MacroMania

You're probably thinking no, of course not. The dollar price of bitcoin can be quite volatile (see here). One can easily gain or lose 50% over a very short period of time. So if we're talking about an asset that offers a stable rate of return, Bitcoin ain't it.

Former Minneapolis Fed president Narayana Kocherlakota thinks that the Fed's recent communication strategy has resulted in an unforced "credibility dilemma." (The Fed's Credibility Dilemma.) What is the nature of this dilemma?

The message coming out of the Fed recently is one of "gradual normalization." Normalization refers to returning to the state of affairs that prevailed prior to 2008, when the Fed's balance sheet was much smaller and the policy interest rate (short term nominal interest rate) was much higher. "Gradual normalization" means that the Fed's policy rate is likely to move slowly and in an upward direction over the indefinite future.

But what "gradual normalization" means and how it is interpreted by market participants can be two different things. Kocherlakota is worried that the market is interpreting the phrase as meaning the Fed will raise its policy rate slowly and in an upward direction. While this may very well be the case, it should be clear that this is not what Fed officials mean to say. Consider, for example, this report on a recent speech delivered by Boston Fed president Eric Rosengreen.

He [Rosengreen] added that the Fed’s policy committee stated it “expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”

This is obviously not a commitment to raise interest rates gradually and in an upward direction. It is merely a forecast of the economic conditions that are likely to prevail in the near future, together with a statement of how the Fed is likely to react to these conditions should they be realized. Again, and from the same speech,

The future path of rates, he said, will depend on incoming economic data, and how that data affects policymakers’ outlook for the economy.

This is a statement about state-contingent policy, together with a gratuitous forecast of the conditioning factors. These are two conceptually distinct objects that, when combined, give financial market participants the information they seem to crave: a statement about the likely path of interest rates over the foreseeable future.

Kocherlakota's concern is that this type of communication is misinterpreted by market participants as a commitment to a deterministic policy path. I think he's correct that some (perhaps many) people do misinterpret in this manner. If so, then the Fed faces a "credibility dilemma" because, well, what happens if the conditioning factors turn out not exactly as forecast? If future inflation comes in high above target, then the Fed will be forced to raise rates sharply and prematurely--reneging on its "commitment" to raise slowly--thereby "losing credibility." Or, if the economy turns south, the Fed may be forced to lower its policy rate--again, reneging on its "commitment" and "losing credibility." The apparent dilemma is that commitment along some dimension must necessarily be sacrificed.

Kocherlakota concludes with this:

So what, if any, plans should the Fed communicate? For one, officials must recognize that their expectations for the economy, like all forecasts, are likely to prove wrong. As a result, they should be much clearer about their willingness to make large and rapid changes in monetary policy. Instead of talking about gradual normalization, they should stress that they are ready to do “whatever it takes” to keep employment up and inflation near target.

I mostly agree with this suggestion. The part I disagree with (slightly) is where he says "they should be much clearer about their willingness to make large and rapid changes in monetary policy." I think--although I could be wrong--that the public is already generally aware that the Fed will make large and rapid changes in monetary policy should economic conditions dictate. Look at how the Fed reacted in 2008. Ask yourself: if inflation was to spike up to 5% tomorrow, how do you think the Fed would react? We all know how the Fed would react!

That is, I do not think that the issue Kocherlokota raises has anything to do with credibility. In 1971, the executive branch temporarily hampered the Fed's low-inflation credibility by abandoning the gold standard. [Take note, you End-the-Fed types--Fed chair Arthur Burns argued strongly against abandoning the gold standard.] But that reputation was won back (at a terrible price) by Paul Volcker in the early 1980s. Since that time, inflation has been relatively low and stable. Maybe it's not perfect, but it's an inflation record that many countries would envy. Consider this, for example.


To the extent that we can count on anything, I think we can count on the Fed defending its record of low and stable inflation. It is arguably the only real credibility that a central bank has. On the plus side, it's the most important dimension of credibility. (There is also the second part of the dual mandate but a central bank's influence on long-run labor market conditions is more tenuous than its influence on long-run inflation.)

What about "forward guidance?" Yes, it works great in theory, if one assumes that a central bank can commit to take actions at future dates that are not in the best interest of the economy when that future time arrives (economists call this time-inconsistent policy). But let's just face it -- the reality is that commitment along this dimension does not likely exist. Does anyone really believe that the "commitment" made by FOMC voting members today will bind a future FOMCs comprised of completely different people with different points of view? Convince me otherwise.

The Fed is credible where it matters most: its commitment to keep inflation low and stable, and to do whatever it can, within its legislated powers, to help the economy function in the best manner possible for the good of the country at large. Is it a perfect institution? No. Can policies be improved along various dimensions? Almost surely. We're all in this together. Let's try to figure it out.

In the meantime, Kocherlakota is probably correct in suggesting that communications which imply (or are wrongly interpreted) as commitments that cannot possibly be met in most states of the world are not likely to be very useful. They may even prove counterproductive. But would taking an unexpected policy action necessarily whittle away at Fed credibility? I don't think so--not along the dimensions that matter. There is no credibility dilemma here. And it does little good to cast the issue in this light.  

***

Postscript. Friday, March 25, 2016. Tim Duy weighs in here claiming that there are two types of credibility (hard and soft) and that the Fed cares about both of them (when it should perhaps only care about one). 

I think her 1942 book was the very first "Keynesian" text and, among other things, included the first drawing of a demand for money-interest rate curve showing a liquidity trap. Modigliani cited her in 1943, but inadequately. [Correction: Modigliani "Liquidity preference and the theory of interest and money" Econometrica Jan 1944.]

Secular stagnation refers to a prolonged and indefinite period of slow growth and high unemployment (or subnormal factor utilization). When was the last time this happened in the United States? Most people are likely to say the 1930s. In fact, it was the 1970s.

The 1970s were tumultuous years. There was the Vietnam war, oil supply shocks, and Watergate. The anchovies had disappeared off the coast of Peru. Clothing styles ranged from dreadful to appalling. Disco music was in. It was an awful time for those of us who lived through it.

The seventies are also known for a significant slowdown in measured productivity growth. (See Cullison 1989 for a useful review of issues related to measurement and interpretation). The most common measure of aggregate productivity is called Total Factor Productivity, or TFP for short (See Hulton 2000.)

Aside: What is TFP?  Let Y denote the value of what is produced in an economy over the course of a year. Let (K,L) denote measures of the capital and labor services used to produce Y. Let F(K,L) denote an "aggregator function" that specifies the manner in which capital and labor are combined to form output. Given an assumed F and measurements on (Y,K,L), the TFP is computed as the residual TFP = Y/F(K,L). That is, the TFP measures the value of output unaccounted for by K and L. (Alternatively, think of TFP as measuring the average product of a list of factor inputs aggregated in a particular way.)

The San Francisco Fed produces its own "utilization-adjusted TFP" series here. This is what  what their measure of TFP looks like since 1960.


The 1970s episode was called stagflation (an era of high inflation and high unemployment).

The two low-growth regimes above were different in an important way. When the economy transitions from a high to low-growth regime, the shock of regime change produces uncertainty. Investors will naturally move resources out of capital expenditure and into safer asset classes. Here is a critical question: What are the safe asset classes when a productivity slowdown occurs? The answer to this question seems to vary across episodes.

In the 1970s, the USD and UST securities were not among the set of safe assets. This was in large part due to the "unanchoring" of U.S. monetary policy following the breakdown of the Bretton Woods fixed exchange rate system. In August 1971, President Nixon announced that the USD would no longer be pegged to gold. More importantly than this, the public likely did not believe that monetary policy would keep inflation in check through other means (it took Volcker to convince the public of this several years later). The added fiscal pressures of the Vietnam war and the Great Society spending could not have helped this perception. As a result, the safe assets back then did not include government securities. Instead, investors flocked to assets outside the direct control of government, like gold and real estate.

In the most recent episode, real estate was most certainly not considered a safe asset. Investors began to walk away from real estate in 2006. They then ran way in 2008. Ironically, it was the USD and UST securities that proved to be among the most highly regarded assets this time around. This is no small part attributable to the fact that U.S. monetary and fiscal policies are presently perceived to be "anchored" (unsustainable paths for money and debt are viewed as temporary departures from a long-run stable anchor).

It's worth thinking about just how large the worldwide demand for U.S. money/debt must have grown since 2008. We can infer this enhanced demand from two observations. First, the supply of debt was increased substantially. Second, the price of that debt went up, not down (safe bond yields generally declined). What might have happened had the Fed/Treasury not intervened in the way they did?

To answer this latter question, we can look to the "hard money, tight fiscal" policy regimes in place when a low-growth regime hit the U.S. economy in 1929. In the early 1930s, short-term bond yields plummeted as today, and CPI inflation ran close to negative 10%.  The unexpected and dramatic deflation--produced by an elevated demand for money against a fixed money supply--almost surely exacerbated the depth of the contraction through well-known channels.

The lesson here is that responsible monetary and fiscal policy "anchors" a regime, rendering its money/debt a safe asset. But anchoring a policy regime does not require strict adherence to a fixed asset supply rule, like the gold standard, or year-over-year balanced budgets. A credible regime will permit the supply of safe assets to expand "elastically" when the demand for the product is enhanced. Doing so can help stabilize inflation around its expected value. Of course, it is important to let the elastic snap back should economic conditions dictate. The experience of the 1970s demonstrates what can happen when a policy regime becomes unanchored.

The optimal conduct of monetary and fiscal policy over the longer term when a productivity slowdown hits is much less clear. Alvin Hansen expressed skepticism that expansionary monetary and fiscal policy could do much of anything beyond the initial shock period. If anything, it might even do some harm if, for example, such policies led to a very large public debt. Instead, Hansen favored what today we would label "pro-growth policies." His conclusions stemmed from the fact that he viewed growth slowdowns as the byproduct of slowing innovation and population growth--phenomena that monetary and fiscal policies are ill-equipped to deal with.

The situation is slightly different today in that, unlike in Hansen's time, there is presently a huge worldwide demand for U.S. treasuries. This demand stems from three major sources. First, the UST is used widely in the shadow banking sector (in repo and credit derivatives markets) as collateral, a sector that has grown significantly since the 1980s. Second, many emerging market economies want to hold USTs as a safe store of value. And third, there has recently been an added regulatory demand for USTs stemming from financial reforms like Dodd-Frank and Basel III. Because of these factors, it is likely that the U.S. economy can sustain a much higher debt-to-GDP ratio than it has in past.

Much of what one might recommend in terms of optimal policy stems from what is assumed to drive productivity (and population growth). For economies operating below the technological frontier (e.g., EMEs), productivity slowdowns might be avoided, in principle at least, through some type of policy change.  However, the case is much less clear (to me) for economies operating near the technological frontier, where the Schumpetrian dynamic is more likely to govern the productivity dynamic. Some may point to the innovations produced during the second world war as example of how expansionary fiscal policy might enhance productivity growth. But surely, basic research and development can be better subsidized in a more targeted manner, without appealing to a massive and broad-based fiscal expenditure.

The phrase secular stagnation was first introduced by Alvin Hansen in a speech he prepared for the AEA meetings in 1938: Economic Progress and Declining Population Growth. If you haven't read the speech, I recommend that you do--it's an interesting and easy read. (Alternatively, Tim Taylor provides a concise and accurate summary here: Secular Stagnation: Back to Alvin Hansen.)

Back in 2010, I asked whether the U.S. might be in for a prolonged economic slump, similar to what Canada experienced in the 1990s (The Great Canadian Slump). It looks like the answer should have been "yes."

I think this is an interesting comparison because the slump in Canada was not precipitated by a financial crisis. Moreover, there was no "zero lower bound" issue at the time. Unlike in the U.S. today, the yields on Canadian government debt were high, not low.

Let's take a look at some data. Consider first the employment-population ratio (population of adults), or EPOP for short.


In the early 1990s, employment in Canada dropped very sharply and dramatically. This decline was as severe as the decline in U.S. employment during the great recession. It took roughly a decade for the Canadian EPOP to attain its previous peak. In the Great White North, this episode is called the Great Canadian Slump.

The parallel between these two recovery dynamics, for two different countries, at two different times, is really quite remarkable. The following diagram normalizes the EPOP to 100 at its cyclical peak (1990Q1 for Canada and 2008Q1 for the U.S.) and then plots the recovery dynamic in each case.


We can repeat the same exercise for the labor-force participation rate (LFPR).



The declining U.S. labor force participation rate has been much talked about, of course. Some analysts believe that the decline is driven primarily by demographics. Canada's LFPR has also declined since 2008, but not nearly as dramatically as the U.S. To the extent that Canadian and American demographics are similar, the comparison above suggests a more prominent role for other factors (e.g., differences in national policies, cyclical conditions, etc.). In an earlier post comparing U.S. border states to Canada and the rest of the U.S., the evidence suggests that differences in national policies may be important:


Let me finish up here with one more comparison. Here I plot real per capita GDP against EPOP for Canada:

Back then people were talking about "jobless recoveries." As you can see from the diagram above, that's quite a jobless recovery. Here's what the corresponding data looks like for the United States today:


I don't hear too much talk about "jobless recovery" in relation to the U.S. today. The language has shifted to describing this recovery dynamic as "secular stagnation."

I'm still not entirely clear what people mean by term "secular stagnation." The phrase was originally coined by Hansen (1939). Hansen argued that rapid growth in technology and/or population was necessary to keep the economy at "full employment." The proposition sounds like a version of Okun's Law, except that the relationship posited seems to be between the level of employment (EPOP) as a function of the growth rate of the economy.

Hansen did not have much to say about interest rates, except to remark that they're mainly symptomatic and that economists tend to make too much of them. This view seems somewhat different from the one espoused by Larry Summers, who attaches greater significance to low interest rates--even suggesting that they're a defining characteristic of secular stagnation. Moreover, unlike Hansen, he seems to suggest at times that the direction of causality can be reversed; i.e., that a policy that increases the level EPOP can stimulate GDP growth (both in the short and long run, I presume). This latter proposition sounds a bit like Verdoorn's law. I'll have a bit more to say about all this in a future post.