Economics

Monetary Policy

  • United States
    The Shrinking U.S. Labor Force and Fed Policy
    Does the large drop in the U.S. labor force participation rate justify a monetary policy that is easier, for longer, than suggested by our models or the Fed’s current description of its policy?  Chris Erceg and Andy Levin, two senior researchers at the Fed now on leave at the IMF, argue yes.  Their analysis will provide fuel to the monetary policy doves who argue the Fed is failing to meet its employment mandate, and points to a battle ahead.  But it doesn’t really settle questions about whether monetary policy is an effective tool for bringing these workers back into the work force, or whether it can be done without creating inflationary pressure (which speaks to other leg of the Fed’s mandate). Still, their paper is an important read. The unexplained fall in labor force participation Their first chart shows the decline in labor force participation since 2007, both in absolute terms and relative to a Bureau of Labor Statistics (BLS) forecast for the future path of the participation rate made in 2007.  It suggests that the sharp drop in the participation rate since 2007 was unexpected and hard to explain by the structural factors that affected participation in the past such as the aging of the population, or shifts in specific groups such as female or youth workers.  This means that the gap between the two lines, the "participation gap," must be cyclical--the result of the great recession--or because of some new structural factors that the BLS didn’t anticipate.   The structural argument deserves some elaboration.  Recall that labor force participation actually peaked around 2000 and was on a downtrend even before the great recession (see next chart). One view is that this means there are even more "missing workers" put out of jobs, involuntarily, by the weak recovery of 2000-07.  I think a better explanation is that there were already structural changes underway in the workforce that are not captured by the BLS forecast.  From this perspective, the great recession is an accelerant that forces change (eg, in terms of labor-saving by firms, changes in long-term competitiveness, or changes demand for skills) that had been building already.  Whether you want to describe this as cyclical or structural, these workers may not be easily brought back into the labor force through expansionary macro policies.   Civilian Labor Force Participation Rate, 16 and older Source: BLS This next chart from Erceg and Levin shows that the participation gap (derived from the first chart)-- the orange dotted line--now exceeds the gap between current unemployment and the long-run unemployment rate (the purple line).  It shows that the participation rate adjusts more slowly than the unemployment rate.  It also highlights the amount of slack that needs to be absorbed is potentially much larger than suggested by the unemployment rate alone. The bulk of the Erceg and Levin paper then addresses two critical questions:  Is this structural or cyclical? And will it persist as the economy recovers (and the unemployment rate drops)?  On the question of cyclicality, the paper looks at a cross-section of state participation rates during the recession (see below).  States with the deepest recessions had the sharpest fall in unemployment, which they argue suggests it’s weak demand that is driving much of the recent decline in participation.  State data has been criticized in the past as subject to noise and error, and others suggest that looking at flows into and out of the labor force is more consistent with a structural explanation.  In any event, this result is central to the debate over whether ’this time is different’ because the post-war experience has been that participation is largely non-cyclical. The Fed’s employment mandate "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." (Federal Reserve Act, 1977) The Fed is unusual among central banks in having a statutory dual mandate to ensure both maximum employment and stable prices.  The Fed has long stressed that in most circumstances these two objectives are consistent, and further that it looks at a wide array of indicators in fulfilling its mandate.  However, much economic theory, and the Fed itself, have put the spotlight on the unemployment rate (and its relationship to the longer run, normal rate of unemployment) as the most important single metric of labor conditions.  This focus has intensified since the Fed, in December 2012, announced that an unemployment rate of 6.5 percent would serve as a threshold (not a trigger) for tightening policy from the current near-zero levels. The dilemma for the FOMC is how to react if the unemployment rate declines to below 6.5 percent while the participation rate remains low.  Should we look at the sum of the unemployment and participation gaps as the measure Fed policy must address?  In assessing this argument, the Fed will have to answer three questions in particular: How low can the unemployment rate go before inflationary pressures emerge? The Fed’s estimates of the central tendency for the longer-run, normal unemployment rate, at 5.2-6 percent, is substantially higher than they forecast several years ago, reminding us of the inherent uncertainty in these traditional macro relationships. Does a high participation gap put downward pressure on inflation?  Certainly inflationary pressures remain muted, even too low (recent work by Lars Svensson and others suggest inflation below 1 percent can be distortionary and undermine a credible central bank’s policy).  But the great recession also has undermined notions of a tight relationship between slack in the economy and inflation (inflationary expectations haven’t moved very much with the recession) suggesting the need for caution during the upturn as well.  Does the existence of a pool of workers that have left the workforce, for example to retire or to go to school because there are limited job opportunities, put downward pressure on the wages of those who have jobs? Is monetary policy the right tool to address the participation gap? Recent research on long-term unemployment suggests that, once workers are unemployed more than six months, their connection to the work force become tenuous.  In such cases, even if their exit was the result of a demand shock, at some point they lose the skills, the connectivity, and the resume to reenter easily. What starts as cyclical becomes structural.  Monetary policy may be a blunt tool for addressing the participation gap, suggesting targeted fiscal policies (e.g., job retraining and employment subsidies) may be more effective tools.  The monetary policy dove will argue that absent fiscal policy, monetary policy is the best tool in the toolbox, while critics will weigh these potentially modest benefits against the cost of an even larger balance sheet. None of these questions have easy answers. Erceg and Levin are careful to emphasize the limits of their analysis.  But their work, and the notion that the Fed needs to target policy to reduce this gap, may be front and center at future FOMC meetings.
    Blog Post by Robert Kahn May 8, 2013 Macro and Markets
  • United States
    HBO History Makers Series With Paul Volcker
    Play
    The Home Box Office History Makers Series focuses particular attention on the contributions made by a prominent individual at a critical juncture in international relations.
    Event with Paul A. Volcker and Andrew Ross Sorkin May 6, 2013 HBO History Makers
  • United States
    HBO History Makers Series with Paul Volcker
    Play
    Paul Volcker discusses the U.S. economy and his career.
    Event May 6, 2013 HBO History Makers
  • Europe and Eurasia
    Draghi's Dilemma
    The Governing Council of the European Central Bank meets on May 2, with a possible rate cut in the offing. Yet a rate cut is not the no-brainer the Bank’s critics often suggest, as today’s Geo-Graphic shows. The ECB’s official inflation-rate target is “below, but close to, 2%.” Both Portugal and Greece have inflation under 1% , but the transmission mechanism from ECB rates to business borrowing rates in those two countries has been virtually severed by the crisis. In short, they need a rate cut, but the ECB can’t deliver them one. In those Eurozone countries where the monetary transmission mechanism is still working normally—Austria, Finland, France, Germany, and the Netherlands—the GDP-weighted-average inflation rate is 1.8%, right near the ECB’s target. France, with 1.1% inflation and 10.8% unemployment, would appear a strong candidate for a rate cut, but not the others. Germany has 1.8% inflation and only 5.4% unemployment. The other three all have above-target inflation rates: Austria at 2.4%, Finland 2.5%, and the Netherlands 3.2%. Austrian unemployment is low, at 4.8%. Dutch unemployment is a moderate 6.4% Only Finnish unemployment is high, at 8.2%. Some will argue that a bout of robust inflation in the north is just what is needed to restore competitiveness in the south. But the ECB will have to willfully ignore its price-stability mandate if it is to justify a rate cut right now, and it will almost certainly need to apply more radical tools if it is to aid the south quickly. “The ECB is obviously in a difficult position,” German Chancellor Angela Merkel said on April 25. “For Germany, it would actually have to raise rates slightly at the moment, but for other countries it would have to do even more for more liquidity to be made available and especially for liquidity to reach corporate financing.” Yes indeed. This is Draghi’s Dilemma. Geo-Graphics: Is the ECB Draining Its Own Powers? Financial Times: Merkel Speech Highlights European Divide Reuters: Merkel Says Germany Would Need Rate Rise Wall Street Journal: Bleak Europe Data May Prompt ECB Action
    Blog Post by Benn Steil and Dinah Walker April 26, 2013 Geo-Graphics
  • Capital Flows
    Krugman’s Data-Picking Downplays U.S. Debt
    Paul Krugman recently dismissed concerns about America’s large international debt.  “America’s debtor position,” he writes, “isn’t actually that deep, because of capital gains.” When Krugman talks about “America’s debtor position” he is referring to the net international investment position (NIIP), which is the difference between the value of the U.S. portfolio of foreign assets and the value of the foreign portfolio of U.S. assets.  Krugman demonstrates that the NIIP is fairly flat over the period 2002 to 2010, which presumably shows that concern over U.S. debt is uninformed or disingenuous.  Or does it? As with Krugman’s “Icelandic Miracle” posts, his conclusion is just an artifact of the starting and ending dates he chooses.  In today’s Geo-Graphic above, note what happens to the trend line when Krugman’s data are brought up to date – adding the data, which he had easy access to, for 2011 and 2012.  Now, the trend is decidedly downward – considerably worse than his. And what about when we back up the starting date to the mid-1980s, as we do in our graphic?  Now we can clearly see the effect of Krugman’s chosen data period – it wipes off the steep decline in U.S. NIIP before 2002 and after 2010. Note that in 2009 the U.S. portfolio of foreign securities, which is riskier than the foreign portfolio of U.S. securities, outperformed the foreign portfolio by such a significant margin that the NIIP shrank by nearly $1 trillion – this despite the fact that foreigners continued to buy more assets in the U.S. than the U.S. bought abroad.  This is captured in Krugman’s data.  But in 2011, which Krugman leaves out, this U.S. outperformance was reversed and then some: the NIIP deteriorated by a whopping $1.6 trillion, bringing the NIIP to a record negative $4 trillion.  It continued further down to a record negative $4.4 trillion in 2012. Which all goes to show that not all graphics are as reliable as Geo-Graphics . . . Krugman: America the Debtor Wall Street Journal: For U.S., Big Foreign Investment Is a Mixed Blessing Chart Book: Foreign Ownership of U.S. Assets BEA: Quarterly and Year-End Update on U.S. Net International Investment Position
    Blog Post by Benn Steil and Dinah Walker April 16, 2013 Geo-Graphics
  • Economics
    Why Abenomics Matters
    Last week, I wrote on the ECB’s meeting and the case for easing credit conditions in the periphery (a recommendation that they didn’t heed, though pressure to act is building).  I ignored the upcoming Bank of Japan (BoJ) meeting.  My wife’s comment the next day summed it up well:  “you blogged on the wrong central bank.” For those that don’t follow central banking closely, it’s worth a moment of reflection on why what the BoJ did last week was so important. In his first meeting as central bank governor, Mr. Kuroda produced a package that easily meets an economic “Powell Doctrine” test–having exhausted all the other options, it brings overwhelming force to bear in order to change expectations for financial conditions, inflation, and growth in Japan. The Bank adopted a price stability target of 2 percent for the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. To get there, it targeted a doubling of the monetary base (the previous target was the overnight interest rate), an annual increase of 60 to 70 trillion yen. It will double its holdings of Japanese government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years (a net purchase of around ¥5 trillion per month), and more than double the average remaining maturity of JGB purchases.  The decision to purchase bonds of longer maturity gets the BoJ more bang for the yen then if they had stuck to the old practice of focusing on short-duration bonds. Scaled for the economy, this is not that much different from what the Fed has done and twice the current pace of Fed purchases. The Bank is committed to continue with its quantitative monetary easing as long as necessary to achieve these targets. At some level, this should look familiar as it in substance mirrors the non-conventional easing strategy followed by the Fed in recent years in its combination of purchases of longer-duration assets with a commitment to maintain such policies for longer than markets might otherwise expect.  In the presence of a liquidity trap, the key to making quantitative purchases effective is to credibly promise to raise inflation, and this effort goes in that direction.  Some also are comparing the action to Paul Volcker’s anti-inflation policy of 1979.  Like that experiment, the Bank of Japan recognizes the uncertainty in how the experiment will play out and, by shifting to a monetary base, signals its willingness to accept whatever rates are needed to reach their quantitative targets. It’s a major break with past policy, and that is the central point:  the new policy represents a fundamental shift in the paradigm that has guided Japan monetary policy for the last 25+ years.  Since the bubble of the late 1980s, economists have criticized the BoJ policy as too tight, too tentative, and too willing to tighten prematurely when green shoots of recovery appeared.  BoJ staff repeatedly justified their policies with the argument that deflation in Japan was structural, a function of demographics and the special characteristics of Japan’s economy, and thus outside the ability of the monetary policy to reverse.  Last week’s package of measures, adopted unanimously (some of the measures were rejected by an 8 to 1 vote last month), represents a repudiation of that view. The effect of the announcement on markets–a sharp decline in the yen from below 93 per dollar earlier this month to 98.9 currently, an increase in the Nikkei, and strength in a range of other currencies whose markets are expected to benefit from Japanese capital outflows–was dramatic and is likely to continue to percolate this week.  The IMF and key central bankers saluted the action, while others expressed concern about the yen’s depreciation.  Whether this is the green light to “currency wars” and capital controls that bubbled to the surface at last months’ G-20 meeting remains to be seen. What the Bank of Japan did last week is an important moment.  It also puts in sharp contrast the inadequacy of the ECB’s approach to ending deflation pressures in Europe.
    Blog Post by Robert Kahn April 8, 2013 Macro and Markets
  • Europe
    Cyprus: Hope Trumps Reality
    Cyprus has reached a tentative agreement with the IMF-EU-ECB team (Troika) on the economic program that will be backed by its €10 billion rescue package.  The IMF will put €1 billion, small in absolute terms and relative to the one-third share that it has had in most of its European programs but a very high share (563 percent) of Cyprus’ contribution, or quota.  The plan is for European political approval in coming days, followed by legislative approval where needed during the course of April, and IMF Board approval in early May.  If Cyprus passes all the prior actions required in the program, it could get the first drawing on the package in mid-May, well ahead of their early June debt maturities. The critical prior actions are fiscal.  On top of a 5 percent of GDP multi-year fiscal consolidation already underway, the government has committed to pass an additional 2 percent of GDP in new, permanent measures for this year as a condition for receiving its first drawing under the program.  In future years, 4 ½ percent of GDP in measures will be passed, and if performance falls short of targets, the government must stand ready to take additional measures (though presumably slippages due to a larger-than-expected recession, rather than incomplete policy implementation, may be excused).   The prior actions include significant increases in taxes on corporate income (from 10 to 12 ½ percent), interest income (from 15 to 30 percent), property, and banks, as well as higher fees for health care and government services. There are also a broad and ambitious set of structural reforms, including fiscal management, privatization/commercialization of state-owned agencies, and pension reform.  While not prior actions, it does look like they have to take substantial steps by the first review (presumably slated for this summer, though it could be delayed), and this is another reason to question how long the program can remain on track. Overall, it’s hard to take this program very seriously as a document of what can and will happen, rather than what creditors would like to see happen.  It further will play right into the hands of those who criticize Europe for ignoring the contractionary effects of excessive fiscal consolidation in the crisis.  The Fund anticipates this criticism:  “The second pillar entails an ambitious and well-paced fiscal adjustment that balances short-run cyclical concerns and long-run sustainability objectives, while protecting vulnerable groups.” However, against the backdrop of a frozen banking system that will need major further deleveraging and a sharp fall in economic activity already in train, it’s hard to square that judgment with the numbers. To put the fiscal point in context, a rough guess is that the fiscal drag in the program for this year alone will be on the order of 4 ½ percent of GDP.  The effect on the economy will be multiplied: the Fund’s work suggests a multiplier of 1.7 or so in a declining growth and low interest rate environment, resulting in a GDP hit of perhaps 7 ½ percentage points.  This doesn’t account for capital controls that make it even harder for individuals and firms to smooth or adjust to the effects of these new taxes, so this estimate may be low. It will be interesting to see if the government has trouble mobilizing support in parliament for this package.  The presumption of analysts wiser than me is that the hard decisions have been taken with the bank restructuring, and incentives in Cyprus and elsewhere in Europe are strongly supportive of getting this deal done.  The one caution in this regard comes from a recent survey that found that support for the euro outstripped opposition in all countries in the Eurozone…except Cyprus, where sentiment was balanced (see below).  If it goes down to the wire, we may find that Cyprus event risk isn’t over yet.   Source: Eurobarometer data
    Blog Post by Robert Kahn April 4, 2013 Macro and Markets
  • Europe
    ECB Policy for a Fragmented Financial Market
    The ECB meets tomorrow and is expected to remain on hold.  Of the 44 market participants surveyed by Bloomberg, only one thought that the ECB would lower interest rates at this week’s meeting.  Markets do seem to hope, and may be pricing in to some extent, a more dovish tone from Governor Draghi, but at a time when the Fed is continuing expansionary policies, and the Bank of Japan is set to join them, the unwillingness of the ECB to do more stands out. I see the case for a rate cut as powerful.  Weak activity indicators, deflationary pressures, and tightening financial conditions suggest that the euro area will continue to stagnate through 2013 and into 2014.  This lack of euro-area growth, if it persists, represents a bigger threat to the survival of the Eurozone than Greece, Cyprus or the next financing crisis.  A 50 basis point (bp) cut in rates would send a strong message regarding the ECB’s commitment to "do whatever it takes."  It is all the better if it brings about a necessary weakening of the euro. A threat that the ECB does acknowledge arises from the growing fragmentation of European financial markets.  A small-to-medium sized company in Spain or Italy, especially if it’s normally funded by a second tier bank, will find credit difficult to get and if available, they will pay up to 300 bp more than a similar company in Germany (see chart).  Some portion of the premium is justified by the higher risk of doing business in the periphery, and it’s worth remembering that excessive spread compression during the years following creation of the euro was central to the buildup of imbalances.  But another portion presumably is an “excessive” risk premium that would not exist if European banks and financial markets were functioning smoothly. For the ECB, this is a job for financial policy, not monetary policy--a separation principle that most major central banks would not see as appropriate in current conditions.  From this perspective a rate cut should not be chosen if the rate is already appropriate for some hyopothetical average.  That said, the case can be made that the first best policy response is a measure targeted directly at the market imperfection that threatens fianncial stability, which in this case is the financial intermediation channel in the periphery.  The question is then how best to create incentives for banks to lend to these firms.  Central banks are understandably skeptical of the directed credit schemes in normal times, but in stress periods such as the present they need to be considered. It’s worth noting we have two recent models on which the ECB can draw.  The first is the Bank of England’s (BoE) July 2012 Funding for Lending Scheme.  The BoE scheme provides lower cost funding for banks and building societies that increase lending to U.K. households and businesses.  For additional lending up to 5 percent of total loans, participating institutions can receive 0.25 percentage point loans, provided they have sufficient eligible collateral.  While evidence on the effectiveness of the scheme is mixed (we don’t know what lending would have been absent the scheme), the BOE sees the program as successful.  Gavyn Davies is among those recently advocating that this approach get a serious look from the ECB. When asked whether the ECB would consider such a scheme, Mario Draghi argued that the existence of long-term refinancing operations, or LTROs, coupled with an easing of collateral requirements late last year, in essence replicated the effects of Funding-for-Lending.  That’s true in a sense, but its hard to make the case in current conditions that there isn’t more that can be done.   A targeted easing of collateral requirements for financing for new loans in periphery (for banks in countries where spreads are above some level?) – combined with a new LTRO -- would be a better parallel. A second recent model is the Term Asset-Backed Securities Loan Facility (TALF) that was created by the Fed in November 2008 to spur consumer lending by supporting the issuance of asset backed securities (ABS). The sharp decline in new ABS issuance in September 2008, coupled with sharply rising spreads, was the basis for the program.  The program extended loans on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. Though the borrower retained the first loss, the program was seen as effective in restarting the ABS market and keeping the flow of loans going. What both these approaches share is a targeted change in incentives to lend in the periphery.  My suspicion is, if not this week, then soon, the growing fragmentation of euro financial markets will call for a change in policy. It’s worth remembering we have models for what could come next.
    Blog Post by Robert Kahn April 3, 2013 Macro and Markets
  • Europe and Eurasia
    Why Easy Money Is Not Enough: U.S. vs. the Eurozone
    European Central Bank president Mario Draghi has promised to do “whatever it takes to preserve the euro,” and the bank’s Outright Monetary Transactions initiative last September, aimed at pulling down crisis-country bond rates, no doubt calmed market fears of a eurozone breakup. But whereas eurozone sovereign bond spreads have narrowed, the gap in real economic performance – particularly unemployment – between the best and worst performers, as shown in today’s Geo-Graphic, has continued to grow precipitously. Compare this to the United States, which has a fiscal and banking union as well as a monetary one. There, jumps in unemployment rate dispersion across states caused by financial and other shocks are reversed in relatively short order. Draghi: "Whatever It Takes" Bini Smaghi: Ireland Points Way for Cyprus and Euro Periphery IMF: Europe Needs Banking Union Bordo, Jonung, Markiewicz: Some Historical Lessons on Fiscal Union
    Blog Post by Benn Steil and Dinah Walker March 20, 2013 Geo-Graphics
  • Monetary Policy
    Exiting from Monetary Stimulus: A Better Plan for the Fed
    The U.S. Federal Reserve's monetary stimulus efforts have an undesirable side effect that needs to be managed with great care: the Fed has amassed a huge stock of mortgage-backed securities (MBS) that it will eventually want to liquidate without damaging the nascent housing recovery. What is needed to accomplish this is a relatively simple but innovative scheme whereby the Fed can, in one transaction, transform its MBS holdings into an equivalent amount of U.S. Treasury securities. Such an arrangement would allow the Fed to use conventional means of raising interest rates when inflation threatens without the worrisome economic and political consequences of selling mortgage-backed securities. The Problem In a sustained, extraordinary policy undertaking to counter the enduring economic headwinds of the 2008 financial crisis, the Fed has pumped trillions of dollars of liquidity into the banking system over the past four and a half years. It has accomplished this by buying, with newly conjured dollars, a historically unprecedented amount and variety of securities. In the process, its balance sheet has ballooned from $900 billion to $3.1 trillion, and it is expected to expand further, to about $4 trillion, later this year. At some point as the economy normalizes, most likely around 2015 according to the Fed's current view, the Fed will wish to begin tightening monetary policy in order to prevent the exceptional level of liquidity in the banking system from feeding into inflation. It would normally do this by selling securities from its oversized balance sheet. The big challenge the Fed will face in carrying this out, however, will be managing the economic and political impact of liquidating the huge stock of MBS it has amassed—currently amounting to nearly $1 trillion, and expected to reach $1.5 trillion by the end of the year. Doing so has the potential to drive up mortgage rates, depress house and real estate prices, and trigger intervention from policymakers reacting to aggrieved constituents. Federal Reserve Board chairman Ben Bernanke appears to be very aware of such risks, and he has suggested that the Fed might, at least initially, use alternative means of tightening monetary conditions—not involving securities sales—when the time comes. Yet these means are likely to be less effective, as well as equally controversial. Getting From Here to Normal If the amount of MBS outstanding remains roughly flat over the coming year, and the Fed winds up swallowing $1.5 trillion of the total stock, it will own a massive 30 percent of the market. This is not the sort of market in which the Fed will wish to be selling securities when it judges the time right to tighten monetary conditions. Such sales have the potential to generate large and sudden falls in the price of MBS, making it costlier for banks to issue mortgages and therefore driving up their rates—rates that the Fed has worked hard to push down over the past four years. Bernanke has been anxious to assure the markets that he has other tools in his chest for tightening monetary policy—two in particular. The first is to entice banks to move a portion of their excess monetary reserves held at the Fed to term deposits (similar to CDs), which would lock up that money for a fixed period. The second is to use "reverse repos," in which the Fed continuously borrows money from the banks, using its Treasury securities as collateral. Though repos are collateralized, and term deposits are not, the two tools are functionally identical. Both reduce the amount of funds banks have available to loan out, which serves the Fed's purpose of restraining credit growth and inflation. But both also have a hidden catch: the Fed will lose control over interest rates. If the Fed is unwilling to sell its mortgage securities in order to tighten policy, and if it is instead determined to drain a specific quantity of bank reserves through term deposits or the like, it will have to pay whatever rate the market demands. Simply put, the Fed must choose between managing the level of reserves and managing rates. It cannot do both. Yet the Fed is unlikely to be willing to allow rates to rise as far and as fast as the market may demand in a term deposit auction. Indeed, the European Central Bank (ECB), which has carried out many such auctions since 2010, places caps on the rates it pays. In consequence, seven of its auctions have failed, meaning that the ECB failed to withdraw euros from the market despite its public pledges to do so. The Fed will lose credibility at a crucial time if it does the same. Therefore, a conventional Fed approach to monetary tightening—selling securities from its balance sheet—is the better one, at least provided that the composition of its balance sheet does not force it to sell illiquid and sector-specific securities like MBS. The question then becomes how the Fed can normalize the composition of its balance sheet—that is, fill it completely with Treasury securities—before it needs to tighten monetary policy. The Plan The Fed should sell its MBS portfolio to the Treasury at face value in exchange for an actuarially equivalent amount of Treasury securities, newly issued for the purpose of facilitating the swap. The maturity of these new Treasury securities could be set either to match the expected maturity of the Fed's MBS portfolio or to allow them to roll off at the same pace as the Fed expects it will wish to contract its balance sheet (each approach has its own technical merits). The transaction would be neutral for the size of the Fed's balance sheet; only the composition would change. There is a clear precedent for the Treasury doing this. The Housing and Economic Recovery Act of 2008 (HERA) gave the Treasury the authority to purchase MBS guaranteed by Fannie Mae and Freddie Mac. The Treasury started buying MBS in October 2008, stopping in December 2009 when the face value of its holdings reached $192 billion. The effect of these transactions was to transfer riskier securities from the private sector to the public sector. In the case of the proposed Fed-Treasury securities swap, however, there is no such transfer of risk from the private sector to the public—one arm of government is merely swapping securities with another. The overall financial risk to the government as a whole remains unchanged. Benefits Versus Costs The benefits to the government, however, in terms of carrying out monetary policy effectively would be considerable. Instead of having to sell MBS on the market in order to soak up dollars and restrain credit growth and inflation, the Fed would be able to sell Treasury securities. The market for Treasury securities is the deepest and most liquid in the world, meaning that disruption to the market would be minimal while the impact on mortgage rates and house prices would be more moderate and less sudden than if the Fed was selling MBS. In consequence, there will also be less alarm in Congress over the possible negative economic side effects of the Fed tightening monetary policy. Concern may be raised in Congress about the risk to the Treasury of absorbing the Fed's MBS portfolio. Of course, the value of the securities can rise or fall as mortgage default rates and other factors change. The U.S. taxpayer will bear that risk for as long as any arm of the U.S. government holds them. Yet it is worth noting that if the Treasury buys them from the Fed at face value, it will immediately acquire a portfolio with unrealized gains of roughly $53 billion, according to the Fed's most recently published estimate. And if the Treasury simply holds the MBS until they mature, it will avoid the losses the Fed would suffer if it were obliged to sell those same securities in an environment in which interest rates were rising (and bond prices, therefore, falling). In short, the Fed swapping its mortgage-backed securities with the Treasury in return for Treasury securities is better for U.S. taxpayers. It preserves the value of the securities. More important, it is better for sustaining the recovery of the U.S. economy, as it affords the Fed an exit strategy from its long period of extraordinary monetary interventions that will be less disruptive to the mortgage and housing markets. Valid concern may still be raised that the Treasury, in buying the Fed's MBS portfolio, would be abetting the Fed in escaping responsibility for managing the necessary aftermath of its extraordinary market interventions. Bernanke has acknowledged that "the hurdle for using nontraditional policies should be higher than for traditional policies" because of the attendant costs, such as exposing the Fed to abnormally high financial risks. Yet if such costs can be off-loaded onto another arm of government, they may be insufficiently accounted for. HERA offers a template for future crisis interventions that addresses this concern—a template in which only the Treasury, and not the Fed, intervenes in markets other than those for its own securities.
    Policy Innovation Memorandum by Benn Steil March 14, 2013 Greenberg Center for Geoeconomic Studies
  • China
    Dr. Strangelove or: How China Learned to Stop Worrying and Love the Dollar
    China has since 1994 operated some form of currency peg, harder or softer, between its yuan and the U.S. dollar. While China’s state-run Xinhua news agency has in recent years railed against U.S. management of the dollar, and has called for “a new, stable, and secured global reserve currency,” this week’s Geo-Graphic illustrates why China has little incentive to press for such a thing. During the 1956 Suez crisis the Eisenhower administration threatened to create a sterling crisis in order to force Britain out of Egypt. A collapse in sterling would have caused minimal collateral financial damage in the United States owing to trivial U.S. government holdings of British securities – amounting to just $1 per U.S. resident. In contrast, China’s holdings of U.S. securities today amount to over $1,000 per Chinese resident. Any major fall in demand for dollar-denominated assets would cause a collapse in the global purchasing power of China’s massive dollar hoard. For its part, the United States finds congenial a world in which a dollar sent to China for cheap goods comes back overnight in the form of a near-zero interest loan, which can then be recycled through the U.S. financial system to create yet more cheap credit. Neither partner in this monetary marriage is, therefore, likely to file for divorce any time soon. Steil: Red White Steil: The Battle of Bretton Woods Eichengreen: Exorbitant Privilege Treasury: Report on Foreign Portfolio Holdings of U.S. Securities Xinhua: U.S. Must Address Its Chronic Debt Problems
    Blog Post by Benn Steil and Dinah Walker February 21, 2013 Geo-Graphics
  • Financial Markets
    The G-7, the G-20 and Exchange Rates
    For those interested in policy coordination and exchange rate policy, last week was both entertaining and informative.  U.S. Treasury official Lael Brainard’s G-20 background briefing last Monday, interpreted by some as signaling a green light to Japan for further yen depreciation in support of growth, was followed by statements that seemed to repudiate, support, then reinterpret the statement. The result was significant volatility in foreign exchange markets.  I suspect that was the opposite of what was intended.  Beyond the noise, events last week signal a policy environment where countries have great latitude to take measures that have significant effects on exchange rates.  “Currency wars” is hyperbole, but it’s capturing something real. On the surface, policy appears unchanged.  The G-7 statement on Tuesday reiterated established policy–a commitment to market determined exchange rates, a call to not target specific rates, and a willingness to act when there are excessive volatility and disorderly movements:   We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate. --Statement by G-7 Finance Ministers and Central Bank Governors, February 12, 2013.   The G-7 doesn’t always issue statements, so it was reasonable to assume that this time: (1) there was concern that the yen’s depreciation had gone far enough, for now, and that Japan shouldn’t use the bully pulpit to further talk down the currency or use foreign currency instruments to intervene; (2) concern that discussion about “currency wars” was building momentum; and (3) a desire to put down a marker that exchange rate policy coordination is primarily the domain of the G-7, not the G-20 (with U.S.-China exchange rate issues handled bilaterally). In this regard, it succeeded.  The key paragraph from the G-20 communique, along with comments from participants, signaled a tamping down of the debate:   5.  We reaffirm our commitment to cooperate for achieving a lasting reduction in global imbalances, and pursue structural reforms affecting domestic savings and improving productivity. We reiterate our commitments to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments and in this regard, work more closely with one another so we can grow together. We reiterate that excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open. --G-20 communique, February 16, 2013.   But context matters.  In a world where the major countries are enacting unorthodox policies to spur their economies, where the new Washington consensus allows for a greater role for capital controls and other macro-prudential measures, and where the United States arguably has less leverage on countries’ policies, these words take on different meaning.  My take is that, looking ahead, any country that can make a domestic case for measures that weaken the exchange rate can do so without concern for sanction from the G-7.  The country shouldn’t talk down the currency, or use a foreign currency instrument that specifically targets exchange rates, but otherwise the door is more open than it has been for some time. Of course, the lines on what is acceptable are fuzzy and will be debated.  When monetary operating systems differ, one country’s unorthodox monetary policy is another’s exchange rate intervention.  For example, it appears unacceptable in any circumstance for Japan to buy foreign currency bonds for yen, while at the same time it’s ok for countries to buy mortgage backed securities in their own currency.  Also, while fixing exchange rates is not allowed, China’s commitment to incremental, managed yuan appreciation remains acceptable. If we do have a new policy, it may be first seen in capital controls in emerging markets to stem hot money inflows.   Large scale Quantitative Easing (QE) programs, though motivated by domestic considerations, have the result that some of the newly created money will flow overseas.  This is particularly true when QE creates an expectation of currency depreciation. As these flows make their way to emerging markets, we should expect them to react.  Speculation revolves around Korea and Taiwan, given both stated hot money concerns and the importance of their trade relationship with Japan.  The hot-money story was well captured by Mexican Central Bank Governor Augustin Carstens in Singapore earlier this month (as reported by the Wall Street Journal): "Today my fear is that a perfect storm might be forming as the result of massive capital flows to some emerging-market economies and some strong performing advanced economies," Mr. Carstens said in his speech. "This could lead to bubbles characterized by asset mispricing. [Countries could] then face a reversal in flows as the major advanced economies start exiting their accommodative monetary policy stance." Carstens called for more work on when macroprudential policies should be used to address these concerns.  Carstens has strong market credentials so when he warns of a problem, his words catch attention. It may be that, within the G-20, current monetary policies are broadly appropriate for domestic considerations, and there is little reason in the near term to expect an outbreak of competitive depreciation.  But if pressures continue to build, it may become clearer that the debate over exchange rates has entered a new phase.  
    Blog Post by Robert Kahn February 19, 2013 Macro and Markets
  • Monetary Policy
    Why NGDP Targeting is a Fad
    Big-name economists have been lining up to show their support for yet another target-based approach to monetary policy making: nominal gross domestic product level (NGDP) targeting. The basic idea is that a central bank should aim to stabilize GDP, unadjusted for inflation, at around 4.5% as a means of stabilizing aggregate demand and avoiding recessions. NGDP targeting having once been the intellectual stomping ground of economists on the right (notably Scott Sumner), its newest supporters come overwhelmingly from the left (such as Christy Romer). After the collapse of Bretton Woods in the 1970s, targeting of the money supply became the monetary Holy Grail. In the 1990s, as money supply targeting became operationally too problematic, the world shifted to the targeting of consumer price inflation. But after 2008, when July U.S. CPI hit 5.6% in the midst of a financial crisis, support for inflation targeting – which had become as close to global monetary orthodoxy as the gold standard had been in the late 19th century – melted away. Credible justification was needed for loosening policy at a time of elevated inflation. A year later, with CPI at -2.1%, such justification was no longer necessary. But those fearing a too-early tightening in policy turned to other targets. Targeting the price level, rather than price inflation, became popular, as it required the Fed to tolerate more inflation in the future to compensate for deflation and under-inflation in the past. The Fed itself has now turned to a temporary unemployment-level target. But NGDP targeting is truly the new intellectual rage. New Bank of England governor Mark Carney is the most prominent advocate in policy-making circles. We think the rage will be short-lived. The reason is that NGDP targeting’s newest supporters are bad-weather fans. That is, they like it now, when NGDP is well below its 2007 “trend” line, meaning that the policy implies extended and more aggressive monetary loosening. But what happens when NGDP goes above its target, as it eventually will? NGDP targeting then requires tightening, even if inflation is low – it may even require a deliberately deflationary policy stance. In this week’s Geo-Graphic, we identify in yellow 11 periods between 1983 and 2003 when the Fed was loosening policy but where a 4.5% NGDP target would have prescribed tightening.* This suggests strongly that NGDP targeting has no legs: when it tells the Fed to tighten, its prominent new supporters will abandon it even more quickly than they embraced it. Indeed, two noted monetary economists have even called pre-emptively for the abandonment of NGDP targeting once it’s done its job of justifying looser policy today. “Once the nominal GDP growth shortfall has been eliminated,” Michael Woodford and Frederic Mishkin wrote in the Wall Street Journal on January 6, “ it will be appropriate to again conduct policy much as was done before the crisis.” Yet since the rationale behind both inflation targeting and NGDP targeting is that they anchor public expectations for the long-term, adopting them opportunistically is a particularly bad idea. * We look at the annual rate of NGDP growth, rather than NGDP levels—using levels would suggest continuous tightening throughout the period and many more yellow bars. Sumner: The Money Illusion Romer: Dear Ben: It’s Time for Your Volcker Moment Steil: The Battle of Bretton Woods Mishkin and Woodford: In Defense of the Fed's New Interest-Rate Policy
    Blog Post by Benn Steil and Dinah Walker February 12, 2013 Geo-Graphics
  • Economics
    The Fed, Credit Bubbles, and Exit
    Jeremy Stein’s speech  today–“Overheating in Credit Markets:  Origins, Measurement, and Policy Responses”–provides valuable insight on the issue of credit bubbles that could result as a consequence of current Federal Reserve policy.  As such, it speaks to the upcoming debate over the Fed’s exit strategy.  It’s a must read. Stein’s review of credit markets suggest “we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.”  Even so, that by itself is not a reason for policy to react–in Stein’s view, its when bad credit decisions are combined with excessive maturity transformation that troubles occur. One important contribution of the paper is the tour he takes through credit markets, trying to measure reach-for-yield and maturity extension behavior.  This includes major markets (e.g., high-yield corporate bonds and syndicated-leverage loans), the instruments that fund them (including money market/collateral markets) and other indicators of maturity transformation.  The evidence is mixed, but my read is that, if trends continue, eventually these patterns will become a source of concern.  At a minimum, it points to indicators  that should be followed and that are likely to make their way into Fed discussions. Finally, Stein reviews the debate over whether monetary policy, rather than supervisory/regulatory policy, should be used to deflate bubbles.  His conclusion is that while monetary policy may not be the best tool for the job, it has the important advantage of broad market effect, “reaching into corners” that supervision and regulation cannot. That could be true even if the dual mandate pointed towards a continuation of current accommodative policies.  When you have multiple instruments, you can pursue multiple objectives.  That’s a powerful statement.
    Blog Post by Robert Kahn February 7, 2013 Macro and Markets
  • Europe
    Germany’s Central Bank and the Eurozone
    Germany’s Bundesbank remains an influential actor in eurozone policymaking, and its recent disagreements with the ECB raise concerns about managing the zone’s debt crisis. This Backgrounder explains.
    Backgrounder by Christopher Alessi February 6, 2013