Category Archives: Monetary Economics

Macro Theory and Macro Practice

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John Cochrane writes,

Perhaps academic research ran off the rails for 40 years producing nothing of value. Social sciences can do that. Perhaps our policy makers are stuck with simple stories they learned as undergraduates; and, as has happened countless times before, new ideas will percolate up when the generation trained in the 1980s makes their way to [the] top of policy circles.

I was with him up to the semicolon. But Fischer and his students made it to the top of policy circles some time ago. My sense is that their policy decisions are not driven by the models that they taught graduate students. They are going on the basis of intuition, and the intuition is in turn shaped more by the undergraduate IS/LM story than by anything else.

My own view is that the tools that they are playing with have very little impact on financial markets or the economy. Meanwhile, the bank regulations, both formal rules and informal slaps on the wrist, play a huge rule in directing bank capital toward government bonds and away from commercial loans. And that capital allocation has real consequences.

A Question from a Commenter

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On this post.

Even if no arbitrage opportunity exists, why would anyone buy a TIPS in your scenario when they get a 1% higher real rate of return on the nominal treasury?

Suppose that actual inflation is 1 percent and the real five-year risk-free rate of interest wants to be 2 percent. Then five-year TIPS should yield 2 percent and five-year nominal Treasuries should yield 3 percent.

Next, the Fed wants to raise expected inflation to 2 percent. So it buys five-year TIPS to lower that interest rate and sells five-year nominal Treasuries to raise that interest rate. The commenter’s point is that the public will want to do the reverse. Some possibilities:

1. The Fed’s actions do not change market spreads at all.

2. The Fed’s actions change market spreads because the Fed becomes really large in these markets.

3. The Fed does some of its buying of five-year TIPS with newly-created money, leading to more actual inflation.

Each of these is possible, but I want to emphasize that we could see (1).

John Cochrane’s Monetary Thought Experiment

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He writes,

The Fed or Treasury could easily say that the yield difference between TIPS and Treasuries shall be 2%. (I prefer 0, but the level of the target is not the point.) Bring us your Treasuries, say, and we will give you back 1.02 equivalent TIPS. Give us your TIPS, and we will give you back 0.98 Treasuries. (I’m simplifying, but you get the idea.) They could equivalently simply intervene in each market until market prices go where they want. Or offer nominal-for-indexed swaps at a fixed rate.

Scott Sumner enthuses,

Excellent. And so Neo-Fisherism has now arrived where David Glasner, Bill Woolsey, Bob Hetzel, Milton Friedman and I were a few decades back. Target the market forecast.

The idea is to pin down expected inflation at 2 percent. I gather that Cochrane figures that actual inflation will then converge to expected inflation. I am not so sure. Suppose that “expected inflation” (defined as the spread between the interest rates on the 5-year nominal Treasury and the five-year TIP) is 2 percent but actual inflation is running at 1 percent for the indefinite future. What sort of arbitrage is available? Go long the spread and short everything in the CPI?

I think that the error is in thinking in terms of “the” rate of interest. There are many different rates of interest. The five-year nominal Treasury and the give-year TIP are just two of them. If the Fed pegs the spread between the two, I am not sure that has any consequences for the other interest rates in the economy. In particular, as I see it, there is nothing to ensure that actual inflation converges to the targeted spread.

If you’re new to this blog, I take an outlier point of view, which is that the Fed is not important for the macro economy. Walrasian economists needed something to pin down the nominal price level, so they nominated the money supply. I instead take the view that money and inflation are largely social conventions. Extreme measures by the government can change these social conventions. Otherwise, in my view, the belief in the power of the Fed is a superstition. This superstition is best maintained if the Fed’s actions are mysterious. If the Fed were to follow a transparent rule, I think that the superstition would be exposed for what it is.

How the Fed Became a Giant Hedge Fund

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Jeffrey Rogers Hummel tells the story.

Phase Two of Bernanke’s policies transformed the Federal Reserve from a central bank confined primarily to managing the money supply into an institution that is now a giant government intermediary borrowing massive sums in order to allocate credit. In that respect, the Fed has become similar to Fannie or Freddie, with the important distinction that the Fed has greater discretion in subsidizing a wider variety of assets.

Target the S&P 500?

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Lifted from the comments:

EMH has me puzzled. Since stocks are linked to the economy you must also conclude that long-range predictions of the economy are no better than throwing darts. Yet many economists seem to believe that the Fed could in fact target NGDP and therefore create the economy they want in some respect (obvisously there are plenty of variables they can’t control). Is a variable really efficient if someone can target it?

To put it more simply perhaps, the Fed COULD target the S&P 500 if they wanted to (essentially pick a value). If an entity exists that can control a variable then isn’t it impossible for that variable to be completely unknowable?

1. Long-range predictions of the economy are not much better than throwing darts. Even projections of a year ahead are not much better than just guessing that the real GDP will grow by 2.5 percent.

2. I think that Scott Sumner would say that the Fed could target the level of the S&P 500. That is a nominal variable.

3. However, the Fed cannot target the real return on stocks. If the Fed targets an S&P 500 of 2200 for one year from now, and this is credible, then the S&P 500 has to rise today to the point where the expected real return is comparable to that on other assets.

4. Part of the EMH is that markets anticipate what the Fed will do. So the Fed cannot suddenly surprise markets by targeting an S&P 500 of 2200. If you extend that, you would say that the Fed cannot suddenly surprise markets by targeting a particular level of NGDP.

5. I think there is a bit of tension between believing in the EMH and believing that the Fed can choose any NGDP value it wants. I think Scott is aware of the tension, and I forget how he resolves it.

6. I think that bringing up the stock market is a very good way to raise the issue of whether the Fed can target any nominal variable.

7. Of course, I am not the one who has to defend the proposition that the Fed can target nominal variables. I believe that financial markets can do what they want with asset prices, and that money and prices are consensual hallucinations.

QE and Fiscal Offset

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Tony Yates writes,

As Summers reportedly put it, while the Fed was engaged in quantitative easing, the Treasury was doing ‘quantitative contraction’. And surely the two arms of government should be better coordinated than that.

Pointer from Mark Thoma. My remarks.

1. Read the rest of his post.

2. Larry Summers is quite late to the party. Some of us have been talking about this issue for years. For example, almost four years ago, James Hamilton wrote,

since 2008, the Treasury has been issuing more long-term debt faster than the Fed has been buying it… What we find in the latest data is that this trend has continued over the last 3 months, even with QE2.

3. Wikipedia defines superstition as

the belief in supernatural causality—that one event causes another without any natural process linking the two events—such as astrology, religion, omens, witchcraft, prophecies, etc

I think that belief in the macroeconomic impact of the Fed can be properly regarded as a superstition. The Fed’s rules and regulations affect the allocation of credit, and it can aid particular banks when they get in trouble. However, its ability to control interest rates and nominal GDP is far less than most economists and investors believe.

Note that, as with the vast majority of my posts, this was written a few days ago and scheduled to be posted at this time. I find that staying away from immediate publication encourages me to evaluate the wisdom of a post using my “future self.”

Peter Thiel’s Interview Question

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In his new book, Zero to One, he writes,

Whenever I interview someone for a job, I like to ask this question: “What important truth do very few people agree with you on?”

My answer would be that I believe that the Fed has very little influence on inflation and interest rates. I think it is fair to say that very few people agree with me on that.

His rationale for asking the question is that if you cannot be truly contrarian, then you cannot be an innovator.

You should read Thiel along with my own Under the Radar. We are similar in our characterization of the business environment, and yet we are polar opposites in terms of where we favor positioning oneself within it. Also, perhaps read Joel Kotkin on The New Class Conflict (which I have not read) and decide to what extent Thiel exemplifies what Joel Kotkin calls the Tech Oligarchy.

The Fed and Money Markets

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Jon Hilsenrath writes,

Because banks have so much cash, the fed-funds market where they tap reserves experiences very little day-to-day trading. One New York Fed study shows daily trading volume in the market has contracted from an already-thin $200 billion before the financial crisis to nearly $50 billion. Moreover, traditional U.S. commercial banks are especially inactive. The most active players are government sponsored Federal Home Loan Banks and foreign banks.

“The fed funds market is but a shadow of what it was prior to the crisis,” Raymond Stone, an analyst at Stone McCarthy Research, said in a note to clients Wednesday. “It is no longer clear that the funds rate is the key determining factor of the behavior of short-term interest rates.”

Read the whole thing.

Nick Rowe on Monetary Theory

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He writes,

2.1 Home production increases in a recession. People grow their own veggies, cook their own meals, fix their own cars, and go back to school. Because investment in human capital is a form of investment that requires mostly one’s own time, on top of inputs bought for money. Home production of investment goods rises, even as all other forms of investment fall.

2.2 If trade were harder in a recession, we would expect to see trade in all goods falling, and not just trade in newly-produced goods. And, as far as I can tell, that is what we do see. It gets harder to sell old houses, as well as newly-produced houses.

2.3 Barter increases in a recession, as far as I can tell. Barter is usually very difficult, but some barter exchanges are more difficult than others. If recessions were caused by something that made monetary exchange more difficult than normal, we would expect to see abnormally high levels of barter in a recession. I think we do.

2.4 Some goods are easy to sell for money even in a recession. Which goods are those? It is those that are traded in organised central markets, where problems due to asymmetric information are small, and where prices are very flexible. It is precisely those goods that are more like money, where if all goods were like that we wouldn’t need money as much to help economic coordination. It is those goods that are traded in markets that approximate the market of the Walrasian auctioneer. If all goods were like that, and if all markets were like that, we wouldn’t observe recessions. And we wouldn’t need money.

But we don’t see increased use of foreign currency in a recession. We don’t see increased use of buying on credit–we see the opposite. And as for point 2.3, as far as I can tell, the use of barter in the 2008-present episode has been minimal.

Later, he writes,

Lots of things can cause coordination failures. Not all coordination failures are monetary coordination failures. There are many coordination failures that monetary policy cannot cure.

I don’t think that the last six years represents an example of the latter.