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August 26, 2010

Economist's View - 7 new articles

"The Real Activity Suspension Program"

I know how much some of you will disagree with this, but I have a hard time ascribing bad motives to people at the Fed and using it to explain policy decisions. I think people at the Fed believe in their heart of hearts that they are doing what's best for the economy as a whole as opposed to what's best for a particular party or some small group of people pulling the strings, but they are relying on bad assumptions, questionable models, convenient interpretations, etc. To me, some of the beliefs held by the other side are astoundingly unbelievable, but they would, of course, say the same thing about me. I don't deny that those beliefs can be convenient for the person holding them, but the idea that people at the Fed are consciously holding down the larger economy in order to benefit Republicans or some group of people is hard for me to buy into. There are certainly ideological divides that lead the other side to policies that I think are misdirected, or even counterproductive, but the bad motive explanation is hard to swallow. I'm more inclined to think this goes on in Congress where to some, winning the election is the only thing, but even then it's hard to assert this as a general proposition. But perhaps I have too much belief that people mostly try to do the right thing, and I am hopelessly trusting and naive (though see here). I expect to be told that I am.

Here's Andy Harless:

The Real Activity Suspension Program, by Andy Harless: (Think of this as a guest post by the Cynic in me. I'm not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word "recession" to include the period since our inadequate recovery began.)
Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.
How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.
Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.
Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks' Treasury note holdings and an increase in their cost of funds.
Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.
So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC's policy meetings?
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"Find the Unemployed and Hire Them"

It's my understanding that the editors at Bloomberg will not let their columnists say certain things, and that's one of the reasons I stopped, for the most part, sending any traffic in their direction. If the columnist persists and tries to say it anyway, the column is spiked.

I don't know the extent to which Kevin Hassett is constrained by these puppet strings, but it's interesting to hear the change in tone when he is not writing for Bloomberg.

Let's start this with a recent Hassett opinion piece at Bloomberg entitled "Bury Keynesian Voodoo Before It Can Bury Us":

Bury Keynesian Voodoo Before It Can Bury Us All, by Kevin Hassett: Initial claims for unemployment benefits surged to 500,000 in mid-August, a level more typical of a recession than a recovery. ...
In all likelihood, the data will soon be so convincingly bad that we'll again debate the need for an economic stimulus. Let's hope that when that begins, all will finally concede that the ideas of John Maynard Keynes are as dead as the man himself, and that Keynesianism is the real voodoo economics.

And here's Kevin Hassett when he's not writing for Bloomberg:

Conservative Economist: 'Find the Unemployed and Hire Them', by Derek Thompson: Let's put this gently: economist Kevin Hassett is no Keynesian.
Hassett, the director of economic-policy studies at the American Enterprise Institute and an economic adviser to Sen. John McCain, recent attacked President Obama's economic plan as "voodoo economics"...
But when I got him on the phone to talk about the unemployment crisis, he struck a different tone. ... The problem, he said, was that Obama's stimulus was not direct enough.
With the Recovery Act, the White House eschewed direct hiring and aimed instead to raise overall economic output in the hope that more activity would lead to more demand...
"My idea is simpler. Find the unemployed and hire them."
If the government had spent the stimulus hiring people directly, we could have supported 23 million jobs, Hassett claimed. Hiring millions of unemployed workers directly into government organizations that already exist -- such as the military and the Army Corps of Engineers -- would be a much more efficient use of government funds.
Hassett defended direct government hiring, which the federal government used en masse during the Great Depression...
"Employers don't want to take a chance on some guy without a job for two years," he said. "The cycle is so long and deep that the cyclical becomes the structural." The easiest way for the government to end somebody's jobless spell is, very simply, to end it by straight-up hiring the worker.
"Since the economy has created this class of long-term jobless, the arguments for government hiring becomes stronger," he said. "If you give the person a job for a while, it helps them get a job later. You remove the stigma."
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The Relationship Between Nominal Interest Rates and Inflation: Should Jaws be Dropping?

I'm getting some pushback on my post entitled "Jaws are Dropping," which is derived from a statement in one of the links I provided in the post. I think it must be either the title of the post or, when correcting a typo, the afterthought I added about the right answer to the question of whether a low federal funds rate eventually leads to a fall in inflation that has some people so worked up (good to see that Williamson has taking a break from his exhibitions of Krugman Derangement Syndrome, bashing Krugman seems to be the main point of his blog lately). It can't be anything else I said since my main point was that I didn't have time to say much about the whole controversy due to an impending deadline.

The main issue revolves around this statement from Minnesota Fed President Narayana Kocherlakota:

To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation

I think the assertion that it "must" lead to that outcome is unsupportable, there are models where that isn't true, but he means "must" in terms of a very specific model of how the economy works, including an assumption of the super neutrality of money (which is asserted as an uncontroversial assumption, but I'd quarrel with that). So, yes, it's possible to write down a very specific model that has this as an implication, but does that make it generally true? Not to me.

In any case, here's an email from a friend of Narayana defending his statements:

Hi:

I rarely comment on posts on blogs, since most of the discussion seems to be most interested in scoring political points than in economic analysis. However today I will make an exception since Kocherlakota's words come directly from any standard treatment of monetary theory, and hence, they should have been anything except controversial.

In a large class of monetary models, the Euler equation of intertemporal maximization is:

FFR = (1/beta) *(u'(ct)/u'(ct+1))*inflation

where u'(.) is the marginal utility of consumption, FFR is the federal funds rate, and beta is the discount factor (see, for instance, equation 1.21 in page 71 of Mike Woodford's Interest and Prices for a derivation in a simple context).

Let us take first the case where money is neutral, probably an implausible case but a good starting point. In this situation, the ratio of marginal utilities is unaffected by the change in inflation or the FFR. Thus, a lower FFR means lower inflation. Otherwise, there are arbitrage opportunities left on the table. What is more, in such a world, the Fed can control inflation by controlling the FFR, so the relation is causal in a well-defined sense.

Now, let's move to the much more empirically relevant case of a New Keynesian model (here I am thinking about the standard NK model people use these days to analyze policy in the style of Mike Woodford, Larry Christiano or Martin Eichenbaum, with a lot of nominal and real rigidities, so I will not discuss the assumptions in detail).

Imagine that the Fed is targeting the FFR and decides to lower the long run target from, let's say 4% to 2%. What happens? Well, in the very short run, nominal rigidities imply that we will have a transition where inflation might (but not necessarily, it depends on details of the model) be temporarily higher but, after the necessary adjustments in the economy had occurred (adjustments that can be quite painful, generate large unemployment, and might reduce welfare by a considerable amount), we settle down in the lower inflation path. Again, the reason is that in most New Keynesian models, the ratio of marginal utilities is independent of the FFR (this will happen even in many models with long-run non-neutralities) and the Euler equation will reassert itself: the only way we can have a real interest rate of 3% when the target FFR is 2% is with a 1% deflation.

Hence, in the long run, as Kocherlakota's speech explicitly says:

"To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."

An alternative way to see this is to think about a Taylor rule of the form:

Rt/R = (πt/π)γ

where γ>1 (here I am eliminating extra terms in the rule for clarity) where Rt is the FFR, R is the long run target for the FFR, πt is inflation, and π is the long run target for inflation. In a general equilibrium model, the Fed can only pick either R or π but not both. If it decides to pick a lower R, the only way the rule can work is through a fall in π.

While one may disagree with many aspects of modern monetary theory (and I have my own troubles with it), one must at least acknowledge that Kocherlakota's treatment of this issue or the relation between the FFR and inflation in the long run is what would appear in any standard macro model.

Thanks

Jesus Fernandez-Villaverde
And, he sends along an update:
One thing I forgot to mention: I guess that the intuition that most people have (and that reacts in a somewhat surprised way to Narayana's words) comes from a New Keynesian model, where lowering the FFR with respect to what the Taylor rule indicates (what we call a "monetary shock") increases inflation in the short run. But here we are not talking about the effects on inflation of a transitory monetary shock, but, as Narayana clearly says in his speech, about the long run effects of a change in the target of the FFR.

If you commit to a single class of models and the interpretation of the shocks within them, the kind of models and interpretations that Narayana Kocherlakota has questioned, at least in their standard forms, and if you buy all the embedded assumptions that are needed to obtain the result, not all of which are easy to defend (e.g. the assumption of long-run neutrality), then yes, "must" is correct. But "must" must be interpreted in a rather limited context, and in a more general setting it's not at all clear that this result will hold.

However, my real problem with this defense is that it doesn't deal with the assertion that if real rates normalize and the Fed doesn't raise its target rate in response, it will lead to deflation., i.e. it doesn't address Nick Rowe's point. If the target real rate is below the normal real rate, how does that cause deflation? That's the part that caused the objection in the first place, and the part that still leaves me puzzled. Here's Nick:

"To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."

That could be interpreted two ways: a wrong way, and maybe, just maybe, a right way.

"When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."

Nope. He definitely meant it the wrong way. If the economy returns to normal, and the natural rate of interest rises, the Fed must raise its target rate of interest. (So far so good). If it doesn't, the result would be....deflation. ("Inflation" would be the right answer).

I also wonder if a permanent shock is the right way to think about this type of a policy, but I'll leave that as a question since I don't want to distract from Nick's point.

Update: Here's more from Nick:

What standard monetary theory says about the relation between nominal interest rates and inflation, by Nick Rowe: This is what I understand "standard" monetary theory to say about the relation between inflation and nominal interest rates.

I want to distinguish two cases.

In the first case the central bank pegs the time-path of the money supply. The money supply is exogenous. The nominal interest rate is endogenous. Standard monetary theory says that a permanent 1 percentage point increase in the growth rate of the money supply will (in the long run) cause both the nominal interest rate and the rate of inflation to rise by 1 percentage point. The Fisher relation holds as a long-run equilibrium relationship. The real interest rate is unaffected by monetary policy in the long run.

In the second case the central bank pegs the time-path of the nominal rate of interest. The nominal interest rate is exogenous. The money supply is endogenous. Start in equilibrium (never mind how we got there). Standard monetary theory says that if the central bank pegs the time-path of the nominal interest rate permanently 1 percentage point higher, this will cause the price level, and the rate of inflation, and the stock of money, to fall without limit. The Fisher relation will not hold, because there is no process that will bring us to a new long run equilibrium. The real interest rate will rise without limit.

These two cases are very different, because a different variable is assumed exogenous in each case.

I am assuming super-neutrality of money, in long-run equilibrium. The Fisher relation is a long run equilibrium relationship. We never get to the new long-run equilibrium in the second case, and so the Fisher relation does not hold.

Update: Brad DeLong comments.

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Fire at the Fire Station

This must have been embarrassing:

Rural fire engine burns in Alvadore, by Emily Gillespie, The Register-Guard: The Santa Clara fire station responded to a fire at the Alvadore fire station near Junction City at around 8:45 p.m. on Tuesday night where a fire engine was burning. The 1980s-era vehicle was lost in the fire and is also presumably the cause of the fire...
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"Inequality and the High-End Bush Tax Cuts"

Chuck Marr of the Center on Budget and Policy Priorities on the relationship between tax policy and inequality:

Inequality and the High-End Bush Tax Cuts, Off the Charts, CBPP: As I've said before, from the standpoint of economic efficiency there's a clear-cut case for letting the Bush tax cuts for people over $250,000 expire on schedule in December. Sunsetting the high-income tax cuts makes just as much sense from the standpoint of equity. Recent data from the Congressional Budget Office (CBO) show a stunning shift in income away from the middle class and towards the highest-income people in the country over the last three decades:

  • In 1979, the middle fifth of Americans took home 16.5 percent of the nation's total after-tax income. By 2007, after several decades of stagnant incomes in the middle and surging incomes at the top, the middle fifth's share had dropped to 14.1 percent. Over the same period, the top 1 percent's share more than doubled, from 7.5 percent of total after-tax income to 17.1 percent (see graph below). So by 2007, the top 1 percent had a bigger slice of the national income pie than the middle 20 percent.

  • If the distribution of after-tax incomes had remained unchanged between 1979 and 2007, the after-tax income of the average family in the middle would have been $9,000 (16 percent) higher in 2007 than it actually was. Instead of an income of $55,300, this typical family would have had $64,700 (see table below). ...

Here's how that income shift looks in graph form:

Tax policy is one of the best tools we have to help offset the troubling trend of growing inequality. Unfortunately, the Bush tax cuts have had the opposite effect, providing much larger benefits — both in dollar terms and as a percentage of income — to people at the very top than to middle- and lower-income people. People making more than $1 million get an average of about $124,000 each year in tax cuts, according to the Urban-Brookings Tax Policy Center. The main reason, of course, is the large tax cuts targeted specifically at high-income households.

So this fall, when policymakers decide whether to extend the high-end tax cuts, they should keep in mind just how unequal incomes in the United States have become. As former Federal Reserve Vice Chairman Alan Blinder wrote recently in the Washington Post, is the rationale for extending these tax cuts "that America needs more income inequality? Seems to me we have enough." To me, too.

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"Fed to Outline Future Actions"

Is Ben Bernanke about to "stake out a public position"?:

Fed to Outline Future Actions Friday, by Sewell Chan, NY Times: With fresh signs that the housing market is weakening,... Ben S. Bernanke, on Friday will offer his outlook on the economy, explain the Fed's recent modest move to halt the slide and possibly outline other actions. ...
It is not known what Mr. Bernanke will say, but some insight may come from an episode in his past: his concern, soon after he became a Fed governor, that the economy was at risk of deflation as the nation gradually recovered from the dot-com bust a decade ago.
Mr. Bernanke's worry then is similar to what troubles the Fed now, and his views will have no small bearing on the Fed's course of action. ... Whether policy makers should take big steps to tackle the economic doldrums — by printing even more money and buying even more assets — [is] the dominant question...
Within the central bank, several officials are alarmed at the threat of the economy falling into a dangerous cycle of declining demand, wages and prices not experienced since the Depression. They say that a deflationary, double-dip recession is unlikely, but want to formulate concrete steps to ward it off.
Other officials contend the economic indicators, while dismaying, do not represent an immediate threat, and worry that additional monetary stimulus by the Fed could erode the already shaky confidence of the markets, or even backfire by eventually spurring uncontrolled inflation. ...

The risks are not symmetric. An extended period of stagnation is a highly undesirable outcome, and the Fed needs to take steps to try to prevent this from happening.

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links for 2010-08-25

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