Thursday, April 13, 2017

The Zero Lower Bound and Monetary Policy

Ben Bernanke has written a couple of blog posts on the zero lower bound (ZLB) on nominal interest rates, and some implications for monetary policy going forward. The first deals with the extent of the ZLB "problem," and the second with monetary policy solutions.

In a previous post I wrote about the low-real-interest-rate phenomenon, and how central bankers view the implications for monetary policy. Basically, the real rate of return on government debt in the United States, and around the world, has been persistently low because of low productivity growth, demographic factors, and - most importantly, I think - the high demand and low supply of safe and liquid assets.

In his first piece, Bernanke is primarily interested in a paper written at the Federal Reserve Board by Kiley and Roberts, which I also commented on in my earlier post. Kiley and Roberts determine, based on simulations of the Board's FRB/US model, that if low real interest rates persist into the future, then US monetary policy will more frequently be constrained by the zero lower bound - assuming that negative nominal interest rates are not an option. The consequences, according to Kiley and Roberts, are that inflation will tend to fall short, on average, of the 2% inflation target, and - by Phillips curve logic - real output will fall short of "full employment" output.

But, Bernanke finds it puzzling that most of the measures of inflation expectations he has been looking at tend to be fairly persistent at about 2%. If the ZLB were such a big problem for inflation control, in the way that Kiley and Roberts envision, shouldn't market participants be predicting low inflation? Let's look at one measure of inflation expectations - the 10-year breakeven rate (the yield on a 10-year Treasury bond minus the yield on a 10-year TIPS):
Currently, that measure has dropped a bit below 2%. Recall that TIPS are indexed to CPI inflation, not PCE inflation, which is what the Fed targets. Here's the difference between CPI inflation and PCE inflation:
As you can see, the difference is on average positive, and quite variable. But, if the 10-year breakeven rate is biased upward as a measure of anticipated inflation, then maybe anticipated inflation is in fact substantially lower than 2%. So maybe Bernanke shouldn't be so puzzled.

But suppose that we take other measures of anticipated inflation seriously, as Bernanke does (and perhaps as we should not). For example, professional forecasters, rightly or wrongly, tend to persistently forecast 2% inflation over the medium term. Bernanke's interpretation is that Kiley and Roberts are doing the analysis right, but they're not taking into account other aspects of policy - forward guidance and quantitative easing (QE). That is, according to Bernanke, the Fed will "do what it takes" to maintain its 2% inflation target in the future - binding ZLB or not.

Perhaps unsurprisingly, Bernanke's advice for hitting the 2% inflation target given a frequently binding ZLB constraint is to do what he did:
One possibility, which seems desirable in any case, is just to build on and improve the approaches used between 2008 and 2015. Strategies the Fed used to address the zero lower bound included aggressive rate-cutting early on, quantitative easing, forward guidance about future rate paths, and a “risk-management” strategy that entails a very cautious liftoff from the zero bound when the time comes.

It seems to me that Bernanke has mischaracterized the problem and, given that, he's not going to do well in solving it. Here's my take on this:

1. A persistently low real interest rate, if it is a problem for inflation control, would imply that the central bank on average misses on the high side. This is just the logic of the Fisher effect. As Kiley and Roberts say,
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
But they don't seem to understand that a corollary is that, if the ELB (effective lower bound) is encountered more frequently, this implies that the nominal interest rate is on average higher than what is required to hit the 2% inflation target. So, "according to the Fisher equation," as they say, inflation will be higher, on average, than 2%, not lower.

I've written a paper about this. My model can accommodate a number of things - sticky prices, money, credit, open market operations, collateral, safe asset shortages. And it's got neo-Fisherian properties, as all mainstream macroeconomic models do. In the model, one can work out optimal monetary policy, and I do this in the context of different frictions, to separate out how these frictions matter for policy. With just a basic sticky price friction, the model exhibits a Phillips curve, and if the ZLB binds in the optimal monetary policy problem, due to a low real interest rate, then inflation and output are too high. If we take this version of the model seriously, an interpretation in terms of recent history, is that low real interest rates have not been impinging on monetary policy in the United States. Inflation has persistently come in below the 2% target, and the Fed was doing the right thing in raising nominal interest rates, so as to increase inflation.

2. If forward guidance works, it does so through commitment to higher future inflation. And this promise is carried out with a higher future nominal interest rate. Again, this is just standard neo-Fisherian logic. The current nominal interest rate determines anticipated future inflation. So, if the problem is a binding ZLB constraint, and current inflation is too high as long as the ZLB binds, then the central bank can reduce current inflation while at the ZLB by promising higher inflation when the ZLB no longer binds. But, according to the Fisher effect, the central bank achieves higher inflation through a higher setting for the nominal interest rate. That's in my paper too.

Conventional ZLB economics doesn't work that way. Work by Eggertsson and Woodford and Werning derives results that Bernanke describes as "make-up" policy. That is, the central bank makes up for a period during which the ZLB binds by committing to staying at the ZLB for longer than it othwerwise would. As far as I can make out, these results are particular to how these authors set up the problem. I can turn the results on their head in a model with sticky prices, demand-determined output, and a Phillips curve. And I can do it in a way that doesn't yield various "paradoxes" - a paradox such as less price stickiness being a bad thing (Werning).

But that's forward guidance in theory. I have yet to see forward guidance work in practice. Indeed, Bernanke's execution of forward guidance in the post-financial crisis period is an example of how not to do it.

3. Quantitative easing as an approach to inflation control? Forget it. A great example here is Japan, which I most recently discussed in this post. QE appears to be ineffective in pushing up inflation in a low-nominal-interest-rate environment - the solution if inflation is too low is what comes naturally: increase the nominal interest rate.

In conclusion, if low real interest rates persist, at the levels we have seen, then this should not be a problem for inflation control. The Fed can control inflation, albeit with a lower average level of short-term nominal interest rates than we have seen in the past. Potentially, problems could be encountered, not with inflation control, but in affecting real economic activity. Though neo-Fisherism says increases in the central bank's nominal interest rate target make inflation go up, these ideas do not suggest that an increase in the nominal rate makes output go up. The conventional notion that monetary stabilization policy is about reducing interest rates in the face of shocks that make output go down seems to be strongly supported by the data. Thus, if there is a problem for monetary policy in a low-real-interest-rate environment, it's that the nominal interest rate cannot fall enough in the face of a recession. Between mid-2007 and late 2008, the fed funds rate target fell from 5.25% to (essentially) zero. But, if the average fed funds rate is 3%, or 2%, it can't fall by 500 basis points or more in the event of a downturn.

But how do we know that historical Fed behavior was optimal, or even close to it? Standard New Keynesian theory says that, if the real interest rate is sufficiently low, then the nominal interest rate should go to zero. But in my paper, if we're explicit about the reasons for the low real interest rate - in this case a tight collateral constraint - then the low real interest rate implies that the nominal interest rate should go up. That is, a low real interest rate reflects an inefficiently low supply of safe collateral, and an open market sale by the central bank can mitigate the collateral shortage, which results in higher nominal and real interest rates.

Sunday, April 2, 2017

Plain Speaking

Andy Haldane, Chief Economist at the Bank of England, gave a speech last Friday at the San Franciso Fed titled "A Little More Conversation, a Little Less Action." What was Haldane trying to get across? He wants to build "trust and legitimacy" by "rethinking how and with whom central banks engage." Why should we do this?
...two recent developments mean that central banks’ engagement strategies may need to be widened and deepened. First, the global financial crisis has dealt a trust-busting blow to many institutions, including central banks. Second, the way trust is built has been fundamentally reconfigured. Where once trust was anonymised, institutionalised and centralised, today it is increasingly personalised, socialised and distributed.
Andy's speech was about central bank communication, but he started by saying something general about the place of institutions in contemporary society. First, according to Andy, the financial crisis changed things. With respect to central banks, there has been more questioning of what central banks and economists do. And a lot of the that criticism is coming from economists - including Andy Haldane himself. In this article, from earlier this year, Haldane is quoted as saying:
It’s a fair cop to say the profession is to some degree in crisis.
So, seemingly, one of the trust-busting punches to central banks and economists was thrown by Andy Haldane, and now Andy Haldane wants to tell us how we can built up the trust he is helping to destroy. Let me emphasize at this point that the economics profession is not in crisis. The profession is fundamentally healthy and, like any science, is constantly reinventing itself in its usual methodical ways.

Haldane's second point is... wtf? Let me repeat it again, so we can attempt to dissect it:
Second, the way trust is built has been fundamentally reconfigured. Where once trust was anonymised, institutionalised and centralised, today it is increasingly personalised, socialised and distributed.
What is trust? My online dictionary says:
firm belief in the reliability, truth, ability, or strength of someone or something.
So, trust cannot be "anonymous." It has to be attached to someone or something we can name - Andy Haldane, or the Bank of England, for example. Was trust "institutionalised?" What would that mean, exactly? As per the definition, we could trust an institution, such as the Bank of England, or we could think of trust being built up as a kind of implicit institution - the institution of trust, as it were. Is trust now "socialised?" Now I'm really befuddled. Is it distributed? Haven't a clue. Who would be doing the distribution? Does it distribute itself or what? You can see that, in giving a speech on how to communicate, Andy isn't exactly demonstrating the state of the art.

After the preliminaries, Haldane then settles in to what is, in part, a fairly conventional speech on central bank communication. He talks about some of the history of central bank communication and why we do it. Though he uses the word "trust" a lot, we could translate this into the standard language of "commitment," I think, without any loss. What are Haldane's recommendations for improvement in central bank communication? You could summarize this as:

1. Understand who you're talking to.
2. Speak and write simply and clearly.
3. Listen.
4. Be on the lookout for new ideas.
5. Tell people what you're doing.

And that's about it. This paragraph in the conclusion sums things up nicely:
It is an irony, and not one lost on me, that this speech is a classic example of one-way central bank communications. Worse still, it comes in at around 11,500 words, contains 2,000 adverbs and adjectives and has a reading grade score of around 11. Perhaps central bankers, like this one, have always been better at preaching than practicing. If so, that needs to change. And when better to change than now.
Yes, Andy, no time like the present. In plainspeak, cut the bullshit.

That said, Andy's topic is very important - communication is the key problem for central bankers, and we don't always do it well. In order to do our jobs, and to ensure that our institutions survive and thrive, we have to communicate well. How should we do it? In his speech, Andy mentions the songs of Elvis Presley. Though Elvis was indeed a great communicator, he didn't actually write songs. One song that Elvis sang but didn't write is "Baby, Let's Play House," written by Arthur Gunter. For "Baby Let's Play House," even the title communicates well - you know exactly what this song's about. Here's the first verse, the way Elvis sang it:
Oh, baby, baby, baby, baby baby. Baby, baby baby, b-b-b-b-b-b baby baby, baby. Baby baby baby. Come back, baby, I wanna play house with you.
Genius. Gunter - speaking through Elvis - tells you exactly what's on his mind. But he also wants to sell some records, and he knows he can't do that if he actually spells it out. He communicates precisely to the listener, but in a way that will slip by the censors. However, though 50s rock and roll is great communication, I don't think Janet Yellen would be bringing Elvis - or Arthur Gunter - to her press conferences to explain things, if they were still alive.

So, to get more specific about monetary policy, here's a piece of Fed communication, from the last FOMC statement:
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
Who is the intended audience for this? Who should it be? Clearly, one would need to know some economics to understand the above paragraph - it can't be intended for the general public. Should it be targeted to a less-specialized audience? Probably not. Maybe it's better for the Fed to communicate in more simple, direct, language in other forums. That's typically done in talks given by Governors and Fed Presidents to lay audiences. Other people at the Board and the regional Feds do that too. But, in the FOMC statement, the language needs to be precise - the FOMC wants to get across to financial market participants, and others who care about the nitty gritty of monetary policy, why it is doing what it's doing, and what it intends to do in the future.

What does the paragraph say? I'll take a stab at translating it into plainspeak: The FOMC has interpreted its dual mandate, specified by Congress, to be maximum employment and a symmetric 2% inflation target. The Committee currently attempts to achieve this goal, in part, through adjustments in the target range for the federal funds rate. Changes in the fed funds rate target range are made in response to all available information. The Committee is currently normalizing policy, which implies that further increases in the target federal funds rate range are expected, but such changes will probably occur gradually. That was actually harder than I thought it would be, and the end result is still not as simple as we might like. What's a "symmetric 2% inflation target," anyway?

But what's wrong with the original paragraph in the FOMC statement? It both says too much, and too little. Do people need to be told the Fed is looking at everything? Don't they understand that? The Fed is going to monitor actual and expected inflation developments, but so what? What's it going to do in response to what it sees? What exactly are the levels of the fed funds rate that are expected to prevail in the long run? An informed person would know that some of that information is in the Summary of Economic Projections, but why isn't there a reference to that in the statement?

People have agonized and argued at great length over the wording of FOMC statements. Sometimes a single word can get considerable attention. But, if the goal is communicating with the informed public, all the effort in crafting the statement has perhaps been wasted if people can't understand it, or if they feel it leaves them no better informed. But perhaps the FOMC statement serves as a vehicle for obtaining consensus among the Committee's members and achieving continuity in its decisions. Maybe it's not about communication with the outside world at all - possibly we should just think of the statement as a small window through which we can view some of the intricacies of FOMC decisionmaking.

But, I think the Fed is actually pretty effective at communicating with the public, and communication is a two-way street. If there are people complaining that the Fed isn't keeping them up to speed, they should first spend some time on the receiving end of Fed communications, and see if their attitude changes. What's the Fed doing, with respect to communications? I'll give you a sample, based on what I know about the activities of the St. Louis Fed:

1) The St. Louis Fed President, Jim Bullard, has a very active schedule of speeches and interviews. Jim is a great communicator (though whether he's at Elvis level I'm not sure) and does a first rate job of getting ideas into the public forum.

2) There are many people at the St. Louis Fed who give public presentations and interviews. For example, Research department economists are trained in media relations, and some of the community outreach we do is through our branches - in Memphis, Louisville, and Little Rock. Economists do presentations for Boards of directors, and for members of the general public at these institutions.

3) The St. Louis Fed has been a world leader in consolidating economic data, and making it accessible to the public. That's what FRED, Geofred, and Fraser are about. These products help promote financial literacy, and allow people to engage with economic ideas.

4) You probably didn't know this, but the St. Louis Fed is an educator, through its econlowdown program. The group responsible for these programs was awarded the 2017 Excellence in Financial Literacy Education (EIFLE) Award for Education Program of the Year: Children, General.

5) An annual event at the St. Louis Fed is Dialogue with the Fed, where an economist gives a prepared talk to the public, and a panel then answers questions from the audience.

6) The St. Louis Fed has an array of publications. On the higher end is the St. Louis Fed Review, for which some knowledge of economics is required; the Regional Economist is a more widely-accessible economics publication, and there are shorter pieces in Economic Synopses, and the On the Economy Blog.

So, I think the state of central bank communication - at least the part of it I know something about - is very healthy. That said, the issues are technical, and sometimes complicated, and a lot more can be done by central banks and educators to make those issues better-understood.

Wednesday, March 29, 2017

Low Real Interest Rates and Monetary Policy

That real rates of return on government debt are at historical lows is well-established. Of course, the anticipated real rate of return on government debt - which is what matters for economic behavior - is unobservable, and that's problematic. Typically, macroeconomists resort to proxy measures as a starting point for addressing issues related to low real interest rates. For example, we could use the current twelve-month measured inflation rate as a proxy for anticipated inflation, and subtract that from some observed nominal interest rate to get a crude measure of the real interest rate. Like this, for example:
The chart shows the three-month US T-bill rate, minus the 12-month pce inflation rate. As you can see, it's not like we have never seen real rates of interest (by this measure) as low, but short-term real interest rates have never been as persistently low, at least in the post-1960 sample.

Typically, though, when low real interest rates are discussed in policy circles, the discussion does not revolve so much around actual real rates of interest, but some other real interest rate concept. And there are several such concepts, which is bound to make things confusing, if not totally impenetrable. Let's try to sort this out.

(1) The natural real rate of interest: For the average macroeconomist, this measure is well-defined, though not necessarily useful. The natural real rate of interest, or Wicksellian natural rate is the real interest rate in a New Keynesian (NK) macroeconomic model, if we remove all wage and price stickiness. For simplicity, early NK models were built so as to leave out all sources of inefficiency, except for wage stickiness (sometimes) and price stickiness (usually). These models may have efficiency loss due to monopolistic competition, but that's a by-product of the approach to price stickiness. So, essentially, the natural real rate of interest is the real rate of interest in the underlying real business cycle model with flexible wages and prices. Why am I saying this concept is "not necessarily useful?" First, while there is some complacency among NK practitioners that NK is all we need to think about in understanding monetary policy, that's a dangerous idea. The basic model has many faults, not least of which is that it neglects the essential details of monetary policy - assets actually play no role in the model, in that there is no central bank balance sheet, no open market operations, no banks, no role for credit, for money, etc. Second, the baseline NK model cannot explain why the natural real rate of interest might be low. For example, low-real-interest-rate NK macroeconomics, such as Eggertsson and Woodford's work or Werning's, typically assumes the real interest rate is low because the subjective discount factor is high. That is, the low natural rate results from a contagious attack of patience. As is well-known, preference shock "explanations" for economic phenomena aren't helpful. If you like explaining the financial crisis as a contagious attack of laziness accompanied by an increased dislike for some assets and an infatuation with some other assets, most people aren't going to listen to you - and those that do listen shouldn't. I think some NK practitioners think of the high discount factor as a stand-in for something else. If so, it would be more useful to develop explicitly what that something else is.

(2) The equilibrium real interest rate: I'll let Ben Bernanke explain this one:
...it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
This is where the confusion starts. Bernanke tells us this is a synonym for the "Wicksellian interest rate," suggesting that the "equilibrium rate" is the same as the "natural rate." And he says that the equilibrium real interest rate is the "rate consistent with full employment of labor and capital resources," which would tend to steer the reader in the direction of thinking this is an NK natural rate of interest. But, the remainder of the paragraph appears to describe what happens in an IS-LM model, so Bernanke is mixing theories - never a recipe for clarity. Further, "equilibrium real interest rate" is bad language for describing the natural rate of interest in the NK model, as the sticky-prices-and-wages real interest rate is in fact an equilibrium real interest rate - but it's a non-standard equilibrium concept.

(3) The neutral real interest rate: Janet Yellen covered this one in a recent speech:
Gauging the current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance at a given time. A useful concept in this regard is the neutral "real" federal funds rate, defined as the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a "neutral" policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator. Although the concept of the neutral real federal funds rate is exceptionally useful in assessing policy, it is difficult in practical terms to know with precision where that rate stands. As a result, and as I described in a recent speech, my colleagues and I consider a wide range of information when assessing that rate. As I will discuss, our assessments of the neutral rate have significantly shifted down over the past few years.
To clarify, here's what I think she means. It's common to think of monetary policy in terms of a Taylor rule, which we can write as:

R = r* + a(i-i*) + b(y-y*) + i*,

where R is the fed funds rate, r* is a constant, i is the actual inflation rate, y is the actual level of output, i* is the inflation target, and y* is full-employment output. It's typical for people to assume that a > 1 and b > 0. Then, if there is full employment and the central bank is hitting its inflation target, we have R = r* + i*. So, in the Taylor rule, r* is the neutral real interest rate, and r* + i* is the neutral nominal fed funds rate before we have "adjusted for inflation," as Janet Yellen says.

So, given that r* is low, what implications does this have for monetary policy? Of course, the answer to that question should depend on why it is low. Economists have discussed several reasons for low real interest rates:

1. Low productivity growth: In standard models, the real interest rate falls when consumption growth falls. Lower growth in total factor productivity growth implies lower growth in consumption in the long run, which implies a lower real interest rate.

2. Demographics: Demographic structure matters for savings behavior, which in turn matters for the real interest rate. In particular population growth and longevity are important. For example, lower population growth tends to increase capital per worker and lower the real interest rate, and people save more if they expect to live longer, which also will tend to increase capital per worker and reduce the real interest rate. A paper by Carvahlo et al. is an attempt to disentangle some of those effects.

3. Higher demand and lower supply of safe, liquid assets: The low real interest rates we observe are interest rates on government debt, and such assets have functions that go well beyond providing a safe vehicle for savings. Government debt is widely traded in financial markets, and is the principle form of collateral in the market for repurchase agreements, which is a key part of the "financial plumbing" that helps financial markets run efficiently. Much like money, government debt bears a liquidity premium - market participants are willing to hold government debt at lower rates of return than if they were holding it purely for its associated payoffs. Then, the higher the demand for government debt relative to its supply, the higher the liquidity premium, and the lower the real interest rate on government debt. The supply of safe collateral fell as a result of the financial crisis - some types of private collateral and sovereign debt were no longer considered safe. As well, the crisis engendered an increase in demand for safe collateral due to an increase in perceived crisis risk, and because of new financial regulations, associated with Dodd-Frank and Basel III, for example.

I tend to think that (3) is most important, but that's based on working through some models, like this one and this one, and my own informal views on what is going on in the data. On that note, I should add a fourth factor:

4. Monetary policy: Indeed, the real rate of interest on government debt may in part be low because of monetary policy. First, conventional monetary policy can make the real interest rate permanently low. For example, in this paper, if safe collateral is scarce, a reduction in the nominal interest rate also reduces the real interest rate - permanently. That's because the open market operation that reduces the nominal interest rate is a purchase of good collateral (same effect under a floor system with reserves outstanding). Second, an expansion in the central bank's balance sheet can reduce the real interest rate, as I show in this paper. Basically, swapping reserves for government debt reduces the effective stock of safe collateral, as reserves are an inferior asset to government debt (why else would the interest rate on reserves exceed the T-bill rate?). Thus a central bank balance sheet expansion exacerbates the problem of collateral scarcity - quantitative easing may be a bad idea.

What we need to evaluate what is going on is a model that can incorporate these factors, and can be used both to evaluate quantitatively how (1)-(4) matter, and the implications for optimal monetary policy. So what are economists in central banks up to in this respect? At the most recent Brookings paper conference, there are a couple of papers that deal with the problem, one by Kiley and Roberts, at the Federal Reserve Board, and the other by Del Negro et al. at the New York Fed.

Let's look first at the Kiley and Roberts (KR) paper. The key monetary policy problem KW perceive with low r* - and this, not surprisingly, is consistent with mainstream policy views - is that this will cause the effective lower bound (ELB) on the nominal interest rate to bind more frequently. As they say,
ELB episodes may be more frequent and costly in the future, as nominal interest rates may remain substantially below the norms of the last fifty years.
Why would this happen? Going back to our Taylor rule, a lower r* implies that, when the central bank is hitting its targets, then the nominal interest rate has to be lower. So, if the economy is being hit by shocks which cause the central bank to move the nominal interest rate up and down, and if the average nominal interest rate is lower, then the central bank will find itself more frequently constrained by the ELB. Then, periods at the ELB will be periods when the central bank departs from its goals, and there is nothing (other than unconventional policy) that the central bank can do about it. Faced with this perceived problem, some policymakers contemplate increases in the central bank's inflation target - inflation would on average be higher, which may imply a welfare loss but, as the argument goes, there are benefits from being constrained by the ELB less frequently.

This is basically Fisherian logic. Over the long run, a higher nominal interest rate will be associated with higher inflation. Perhaps curiously, KR studiously avoid mention of Irving Fisher, though Jonas Fisher gets several mentions. The one callout to I. Fisher is this:
According to the Fisher equation, higher average inflation would imply a higher average value of nominal interest rates, and so the ELB would be encountered less frequently.
By the "Fisher equation" they mean the long-run Fisher effect, I think. Supposing that the long run real interest rate is a constant, r*, the long run relationship between the nominal interest rate and inflation is R = r* + i. But, of course, in the quote they have the causality going the wrong way. In their models, it's the central bank that controls inflation by controlling the nominal interest rate, so it's the nominal interest rate that's causing the inflation rate to be what it is, not the other way around. That's basic neo-Fisherism.

So what do KR do? They simulate a couple of models to determine what the potential losses are from retaining a 2% inflation target in a low-r* environment. The first model (and this won't surprise you if you know anything about quantitative policy analysis at the Board) is the FRB/US model. For the uninitiated, the FRB/US model is basically a relic of the 1960s - the type of large-scale econometric model that Lucas convinced us in 1976 should not be used for policy analysis. And, 41 years later, here's FRB/US - being used for policy analysis. As KR say:
As emphasized in Brayton, Laubach, and Reifschneider (2014) and Laforte and Roberts (2014), the FRB/US model is extensively used in monetary-policy analysis at the Federal Reserve and captures features of the economy that reflect consensus views across macroeconomists, but is not strictly “micro-founded” in the manner used in many academic analyses.
So, apparently, economists at the Board choose to ignore academic standards (no reputable academic journal would - or should - publish an article about the policy predictions of FRB/US), and go about "extensively" using FRB/US to think about policy.

And you can see where it goes wrong. Here's what FRB/US tells us about what happens in a low-r* world:
... the ELB binds often and inflation falls systematically short of the 2 percent objective; in addition, output is, on average, below its potential level.
Basically, FRB/US is an extended IS/LM/Phillips curve model. In it, long-run inflation is exogenous (2% basically), and inflation will deviate in the short run from its long run value due to Phillips curve effects. So, not surprisingly, in this type of framework, when the ELB binds, output is below "potential" and this causes inflation to fall short of its target. But, by neo-Fisherian logic, if on average the nominal interest rate is too high, because it keeps bumping up against the ELB, inflation should, on average, be exceeding its target. For example, in recent history in the US, some people think that the inflation rate was persistently below target because the nominal interest rate was effectively at the ELB, and we could have done better (have had higher inflation) if the nominal interest rate were permitted to go below zero. Not so. The fact that inflation was persistently below target indicates that the ELB was not a binding constraint. The nominal interest rate was too low.

What else are KR up to? They also use an off-the-shelf DSGE model, developed by Linde, Smets, and Wouters, to address the same policy question. Is this model an better-equipped to answer the question than the FRB/US model? No. Such models, though smaller and more manageable than old-fashioned large-scale macroeconometric models like FRB/US, certainly can't lay any claim to structural purity - there are plenty of ad-hoc features (adjustment costs, habit persistence) thrown in to fit the data, and the model certainly was not set up to capture the phenomenon at hand. Though this DSGE model can certainly capture a decline in productivity (feature (1)) there's nothing much in there with regard to (2)-(4), and the monetary policy detail is shockingly weak. So, I don't think we should take the results seriously.

The second paper, by Del Negro et al. (DGGT) is more of a straightforward time series exercise - but there's some DSGE in this one too. This paper confronts the data in a useful way, focusing on the "convenience yield" on government debt (which I called a "liquidity premium" above), and showing, for example, that corporate debt does not share this convenience yield, which is important. The analysis documents a fall in the real rate of interest beginning in the 1990s, and the estimate of the current real interest rate is 1.0-1.5%. The econometrics in DGGT is sophisticated, but ultimately I'm not sure if I trust it more than what I see in the chart at the beginning of this post. Currently, the 3-month T-bill rate rate is about 0.80%, and the last reading for the twelve-month pce inflation rate is 1.9%. So, by my crude measure, the current real interest rate is -1.1%. If someone is giving me an estimate of 1.0-1.5%, I'm going to think that's way too high. If, given current policy settings, inflation is roughly at target, as is labor market tightness, then the nominal interest rate must be about right, if we follow our Taylor-rule logic.

Monday, March 20, 2017

Do policymakers need more advice from sociologists?

Sociologists sometimes feel neglected. And this can cause them to complain - about economists. Economics is a successful social science. While most social sciences do well in attracting undergraduate students, economics has performed well off campus. An undergrad economics major pays well, and an economics PhD provides entry into plentiful high-paying jobs on Wall Street, and in government, central banks, and academia. As well, policymakers care what economists think, and seek their advice (current occupants of the executive branch excepted).

But life isn't so easy for the downtrodden sociologist, which has led to writing like this piece in the Journal of Economic Perspectives. I discussed that article in this blog post. Seems the upshot of the authors' critique is that economics would be much better if it adopted ideas from other social sciences - sociology in particular.

Economics is hardly perfect. To move forward as a science, we need to be objective, heartlessly self-critical, and outward-looking - ready to absorb new and useful ideas from other fields. So what does sociology have to offer us? Neil Irwin, at the New York Times, suggests that there are some key ideas in sociology that economists, and policymakers, are not absorbing. Irwin says:
They say when all you have is a hammer, every problem looks like a nail. And the risk is that when every policy adviser is an economist, every problem looks like inadequate per-capita gross domestic product. Another academic discipline may not have the ear of presidents but may actually do a better job of explaining what has gone wrong in large swaths of the United States and other advanced nations in recent years.
So, (i) things have gone wrong in the US and elsewhere. (ii) We may be ignoring better explanations for these things than what economists are supplying.

That other academic discipline with the explanations is sociology, of course. Neil then interviews a sociologist, to get her perspective:
“Once economists have the ears of people in Washington, they convince them that the only questions worth asking are the questions that economists are equipped to answer,” said Michèle Lamont, a Harvard sociologist and president of the American Sociological Association. “That’s not to take anything away from what they do. It’s just that many of the answers they give are very partial.”
So apparently we have been somewhat conspiratorial, whispering in the ears of the Washington elite that economics is it - and all the time neglecting some important stuff. But what exactly are we missing?

The rest of Neil's article details what he views as important contributions of sociology, that help us understand current problems:

1. “Wages are very important because of course they help people live and provide for their families,” said Herbert Gans, an emeritus professor of sociology at Columbia. “But what social values can do is say that unemployment isn’t just losing wages, it’s losing dignity and self-respect and a feeling of usefulness and all the things that make human beings happy and able to function.”

2. Jennifer M. Silva of Bucknell University has in recent years studied young working-class adults and found a profound sense of economic insecurity in which the traditional markers of reaching adulthood — buying a house, marrying, landing a steady job — feel out of reach.

3. “Evicted,” a much-heralded book by the Harvard sociologist Matthew Desmond, shows how the ever-present risk of losing a home breeds an insecurity and despondency among poor Americans.

4. ...a large body of sociological research touches on the idea of stigmatization, including of the poor and of racial minorities. It makes clear that there are harder problems to solve around these issues than simply eliminating overt discrimination.

So, unemployed people feel really bad, young people worry about the future, poverty is horrible, and stigma exists. I would hope that most people would know these things, and that they shouldn't need sociologists to point out the importance of these observations. But, if the role of sociologists is to inform otherwise-oblivious people about this stuff, then good for them.

But we're looking for something more, I think. Surely sociologists have ideas about solutions to these problems that they have spent so much time studying? Well, no.
And trying to solve social problems is a more complex undertaking than working to improve economic outcomes. It’s relatively clear how a change in tax policy or an adjustment to interest rates can make the economy grow faster or slower. It’s less obvious what, if anything, government can do to change forces that are driven by the human psyche.
Apparently sociology is so much harder than economics that sociologists are bereft of solutions. And no one's asking them anyway, so why bother?
But there is a risk that there is something of a vicious cycle at work. “When no one asks us for advice, there’s no incentive to become a policy field,” Professor Gans said.
Still glad to be an economist, I think.

Sunday, March 19, 2017

What is full employment anyway, and how would we know if we are there?

What are people talking about when they say "full employment?" Maybe they don't know either? Whatever it is, "full employment" is thought to be important for policy, particularly monetary policy. Indeed, it typically enters the monetary policy discussion as "maximum employment," the second leg of the Fed's dual mandate - the first leg being "price stability."

Perhaps surprisingly, there are still people who think the US economy is not at "full employment." I hate to pick on Narayana, but he's a convenient example. He posted this on his Twitter account:
Are we close to full emp? In steady state, emp. growth will be about 1.2M per year. It's about *twice* that in the data. (1) Employment is growing much faster than long run and inflation is still low. Conclusion: we're well below long run steady state. end
Also in an interview on Bloomberg, Narayana gives us the policy conclusion. Basically, he thinks there is still "slack" in the economy. My understanding is that "slack" means we are below "full employment."

So what is Narayana saying? I'm assuming he is looking at payroll employment - the employment number that comes from the establishment survey. In his judgement, in a "steady state," which for him seems to mean the "full employment" state, payroll employment would be growing at 1.2M per year, or 100,000 per month. But over the last three months, the average increase in payroll employment has exceeded 200,000 per month. So, if we accept all of Narayana's assumptions, we would say the US economy is below full employment - it has some catching up to do. According to Narayana, employment can grow for some time in excess of 100,000 jobs per month, until we catch up to full employment, and monetary policy should help that process along by refraining from interest rate hikes in the meantime.

Again, even if we accept all of Narayana's assumptions, we could disagree about his policy recommendation. Maybe the increase in the fed funds rate target will do little to impede the trajectory to full employment. Maybe it takes monetary policy a period of time to work, and by the time interest rate hikes have their effect we are at full employment. Maybe the interest rate hikes will allow the Fed to make progress on other policy goals than employment. But let's explore this issue in depth - let's investigate what we know about "full employment" and how we would determine from current data if we are there or not.

Where does Narayana get his 1.2M number from? Best guess is that he is looking at demographics. The working age population in the United States (age 15-64) has been growing at about 0.5% per year. But labor force participation has grown over time since World War II, and later cohorts have higher labor force participation rates. For example, the labor force participation rate of baby-boomers in prime working age was higher than the participation rate of the previous generation in prime working age. So, this would cause employment growth to be higher than population growth. That is, Narayana's assumptions imply employment growth of about 0.8% per year, which seems as good a number as any. Thus, the long-run growth path for the economy should exhibit a growth rate of about 0.8% per year - though there is considerable uncertainty about that estimate.

But, we measure employment in more than one way. This chart shows year-over-year employment growth from the establishment survey, and from the household survey (CPS):
For the last couple of years, employment growth has been falling on trend, by both measures. But currently, establishment-survey employment is growing at 1.6% per year, and household survey employment is growing at 1.0% per year. The latter number is a lot closer to 0.8%. The establishment survey is what it says - a survey of establishments. The household survey is a survey of people. The advantages of the establishment survey are that it covers a significant fraction of all establishments, and reporting errors are less likely - firms generally have a good idea how many people are on their payrolls. But, the household survey has broader coverage (includes the self-employed for example) of the population, and it's collected in a manner consistent with the unemployment and labor force participation data - that's all from the same survey. There's greater potential for measurement error in the household survey, as people can be confused by the questions they're asked. You can see that in the noise in the growth rate data in the chart.

Here's another interesting detail:
This chart looks at the ratio of household-survey employment to establishment-survey employment. Over long periods of time, these two measures don't grow at the same rate, due to changes over time in the fraction of workers who are in establishments vs. those who are not. For long-run employment growth rates, you should put more weight on the household survey number (as this is a survey of the whole working-age population), provided of course that some measurement bias isn't creeping into the household survey numbers over time. Note that, since the recession, establishment-survey employment has been growing at a significantly higher rate than household-survey employment.

So, I think that the conclusion is that we should temper our view of employment growth. Maybe it's much closer to a steady state rate than Narayana thinks.

But, on to some other measures of labor market performance. This chart shows the labor force participation rate (LFPR) and the employment-population ratio (EPOP).
Here, focus on the last year. LFPR is little changed, increasing from 62.9% to 63.0%, and the same is true for EPOP, which increased from 59.8% to 60.0%. That looks like a labor market that has settled down, or is close to it.

A standard measure of labor market tightness that labor economists like to look at is the ratio of job vacancies to unemployment, here measured as the ratio of the job openings rate to the unemployment rate:
So, by this measure the labor market is at its tightest since 2001. Job openings are plentiful relative to would-be workers.

People who want to argue that some slack remains in the labor market will sometimes emphasize unconventional measures of the unemployment rate:
In the chart, U3 is the conventional unemployment rate, and U6 includes marginally attached workers (those not in the labor force who may be receptive to working) and those employed part-time for economic reasons. The U3 measure is not so far, at 4.7%, from its previous trough of 4.4% in March 2007, while the gap between current U6, at 9.2% and its previous trough, at 7.9% in December 2006, is larger. Two caveats here: (i) How seriously we want to take U6 as a measure of unemployment is an open question. There are problems even with conventional unemployment measures, in that we do not measure the intensity of search - one person's unemployment is different from another's - and survey participants' understanding of the questions they are asked is problematic. The first issue is no worse a problem for U6 than for U3, but the second issue is assuredly worse. For example, it's not clear what "employed part time for economic reasons" means to the survey respondent, or what it should mean to the average economist. Active search, as measured in U3, has a clearer meaning from an economic point of view, than an expressed desire for something one does not have - non-satiation is ubiquitous in economic systems, and removing it is just not feasible. (ii) What's a normal level for U6? Maybe the U6 measure in December 2006 was undesirably low, due to what was going on in housing and mortgage markets.

Another labor market measure that might be interpreted as indicating labor market slack is long term unemployment (unemployed 27 weeks or more) - here measured as a rate relative to the labor force:
This measure is still somewhat elevated relative to pre-recession times. However, if we look at short term unemployment (5 weeks or less), this is unusually low:
As well, the insured unemployment rate (those receiving unemployment insurance as a percentage of the labor force) is very low:
To collect UI requires having worked recently, so this reflects the fact that few people are being laid off - transitions from employment to unemployment are low.

An interpretation of what is going on here is that the short-term and long-term unemployed are very different kinds of workers. In particular, they have different skills. Some skills are in high demand, others are not, and those who have been unemployed a long time have skills that are in low demand. A high level of long-term unemployed is consistent with elevated readings for U6 - people may be marginally attached or wanting to move from part-time to full-time work for the same reasons that people have been unemployed for a long time. What's going on may indicate a need for a policy response, but if the problem is skill mismatch, that's not a problem that has a monetary policy solution.

So, if the case someone wants to make is that the Fed should postpone interest rate increases because we are below full employment - that there is still slack in the labor market - then I think that's a very difficult case to make. We could argue all day about what an output gap is, whether this is something we should worry about, and whether monetary policy can do much about an output gap, but by conventional measures we don't seem to have one in the US at the current time. In terms of raw economic performance (price stability aside), there's not much for the Fed to do at the current time. Productivity growth is unusually low, as is real GDP growth, but if that's a policy problem, it's in the fiscal department, not the monetary department.

But there is more to Narayana's views than the state of the labor market. He thinks it's important that inflation is still below the Fed's target of 2%. Actually, headline PCE inflation, which is the measure specified in the Fed's longer-run goals statement, is essentially at the target, at 1.9%. I think what Narayana means is that, given his Phillips-curve view of the world, if we are close to full employment, inflation should be higher. In fact, the long-run Fisher effect tells us that, after an extended period of low nominal interest rates, the inflation rate should be low. Thus, one might actually be puzzled as to why the inflation rate is so high. We know something about this, though. Worldwide, real rates of interest on government debt have been unusually low, which implies that, given the nominal interest rate, inflation will be unusually high. But, this makes Narayana's policy conclusion close to being correct. The Fed is very close to its targets - both legs of the dual mandate - so why do anything?

A neo-Fisherian view says that we should increase (decrease) the central bank's nominal interest rate target when inflation is too low (high) - the reverse of conventional wisdom. But maybe inflation is somewhat elevated by increases in the price of crude oil, which have since somewhat reversed themselves. So, maybe the Fed's nominal interest rate target should go up a bit more, to achieve its 2% inflation target consistently.

Though Narayana's reasoning doesn't lead him in a crazy policy direction, it would do him good to ditch the Phillips curve reasoning - I don't think that's ever been useful for policy. If one had (I think mistakenly) taken Friedman to heart (as appears to be the case with Narayana), we might think that unemployment above the "natural rate" should lead to falling inflation, and unemployment below the natural rate should lead to rising inflation. But, that's not what we see in the data. Here, I use the CBO's measure of the natural rate of unemployment (quarterly data, 1990-2016):
According to standard Friedman Phillips-curve logic, we should see a negative correlation in the chart, but the correlation is essentially zero.

Friday, March 3, 2017

What's Up With Inflation?

In the past year, inflation rates have increased in a number of countries. Are these increases temporary or permanent? What do they imply for monetary policy?

One of the more stark turnarounds in inflation performance is in Sweden. To see what is going on, it helps to look at CPI levels:
Sweden had four years of inflation close to zero, but in the last year prices have been increasing, and the current 12-month inflation rate is 1.4%, which is getting much closer to the Riksbank's 2% inflation target. The path - actual, and projected by the Riksbank - for the Riksbank's policy interest rate looks like this:
So, the Riksbank's policy rate has been negative for about two years, and it envisions negative rates for the next two years.

For the Euro area, the story is similar. Here's the Euro area CPI:
The difference here, from Sweden, is that the inflation rate has been at zero for only three years, but you can see a similar increase in the inflation rate in the last year, with the current 12-month Euro area inflation rate at 1.6%. And the overnight interest rate in the Euro area looks like this:
As you can see, overnight nominal interest rates entered negative territory in 2015, and went significantly negative last year.

Another instance of increasing inflation is the UK:
In this case, it's more like two years of inflation close to zero, followed by an increase in 2016. The current 12-month inflation rate in the UK is 1.9%. The Bank of England's policy interest rate was targeted at 0.50% from March 2009 to August 2016, when it was reduced to 0.25%.

What's the most likely cause of the increase in the inflation rate in these three countries? I don't think we have to look far:
Crude oil prices fell from $100-110 in mid-2014 to about $30 in January 2016, and have since increased to $50-55. While changes in relative prices should not matter in the long run for inflation, a strong regularity is that, in the short run, shocks that cause large relative price movements are reflected in changes in inflation rates. As is well-known, that's particularly the case for crude oil prices, which are highly volatile and tend to move aggregate price indices in the same direction.

The timing certainly seems to suggest that oil price increases are responsible for the increase in inflation in Sweden, the Euro area, and the UK. But, of course, the monetary policies of the Riksbank, the ECB, and the Bank of England were specifically designed to increase inflation. These policies included low or negative nominal interest rate targets and large-scale asset purchases by the central bank. Most of the central bankers involved tend to subscribe to a simple Keynesian story: inflation expectations are fixed (i.e. "anchored"); lower interest rates reduce real rates of interest, which increase spending, output, and employment; inflation increases through a Phillips curve effect. Why can't we always see these effects? True believers might appeal to "long and variable lags" and a "flat Phillips curve." Those are dodges, I think. IS/LM/Phillips curve isn't a helpful framework for thinking about monetary policy if I have to worry about whether it's going to take six weeks or six years for monetary policy to work, or if I need to be concerned whether the Phillips curve is just resting, flat, sloping the wrong way, or deceased.

Further, there are countries in which extreme forms of negative interest rate monetary policy and a large central bank balance sheet don't appear to have moved inflation in the desired direction. One is Switzerland. Here's the Swiss CPI:
So, the recent history in Switzerland if one of unabated trend deflation. And overnight interest rates in Switzerland look like this:
Next, since April 2013 the Bank of Japan has resorted to every trick in the book (massive quantitative easing, low and negative nominal interest rates) to get inflation up to 2%. Here's the result:
I've told this story before, but it bears repeating. Since the BoJ's easing program began in April 2013, most of the increase in the CPI level has been due to an increase of three percentage points in the consumption tax in April 2014 in Japan. Inflation has averaged about zero for almost three years.

What's the conclusion? For all these countries, recent data is consistent with the view that persistently low nominal interest rates do not increase inflation - this just makes inflation low. If a central bank is persistently undershooting its inflation target, the solution - the neo-Fisherian solution - is to raise the nominal interest rate target. Undergraduate IS/LM/Phillips curve analysis may tell you that central banks increase inflation by reducing the nominal interest rate target, but that's inconsistent with the implications of essentially all modern mainstream macroeconomic models, and with recent experience.

But, even if we recognize the importance of Fisher effects, that will not make inflation control easy. (i) Shocks to the economy - for example large changes in the relative price of crude oil - can push inflation off track. (ii) The long-run real rate of interest is not a constant. As is now widely-recognized, the real rate of return on government debt, particularly in the United States, has trended downward for the last 35 years or so, and shows no signs that it will increase. By Fisherian reasoning, a persistently low real interest rate implies that the short-term nominal interest rate consistent with 2% inflation is much lower than it once was. But what's the best guess for the appropriate nominal interest rate currently, in the United States? Here's the inflation rate, and the 3-month T-bill rate in the United States (I'm using the T-bill rate to avoid questions as to what overnight rate we should be looking at):
So, the Fed's preferred measure of inflation (raw PCE inflation), at 1.9%, is very close to its target of 2%, after two interest rate hikes (in December 2015 and December 2016), which some claimed would reduce inflation and/or push the economy off a cliff. Looking at this same data in another way, subtract the 12-month inflation rate from the 3-month T-bill rate to get a measure of the real interest rate:
So, from mid-2012 to mid-2014, the real interest rate averaged about -1.3%, before oil prices fell. Now that the price of crude oil has again increased somewhat, the real interest rate is back in that ballpark again, with inflation close to the 2% target. So, what would a neo-Fisherian do? (i) There's no good reason to think that oil prices will keep going up, so the effects of the recent oil price increases should dissipate. So, with no change in monetary policy, we might expect a small reduction in the PCE inflation rate. (ii) There's no good reason to anticipate an increase in the long-run real rate of return on government debt, given our knowledge of what makes the real interest rate low (a shortage of safe assets, low average productivity growth). Therefore, a neo-Fisherian inflation-targeting policy maker might want another 1/4 point increase in the fed funds target, but not much more.

Tuesday, February 21, 2017

Tim Fuerst

I was sad to learn today that Tim Fuerst has passed away. Tim received his PhD from Chicago in 1990, was the William and Dorothy O'Neill Professor at the University of Notre Dame, and had a long relationship with the Cleveland Fed. Tim was one of the most enthusiastic human beings I have ever met. He did pathbreaking work on liquidity effects, and his joint work with Chuck Carlstrom at the Cleveland Fed was very influential. It's tragic to lose such a productive researcher and teacher at the peak in his career. Here's an article on Tim in the University of Chicago Magazine.

Monday, February 13, 2017

Balance Sheet Blues

We're starting to hear some public discussion about Fed balance sheet reduction. For example, Jim Bullard has spoken about it, and Ben Bernanke has written about it.

Balance sheet reduction is part of the FOMC's "Policy Normalization Principles and Plans. Quoting from scripture:
The Committee intends to reduce the Federal Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA.
The normalization plan also states that balance sheet reduction will occur after interest rate increases happen, and that no outright sales of assets in the Fed's portfolio are anticipated. Thus, since we have now seen two increases in the target range for the fed funds rate - in December 2015 and December 2016 - it would be understandable if people were anticipating some consideration of the issue by the Fed in the near future.

What's at stake here? The Fed engaged in several rounds of large scale asset purchases, beginning in late 2008, and continuing through late 2014, which served to more than quadruple the size of the Fed's balance sheet:
But the Fed's assets, which now consist primarily of long-maturity Treasury securities and mortgage-backed securities, mature over time. As the assets mature, the size of the Fed's asset portfolio will fall naturally, and Fed liabilities will be retired. But that isn't happening, because the FOMC instituted a "reinvestment" policy in August 2010, and that policy has continued to the present day. Under reinvestment, assets are replaced as they mature, the result being that the size of the portfolio stays roughly constant, in nominal terms. The Fed's normalization plans state that revinvestment will stop eventually, but there are different ways to phase it out. For example, revinvestment could stop abruptly, or the Fed could somehow smooth the transition.

But, if Ben Bernanke were still Fed Chair, he would be postponing balance sheet reduction. Why? As stated in his post, Bernanke thinks that:

1. There is uncertainty about the effects of ending reinvestment, so the Fed should wait until the fed funds rate is higher, giving it a larger margin to make corrections if something goes wrong with balance sheet reduction.
2. Because the demand for currency is growing over time, this reduces the amount of balance sheet reduction that would be required to return to the pre-financial crisis state of affairs in which reserves are close to zero.
3. There may be good reasons to continue operating a floor system, under which the interest rate on reserves determines overnight interest rates. But, according to Bernanke, it takes a heap of reserves to operate a floor system, giving us another reason to think that the ultimate balance sheet reduction required for normalization isn't so large.

Perhaps the most curious aspect of Bernanke's piece is the absence of any explanation of how quantitative easing (QE) is supposed to work. However, it's easy to find a stated rationale for QE in Bernanke's earlier public statements as Fed Chair, for example in his 2012 Jackson Hole speech. Basically, Bernanke argues that QE affects asset prices because of imperfect substitution among assets. Thus, for example, swaps of reserves for long-maturity Treasuries will increase the prices of long-maturity Treasuries, reduce long bond yields, and flatten the yield curve, according to Bernanke. He also claims there is solid empirical evidence supporting this theory. In Bernanke's mind, then, QE is just another form of "monetary accommodation," which substitutes for reductions in the policy interest rate when such interest rate reductions are not on the table. The reductions in long bond yields should, in Bernanke's view, increase real economic activity and increase inflation.

Actually, the evidence that QE works as intended is pretty sketchy. For the most part, the empirical work consists of event studies - isolate an announcement window for a policy change, then look for movements in asset prices in response. There's also some regression evidence, but essentially nothing (as far as I know) in terms of structural econometric work, i.e. work that is explicit about the theory in a way that allows us to quantify the effects. But surely, since QE has been in use for so long a time, it should have found a place in models that are widely used for policy analysis. Indeed, a paper by David Reifschneider at the Board of Governors uses the Board's large scale macroeconometric FRB/US model to conduct a policy exercise that, in part, evaluates the efficacy of QE. The conclusion is:
...model simulations of a severe recession suggest that policymakers would be able to use a combination of federal funds rate cuts, forward guidance, and asset purchases to replicate (and even improve upon) the economic performance that hypothetically would occur were it possible to ignore the zero lower bound on interest rates and cut short-term interest rates as much as would be prescribed by a fairly aggressive policy rule.
So, that's consistent with Bernanke's post. Bernanke argues that it was necessary to use QE in 2008 and after because the Fed was constrained by the zero lower bound on nominal interest rates. More accommodation was needed, according to Bernanke, and QE provided that accommodation. Reifschneider says that's exactly what the FRB/US model tells us. QE (along with forward guidance) effectively relaxes the zero lower bound constraint. That is, QE is just like a decrease in the target for the policy interest rate.

Is the FRB/US model the right laboratory for an assessment of the efficacy of QE? Reifschneider says:
For several reasons, FRB/US is well-suited for studying this issue. For one, it provides a good empirical description of the current dynamics of the economy, including the low sensitivity of inflation to movements in real activity. In addition, the model has a detailed treatment of the ways in which monetary policy affects spending and production through changes in financial conditions, including movements in various longer-term interest rates, equity prices, and the foreign exchange value of the dollar.
So, Reifschneider hasn't really told us why using this model is the right thing to do in this circumstance, but he's told us something about how the FRB/US model works. You can read about the FRB/US model here, and even figure out how to run it yourself if you have the inclination. The FRB/US model is a descendant of the FRB/MIT/Penn model, which existed circa 1970. In fact, if we could resurrect Lawrence Klein and show him the FRB/US model, I'm sure he would recognize it. In spite of the words in the FRB/US documentation that make it appear as if the model builders took to heart the lessons of post-1970s macroeconomics, FRB/US is basically an extended IS/LM/Phillips curve model - without the LM. Monetary policy is transmitted, as Reifschneider tells us in the above quote, through asset prices. So how would one use such a model to capture the effects of QE?
... the model’s asset pricing formulas provide a way for long-term interest rates and other financial factors to respond to shifts in term premiums induced by the Federal Reserve’s large-scale asset purchases.
So, in the simulation, QE is assumed to work through a "term premium" effect on asset prices - a flattening of the yield curve. But how large a change in the term premium results from a purchase of $x in assets by the Fed? That's in footnote 8:
The effects of asset purchases on term premiums used in this study are calibrated to be consistent with the estimates reported in Ihrig et al (2012) and Engen, Laubach and Reifschneider (2015) for the second and third phases of the Federal Reserve’s large-scale asset purchase programs, both of which involved buying assets of a longer average maturity (and thus a larger term premium effect) than the original phase. Specifically, the simulations reported here assume that announcing the purchase of an additional $500 billion in longer-term Treasury securities causes an immediate 20 basis point drop in the term premium embedded in the yield on the 10-year Treasury note; for yields on the 5-year Treasury note and the 30-year Treasury bond, the initial decline is assumed to be 17 basis points and 7 basis points, respectively. Thereafter, the downward pressure on term premiums is assumed to decline geometrically at 5 percent per quarter; this rate would be consistent with the Federal Reserve using reinvestments to maintain the size of its portfolio at its new, higher level for several years, and then allowing it to shrink passively by suspending reinvestment.
So, that's quite indirect. In the FRB/US model there are no central bank balance sheet variables. There are equations that capture the relationships among interest rates and asset prices, but there are no asset quantities. Thus, it's impossible to use the model to address directly the question: "What happens if the Fed purchases $600 billion in 10-year Treasury bonds?" To answer the question we have to do it indirectly. What Reifschneider has done is to work with what he's got, which is event studies and regression evidence. This gives him an estimate of the effect of Fed asset purchases on term premia, and he plugs that into the asset pricing relationships in the model. Maybe you're OK with that, but I don't trust it.

What makes me skeptical of Reifschneider's results? One approach to uncovering the effects of QE is to look for natural experiments. This is simple, which is ideal for a simpleton such as yours truly. For example, in April 2013, the Bank of Japan embarked on a QE project, which continues to this day. One objective of the project was to get inflation up to 2%. So, that policy has now had almost 4 years to work. What's happened? First, the magnitude of the BOJ's asset purchases is reflected in the monetary base:
The monetary base has about quadrupled over a period of less than four years. If QE works to increase inflation, surely we would be seeing a lot of it by now, right? Here's the CPI for Japan:
The price level went up alright, but part of that was due to an increase of three percentage points in the consumption tax in April 2014, which feeds directly into the CPI. Even including that, average inflation has been about 0.7% since April 2013, and about zero for the last two years. So, is QE effective in increasing inflation? Japanese experience says no.

Another natural experiment is the US and Canada. Since the financial crisis, the difference in interest rate policy between the Bank of Canada and the Fed has been minimal. For example, the Bank of Canada's current target for the overnight policy rate is 0.50%, while the ON-RRP rate (the comparable secured overnight rate in the US) is also 0.50%. From one of my papers, here's a chart showing what was going on with monetary policy in Canada, post-financial crisis:
We will return to this chart later, but for now just focus on the blue dotted line, which is overnight reserves at the Bank of Canada. For most of this period, except Spring 2009 to Spring 2010, the Bank of Canada operated under a channel system, under which it targets overnight reserves at zero. There is some slippage, with a quantity of overnight reserves typically less than $500 million. That's a very small amount relative to the quantity of interest-bearing Fed liabilities (currently close to $3 trillion). So, the Bank of Canada has not been indulging in QE, but the Fed has been doing it in a big way. Surely, if we believe Ben Bernanke, that would have resulted in observable differences in the behavior of real economic activity and inflation in the two countries. Here's real GDP, and the consumer price index for the US and Canada:
So, since the beginning of 2008, average real GDP growth and average inflation has been about the same in Canada and the US. As an econometrician once told me, if I can't see it, it's probably not there. Sure, since Canada is small and is highly integrated with the US economically, Fed policy will matter for Canadian economic performance. But, if QE were so important, the fact that the US did it and Canada did not should make some observable difference for relative performance.

What else do we know about QE? I thought about it a bit, and wrote a couple of papers - this one and this one. Basically, the idea is to think about QE for what it is - financial intermediation by the central bank. If QE is to work, and for the better, the reason has to be that the central bank can do a better job of turning long-maturity assets into short-maturity assets than either the private sector, or the fiscal authority. So, for example, QE could work because the fiscal authority is not doing its job - there is too much long-maturity government debt outstanding. So, if the central bank swaps reserves for long-maturity government debt, that could bring about an improvement, by improving the stock of collateral that supports intermediated credit. Basically, short-maturity assets are better collateral. But maybe reserves are worse assets than short-maturity government debt. Reserves can be held only by a limited set of financial institutions, while Treasury bills are widely-traded, and very useful, for example in the market for repurchase agreements. So, it's not clear that there is an improvement if, for example, the Fed purchases 10-year Treasuries, thus converting highly-useful 10-year Treasuries into not-so-useful reserves. Some of those concerns could be mitigated by an expansion in the Fed's reverse repurchase agreement (ON-RRP) program, but so far that has been operated on a small scale.
The chart shows outstanding ON-RRPs, which are a relatively small fraction of interest bearing Fed liabilities (approaching $3 trillion).

So, what of Bernanke's first point, that the Fed should postpone the termination of reinvestment, because of uncertainty? My conclusion is that it is hard to make a case that QE does anything at all, and one could make a case that it gums up the financial plumbing. But here's an interesting detail. If we break down the Fed's holdings of Treasury securities by maturity, we get this:
The chart shows the percentage of Treasury securities held by the Fed that will mature within one year, in 1-5 years, in 5-10 years, and in more than 10 years. Before the financial crisis, these percentages did not vary much, with about 80% of the portfolio maturing in less than 5 years - average maturity was relatively short. In early 2013, average maturity reached its peak, with about 75% of the total portoflio maturing in more than five years, and the remainder maturing in 1-5 years. But, since early 2013, the fraction of the portfolio maturing in more than five years has declined to about 40%, with about 10% maturing in less than one year.

So, if one thought that the degree of monetary accommodation was related not only to the size of the Fed's portfolio but to average maturity, then there is considerably less accommodation than was the case three years ago (at least in terms of the Fed's Treasury holdings). Further, if the reinvestment program were halted, the assets will run off more quickly than would have been the case if reinvestment had ceased three years ago.

What of Bernanke's two other points? The first is that the stock of currency is growing, which increases the size of the balance sheet at which interest-bearing Fed liabilities disappear. The next chart shows the stock of currency as a percentage of nominal GDP:
That's remarkable. In 1990, US currency outstanding in the world was about 4.4% of US GDP, and today it is almost 8%. To get some idea what implications this has for the Fed's balance sheet, we'll calculate the interest-bearing portion of Fed liabilities (that's total liabilities minus currency) and express that as a percentage of GDP:
So, you can see that the size of the balance sheet has actually been declining, measured as interest-bearing Fed liabilities relative to GDP. Again, if we took what is in the chart as a measure of accommodation, there is less of it than was the case late in 2014. But how long would it take for this ratio to decline to where it was (0.5%) prior to the financial crisis, if the reinvestment policy stays in place indefinitely. If my arithmetic is correct, about 55 years. Within 55 years, all kinds of things could happen, of course. Ken Rogoff could get his way and 80% of the currency stock could disappear, government currency could be replaced by private digital currencies, etc. So projecting that far into the future is pure speculation.

The final issue Bernanke raises is related to possible benefits for monetary policy implementation from a large Fed balance sheet. A case can be made that, in the U.S. institutional context, it is easier to implement monetary policy under a "floor" system than a "channel" or "corridor" system. There are some complications in the US case but, roughly, under a floor system the interest rate on reserves (IOER) should determine the overnight interest rate. To make the floor system work requires that there be adequate reserves in the financial system, so that a typical financial institution is indifferent between lending to the Fed (at IOER) and lending overnight to another financial institution. But once it's working, a floor system is easy for the Fed, as overnight interest rates are effectively set administratively, rather than through the hit-and-miss approach the Fed followed pre-financial crisis. But the key question is: How much reserves need to be in the system to make the floor system work? Here's what Bernanke says:
To ensure that the floor rate set by the central bank is always effective, the banking system must be saturated with reserves (that is, in the absence of the interest rate set and paid by the central bank, the market-determined return to reserves would be zero). In December 2008, when the federal funds rate first fell to zero and the Fed began to use the interest rate on bank reserves as a tool of monetary policy, bank reserves were about $800 billion. Taking into account growth in nominal GDP and bank liabilities, the critical level of bank reserves needed to implement monetary policy through a floor system seems likely to be well over $1 trillion today, and growing.
If you look at the very first chart, you can see what he's thinking. In October 2008 the Fed began paying interest on reserves in the midst of turmoil in financial markets. By the end of the year, overnight rates were essentially zero, and the size of the balance sheet had increased by a very large amount with reserves increasing about $800 billion. So, Bernanke is assuming that, at the end of 2008, it took $800 billion to make the overnight interest rate go to the floor - the IOER. If the balance sheet increase had occurred gradually in a relatively calm financial market, we might take that seriously, but I'm not buying it.

To see this, go back to the fourth chart, which shows what the Bank of Canada was up to. The chart shows three interest rates: (i) the rate at which the central bank lends to private financial institutions (green); (ii) the overnight interest rate the Bank of Canada targets (blue); (iii) the interest rate on deposits at the Bank of Canada - the interest rate on reserves (orange). Normally, the Bank operates a channel system, under which the overnight rate falls between the other two rates. But, for about one year, from Spring 2009 to Spring 2010, the Bank operated a floor system. As you can see, the policy rate goes to the floor for this period of time. How much reserves did it take to make the floor system work? The Bank targeted overnight reserves to $3 billion (Canadian) over this period. To get an idea of the order of magnitude, a rule of thumb is that the Canadian economy is roughly a multiple of 10 of the US economy, so this quantity of reserves is roughly comparable to $30 billion in the US. We need to account for the fact that there are reserve requirements in the US, and none in Canada, and that the US institutional setup is very different (many more banks for example). But, I think it's hard to look at the Canadian experience and think that it takes as much as $1 trillion in interest bearing Fed liabilities to make a floor system work in the US, as Bernanke is suggesting. I would be surprised if we needed as much as $100 billion.

So, in conclusion, I think Bernanke's arguments are weak. It's hard to make a case that QE is a big deal, or that stopping the Fed's reinvestment policy is risky or harmful - indeed it might improve economic welfare. Further, if one thinks that QE is accommodative, and that we can measure accommodation by the average maturity of the Fed's asset portfolio, or by the ratio of interest-bearing Fed liabilities to GDP, then withdrawal of accommodation has been underway for some time.

Addendum: This pertains to JP's comment below. Here's real GDP for Japan:
I don't see any break in the recovery from the recession associated with Abenomics. Do you? Just for good measure, we can look at the GDP price deflator for Japan:
So, you can see that it's the price behavior that's giving the nominal GDP increase. But, most of the price deflator increase is in 2014 - the price level increased by about 4% in a year's time. But, again, some of this is due to the direct effect of the consumption tax increase of three percentage points in April 2014. Note that inflation, measured by the increase in the GDP price deflator, has been about zero for the last two years.