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

Thursday, April 7, 2022

What economic model produces the Fed's inflation forecast?

John Cochrane's blog has always been a favorite of mine. It's provocative. It's entertaining. And it invariably leads me to reflect on a variety of notions I have floating around in my head. 

In his latest piece,  he asks an interesting question: How does the Fed come up with its inflation forecast? What sort of model might be embedded in the minds of FOMC members? I like the question and the thought experiment. My comments below should not be construed as criticism. Think of them more as thoughts that come to mind in a conversation. (It's more fun to do this in public than in private.)

John begins with the observation that while the Fed evidently expects inflation to decline as the Fed's policy rate is increased, at no point in the transition dynamic back to 2% inflation is the real rate of interest very high. To quote John (italics in original): the Fed believes inflation will almost entirely disappear all on its own, without the need for any period of high real interest rates. Of course, this is in sharp contrast with the Volcker disinflation, an episode that demonstrated, in the minds of many, how a persistently high real rate of interest was needed to make inflation go down (some push back in this paper here).

John believes that the current inflation was generated in large part by a big fiscal shock in the form of a money transfer (an increased in USTs unsupported by the prospect of higher future taxes). I'm inclined to agree with this view, though surely there other factors playing a role (see here). John asks how this type of shock can be expected to generate a transitory inflation with the real interest rate kept (say) negative throughout the entire transition dynamic. Below, I offer a simple model that rationalizes this expectation. Whether it's the model FOMC members have in their heads, I'm not sure. (Well, I happen to know in the case of two FOMC members, but I won't share this here.)

Formally, I have in mind a simple OLG model (see, here). The model is Non-Ricardian (the supply of government debt is viewed as private wealth). The model's properties are more Old Keynesian than New Keynesian. The model is also consistent with Monetarism, except with the supply of base money replaced with the supply of outside assets (i.e., all government securities--cash, reserves, bills, notes and bonds). 

So, I'm thinking about my model beginning in an hypothetical stationary state. The real economy is growing at some constant rate (say, zero). The supply of outside assets consists of zero interest securities (monetary policy is pegging the nominal interest rate to zero all along the yield curve). This supply of "debt" is also growing at some constant rate. Debt is never repaid--it is rolled over forever. Indeed, the nominal supply of debt is growing forever. New debt is used to finance government spending. The real primary budget deficit is held constant. The government is running a perpetual budget deficit via bond seigniorage; see here. The steady-state inflation rate in this economy is given by the rate of growth of the supply of nominal outside assets. (It is also possible that the inflation rate is determined by shifts in the demand for USTs; see here, for example). The real interest rate (on money) is negative. 

OK, now let's consider a large fiscal shock in the form of a one-time increase in the supply of outside assets (i.e., a helicopter drop of money that is never reversed).  The effect of this shock is to induce a transitory inflation (a permanent increase in the price-level). An increase in the nominal supply of money at a given interest rate at full employment makes the cost of living go up -- it makes the real debt go down. And oh, by the way, the debt-to-GDP ratio is declining thanks in part to inflation:

This is despite the persistent negative real interest rate prevailing in the economy. I mean, what else might one imagine from a one-time injection of money? Is this is what the Fed is thinking? (This is what I'm thinking!) Note: an increase in the interest rate in this model would unleash a disinflationary force, but this would only serve to speed up the transition dynamic. 

As it turns out, this simple story seems consistent with what I take to be John's preferred theory of inflation. The large fiscal shock here is unaccompanied by the prospect of future primary budget surpluses. The effect is to increase the price level (i.e., a temporary inflation). Maybe the Fed has John's FTPL model in mind? 

Neither of these stories line up particularly well with the New Keynesian model, which emphasizes interest rate policy as *the* way inflation is controlled. There are, however, many strange things going on in this model. First, while no explicit attention is paid to fiscal policy, the fiscal regime plays a critical role in determining model dynamics (basic assumption is lump-sum taxes and Ricardian fiscal regime). Second, the Taylor principle that is needed to determine a locally unique rational expectations equilibrium is an off-equilibrium credible threat to basically blow the economy up if individuals do not coordinate on the proposed equilibrium (I learned this from John here.)  By the way, Peter Howitt provides a different (and in my view, a more compelling) explanation for the "Taylor principle" here--published a year before Taylor 1993. Given these shortcomings, why are we even using this model as a benchmark? This is another good question. 

John presumably picks this model because he sees no better alternative for modeling monetary policy via an interest rate rule. If he wants an alternative, he can read my paper above. Or, he can appeal to his own class of models extended to permit a liquidity function for USTs. These models easily accommodate stable inflation at negative real rates of interest. But whether this is how FOMC members organize their thinking, I'm not sure.

In any case, John picks an off-the-shelf NK model and assumes that it adequately captures what is in the mind of many FOMC members. Let's see what he does next (Modeling the Fed). 

He writes: "The Fed clearly believes that once a shock is over, inflation stops, even if the Fed does not do much to nominal interest rates. This is the "Fisherian" property. It is not the property of traditional models. In those models, once inflation starts, it will spiral out of control unless the Fed promptly raises interest rates." [I think he meant "threatens to raise interest rates.]

Comment 1: I'm not sure what he means by a "Fisherian" property. (Note: the Fisher equation holds in the OLG model I cited above--though the real rate of interest is not generally fixed in those settings.) 

Comment 2: Conventional models? I presume he means Woodford's basic NK model. It seems likely to me, however, that FOMC members may have other "conventional" models in their heads -- like the Old Keynesian model or the Old Monetarist model--both of which continue to be taught as standard fare in undergraduate curricula.  

OK, so John considers a very basic IS-PC model and considers two alternative hypotheses for how inflation expectations are determined. The first hypothesis is a simple adaptive rule (see also Howitt's work above). The second hypothesis is perfect foresight (rational expectations) -- which, by the way, implicitly embeds knowledge of the Ricardian fiscal regime. 

Under the adaptive expectations model, inflation explodes. Under the rational expectations hypothesis, inflation largely follows the Fed's actual forecast. Maybe this is what the Fed is thinking? The Fed has rational expectations? 

Except that I'm not really sure what this means. John does give us a further hint though. He goes on to say "Not only is the Fed rational expectations, neo-Fisherian, it seems to believe that prices are surprisingly flexible!" 

Right. So the Neo-Fisherian hypothesis is that to get a permanently lower rate of inflation, the Fed must (at least eventually) lower its policy rate (and vice versa to raise the rate of inflation). I've questioned this hypothesis in the past (see here). But what's going on here now? Is John suggesting that the FOMC is made up of closet Neo-Fisherians? Steve Williamson would no doubt be pleasantly surprised. 

John writes: "The proposition that once the shock is over inflation will go away on its own may not seem so radical. Put that way, I think it does capture what's on the Fed's mind. But it comes inextricably with the very uncomfortable Fisherian implication. If inflation converges to interest rates on its own, then higher interest rates eventually raise inflation, and vice-versa." 

No, I'm afraid the conclusion that inflation is transitory (even with negative real rates) is NOT inextricably linked to the Neo-Fisherian proposition. It is only inextricably linked this way in a class of economic models that: [1] are pretty bad; and [2] highly unlikely to be in the heads of most FOMC members. 

Saturday, January 29, 2022

The Inflation Blame Game

Inflation is back together with a new season of America's favorite sport: zero-contact, finger-pointing. I thought I'd sit back and share a few thoughts with you on the subject on this cold Saturday afternoon. Use the comments section below to let me know what you think.

In one corner, I see some pundits somehow wanting to blame the 2021 inflation on workers. Workers are somehow forcing their improved bargaining positions on employers, raising the costs of production, with some or all of these costs passed on to consumers. Then, as workers see their real wages erode, the cycle begins anew begetting the dreaded "wage-price spiral." Those pesky workers. 

There's no doubt something to the idea that wage demands can lead to higher prices (and why shouldn't workers want cost-of-living adjustments?) But what is the evidence that this behavior was the impulse behind the 2021 inflation? 

While it's difficult to tell just by eye-balling the data, I think it's reasonable (under this hypothesis) to see wage growth precede (or at least be coincident with) inflation. Unfortunately (for this hypothesis), this is not what we see in the data. In the diagram below, use the Atlanta Fed's Wage Growth Tracker to construct nominal wage inflation for the bottom (green) and top (yellow) wage quintiles. This is plotted against CPI inflation (blue). 

Another problem for this hypothesis is that wage inflation is moving in the wrong direction for the top three wage quintiles over the Covid era. What we see here is a clear acceleration in the rate of inflation, followed by modest acceleration in wage inflation for the bottom quintile and a deceleration in wage inflation for the top quintile. In 2021, real wages across all quintiles declined (according to this data). So much for increased worker bargaining power. [Note: it is quite likely that net income for the bottom one or two quintiles increased, thanks to government transfers.] 

On the other side of the political spectrum, we see pundits and politicians blaming the 2021 inflation on "corporate greed." Framing the issue in terms of "corporate greed" is not especially helpful, in my humble opinion. The substantive part of this claim is that large firms were somehow able to leverage their pricing power in 2021 into higher profit margins and record corporate profits. There is, in fact, some evidence in support of this. The diagram below plots profit margins for firms in the Compustat database. Profit margin below is computed on an after tax basis (net income divided by sales). The data is divided between large and not-large firms. Large firms are those in the top 10% of sales volume.

 

By this measure, profit margins seem remarkably stationary over long periods of time. There is some evidence of a modest secular increase in margins c. 2003. Large firms have higher margins. But the part I want to focus on here is near the end of the sample. Profit margins for 90% of firms seem close to their historical average. We see some evidence that profit margins for the top 10% of firms increased in 2021. But this increase peaked in Q3 and then declined back to historical norms in Q4. While the spike in profit-margins likely contributed to inflation, it hardly seems like a smoking gun. And the Q4 reversion to the mean suggests that "corporate greed" is not likely to be a source of inflationary pressure in 2022. 

Well, if workers and firms are not to blame, then who or what is left? There's the C-19 shock itself, of course, along with the effects it has had on the global supply chain. But the 19 in C-19 refers to the year 2019 (and 2020). We're talking about 2022 here. Sure, the supply chain issues are still with us. But at most, I think they account for a substantial change in relative prices (goods becoming more expensive than services) and an increase in the cost-of-living (an increase in the price-level--not a persistent increase in the rate of growth of the price-level). 

While the factors above no doubt contributed in some way to the 2021 inflation dynamic, let's face it--the size and persistence of the inflation was mainly policy-induced. The smoking gun here seems to be the sequence of the C-19 fiscal transfers. As we know, this had the unusual and remarkable effect of increasing personal disposable income throughout most of the pandemic. The Fed also had a role to play here because it accommodated the fiscal stimulus (normally, one might have expected a degree of monetary policy tightening to partially off-set the inflationary impulse of fiscal stimulus). Below I plot retail sales (actual vs trend) and the timing of the fiscal actions. 

I used retail sales here (I think I got this from Jason Furman), but the picture looks qualitatively similar using PCE (the path of nominal PCE went above trend in 2021 and not earlier in the way retail sales did). Just eye-balling the data above, I'd say the CARES Act was a major success (especially under the circumstances). The subsequent two programs might have been scaled back a bit and/or targeted in a more efficient manner. And, knowing what we know now, the Fed could have started its tightening cycle in 2021. 

Having said this, I wouldn't go so far as to say these were flagrant policy mistakes--given the circumstances. If there was a policy mistake, it was in not having a well-defined state-contingent policy beforehand equipped to deal with a global pandemic. Not having that plan in place beforehand, I think monetary and fiscal policy reacted reasonably well.

Policymaking in real-time is hard. And policy, whether formulated beforehand or not, must necessarily balance risks. There was a risk of undershooting the support directed to households. We saw this during the foreclosure crisis a decade ago. And there was a risk of overdoing it in some manner. Keep in mind that it was not clear when the legislation was passed how 2021 would unfold. Similarly, for the Fed--perhaps still feeling the sting of having moved too soon and too fast in the past, hopeful that inflation would decline later in the year--delayed its tightening cycle to 2022. It wasn't perfect. But taken together, the economic policy responses had their intended effect of redistributing income to those who suffered disproportionate economic harm during the pandemic. 

Finally, what does all this mean for inflation going forward? Well, as I suggested above, I don't think we have to worry about a wage-price spiral (the fiscal policy I think is necessary to support such a phenomenon is not likely to be present). Profit margins appear to be declining (reverting to their long-run averages). The money transfers associated with the last fiscal package are gone for 2022. No big spending bills seem likely to pass in 2022. For better or worse, we're talking a considerable amount of "fiscal drag" here (although, some have pointed to how flush state government coffers are at the moment). Hopefully (fingers crossed), supply-chain problems will continue to be solved. If so, then all of this points to disinflation (a decline in the rate of inflation) going forward. Some recent promising signs as well: [1] month-over-month CPI inflation has declined for two consecutive months (November and December); and [2] the ECI (employment cost index) decelerated in Q4 of 2021. (These numbers are notoriously volatile, so don't put too much stock in the direction. But still, it's better than seeing them go the other way.)

Some caveats are in order, of course. In December 2020, I suggested we prepare for a "temporary" burst of inflation in 2021. While this came to pass, the level of inflation surprised me (to be fair, I hadn't incorporated the ARP in my assessment, but even if I had, I think I still would have been surprised). Moreover, I was also surprised by the persistence of inflation--I thought it would decelerate more rapidly (even given the ARP). This just serves to remind me how bad I am at forecasting. Someone recently mentioned a great quote by Rudi Dornbusch: "In economics, things take longer to happen than you think they will, and then they happen faster you thought they could." I can relate to this. 

Inflation may turn out to be more persistent that I am suggesting. But how might this happen, given the disinflationary forces I cited above? One reason may have to do with the tremendous increase in outside assets the private sector has been compelled to absorb--the increase in the national debt has manifested itself as an increase in private sector wealth. Jason Furman sees this as "excess saving." The question going forward is whether the private sector will be compelled to spend this (nominal) wealth (it already has done so, as my chart above shows) or continue to save (not spend) it? It is possible that this "pent up demand" will be spent over a prolonged period of time. The effect of this would be to keep inflation elevated higher than it would otherwise be (serving to reduce real nominal wealth). How long this might take, I have no idea. But even so, it seems clear that the effect cannot persist indefinitely. At some point the debt-to-GDP ratio will decline to its equilibrium position (D/Y has already started to decline; see here). 

Another reason why inflation forecasts should be discounted is that it's very difficult to forecast future contingencies. What might happen, for example, if Russia invades the Ukraine this year? Events like these will create disruptions and there's not much monetary and fiscal policy can do about them. But whatever happens, I think the long-run fiscal position of the U.S. will remain anchored (Americans will demand this). And remember, the Fed is bound by its Congressional mandates to keep inflation "low and stable." The Fed's record on inflation since the Volcker years has been pretty good. I'm betting that the record will be equally good over the next 10 years.

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PS. I see some people out there strongly asserting it is a "fact" that fiscal policy did not cause the 2021 inflation (see here, for example). The reason, evidently, is because inflation is a global phenomenon. There's something to this, of course. After all, C-19 is a global pandemic. But this reasoning nevertheless seems faulty to me. First, the USD is the global reserve currency. It's quite possible that the U.S. exported some of its inflation to the world (much in the way it did in the 1970s). Second, many other countries (like Canada, for example) adopted similar fiscal policies. Those countries with less expansive fiscal policies also displayed lower inflation, as far as I know. Rather than deflect the blame, we should own it here. Fiscal policy had a lot of positive effects too (e.g., lowering child poverty). The challenge, as always, is to develop ways to calibrate these policies in a more effective manner. 


Some Thoughts on the Fed's CBDC Report

Economists within the Federal Reserve System have been musing about central bank digital currency for a while now. For example, yours truly provided a few thoughts on the possibility way back in 2015 (see here) and most recently here. But the views of individual Fed researchers are simply our own personal views. What people are really interested in is an official view--namely the view of the Board of Governors of the Federal Reserve. At long last, their report is now available here). 

The report makes it clear that the Fed has no immediate plans to issue a CBDC. The main purpose of the report is to provide some background information, discuss the potential costs and benefits of a CBDC, and solicit feedback from the general public. It is a very nice educational piece. There was nothing really new in it for people who have been following the discussion over the past few years, but there was one thing I found interesting (and potentially important). The interesting part, I think, has to do with their definition of CBDC:

For the purpose of this paper,  a CBDC is defined as a digital liability of the Federal Reserve that is widely available to the general public.
I used bold font to highlight the important part in the passage above. Most of the digital money Americans use today consists of dollar credits in transaction accounts that reside in the broader bank sector (which includes non-banks providing digital payment services). This form of digital money is technically a liability of private sector agencies, not the government. Is this an important distinction to make? I'm not sure--I suppose it depends on what one thinks is important. 

For one thing, the Board's adopted definition appears to rule out the "wholesale CBDC" proposal that some have advocated for (including myself). Wholesale CBDC (also referred to as "synthetic CBDC" or "sCBDC") is essentially a narrow-banking proposal (which has a long history in the banking policy debate). 

In my writings, I contrasted "wholesale CBDC" with "retail CBDC," the latter of which I interpreted as a product that is both a liability of the Federal Reserve and a payment service managed by the Federal Reserve. I thought this latter property was a bad idea--the Fed should probably not get involved with the challenges of retail banking. I missed the possibility of separating the legal status of digital money from the agencies responsible for managing digital money accounts. As George Selgin explains well here, the Board's definition of CBDC means a privately-intermediated liability of the Federal Reserve (George calls this iCBDC to distinguish it from sCBDC). 

Speaking for myself, I'd be happy with either an sCBDC or an iCBDC (assuming they are properly designed). My main concern was over the prospect of a government agency operating a large retail business. Both sCBDC and iCBDC are intermediated products--we can let the private sector manage the day-to-day operations of processing payments. George, however, believes that sCBDC should be preferred to iCBDC for reasons that he spells out here (I'm not sure I share his concerns).

My own view is that the distinction between sCBDC and iCBDC will be of interest mainly to lawyers and regulators (John Kiff points me to this IMF report). From an economic perspective, the two products appear to be very close--if not perfect--substitutes (again, assuming their design is optimized). The practical difference between a Federal Reserve liability and a private liability fully-insured by the government seems almost non-existent to me. But I'm willing to be persuaded otherwise. 


Tuesday, November 30, 2021

On the Necessity and Desirability of CBDC

Remarks prepared for P2PFISY Panel Discussion, December 1, 2021

At a conceptual level, CBDC is a compelling idea. It envisions everyone having an account with the central bank consisting of a direct claim against digital fiat currency that can be used as a safe and efficient form of payment. Since all debiting and crediting of accounts occurs on the central bank’s balance sheet, all the costs and counterparty risks associated with intermediated payments is eliminated. All individuals and businesses would have access to secure, low-cost real-time payment services. Moreover, concerns over data privacy and ownership can be dealt with directly and in a manner consistent with societal preferences.

I have nothing against a retail CBDC per se. Indeed, there may even be some merit to the idea as a basic public option. But is it really something that is essential? What existing problems is a CBDC supposed to solve that cannot be solved through a wholesale-CBDC with supporting legislation?

A wholesale-CBDC is an old idea. It is basically a proposal to permit free-entry into the business of narrow-banking. Let Novi, Square, PayPal and other reputable firms have Fed accounts. Let them issue “stablecoin” liabilities fully-backed by interest-bearing reserves. Consider adopting the U.K.’s open banking legislation. Let the private sector work its magic. What else needs to be done?

Do we really think that consumers would flock to CBDC for reasons of safety? Bank deposits are close to fully-insured for most people, and all deposits would effectively be fully-insured in a narrow bank. Do we think that big banks overcharge for basic payment services? I see many online banks offering free checking accounts and I see service fees generally declining over time—something that would be spurred on with a wholesale-CBDC. I do see interchange fees in the U.S. remaining stubbornly high. But I diagnose this as a by-product of American’s love-affair with the cash-back and rewards programs offered by credit card issuers. I do not see how a CBDC is supposed to discourage consumers from using cards that effectively pay them to spend money. (This seems to be less of a problem outside of North America.)

But more importantly, do we want to rely on the government sector to deliver high-performance customer service at the retail level and to keep up with technological advances in the space? A well-functioning government is essential for a well-functioning private sector (and vice-versa), but these two sectors should probably stick to their knitting. Let the central bank handle monetary policy, bank supervision, lender of last resort operations, and wholesale payments. Let the private sector handle servicing the vast, demanding and rapidly-evolving retail sector. It’s a model that has proven to work best, in my view.

As for financial inclusion, one should keep in mind that the most significant progress along this dimension in recent years has been the outcome of private initiatives, not state initiatives. Consider, for example, the hundreds of millions people who now have access to digital payments thanks to M-Pesa, WeChat and AliPay. Contrast this to the many developing countries that already have CBDC issued by their state banks. If their state banks have not been able to deliver on this score, what makes us think that retail-CBDC is essential?

Thursday, November 11, 2021

Run-Proof Stablecoins

A stablecoin (SC) is a financial structure that attempts to peg the value of its liabilities (or a tranched subset of its liabilities) to an object outside its control, like the USD. To do this, the SC must effectively convince its liability holders that SC liabilities can be redeemed on demand (or on short notice) for USD at par (or some fixed exchange rate). 

The purpose of this structure is to render SC liabilities more attractive as a payment instrument. Pegging to the USD is attractive to people living in the U.S. because the USD is the unit of account. Non-U.S. holders may be attracted to the product because the USD is the world's reserve currency. This structure serves to increase the demand for a SC pegged to the USD. 

To a macroeconomist, an SC looks like a unilateral fixed exchange rate regime or a currency board. The structure also resembles a money market fund that pegs the price of its liabilities with the USD at par (presently, government money funds in the United States). It also looks like a bank without deposit insurance (bank deposit liabilities are pegged at par value against cash). 

The history of unilateral fixed exchange rate regimes is mixed. Hong Kong has successfully pegged its currency to the USD for decades. But the experience for many countries seems closer to that of Argentina. Unless a USD-based SC is backed fully by USD reserves (it needs an account at the Fed for this) or by USD bills (maximum denomination is $100, so unlikely), it may be prone to a bank run. Any other security (including USTs, as the events of March 2020 demonstrated) is subject to liquidity risk -- i.e., a risk that the market for the security suddenly freezes, or demand for the security vanishes as investors seek safer havens. If a SC cannot dispose of its assets at "fair" or "normal" prices, it will fail to raise the money it needs to meet its par redemption promise. The SC will turn out to be not so stable. 
 
The theory of bank runs suggests that SCs might be rendered run-proof if their liabilities are properly designed. The famous Diamond and Dybvig (JPE 1983) model of bank runs is, in fact, a paper that demonstrates how banks can be rendered run-proof. In the first part of their paper, the explain how a credible promise to suspend redemptions when redemption activity is abnormally high can serve to discourage runs (redemptions based on belief of failure, rather than a need for liquidity) altogether. There is no need for deposit insurance (the second part of their paper is devoted to explaining why deposit insurance may nevertheless be needed, but their argument is not entirely satisfactory). 
 
In reality, we do see attempts to render run-prone structures less prone to runs. The Dodd-Frank Act, for example, prevented institutional money funds from pricing their liabilities at par with the USD (only government funds can now do this). In addition, the Act required that fund managers implement liquidity fees and redemption gates in the event of heavy redemption activity. These provisions have not been entirely successful. Even banks that suspended redemptions in the old days did not manage to prevent mass redemption events. The theory suggests that what is needed is a *credible* policy. Evidently, when push comes to shove, people cannot always be expected to follow through on their promises. 
 
Back in my teaching days, I used a "crowded movie theatre" as a metaphor to explain the phenomenon. Imagine a movie theatre that seats 500 people. If someone was to yell "fire!" (for legitimate or illegitimate reasons), people can be expected to rush for the exits. Invariably, some people are likely to be trampled and even killed. If people would instead react to the alarm by rising calmly from their seats and proceeding sequentially to the exits, then only the very last few people in the queue are destined not to make it. Losing one or two people relative to (say) is terrible, but it's preferable to losing 50 people in a mad rush for the exits. 

An economist might detect a missing market here. Why not sell tickets with queue positions (in the event of fire)? The tickets with the last few queue positions are likely to sell at a discount (that would depend on the likelihood of the event). This way, if someone yells "fire!", customers will simply show their assigned queue position to the ushers and proceed calmly out of the exits. If the fire does exist, the few people know they are doomed and accept their fate with stoic resignation, knowing that they are dying so that many others may live. (And if it turns out there is no fire, they are saved from the fire and the prospect of death that would have been present had they joined the rush to the exits). 

Except we know that's not what is likely to happen. People cannot be expected to commit in this manner. And there's no obvious way to enforce such contractual stipulations. 
 
But this is where SCs may have an advantage over conventional institutional structures. In particular, their use of "smart contracts" means that commitment is not an issue. The terms of such contracts are executed under the specified contingencies whether you like it or not. You may not like it ex post, but such commitment can be valuable ex ante. In the context of SCs, the credible threat of suspending redemptions in the event of abnormal redemption activity may actually prevent any runs from occurring in the first place

There are, of course, limits to what smart contracts can achieve. They wouldn't, for example, solve the movie theatre problem I just described. This is because people do not live "on-chain." (See also my blog post Smart Contracts and Asset Tokenization.) To some extent, the same issue exists for USD SCs because USDs and USTs exist "off-chain." Nevertheless, money accounts are different than people, so I think the principle described above can apply to financial products. 

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Related work: Preventing Bank Runs (w/ Nosal and Sultanum, TE 2017).
 

Wednesday, September 29, 2021

EEA-ESEM Panel: Macroeconomic Consequences of the Pandemic

I was recently asked whether I'd like to share my thoughts on monetary policy in a post-pandemic world. Sure, why not? Thanks to Jan Eckhout for thinking of me. The panel was hosted by the European Economic Association last month and moderated by Diane Coyle. I was honored to speak alongside Ricardo Reis and Beata Javorcik, both of whom provided riveting presentations. For what it's worth, I thought I'd provide a transcript of my remarks here. 

Lunch Panel EEA-ESEM Copenhagen
August 25, 2021

I want to focus my discussion on the U.S. economy and from the perspective of a Fed official concerned with the challenges the Fed may face in fulfilling its Congressional mandates in a post-pandemic world.

First, to provide a bit of context, let me offer a bit of history on policy and, in particular, on what I think were some policy mistakes. Let me begin with the 2008-09 financial crisis, which is something I think most people would agree should never have happened. Whether a sufficiently aggressive Fed lender-of-last-resort operation would have averted the crisis remains a open question. Even if it had been successful, such an operation would have had costs. It may, for example, have elicited an even greater political backlash than we saw at the time--and who knows how this may have manifested itself as undesirable changes to the FRA. As well, such an intervention may have just pushed mounting structural problems down the road. In particular, while it’s now clear that some private sector lending practices needed to change, it’s not clear where the incentive to do so would have come from absent a crisis. In any case, the crisis happened. How was it managed?

The ensuing recession was deep and the recovery dynamic very slow. The prime-age employment-to-population ratio did not reach its pre-pandemic level until 2019, a full decade later. Nevertheless, on the whole, I think the Fed followed an appropriate interest rate policy. There were one or two times the FOMC exhibited a little too much enthusiasm for “normalizing” policy, but I think the slow recovery dynamic had more to do with insufficient fiscal stimulus—especially at the state and local level—rather than a consequence of inappropriate monetary policy. The evidence for this can also be seen by the fact that inflation remained below the Fed’s 2% target for most of the time the policy rate was close to its ELB. The Fed has interpreted this low inflation episode as partly a monetary policy mistake, something its new AIT regime is designed to address. But my own view is that persistently low inflation—and the low money market yields that go along with it—have more to do with the supply and demand for U.S. Treasury securities. This is something the Fed does not have very much direct control over.

I know many people are skeptical of fiscal theories of the price-level, but in virtually every economic model I know, a fiscal anchor is necessary to pin down the long-run rate of inflation. Monetary policy—specifically, interest rate policy—can, of course, influence the price-level, so monetary policy can influence inflation dynamics. But it can do so only in the “short run.” Interest rate policy alone cannot, in my view, determine the long-run rate of inflation, at least, not without appropriate fiscal support.

Now, I know many of you may be asking how I can think fiscal policy has very much to do with inflation given how rapidly the debt has risen since the financial crisis and again with the C-19 crisis, all with little apparent pressure on long-run inflation expectations and on long-term bond yields. We should, however, keep in mind that an observed change in the quantity of an object may entail both supply and demand considerations. And one can easily point to several forces that have contributed to increases in the global demand for UST securities in recent decades. For example, the growing use of USTs as collateral in repo and credit derivatives markets beginning in the 1970s and accelerating through the 1980s. The growing demand for USTs as a safe store of value from EMEs. The evaporation of private-label safe assets during the financial crisis that left a gaping hole for USTs to fill. Next, we had a large increase in the regulatory demand for USTs coming out of Dodd-Frank and Basel III. The Fed’s SRF and FIMA facility should further enhance the demand for USTs. On top of all this, we’ve witnessed an emergent class of money funds called “stablecoins” that are further contributing to the demand for USTs. These forces have been disinflationary, leading bond investors to revise down their expectation of the future path of policy interest rates. It is interesting to ponder a counterfactual here. In particular, think of what may have transpired absent an accommodating U.S. fiscal policy. We may very well have experienced the mother of all deflations. If this is correct, then an elevated debt-to-GDP ratio, given a relatively stable inflation and interest rate structure, reflects an elevated real demand for outside assets. The problem is not that the debt-to-GDP ratio is going up. The problem is what disruptions might occur if it goes down owing to a sudden and unexpected inflation.

The recent rise in inflation is concentrated in durable goods, and I think is mostly attributable to ongoing supply-chain issues associated with the pandemic. This effect is likely to reverse itself, the way lumber prices recently have. Some of what I think is temporarily high inflation may not reverse itself, leading to a permanently higher price-level. In this case, households will worry whether their wages will keep pace with the higher the cost of living. There is even the possibility—though I think less likely—that the rate of inflation itself will remain elevated and that inflation expectations will rise well above the Fed’s 2% target. This may happen, for example, if the traditional bipartisan support for fiscal anchoring in the new generation of Congressional representatives is perceived to wane, or if the global demand for safe assets slows. If either or both of these things happen and are persistent, then the Fed may find itself faced with what Sargent and Wallace phrase an “unpleasant monetarist arithmetic.” That paper, which was published exactly 40 years ago, warned how tightening monetary policy without fiscal support might actually make inflation go higher rather than lower.

The implications for U.S. monetary policy are quite interesting should an event like this unfold. A determined Fed may try to fight inflation by raising its policy rate. The result is likely to be a temporary disinflation and recession.  Should fiscal policy remain unaltered, the logic provided by Sargent and Wallace implies that inflation will return even higher than before as the deficit must increase to finance a larger interest expense on the debt. The best the Fed can do in this case is to lower its policy rate, announce a temporarily higher inflation target, and hope that the fiscal authority gets its house in order. The notion that a Volcker-like policy would lower the long-run rate of inflation depends on fiscal capitulation. This capitulation to some extent did happen under Volcker, although keep in mind he had considerable Congressional support from both sides of the aisle. I do not think this type of political support is something one can count on, especially given today’s political climate. So, you may want to buckle up, as we may be in for some interesting times ahead.

Related Readings:

Is it Time for Some Unpleasant Monetarist Arithmetic? Link to blog post. Link to paper.

Monday, April 26, 2021

Labor Force Participation Gaps Between the U.S. and Canada

Am hearing some talk about whether the U.S. labor market can fully recover to its pre-Covid19 levels. Is it possible that a sizeable number of workers with marginal attachment to the workforce decide to remain out of the labor force? For example, this crisis, unlike the one that preceded it, has been associated with large increases in personal wealth. Workers on the cusp of retiring may now choose to do so earlier? (This is just one of the many stories I hear.)

For what it's worth, I thought I'd update my labor market participate blog post from 2013 which compared participation rates across Canada and the U.S., for males and females, and across different age categories. You can find my old post here along with some links to related posts. Below I report the updated data.

Remember, an individual is counted "in the labor force" if they are either employed (working) or unemployed (actively searching for work) in the previous 4 weeks from the time the labor force survey enquires about labor market status. 

First up, prime-age women. 


The increase in female labor participation is well-known. Less well-known is how U.S. female participation rates have diverged from other countries (I think Canada is more similar to Europe, last time I checked).  Let's take a look at prime-age men.


For the U.S., a secular decline throughout the sample, with evidence of a short-lived rebound from 2016-2019. The Canada-U.S. gap emerged during the Great Recession and is now wider than its ever been. This does suggest there's considerable room for an employment rebound for this demographic. But what accounts for the cross-country gap? 

I provide the other diagrams without commentary.