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

Thursday, February 20, 2014


Like many people out there, I am eagerly awaiting the release of the full transcripts of the Fed's monetary policy meetings for 2008. When they come out (and it should be very soon), you will be able to find them here.

I expect that the media will have a field day with these. No doubt a number of Fed officials will have said things that, with the benefit of hindsight, they wish they had not said, or said somewhat differently.

Jim Bullard, president of the St. Louis Fed, recently gave a speech on the subject titled: The Notorious Summer of 2008. The slides associated with that speech are available here.

Bullard makes some very good observations.

First, many people think of the financial crisis as beginning in the fall of 2008, with the collapse of Lehman and AIG. In fact, the crisis had been underway for more than a year at that point (August 2007). The fact that the crisis had gone on for over a year without major turmoil suggested to many that the financial system was in fact relatively stable--it seemed to be absorbing various shocks reasonably well. Throughout this period of time, the Fed reacted with conventional monetary policy tools--lowering the Fed Funds target rate from over 5% to 2% over the course of a year.

So what happened? Essentially, an oil price shock. By June 2008, oil prices had more than doubled over the previous year. The real-time data available to decision-makers turned out to greatly underestimate the negative impact of this shock (and other factors as well). The rapidly slowing economy served to greatly exacerbate financial market conditions.

The Bear Sterns event occurred in March 2008. The firm was purchased by J.P. Morgan with help (bailout, depending on one's perspective) from the Fed. Bullard identifies two problems with that deal. One, it suggested that all financial firms larger than Bear could expect some form of insurance from the Fed. Two, while the deal was successful in calming down markets, it possibly had the effect of lulling them into a false sense of security.

Of course, we then had the infamous Lehman event in the fall of 2008. But as Bullard points out, everyone knew that Lehman's was in trouble for at least a year--surely investors were prepared for this. And in any case, investors would have properly insured themselves, no?

Well, no. The big insurer, of course, turned out to AIG. Evidently, very few people had any idea about the potential problems with AIG at the time (which, by the way, was outside the scope of Fed supervision). And so, it was the Lehman-AIG event that brought all financial firms under heightened suspicion--and it was this event that drove the financial crisis from September 2008 and onwards.

We all know how the Fed reacted at the time, and since then. The interesting question here is what the Fed might have done differently in the time leading up to the start of the crisis in 2007 and beyond? It is important to answer this question, I think, in the context of policy making that is constrained to operate with the use real-time data (that is frequently subject to significant revisions as time unfolds).

In any case, it will be interesting to eavesdrop on the discussions that occurred in 2008.

Wednesday, February 19, 2014

Are negative interest rates really the solution?

Miles Kimball believes that the zero lower bound (ZLB) constitutes a significant economic problem (he is not alone, of course). His viewpoint is expressed clearly in the title of his post: America's Huge Mistake on Monetary Policy: How Negative Interest Rates Could Have Stopped the Recession in its Tracks.

That's quite the bold claim. But what is the reasoning behind it? Yes, I can see how a price floor can distort allocations and make things worse than they otherwise might have been if prices were flexible. But would interest rate flexibility really have prevented the recession?

Suppose I wanted to teach this idea in my intermediate macro class, using conventional tools. How would I do it? (Maybe it can't be done, but if not, then someone present me with an alternative.) I think I might start with the following standard diagram depicting the aggregate supply and demand for loanable funds (the foundation of the so-called IS curve):

Suppose the economy starts at point A. (I am assuming a closed economy, so aggregate saving equals aggregate investment.) The real interest rate is positive.

Next, suppose that there is a collapse in investment demand. For the purpose of the present argument, the reason for this collapse is immaterial. It might just be psychology. Or it might be the consequence of a rationally pessimistic downward revision over the expected future after-tax return to capital spending. In either case, the economy moves to a point like B, assuming that the interest rate is flexible.

But, suppose that the Fed is credibly committed to a 2% inflation target. Moreover, suppose that the nominal interest rate cannot fall below zero (the ZLB). Then, when the nominal interest rate hits the ZLB, the real rate of interest is -2%.

If this was a small open economy, the gap between desired saving and desired investment at -2% would result in positive trade balance (as domestic savers would divert their saving to more attractive foreign investments, over the dismal domestic investment opportunities). But in a closed economy, saving must equal investment and so, as the story goes, domestic GDP must decline to equilibrate the market for loanable funds. As domestic income falls (and as people become unemployed), desired domestic savings decline (the Desired Saving function moves from the Full Employment position, to the Under Employment position, in the diagram above).

Now, if this is a fair characterization of the situation as Miles sees it (and it may not be--I am sure he will let us know), then I would say sure, I can see how the ZLB can muck things up a bit. The economy is at point C, but it wants to be at point B (conditional on the pessimistic outlook).

But while point B might constitute an improvement over point C, it does not mean an end to the recession. Domestic capital spending is still depressed, and ultimately, the productive capacity of the economy will diminish. I'm not sure I see how a negative interest rate is supposed to prevent a recession, or get the economy out of a recession, if the fundamental problem is the depressed economic outlook to begin with.

If anyone out there has another way of looking at the problem, please send it along.


Update:  Here is a reply from Gerhard Illing:

Hello David,

I am not sure if that is what you are asking for, but at least within the standard NKM framework (with negative time preference shocks)  it is fairly straightforward to illustrate that eliminating the ZLB would allow monetary policy to perfectly stabilize the economy at the natural rate. I just finished a sort of “textbook” version (allowing for an explicit analytical solution) of that framework.
In terms of your graph (with the nominal interest rate as adjustment tool to time preference shocks under sticky prices) it looks as follows:


Presumably you are not happy with the NKM framework as a realistic description of current issues - but within that logic, these arguments follow naturally, in particular if you are on the “secular stagnation” trip.

And here is a further elaboration, provided by Gerhard:

Sunday, February 2, 2014

Monitoring Japan

I am as curious as anyone in ascertaining the effects of Japanese Prime Minster Shinzo Abe's QE experiment. Miles Kimball points us here to an early assessment by Marcos Nunes, who writes:
Shinzo Abe was elected in December 2012 on a promise to revive growth and put an end to deflation. How have his promises ‘performed’ one year after taking power? The ‘performance’ will be illustrated by a set of charts.
Nunes focuses on Japanese macroeconomic data beginning roughly with Abe's appointment as PM. But that's only about a year's worth of data. What I want to do here is compare these recent measurements with a longer sample, beginning in the year 2000 (the shaded region in my diagrams correspond to the Koizumi era, which I have written about before here).

First up is Japanese inflation (headline and core):

The evidence unfolding here really does seem to suggest that QE matters for inflation. My coauthor Li Li and I have recently remarked on this here.  Next, let's look at NGDP and RGDP growth:

Well, you know...this does not look so great, does it? While it is true that both NGDP and RGDP are growing, similar growth experiences are evident even in the earlier deflationary periods. Sure, it's nice to see RGDP growth rising recently, but it's still far too early to tell whether it will be sustained. And in any case, note the relatively robust period of growth during the "Koizumi boom" period--an era of deflation and fiscal austerity.

The exchange rate and the stock market:

So the stock market was booming late in the Koizumi era, the exchange rate stable, and core inflation negative. What about trade patterns? Take a look here:

I'll let you make up your own mind. Now for some comparisons with the Eurozone. First, a comparison of broad money growth:

Next, a comparison of inflation rates:

 And finally, a comparison of RGDP growth rates:

So sure, the Eurozone is underperforming as of late, and prospects in Japan are looking relatively good. How good in Japan relative to the Koizuma era, I'm not sure. And how much of the recent Japanese performance can be attributed to QE, one can only speculate. All that I conclude from this data is that QE may be influencing the inflation rate and the exchange rate. But whether it is having a quantitatively significant impact on the real economy is far less certain.


A comment by Noah Smith below suggests that Japanese CPI and GDP deflator are behaving quite differently. This indeed appears to be the case.

So, since about the time of the Asian financial crisis, the relative prices of non-consumer goods and services has declined steadily.