Wednesday, September 16, 2015

WSJ oped, director's cut





Yes,  I'm aware of lots of theory going on:
Granted, economic theories are always in flux. Advocates are ready with after-the-fact patches for traditional theories’ failures. Maybe wages are eternally "sticky" downward, so deflation spirals can't happen. Never mind. Also, researchers are busy adding “frictions” to modern models to try to make them generate huge QE effects. But for policy-making, all of this is new, hypothetical and untested.
We lost an important warning
Economic theories are useful for working out logical connections. The forward-looking [new-Keynesian] theory predicts that an interest rate peg is only stable if fiscal policy is solvent, so people trust government debt. Past interest rate pegs have fallen apart when their governments ran in to fiscal problems. That’s an important warning.
And we lost a lot of nice metaphors
The deflationary spiral story posits that the economy is inherently unstable, like a broom being held upside down. The Fed must actively move interest rates around, as you move the bottom of a broom to keep it toppling over. But when interest rates hit zero, the Fed could no longer adjust interest rates. The broom should have tipped over.  The lesson is clear: In fact, our economy is stable. Small movements of inflation will melt away on their own. The Fed does not need constantly to adjust interest rates to avoid “spirals.”
This forward-looking (new-Keynesian)  theory predicts inflation is stable because it assumes that people are smart, and look ahead. Traditional theories assume that people form their views of the future mechanically from the past. Yes, if you try to drive a car while looking in the rear view mirror, your driving will be unstable, and a Fed sitting in the right seat telling you where to go would help. But if people look out the front window, cars stably converge to the road without direction.
And on theory vs. practice
As Ben Bernanke wisely noted, “The problem with QE is that it works in practice, but it doesn’t work in theory.” That’s a big problem. If we have no theory why something works, then maybe it doesn’t really work. Doctors long saw that bleeding worked in practice— they bled patients, patients got better — but had no theory for it. 
I also had a lot more on the wonders of living the optimal quantity of money. $3 trillion of reserves means 100% reserve deposits are sitting before us. No inflation means no inflation-induced distortions of the tax code. You don't pay capital gains taxes on inflation, or return taxes on the component of return due to inflation. But all that will wait for the next one, I guess.

And the whole Neo-Fisherian question got left on the cutting room floor too. But if a 0% interest rate peg is stable, then so is a 1% interest rate peg. It follows that raising rates 1% will eventually raise inflation 1%. New Keynesian models echo this consequence of experience. And then the Fed will congratulate itself for foreseeing the inflation that, in fact, it caused.

I didn't go so far as to advocate this, back in draft mode. I don't like the way so many economists have a pet theory and rush to Washington to ask that it be implemented. But given that just how monetary policy works is so uncertain,  a robust policy choice ought to put at least some weight on such a cogent view.

The word "normal" has many connotations. John Taylor likes return to "normal," meaning return to something like a Taylor rule. When the Fed says "normal," I sense they simply mean higher nominal interest rates, and a smaller balance sheet, but continuing lots of talk and lots of discretion.   The "normal" I'm dubious of in the oped is the latter version.



    -They could have, but if anything got out of hand, it might have seriously messed up their long-term objectives. The Fed's goals (in real life) relate to the rate of core inflation being between 1 and 2%, and that's it.

    1. If you must buy X to keep the interest rate at 0%, and you buy too much, the rate will be exactly 0%. Pegging the rate at 1% is quite another cup of tea. To do so for a long run, a term in which you get all seasons pass is much easier for 0% than it is for 1%.


    Why not? The Fed pegged long term bond rates through much of WWII up until the Treasury-Fed Accord in 1951.

    1. JP,

      What the U. S. Treasury did was important in 1971. Payments on federal debt held overseas were made in gold prior to Nixon closing the gold window in 1971.

      This was the case during World War II as well. Whenever the U. S. federal government wanted to borrow, it either borrowed domestically or risked a draw down on gold reserves.

  3. Until the YoY growth rate of Corrected Money Supply nears the 0% mark, there is nothing to fear.

    The growth rate two months back was about 5.6%. Nothing catastrophic happens at that rate.

  4. QE primarily works through portfolio rebalancing, not by lowering interest rates or increasing reserves.

    The ultimate to QE bond sellers have $4 trillion in cash, which they deploy into other assets or consumption.

    The primary dealers, which sold the bonds to the Fed get $4 trillion in cash placed into their commercial bank accounts. That's your bulge in reserves.

    The short story on QE is that it resulted in $4 trillion in reserves plus another $4 trillion in the pockets of bond sellers. When the bond seller's redeploy their cash, you get stimulus.

    The NY Fed website discusses primary dealers and reserves.

  5. Dr. Cochrane. Enlightening essay. Thanks. After all these years of reading WSJ op-eds, eds and letters concerning QE, it was refreshing to (finally!) have an explanation of the essentially neutral nature of these transactions. Indeed, I would add that since the reserves generally yield less than the Treasury securities, the private sector loses interest income (about $80B last year I believe) as a result of QE operations - hardly inflationary.

  6. Yes, QE does have a "portfolio rebalancing" effect. However, I believe it may be relatively minor. For example, presumably a small part of the $85B a month transacted with QE3 found its way into equities. However, this number pales in comparison to monthly trading volume of $1T and other sources of market demand.

  7. Mark Sadowski, I know you're out there... what do you make of John's paragraph following this?:

    "Yes, I'm aware of recent empirical work that QE has some effect: [but...]"

    I'd love to see your opinion!

  8. Professor, please expand on the Neo-Fisherian -- evolutionary journey from Irving Fisher to Stanley Fischer

  9. "The experiment was huge, and the lessons are clear"....And when reserves pay the same rate as bonds, banks do not care which one they hold. So even massive bond purchase do not cause inflation. Quantitative easing is like trading a $20 bill for $10 and $5 bills. How would that make anyone spend more money?"

    What if the banking system decided it would rather lend against the excess reserves the Fed has injected into the banking system than earn the short-term reserves rate? Why wouldn't that lead to faster money growth and potential inflation? Is that lesson that QE hasn't caused inflation or that it can't?

  10. "Borrowing at 3% and lending at 6% is the same as borrowing at 0% and lending at 3%."

    I would tend to disagree. The spread income is equal, but if I lend at 6% and things turn out worse than I expect, the value of my loan book is likely to fall as credit risk rises, but the central bank can offset some of those losses by dropping the policy rate. If I lend at 3% with policy rates at zero I better be sure my borrower can pay back in any scenario because the central bank can't bail me out by lowering policy rates. This effect likely gets stronger the longer the policy rate has been at zero. Might prolonged zero rates actually tighten lending standards if not credit conditions more broadly?

  11. Anonymous: Bank loan activity is a function of the demand for loans, credit standards and loan profitability. When you take out a loan, you get credited with a new bank deposit (the bank's liability) and you have a new liability (the loan - the bank's asset). This money is created out of thin air with no reference to reserves (or deposits) - both you and the banking system have expanded its balance sheet. If reserves are in excess, they will then be reduced a bit. If the bank finds itself short of reserves, it will generally borrow in the overnight market. But this is all after the fact of the loan. Thus there is no direct transmission mechanism form higher bank reserves to higher loan activity - and possible inflationary pressures. Loans create deposits, not the other way around. I know this is not what the money and banking and economics textbooks teach, but that's my understanding.

    1. Isn't there an important difference between reserves and short-term treasuries that Dr. Cochrane says are equivalent though? When reserves are held in place of short-term treasuries, if the banking system wants a greater share of total assets in loans/credit securities it must increase loans and expand the money supply to achieve that objective since total reserves are set by the Fed (assuming loan demand of course). If short-term treasuries are held, can't the banking system sell these treasuries to the non-bank sector and achieve a greater share of total assets in higher yielding loans/securities without having to increase the money supply?

      I don't disagree with Dr. Cochrane that QE wasn't very effective. I'm just trying to determine if QE didn't create inflation or if it is impossible for it to create inflation in any environment. Because if it is possible in some scenario wouldn't it be better to reduce reserves rather than maintain them as Dr. Cochrane suggests?

    2. Yes, I believe you are correct that there could be differences between owning short-term Treasuries vs. reserves in terms of the motivation for increasing loans. . In your example, owning reserves could lead to more loans than owning Treasuries.. I was just pointing out that banks don't "lend out" reserves (or deposits) . It is fascinating to me that even though the money and banking textbooks tell us differently, it has always been this way. That is, banks are not "intermediaries" between savers and borrowers. Consider this quote from 56 years ago:


  12. === ===
    Cochrane above: Unemployment, [1] at 5.1%, has recovered to near normal. And banks and businesses [2] sitting on huge piles of cash don’t go bust, a boon to financial stability.

    Yes, economic growth is too slow, [3] too many Americans have dropped out of the workforce, earnings are stagnant, and the country faces other serious challenges. But monetary policy can’t solve long-term structural problems.
    === ===

    The [1] 5.1% unemployment rate is one of many measures, and this is the one that makes things look good. Especially since [3] it leaves out people who have dropped out and doesn't account for movement to lower paying or fewer-hour jobs.

    Businesses used to be favored for efficiently using capital, and not [2] sitting on large piles of cash. That cash represents a reluctance to invest combined with a fear of the future. It would add to inflation if any inflation arises. The cash would be distributed as dividends in better times.

    How can the success of monetary policy be measured by politically prepared statistics? How can an economy benefit by pretending that there is no time-value or scarcity of resources (0% interest rates)?

    The Fed is publicly manipulating interest rates and money without knowing the full effects. Life is hard enough for an investor, and this introduces more things to go wrong. How can this possibly encourage investment and the development of businesses?

    The Fed is afraid to raise interbank interest rates by 1/4%, despite the supposed glowing state of the monetary economy. They understand that they don't understand all of the effects from what they are doing.

  13. Mr. Bear vs. Mr. Market ---- odd are in favor of....


