Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, April 19, 2017

The St. Louis Fed's Macroeconomic Outlook

St. Louis Fed president James Bullard recently gave this speech on the U.S. macroeconomic outlook. The key themes of his talk were:
  1. The U.S. economy has converged to a low-growth, low-safe-real-interest-rate regime, a situation that is unlikely to change dramatically over the near future;
  2. The Fed can afford to take a wait-and-see posture in regard to possible changes in U.S. fiscal and regulatory policies;
  3. The U.S. policy rate can remain relatively low for now and that doing so is consistent with the dual mandate;
  4. Now may be a good time for the FOMC to consider allowing the balance sheet to shrink in nominal terms.
What does Bullard have in mind when he speaks of a low-growth "regime?" The usual way of interpreting development dynamics is that long-run growth is more or less stable and that deviations from this stable trend represent "cyclical" mean-reverting departures from trend. And if it's "cyclical," then it's temporary--we should be forecasting reversion to the mean in the near future--like the red forecasting lines in the picture below.
This view of the world can lead to a series of embarrassing forecast errors. Since the end of the Great Recession, for example, you would have forecast several recoveries, none of which have materialized.

But what if that's not the way growth happens? Suppose instead that growth occurs in decade-long spurts? Something like this.

This view of the development process does not say we're presently stuck forever in a low-growth regime. It simply suggests that we have no idea when the economy will once again embark on a higher (or heaven-forbid, lower) growth regime and that in the meantime our best forecast is for continued low-growth for the foreseeable future.

A reader suggests plotting the annualized ten-year growth rate quarter-by-quarter. Here is what it looks like:
What determines a growth regime? Government policies may play a role. Or perhaps it's just the way economies grow. There is no God-given rule which says that productivity growth must at all times proceed in a straight line. Here is the San Francisco Fed's measure of total factor productivity:
Note that the most recent productivity growth slowdown occurred well before the financial crisis.

The notion that the economy has converged to a low-growth regime is also evident in a variety of labor market measures. The prime-age unemployment rate is essentially back to its recent historical average, for example.
Measures of prime-age employment and participation still have a way to go, but arguably not very much.
Next, what does he have in mind when he speaks of a "low-safe-real-interest-rate regime?" Bullard associates the "safe-real-interest-rate" with the expected real rate of return on (nominally) safe U.S. treasury debt (which he labels "r-dagger"). Operationally, he uses the one-year U.S. treasury yield minus a measure of year-over-year inflation (e.g., the Dallas trimmed-mean inflation). Below I plot "r-dagger" using year-over-year PCE inflation. I also plot an hypothetical "r-star" interest rate which (as suggested by theory) should track the expected growth rate of real per capita consumption expenditure.
The (theoretical) real interest rate (as measured here by consumption growth)--the blue line--is on average high in high-growth regimes and low in low-growth regimes (the 1950s provide an exception). The r-dagger interest rate appears to move broadly with r-star (the early 1980s provide a dramatic exception).  The gap between r-star and r-dagger could be interpreted as a risk-premium (or a liquidity premium). The secular decline in r-dagger since the early 1980s reflects a number of factors. Inflation expectations fell and became anchored under Volcker. And since at least 2000, there's been an ever-expanding global demand for safe assets which are used extensively as collateral in shadow banking, as safe stores of wealth in emerging economies, and as objects that fulfill growing regulatory requirements (Dodd-Frank and Basel III). Evidently, Bullard does not believe that the appetite for these safe assets is likely to dissipate any time soon.
 
As for inflation, headline PCE inflation has only recently ticked back up close to the Fed's official 2% target. Nominal wage growth has also ticked up recently, but remains rather muted. The growth in real wages remains low--which is consistent with the U.S. economy operating in a low-growth regime.
Market-based measures of long-run inflation expectations appear well-anchored. Below I plot the 10-year breakeven inflation rate (expected inflation 10 years out) and the real yield on the 10-year U.S. treasury (blue line).
Given these observations, what's the rush to raise the policy rate?

At the same time, Bullard is suggesting that it might be a good time to think about reducing the size of the Fed's balance sheet. He notes that recent FOMC policy is putting upward pressure at the short end of the yield curve (via recent policy rate increases) at the same time putting downward pressure at the long end of the yield curve (via the long-term securities purchased in the LSAP). Bullard notes that "this type of twist operation does not appear to have theoretical basis." In fact, it's not clear what policy should aim for (if anything at all) in terms of influencing the slope of the yield curve.

Nevertheless, there are some good reasons to shrink the balance sheet (I provide a reason for keeping it large here). First, if there is indeed a shortage of safe assets, why is the Fed buying them up (replacing them with reserves that only depository institutions can access directly)? Ending the reinvestment program would release additional safe assets for the market, the effect of which would be to increase yields on safe assets (a good thing to the extent higher yields represent diminished liquidity premia.) Second, ending reinvestment (especially in MBS) would be a good move politically. One concern about ending reinvestment seems centered around the possibility of creating another "taper tantrum" event. But it seems unlikely that disruption in the bond market would occur if the policy change is communicated clearly and with plenty of advance notice.

Saturday, April 15, 2017

Sectoral and Occupational Trends in the U.S. Labor Market

The labor market is back to normal. Or so we are told. Here's the prime-age unemployment rate for the United States beginning in 1960.
Above we see the familiar cyclical asymmetry, in which the unemployment rate spikes up sharply at the onset of a recession and declines gradually during the recovery. As of today, the prime-age unemployment rate is at 4%, close to its recent historical norm. 

Other measures of labor market activity, however, tell a slightly different story. Here is the prime-age employment-to-population ratio. Employment took a big tumble during the recession--especially for males--and its taken a lot longer to recover than unemployment. In fact, we're not quite back to pre-recession average of about 80%. 
The reason employment has recovered more slowly than unemployment is because significant numbers of prime-age workers left the labor force in the aftermath of the Great Recession. This pattern has reversed only recently.
By these standard measures of aggregate labor market activity, the U.S. labor market appears close to "full employment." Nevertheless, there is still much anxiety concerning the present state and future course of the U.S. labor market. Much of this anxiety stems from the perennial concerns regarding the impact of international trade and technology on future employment opportunities. 

To assess the nature of these concerns, we have to move beyond the standard aggregate measures of labor market activity, which have remained relatively stable since 1990 in the face of growing trade deficits and technological progress. So if trade and technology are going to have an impact on employment opportunities, it's likely going to happen at the sectoral and/or occupational level. 

Of course, a changing allocation of human labor across sectors of the U.S. economy is nothing new. Here is the share of employment in agriculture and manufacturing since 1815. 

In 1815, 80% of employment was devoted toward the production of food. And for those of us who have never worked on a farm, here's how Charles H. Smith describes the venture in 1892:
“It’s about the meanest business I have ever experienced. It’s all fact—solemn fact – no romance, no poetry, no joke. It does seem to me that all this sort of work ought to be done by machinery or not to be done at all.” Source: Farm Life at the Turn of the Century.
As we can see, Smith got his wish. Over the centuries, machines have replaced most of human labor in the production of food. Was this a welcome development? Most of us today would likely answer in the affirmative. However, sectoral transformations like this also come at a cost, borne by those who are compelled to do the adjusting. A shovel that helps ease a manual burden is one thing. A combine harvester that renders a certain kind of labor redundant is another. When the demand for a certain type of labor in a given sector is diminished, what are workers to do? 

One thing they can do is employ their labor in the production of the machines that replaced their labor on the farm. And so youngsters left the family farm and immigrants flowed increasingly into the communities that offered employment in manufacturing and other sectors. I'm not sure how much of an improvement it was to substitute the drudgery of farm work with the drudgery of factory work, but it was probably an improvement in net terms (however small). The relatively high levels of comfort most Americans enjoy today did not come about until the latter half of the 20th century. And by that time, manufacturing employment (as a share of total employment) began its long secular decline. 

So, what accounts for the decline in manufacturing sector employment? According to Dean Baker, the U.S. trade deficit has a lot to do with it. 

Since 2000, employment in the U.S. manufacturing sector has dropped from about 17 million to 12 million workers. The sharp decline started with the "China shock" in 2001 (also a recession year). On the other hand, Germany has also experienced a decline in manufacturing sector employment while running trade surpluses. Arguably, the trade surpluses muted the secular decline in manufacturing employment in Germany, while the U.S. trade deficits exacerbated the process of structural readjustment. The trade deficit has almost surely had some impact on U.S. manufacturing employment, but it's hard for me to escape the conclusion that most of the sectoral reallocation of labor has been driven by technology. The next diagram tells the story. 
But it hardly matters to an individual worker whether they are displaced by a foreigner or an automaton. Where are the new jobs to be found and what are they paying? Are all of our good, high-paying manufacturing jobs being replaced by lousy low-paying service sector jobs? There is an element of truth to this. As Daniel Alpert points out, since the cyclical peak in 2007, the U.S. economy has added close to 7 million jobs. About 60% of these jobs appeared in the "low-wage, low-hours" sectors that account for about 36% of all private sector jobs; see table below. 
The picture is not quite as bleak as Alpert paints it. Andrew Spewak (my trusty RA) took it upon himself to produce this table. 
What this decomposition shows is that there is in fact substantial net job creation in high-wage/high-hour jobs in the service sector. The bleakness is heavily concentrated in manufacturing (which we know is in secular decline) and in construction (which is not in secular decline, but which hit a peak just prior to the housing crisis). 

Let's dig a little deeper and explore the task-based view of the labor market developed by Daron Acemoglu and David Autor (see here). According to this view, goods and services are produced by a set of tasks that can be performed by various inputs, like capital and labor. Tasks differ along two important dimensions. The first dimension measures the relative importance of "brains v. brawn" in performing a task. This is labeled "manual" v. "cognitive" in their analysis. The second dimension measures the extent to which a task can be described by a set of well-defined instructions and procedures. If it is, then it is possible to have an automaton execute a program to perform the task. Acemoglu and Autor label these "routine" tasks. If instead the job requires flexibility, creativity, on-the-fly problem-solving, or human interaction skills, the occupation is labeled "non-routine." 

Here's how some broad occupational classes fall into the four implied categories:
Of course, no classification scheme is perfect, but you get the idea. And here's how the employment shares for each category behave since 1983:
This graph could be labeled "The Decline of Routine Work." We have seen how the machines have substituted for manual labor. Robots are increasingly doing the same thing for many cognitive tasks. Here's a male/female breakdown of the phenomenon:




The decline of routine labor has been associated with "polarization"--that is, a "hollowing out" of America's middle class. This is because routine jobs, whether manual or cognitive, generally pay "middle class" wages.
 
The share of employment allocated to these middle class jobs is declining. Where is this middle class going? Largely to jobs in higher wage category, associated with non-routine/cognitive occupations. But there's also a moderate increase in the share of employment in the lowest wage category, in those jobs associated with non-routine/manual occupations.

This is already a long post, so I don't really have space to ponder the question of Whither Human Labor? It seems likely that an increasing number of tasks presently labeled non-routine will become routine (still lot's of room in manufacturing it seems, see here). We have seen this with robo-advisors in the financial sector and the emergence of artificially-intelligent doctor apps (see here) among many other places. How might the future unfold? Here's one take, by Andrew McAfee: Are Droids Taking Our Jobs?



Saturday, April 8, 2017

Fiscal over monetary policy?

The Economy May Be Stuck in a Near-Zero World (Justin Wolfers).

Justin does a good job describing how many economists view the role of monetary and fiscal policy in the post Great Recession world of low interest rates and low inflation. I am curious to know where I agree and disagree with what he says. So, here goes.

[T]he real (inflation-adjusted) interest rate consistent with the economy operating at its full potential has fallen...from around 2.5 percent to 1 percent, or lower.

I think this is true. I also do not think it's surprising that the "natural rate of interest" (r*) fluctuates and that its trend path may shift over time. Indeed, I'd be surprised to learn this was not the case. According to standard macroeconomic theory, r* should follow the trend in consumption growth. The basic idea is simple. If the economy is expected to grow rapidly, people will want to save less (or borrow against their higher future income) in order to smooth their consumption. Collectively, their efforts to consume more and save less puts upward pressure on the real interest rate. The converse holds true if pessimism reigns: people will want to save more, to make provisions against a bleak future. Collectively, the effect is to depress the real interest rate.

Of course, we cannot observe r*. But theory suggests it should be roughly proportional to consumption growth. We can observe consumption growth. Here is what the growth rate of real (inflation-adjusted) consumption of nondurables and services in the postwar U.S. looks like (series is smoothed):

If you're trained in the art of haruspicy, as most of us appear to be, then you'll divine all sorts of patterns from the picture above. You might see a 2 percent trend growth rate with a break down to 1 percent (or lower) in either 2000 or 2007. You might even detect a decade-long era of low growth in the 1970s.

Combined with the Fed's 2 percent inflation target, this implies...

In "normal times," the nominal interest rate -- the neutral interest rate plus inflation -- has fallen from around 6 percent to 3 percent. That creates a serious problem for the Fed. Here's why: Most recessions can be cured by lowering rates by several percentage points. When interest rates were closer to 6 percent, the Fed could lift the economy with plenty of leeway.

This is textbook stuff, which is not the same thing as saying it's correct. My own view on the matter (which is not necessarily correct either) is that the Fed is largely constrained to follow what the market "wants" in the way of real interest rates. It's not that the Fed "cures" a recession by lowering its policy rate -- the Fed is accommodating market forces that would have driven the real interest rate lower even in the absence of a central bank. Rightly or wrongly, the Fed acts to "smooth" these interest rate adjustments in the short-run. But at the end of the day, the trend path of r* is beyond the control of the Fed.

Yes, but what if r* is so low that the effective zero lower bound (ZLB) on the short-term nominal interest rate (the Fed's policy rate) prevents the Fed from accommodating what the market wants? With 2 percent inflation, the real interest rate can only decline to -2%. What if that's not low enough? Then something else has to give--for example, the unemployment rate will rise and remain elevated for as long as this unfortunate situation persists--a secular stagnation.

Perhaps the answer lies outside the Fed. It may be time to revive a more active role for fiscal policy--government spending and taxation--so that the government fills in for the missing stimulus when the Fed can't cut rates any further. Given political realities, this may be best achieved by building in stronger automatic stabilizers, mechanisms to increase spending in bad times, without requiring Congressional action. 

In this spirit, Justin recommends a mechanism that automatically increases funding for infrastructure programs when economic growth slows. I personally don't think this is a terrible idea. (Though, I'd rather that infrastructure be geared more to long-term needs.) But no doubt it's probably easier said than done.

Sometimes though, when I sit back and reflect on this line of thinking, it strikes me as rather odd in a couple of respects.

First, is the ZLB really a significant economic problem? If it is, then why not abolish it as recommended by Miles Kimball? Would permitting significantly negative real rates of interest solve our problems? I don't think so. I'm inclined to think of a low r* as symptomatic of more fundamental economic forces. And eliminating any (real or perceived) gap between the market interest rate and r* is probably small potatoes (see here).

If r* is low, then we need to ask why it is low. There's no shortage of possible explanations out there (low productivity growth, demographics, etc.). If we somehow decide we'd like to see it higher, the solution is likely to be found in growth-promoting policies. (Whether we want growth-promoting policies is a completely separate matter, by the way. Personally, I think more attention should be paid to policies that encourage social cohesion, which may or may not be consistent with higher growth. But this is a column for another day.)

Second, I think the world has indeed changed for discretionary monetary and fiscal policy, but in a way that almost no one talks about. Quite apart from any possible changes in r* (which we cannot measure), the real rate of return on U.S. Treasury (UST) debt--what my boss James Bullard calls "r-dagger"--has been declining for over 30 years (diagram taken from here).


One interpretation of this pattern is that USTs were initially a flight-to-safety vehicle with the disruptions that occurred in the early 1970s (so real yields declined). With the breakdown of Bretton Woods and fiscal pressures (Vietnam war, War on Poverty, etc.), however, inflation became un-anchored. The high real yield on nominal UST debt reflected a growing inflation-risk premium in the early 1980s (when inflation was high and volatile). Subsequently, as inflation declined and inflation expectations became anchored (thanks to Volcker and a terrible recession) the inflation risk premium declined over time. Since about 2000, a China trade shock and other factors led to a growing world demand for USDs and USTs. R-dagger (r+) remains extremely low even today--reflecting the "liquidity premium" that the market now attaches to UST debt.

Moreover, the distinction between USDs and USTs is much diminished in financial markets. In the old days, when the Fed wanted to move interest rates through an open-market swap of USD for UST, it meant something. But today, it means almost nothing, since interest-bearing reserves are a very close substitute for interest-bearing treasuries. In short, U.S. treasury debt is essentially "money" as far as financial markets are concerned (USTs circulate as such in repo markets, for example).

The implication of all this for monetary and fiscal policy is quite interesting. The fact that the yield on USTs is less than (our estimate of) the natural rate of interest suggests that the policy rate is presently too low -- not too high (as is suggested by standard ZLB concerns). The most direct way to raise interest rates (i.e., eliminate the liquidity premium on USTs) is for the U.S. treasury to issue debt at a faster pace. One way to do this is through Justin's automatic infrastructure funding plan that kicks in when liquidity premia on USTs are elevated (bond yields are low). Another way is to have automatic (temporary) tax cuts kick in. Yet another way (though far less desirable) is to have the Fed increase the interest in pays on reserves. Politically this is dynamite, but from an economic perspective, it forces (ceteris paribus) the treasury to issue debt at a faster pace (because it lowers Fed remittances to the treasury). Yet another way is to have the Fed sell some of its treasury holdings (since treasuries are sometimes more liquid than reserves in financial markets--i.e., only depository institutions have direct access to reserves).

Depending on which view one adopts, the recommended Fed policy action matters a great deal (at least, in principle, if not quantitatively). If the interest rate is too high (ZLB view), then it should be lowered, or the inflation target raised. If the interest rate is too low (liquidity premium view), then it should be raised, through asset sales or some other mechanism.

On the other hand, the recommended Treasury policy action seems robust across the two views: the treasury should expand its debt at a faster pace (via tax cuts or increased spending, or some combination). This seems like a promising development from the perspective of competing theories. If a policy recommendation follows from many different perspectives, we become more comfortable with the idea of actually implement them. Of course, there are some caveats to consider, which I discuss here. But enough for today.

Wednesday, March 1, 2017

A reply to Lawrence White

People are generally not accustomed to the idea of a central bank altering the maturity structure of outstanding government debt in a manner that might confer a financial benefit to the government (and by extension, to the citizens it represents). The purpose of my previous post was to make people aware of this possibility, using the recent experience of the Federal Reserve's quantitative easing (QE) program as an example.

The gist of my story went something like this. Suppose that the Fed makes a one-time purchase of a 10-year treasury bond yielding a risk-free 2.5% annual nominal coupon. Suppose that the purchase is financed by "printing" reserves. (Note, this asset purchase and method of finance describes the basic nature of QE). Suppose further that the interest paid on reserves remains below 2.5% for the duration of the bond. Then the Fed makes a profit off the rate of return differential in each of the 10 years it holds the bond on its books. If I understand my critics correctly, none would dispute the financial benefit associated with this Fed intervention as far as the public purse is concerned; at least, as long as it is somehow known ex ante that the short rate will remain below the long rate in the manner assumed.

One objection to this story asks why the Fed is needed to convert a 10-year bond into a lower-cost short-term instrument when the Treasury itself could have just issued a short-term debt instrument to begin with. That's a good question. I'm not sure what factors determine the Treasury's choice over the maturity structure of its debt. The key question to ask is whether the structure chosen is optimal from a social standpoint. The benefit associated with the Fed intervention I described in my post assumes that it is not. What justifies this assumption? No one really challenged me on this. Another objection relates to the optics of the enterprise from a political perspective. Even if the intervention makes sense from an economic perspective, paying interest on reserves held by big banks with the effect of reducing Fed remittances to the Treasury just looks bad (even though it's equivalent to the Treasury paying those big banks for holding treasury debt).

The main objection to my post seems to rest on the claim that I have ignored "duration risk." Let me quote directly from Lawrence White, who was kind enough to take the time to critque my post:
When the Fed borrows short from the banks to lend long to the Treasury, it does not do so costlessly. Duration transformation carries a risk of capital loss, also known as duration risk. Suppose the yield curve shifts up, both short and long interest rates rising together. The Fed will experience a decline in present value of its assets that will swamp the smaller decline in the present value of its liabilities. Such an event is not unknown: in 1979-81 it rendered insolvent about two-thirds of US thrift institutions, who were financing 30-year fixed-rate mortgages with 1- and 2-year deposits. In cash-flow terms, such an event would mean that the Fed would quickly have to start paying higher interest rates to borrow, while its asset portfolio continues to pay low yields and roll over much more slowly. The Fed’s annual net transfer to the Treasury might even go negative. Smaller or negative transfers from the Fed to the Treasury would mean a sudden jump in the present value of the public’s ordinary tax liabilities. Net interest income from playing the yield curve is not a free lunch.
To assess the merit of this critique, let's consider the following thought experiment. First, imagine that there is no central bank (End the Fed wins). Next, imagine that the Treasury wants to borrow money. One option is to issue the 2.5% 10-year bond described above. But another option would be to issue very short-term treasury debt, rolling it over for 10 years. If the Treasury behaved in this manner, it would in effect be replicating the Fed intervention I described above. There would be obvious cost savings to the government and taxpayer, at least, assuming that short rates remained below 2.5%. So what could possibly go wrong?

Well, the risk is that the short-term rate might rise and stay on average over 2.5% for the next 10 years. In that event, which is certainly a risk to consider, the Treasury will have made a loss relative to locking in its debt at the long-term rate of 2.5%. But from the perspective of the taxpayer, it matters not one iota whether this prospective loss is incurred because of the Treasury action or an equivalent action on the part of a Fed QE program.

So, if the point is that financing short-term at low rates entails risk relative to financing long-term at high rates, then I agree. The question, however, is not whether QE exposes the taxpayer to duration risk. Of course it does. The same would be true if the Treasury was to shorten the average duration of its debt on its own. Whether the Fed or Treasury performs this operation is immaterial (from an economic perspective, not necessarily from a political perspective). The fundamental question then is whether government debt is structured optimally to begin with. To the extent that the fiscal authority relies too heavily on long-term debt, then some QE on the part of the Fed could have the public finance benefit I described in my post.

Does the Treasury rely too heavily on long-term debt? I honestly do not know. Those who warn against the Fed shortening duration must implicitly assume that Treasury debt-structure is optimal. Maybe they're right. But as the following figure shows, the spread between long and short rates is usually (though not always) positive.


If this pattern could be relied on to hold in the future, then the question to ask of a QE program is not whether it entails duration risk (it does). Rather, the question is whether the endeavor constitutes a positive net-present-value project.  The data above suggests that it may very well be. This is not the same as claiming there's a "free lunch." The Fed has saved the government over $80 billion a year over the past seven years. That's about $600 billion in cost savings--money that the government would have had to secure through other means to service its debt. It was fluke, the critics will say. An ex ante gamble that pays off ex post is not a justification. Sure. But billions in remittances, year after year, one fluke after another?

Let me briefly address a few other points made by Larry. In the quoted passage above, he warns that the Fed is exposed to suffering a capital loss on its assets should market interest rates rise, that this has happened to private banks in the past with dire consequences, that the result may be lower (possibly negative) remittances to the Treasury.

I think these concerns are overstated. Warning against the prospect of having to reduce remittances is not an economic argument against exploiting a profit opportunity (although, one could make the case on political grounds).


Yes, if the market price of bonds fell, the market value of Fed assets would decline. Should this be a concern? U.S. treasury bonds are nominally risk-free and the Fed normally holds its assets to maturity. Larry's reference to the plight of U.S. thrift institutions is not, in my view, relevant to the issue at hand. Because Fed liabilities are money (essentially equity shares accepted by all as a payment instrument), the Fed cannot go insolvent in the same way a private company can (although politically, the optics would be bad). In any case, the proper way to view the issue is from the perspective of a consolidated Fed/Treasury balance sheet. The issue concerns optimal maturity structure and the impact on the government's consolidated balance sheet as market interest rates change.

It is also Larry's view that the Fed has been carrying "significant" default risk through its holdings of mortgage-backed securities. While I think there are good reasons to let the MBS portion of the Fed's balance sheet run off, I think Larry is once again overstating concerns (even if I grant his point about potential market distortions). The MBS purchased by the Fed are not legacy assets--they constitute senior tranches of securities issued well after the real estate market bottomed out. In short, they're about as safe as securities backed by private assets get. That's not to say that the Fed should be holding such assets. My own view is that the Treasury should have issued bonds against such securities. Doing so would have gone some way to alleviating the worldwide shortage of safe assets.

Larry concludes with a plea for "normalization." Let's go back to a world where bank reserves are scarce. But why? In what world does it make sense to render liquidity scarce? Milton Friedman argued that optimal debt policy entails eliminating all liquidity premia. Almost every economic model I am aware of supports this notion. An appeal to follow historical norms is not an economic argument.
 
Let me sum up. I think there are two types of arguments one can bring to bear on the question of central bank balance sheet policy as a fiscal debt-management device. The first is economic and the second is political.

The political argument is based on the idea that an independent and accountable central bank is a good idea. To protect central bank independence, it would be unwise for a central bank to operate with the expressed purpose of managing the debt--a realm guarded jealously by the fiscal authority. I think this is a good and practical argument against becoming too enthused with large central bank balance sheets. But this is not the argument that Larry is making.

Larry's argument is an economic one. An economic argument against the Fed helping to manage the debt, suggested to me by my colleague Steve Williamson, is that the Fed does not really have the tools to do the job properly. In particular, the Fed cannot issue debt that can circulate widely. The only liability it can issue--reserves--is clearly inferior to short-term treasury debt. In particular, reserves can only be used by banks with reserve accounts, while treasuries can circulate outside the banking system. This is a good point. It basically says "since the Treasury can do the job better in principle, better the Fed not do it at all." But this not the argument Larry is making either.

Larry's argument implicitly assumes (possibly correctly) that the Treasury has structured its debt optimally. If it has, then there is no "free lunch" for the Fed. If this is the case, then I would have to agree. (And it's heartwarming to see Larry thinking so highly of a government agency's ability to run its operations!)

As I reflect back on the original argument I put forth, I think I would now put it in the following way. First, I would not advocate that the Fed explicitly pursue balance sheet policy as a way to help government financing. As I made clear in my original post, the recommendations I was making were predicated on the assumption of the Fed achieving its dual mandate. If in the course of achieving the dual mandate the Fed is saving the Treasury billions of dollars, then what's the rush to reverse operations? The fear of exposing the taxpayer to duration risk may be a reason--if you feel the Treasury already has its debt structured optimally. But the fact of consistently positive and sometimes very large remittances from Fed to Treasury for years (and even decades) might lead one to question that assumption.

Wednesday, February 15, 2017

A public finance case for keeping the Fed's balance sheet large

Former Fed Chair Ben Bernanke recently asked a question concerning the optimal long-run size of the Fed's balance sheet (Should the Fed keep its balance sheet large?). Bernanke comes down on the side of "keeping the balance sheet close to its current size in the long run." While he does not explicitly say how "size" is defined, I think it's clear he means the size of the balance sheet measured relative to the size of the economy (say, as measured by nominal GDP). According to this measure of size, the Fed would have to grow its balance at the rate of nominal GDP growth.

In addition to the reasons reported by Bernanke, I think there's a public finance argument to be made for keeping the Fed's balance sheet large--at least, under certain conditions--like ensuring that the inflation mandate is met. Let me explain.

Let's begin with a picture that most people are familiar with. 
Prior to 2008, the Fed's balance sheet was under one trillion dollars in size. Prior to 2008, it grew roughly at the same rate as the economy. Most of these assets consisted of short-term U.S. treasury securities. Most of these asset acquisitions were financed with zero-interest money (currency in circulation). Since 2008, the Fed's balance sheet has grown to 4.5 trillion dollars. The composition of assets has moved away from short-term government debt to longer-term debt and mortgage-backed securities. Most of these asset acquisitions were financed with low-interest money (reserves).

Is 4.5 trillion a big number? Well, yes. But then, the U.S. is a big economy: the U.S. nominal GDP for 2016 is close to 19 trillion dollars. So in measuring the size of the Fed's balance sheet, it probably makes more sense to measure size as a ratio. The following graph plots the size of the Fed's balance sheet as a ratio of nominal GDP.
Prior to 2008, the size of the Fed's balance relative to the economy averaged about 6%. The balance sheet size peaked in 2014 at just over 25%. Note that by this metric, the Fed's balance sheet has been contracting since 2014.
 
For the record, note that the large expansion in the supply of Fed money was associated with historically low rates of inflation:
Now let's talk about the business of banking. I like to think of a bank as an asset transformer: a bank converts relatively illiquid assets into relatively liquid liabilities. The Fed buys relatively high-yielding (but safe) securities, like U.S. treasury bonds and AAA-rated mortgage-backed securities. It pays for these acquisitions by issuing liabilities (printing money) in the form of low-interest reserves.
The Fed transforms high-interest government debt into low-interest Fed liabilities (money).

The difference between the interest the Fed earns on its assets and the interest it pays on its liabilities is an interest rate spread. Isn't it wonderful to be able to borrow at low rates and invest at high rates? This is precisely what the Fed did with its large scale asset purchase (LSAP) program. Apart from any other effects that this intervention had on the economy, it resulted in huge profits for the Fed. Keep in mind that any profit made by the Fed is remitted to the U.S. Treasury (and thus, ultimately, to the U.S. taxpayer).

So just how much money does the Fed return to the treasury each year? I'm glad you asked, here you go:
In recent years, the Fed has been returning about $80-90 billion per year to the U.S. Treasury. While interest rates were higher in the past, the Fed's balance sheet was much smaller--and so while the profit margin was high, the volume was low. Today the profit margin is smaller, but the balance sheet is much larger. (The distance between the red and blue lines represents the Fed's foregone profit since it started paying interest on reserves in 2008).
 
What sort of rate of return does the Fed make on its portfolio? The following graph plots Fed payments to the Treasury as a ratio of the Fed's assets.
Since the bulk of the Fed's assets are in the form of U.S. government bonds, it should be no surprise to learn that the rate of return has generally followed the path of market interest rates downward. Still, in recent years, the annual rate of return is about 2%. Given that the Fed is presently financing these assets with cash (0%), ON RRP (0.25%) and IOER (0.50%), the profit margin is still significantly positive (though one wonders about the scope for further policy rate hikes if market rates remain low).

In light of this analysis, why are some people calling for the Fed to reduce the size of its balance sheet? Usually the concern is that a large balance sheet portends higher future inflation. But we've been living in a world of lowflation for many years now and we're likely to stay there for the foreseeable future (though central banks should of course remain vigilant!). There is, in fact, some theoretical support for the notion of reducing the Fed's policy rate (subject to the dual mandate and financial stability concerns); see, for example: The Inefficiency of Interest-Bearing National Debt.

Reducing the Fed's balance sheet at this point in time seems like a needless loss for the U.S. taxpayer. Given that the Treasury is marketing a bond, who do you want to hold it? If the debt is held outside the Fed, the government needs some way to pay the 2% carry cost of the debt. The government will in this case have to reduce program spending, increase taxes, or increase the rate of growth of debt-issuance. Alternatively, if the Fed holds the debt, the carry cost is generally much lower. This cost-saving constitutes a net gain for the government. So why not take advantage of it?

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P.S. I realize there are some who argue that a central bank enables big government. Since the government is too large, we need to end central banking and, in this manner, starve the beast. But this argument amounts to "let's make the government less efficient in terms of financing their operations--that'll force it to get smaller." This line of argument strikes me as naïve--I'm not sure what would prevent the government from simply substituting into different methods of finance. If you want smaller G, then lobby Congress to make G smaller. But given that smaller G, it should still be financed in the most efficient manner possible. And that means following the prescription above.