abate (of Barclays Capital), is that

If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.

I think that Jim Hamilton’s response to this is excellent, so let me just quote it in full:

But Dave doesn’t quite finish the story. If I as an individual bank decide that a repo or T-bill looks better than zero, and use my excess reserves to buy one of these instruments, I simply instruct the Fed to transfer my deposits to the bank of whoever sold it to me. But now, if that bank does nothing, it would be left with those reserve balances at the end of the day on which it earns nothing, whereas it, too, could instead get some interest by going with repos or T-bills. The reserves never get “shifted into short-term, low-risk markets”– instead, by definition, they are always sitting there, at the end of the day, on the balance sheet of some bank somewhere in the system.

The implicit bottom line in the Abate story is that the yields on repos and T-bills adjust until they, too, look essentially to be zero, so that banks in fact don’t care whether they leave a trillion dollars earning no interest every day.

The essence of this world view is that there are two completely distinct categories of assets– cash-type assets which pay no interest whatever, and risky investments like car loans that banks don’t want to make no matter how much cash they hold.

But I really have trouble thinking in terms of such a two-asset world. I instead see a continuum of assets out there. As a bank, I could keep my funds overnight with the Fed, I could lend them in an overnight repo, I could buy a 1-week Treasury, a 3-month Treasury, a 10-year Treasury, or whatever. Wherever you want to draw a line between available assets and claim those on the left are “cash” and those on the right are “risky”, I’m quite convinced I could give you an example of an asset that is an arbitrarily small epsilon to the right or the left of your line. Viewed this way, I have a hard time understanding how pushing a trillion dollars at the shortest end of the continuum by 25 basis points would have no consequences whatever for the yield on any other assets.

Finally, back with Dave Altig, there is the argument that:

the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:

“… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

“… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.”

Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.

But, to me, this really sounds like an argument for having higher reserve requirements, not an argument for encouraging excess reserves.  I’m all for paying interest on required reserves and setting the fraction required at whatever level you judge necessary to ensure the operation of the payments system.  But don’t try to shoe-horn that argument into keeping interest payments on excess reserves.

Nassim Taleb takes bat, ball; goes home

The author of The Black Swan doesn’t approve of the looming reappointment of Ben Bernanke as chairman of the US Federal Reserve.  Writing in the Huffington Post, he says:

What I am seeing and hearing on the news — the reappointment of Bernanke — is too hard for me to bear. I cannot believe that we, in the 21st century, can accept living in such a society. I am not blaming Bernanke (he doesn’t even know he doesn’t understand how things work or that the tools he uses are not empirical); it is the Senators appointing him who are totally irresponsible — as if we promoted every doctor who caused malpractice. The world has never, never been as fragile. Economics make[sic] homeopath and alternative healers look empirical and scientific.

No news, no press, no Davos, no suit-and-tie fraudsters, no fools. I need to withdraw as immediately as possible into the Platonic quiet of my library, work on my next book, find solace in science and philosophy, and mull the next step. I will also structure trades with my Universa friends to bet on the next mistake by Bernanke, Summers, and Geithner. I will only (briefly) emerge from my hiatus when the publishers force me to do so upon the publication of the paperback edition of The Black Swan.

Bye,
Nassim

That’s quite a god complex Taleb’s got going on there (“he doesn’t even know he doesn’t understand how things work”).