Archive for the ‘Macroeconomics’ Category

Yesterday, the Federal Reserve confirmed that it would end new purchases of Treasury bonds and mortgage-backed securities (MBS)—what’s known as quantitative easing—in October. In response, the media are heralding the end of the Fed’s stimulus:

“Fed Stimulus is Really Going to End and Nobody Cares,” says the Wall Street Journal.

“Federal Reserve Plans to End Stimulus in October,” reports the BBC.

This is utterly wrong.

What the Fed is about to do is stop increasing the amount of stimulus it provides. For the mathematically inclined, it’s the first derivative of stimulus that is going to zero, not stimulus itself. For the analogy-inclined, it’s as though the Fed had announced (in more normal times) that it would stop cutting interest rates. New stimulus is ending, not the stimulus that’s already in place.

The Federal Reserve has piled up more than $4 trillion in long-term Treasuries and MBS, thus forcing investors to move into other assets. There’s great debate about how much stimulus that provides. But whatever it is, it will persist after the Fed stops adding to its holdings.

P.S. I have just espoused what is known as the “stock” view of quantitative easing, i.e., that it’s the stock of assets owned by the Fed that matters. A competing “flow” view holds that it’s the pace of purchases that matters. If there’s any good evidence for the “flow” view, I’d love to see it. It may be that both matter. In that case, my point still stands: the Fed will still be providing stimulus through the stock effect.

P.P.S. I wrote about this last year during the tapering debate. In the lingo of that post, the Fed is moving from quantitative easing to quantitative accommodation. To actually eliminate the stimulus, the Fed would have to move on to quantitative tightening.

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Because macroeconomists have messed it up for every one else , says Noah Smith at The Week:

To put it mildly, economists have fallen out of favor with the public since 2008. First they failed to predict the crisis, or even to acknowledge that such crises were possible. Then they failed to agree on a solution to the recession, leaving us floundering. No wonder there has been a steady flow of anti-economics articles (for example, this, this, and this). The rakes and pitchforks are out, and the mob is ready to assault the mansion of these social-science Frankensteins.

But before you start throwing the torches, there is something I must tell you: The people you are mad at are only a small fraction of the economics profession. When people in the media say “economists,” what they usually mean is “macroeconomists.” Macroeconomists are the economists whose job is to study business cycles — booms and busts, unemployment, etc. “Macro,” as we know it in the profession, is sort of the glamor division of econ — everyone wants to know whether the economy is going to do well or poorly. Macro was what Keynes wrote about, as did Milton Friedman and Friedrich Hayek.

The problem is that it’s hard to get any usable results from macroeconomics. You can’t put the macroeconomy in a laboratory and test it. You can’t go back and run history again. You can try to compare different countries, but there are so many differences that it’s hard to know which one matters. Because it’s so hard to test out their theories, macroeconomists usually end up arguing back and forth and never reaching agreement.

Meanwhile, there are many other branches of economics, doing many vital things.

What are those vital things? Some economists find ways to improve social policies that help the unemployed, disabled, and other vulnerable populations. Others design auctions for Google. Some evaluate development polices for Kenya. Others help start-ups. And on and on. Love it or hate it, their work should be judged on its own merits, not lumped in with the very different world of macroeconomics.

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A tribute to Ben Bernanke, sung to the tune of Rudolph the Red-Nosed Reindeer. University of Chicago professor Anil Kashyap unveiled this Friday at economists’ big annual conference.

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The Council of Economic Advisers just released an interesting paper examining the macroeconomic harm from the government shutdown and debt limit brinksmanship. To do so, they created a Weekly Economic Index from data that are released either daily or weekly (and weren’t delayed by the shutdown). These data include measures of consumer sentiment, unemployment claims, retail sales, steel production, and mortgage purchase applications.

The headline result: They estimate that the budget showdown cost about 120,000 jobs by October 12.

Looking ahead, I wonder whether this index might prove useful in identifying future shocks to the economy, whether positive or negative. As the authors note:

In normal times estimating weekly changes in the economy is likely to detract from the focus on the more meaningful longer term trends in the economy which are best measured over a monthly, quarterly, or even yearly basis. But when there is a sharp shift in the economic environment, analyzing high-frequency changes with only a very short lag since they occurred can be very valuable.

P.S. I am pleased to see CEA come down on the right side of the “brinksmanship” vs. “brinkmanship” debate.

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Ray Dalio, founder of the remarkably successful Bridgewater Associates, has released a 30 minute video explaining his vision of “How the Economic Machine Works.” Well worth watching, particularly his description of a beautiful deleveraging.

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James Bullard, head of the St. Louis Federal Reserve Bank, gave a nice presentation on “The Tapering Debate” today. See the whole thing here.

One question he considers is whether the Fed balance sheet is getting scarily big. It’s certainly large by U.S. historical standards — the only time is was bigger, relative to the size of the economy, was in the 1940s.

By current international standards, however, the Fed balance sheet isn’t an outlier. In fact, Japan, Europe, and the United Kingdom all have larger central bank balance sheets, relative to their economies, than we do (FRB = Federal Reserve Bank):


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The Fed believes the stimulus from quantitative easing depends on the stock of Treasuries and mortgage-backed securities that it owns, not on the flow of its purchases. If that view is correct, the future tapering of Fed purchases won’t be monetary tightening, it will a slowing pace of monetary easing (click for larger chart):

Tapering is not tightening

The chart shows a hypothetical trajectory for the Fed’s bond and MBS holdings. Under the stock view, that trajectory will go through three stages, paralleling those of traditional interest rate policy:

  • Quantitative easing: The Fed expands its balance sheet by buying Treasuries and MBS. Current pace: $85 billion each month.
  • Quantitative accommodation: The Fed maintains its balance sheet; it buys new assets to replace older ones as they mature.
  • Quantitative tightening: The Fed contracts its balance sheet by allowing assets to mature without replacement or, more aggressively, by selling them.

In this view, tapering is the final stage of quantitative easing. The Fed buys assets during tapering, but at a slower tempo. Tapering is not tightening.

That view is clear, logical, and elegant. But it utterly fails to explain why financial markets went haywire last week when Ben Bernanke and company talked about tapering.

One reason is investor expectations. The Fed has been trying to stimulate the economy not only through QE, but also by telling investors to expect easing in the future. Such forward guidance can be a powerful lever for monetary policy.

Tapering is tightening

Last week, investors learned that QE might end sooner than they expected. In the stock view with expectations, that is monetary tightening. As illustrated in the second chart, future Fed policy would be tighter than financial markets had previously thought.*

This view likely explains some of the market reaction to recent Fed statements. But it’s hard to reconcile the magnitude of the movements. Suppose markets expected tapering to begin in January and now think September more likely. All else equal, that four-month difference implies a $340 billion reduction in the Fed’s ultimate portfolio. That’s something, but could that alone explain the sharp market response?

My sense it that something else must be going on as well. Some candidates include:

  • Perhaps the flow of Fed purchases matters, not just the stock. This view appears much more common among traders than Fed economists. If anyone has a reference for a good articulation of this view, I’d love to see it. The flow shouldn’t matter in normal times—was the Fed tightening when the flow of purchases was essentially zero for decades before the recent crisis?—but these are hardly normal times. Perhaps the flow matters when you are at the zero lower bound?
  • Perhaps world financial markets expected a much longer period of QE and are highly geared to Fed policy. If I am reading it correctly, that’s the view of Vince Foster who discusses the unwinding of the carry trade (ht Tyler Cowen)

* This definition of tightening compares the new expected trajectory of Fed holdings to prior expectations. Such comparisons are relative; in principle, one could equally say that the Fed announcement indicated that future policy would be less loose, not that it would be tighter. But for most purposes, it seems simpler just to say that future policy has gotten tighter. The same semantic issue exists in fiscal policy. If Medicare spending is scheduled to grow $35 billion next year, what do we call a proposal under which spending increases $30 billion? We usually call that a $5 billion spending cut since it’s a decline relative to an accepted baseline. But we should remember that Medicare spending is growing. The same seems true with early tapering. Tightening seems the cleanest description for most purposes, even though in absolute terms it is slower easing.

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The Federal Reserve reportedly wants consumer inflation of about 2 percent per year, as measured by the personal consumption expenditures price index, affectionately known as the PCE. By that standard, Fed policy appears too tight, despite near-zero rates and ongoing QE:

PCE Inflation - March 2013

Over the past year, the headline PCE (dashed blue line) has increased only 1.0 percent, and the core PCE (orange line) is up only 1.1 percent. The core PCE strips out often-volatile food and energy prices not, as some wags would have it, because economists don’t drive, eat, or heat their homes, but because the resulting series appears to be a better predictor of future inflation trends (i.e., less noise, more signal).

At the moment, both measures are close together — and far below the Fed’s alleged target.

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By many accounts, Sweden did a great job managing its financial and fiscal crises in the early 1990s. But more than 20 years onward, its unemployment rate is still higher than before the crisis, as noted in a recent commentary by the Cleveland Fed’s O. Emre Ergungor (ht: Torsten Slok):


And its labor force participation rate is still lower:


Does Sweden’s experience portend similar problems for the United States? Ergungor thinks not. Instead, he attributes this shift to a structural change in Swedish policy that has no direct analog in the United States:

One study of public sector employment policies published in 2008 by Hans-Ulrich Derlien and Guy Peters indicates that for many years, the labor market had been kept artificially tight by government policies that replaced disappearing jobs in failing industries with jobs in the government. The financial crisis was the breaking point of an economic system that had grown increasingly more unstable over a long period of time. It was a watershed event that marked the end of an unsustainable structure and the beginning of a new one. Public sector employment declined from 423,000 in 1985 to 240,000 in 1996 mainly through the privatization of large employers—like the Swedish postal service, the Swedish Telecommunications Administration, and Vattenfall, the electricity enterprise—and it has remained almost flat since then.

With such a large structural change, what came before the crisis may no longer be a reference point for what will come after. Having corrected the root of the problem, the Swedish labor market is now operating at a new equilibrium.

That doesn’t mean smooth sailing for the United States, as he discusses. But it does leave hope that perhaps we do better than Sweden in creating jobs in the wake of a financial crisis.

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