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.
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):
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):
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:
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.
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:
* 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.
Ezra Klein reports an official statement from Anthony Coley, a Treasury spokesperson, killing the platinum coin strategy:
“Neither the Treasury Department nor the Federal Reserve believes that the law can or should be used to facilitate the production of platinum coins for the purpose of avoiding an increase in the debt limit.”
So R.I.P. platinum coins of unusual size.
The administration has previously ruled out another oft-discussed debt-limit safety valve, overriding the limit based on the 14th amendment. So “Plan B” discussions will now move to two other alternatives that have been bandied about: prioritizing payments or, as Ed Kleinbard suggested the other day, issuing scrip like California did a couple years ago. Of course, issuing scrip *is* prioritizing payments, but with the added feature (or complication) of a written, transferable IOU.
Policy wonks are debating whether a trillion-dollar platinum coin would be a clever or insane way for President Obama to play hardball with Republicans in the upcoming debt limit battle. Here’s what you should know about this crazy-sounding idea:
1. A legal loophole gives the Treasury Secretary apparently unlimited authority to mint platinum coins.
Treasury is forbidden from printing money to cover government deficits. Treasury must issue debt, while the Federal Reserve independently controls our nation’s monetary printing press.
That is exactly as it should be. But there is an arcane exception for platinum coins. To serve coin collectors, Treasury can issue platinum coins of any denomination. That creates an intriguing loophole: Treasury could bypass the collector market and mint a trillion-dollar platinum coin. By depositing it at the Federal Reserve, Treasury could keep paying bills after we’ve fully exhausted our borrowing limit.
2. Most observers think this is a terrible idea, but the legal arguments against it are weak at best.
A who’s who of commentators has already objected to the coin on legal, economic, political, and image grounds (see, for example, John Carney, Matt Cooper, Tyler Cowen, Kevin Drum, Jim Hamilton, Heidi Moore, and Felix Salmon). I’m no lawyer, but the legal arguments seem wholly unconvincing. The language of the statute is clear, and in any case, the executive branch gets away with expansive actions in extreme times. During the financial crisis, for example, Treasury aggressively interpreted its authorities in order to bail out GM and Chrysler and to backstop money market funds. If default became a real possibility, the same expansiveness could easily justify a platinum coin.
3. The economic arguments against the coin are stronger but manageable.
There’s a good reason that Treasury is forbidden from printing money to pay our debts: inflation. Many economies have been ruined when profligate governments turned to printing money. But minting the platinum coin needn’t mean monetizing our debt. The Federal Reserve has ample ability to offset any inflationary impact by selling some of the trillions in Treasury securities it already owns. As long as the Fed does its job, inflation would not be a risk.
4. The best arguments against the platinum coin involve image and politics.
Minting a trillion-dollar coin sounds like the plot of a Simpsons episode or an Austin Powers sequel. It lacks dignity. And despite modern cynicism, that means something.
It would also be premature. President Obama and the Republican and Democratic members of Congress have roughly two months to strike a debt limit deal. There is no reason to short-circuit that process, as painful as it may be, with preemptive currency minting as the now-famous #MintTheCoin petition to the White House suggests.
5. Nonetheless the platinum coin strategy might be better than the alternatives if we reach the brink of default.
Analysts have considered a range of other options for avoiding default, including prioritizing payments, asserting the debt limit is unconstitutional, and temporarily selling the gold in Fort Knox. All raise severe practical, legal, and image problems.
In this ugly group, the platinum coin looks relatively shiny. In particular, it would be much less provocative than President Obama asserting the debt limit is unconstitutional. That nuclear option would create a political crisis, while a platinum coin could be a constructive bargaining chip. As Josh Barro notes, President Obama could offer to close the platinum coin loophole as part of a deal to raise or eliminate the debt ceiling.
6. If necessary, Treasury should mint smaller platinum coins, not a trillion-dollar one.
A trillion-dollar coin is eye-catching and ridiculous. That’s why it’s filled the punditry void left by the fiscal cliff. But a single coin makes no policy sense. No federal transactions occur in trillion-dollar increments.
Among the largest transactions are Treasury bond auctions, which today raise about $25 billion at a time. If necessary, Treasury could issue individual $25 billion coins, each in lieu of a needed bond auction. Still ridiculous, to be sure, but less so as it would calibrate coin issuance to immediate financing needs.
Steve Randy Waldman suggests as even more granular approach: issuing coins denominated in millions not billions. Such “small” denominations would be even less ridiculous and could potentially be used in transactions with private firms, not just Fed deposits.
Of course, the best path would be a bipartisan agreement to increase the debt limit, address spending cuts, and strengthen our fiscal future, all settled before the precipice. If we reach the brink, however, minting million- or billion-dollar platinum coins would be better than default.
Federal Reserve Chairman Ben Bernanke is often characterized as a inflation-monger. There’s just one problem with that criticism. As David Leonhardt demonstrates in the New York Times, when it comes to inflation, Bernanke is a piker compared to most of his predecessors:Inflation has averaged just 2.3% under his leadership (as officially measured), less than under Greenspan, Volcker, Burns, or Miller and only slightly more than under Martin.
It’s conceivable, of course, that inflation will take off in coming years, and the critics will be proven right. At this point, however, that’s nothing more than speculation. And before you make that bet, keep one thing in mind. Bernanke is the first chairman to have the ability to pay interest on excess bank reserves. That’s a powerful tool for keeping reserves out of the marketplace if the inflation genie threatens to come out of its bottle.
The Fed’s quantitative easing programs did indeed lower interest rates, but more so for Treasuries and mortgage-backed securities than for other kinds of debt. Small businesses are overrated as job creators. Extended unemployment insurance does increase unemployment rates, but not that much.
Those are just a few of the findings from papers presented today at the Brookings Institution’s twice-yearly conference, Brookings Papers on Economic Activity.
Courtesy of a Brookings release, here are brief summaries of five papers discussed today:
In Recession and the Costs of Lost Jobs, authors Steve Davis of the University of Chicago and Til von Wachter of Columbia University find that when mass-layoffs occur in good economic times, men with 3 or more years of job tenure suffer a $65,000 loss in the lifetime value of their earnings (a fall of about 10%), relative to otherwise similar workers who retain their jobs. But in a recession, a similar shock causes workers to lose $112,000 in the lifetime value of their future earnings (or about 19%). The authors also track worker perceptions about layoff risks, job-finding prospects, and the likelihood of wage cuts, finding a tremendous increase in worker anxieties about their labor market prospects after the financial crisis of 2008. This heightened anxiety continues today, they find. Davis and von Wachter also show that prior economic employment models have been unable to address the facts about the earnings losses associated with job loss, yet those earnings impacts appear to be one of the main reasons that individuals and policymakers are so concerned with recessions and unemployment. Finally, they note that pro-growth policies may be the most efficient and cost-effective means available to policymakers to alleviate the hardships experienced by displaced workers.
In What Do Small Businesses Do authors Erik Hurst and Benjamin Wild Pugsley of the University of Chicago overturn the conventional wisdom about the role of small business, finding that they aren’t the job engine most believe them to be. Most small business owners neither expect nor desire to grow or innovate, but rather intend to provide an existing service to an existing customer base. Analyzing new survey data, the authors find that, instead, it is non-financial reasons — such as work flexibility and the desire to be one’s own boss – that are the most common reason that entrepreneurs start their own business. Hurst and Pugsley note this behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftsmen, lawyers, real estate agents, doctors, small shopkeepers, and restaurateurs. They conclude that standard theories of entrepreneurship may be misguided and result in sub-optimal public policy, suggesting that subsidies for small businesses may be better spent if they are targeted to businesses that expect to grow and innovate, rather than small businesses in general. They laud the partnership between the US Small Business Administration and venture capital firms as an example of strong targeted public policy.
In Unemployment Insurance and Job Search in the Great Recession, Jesse Rothstein of the University of California, Berkeley finds that recent extensions to the period in which the unemployed can draw unemployment benefits had a significant but small negative effect on the probability that eligible unemployed would exit unemployment, and that the effect is mainly concentrated among the long-term unemployed. Rothstein calculates that without those extensions, the unemployment rate would have been about 0.2-0.6 percentage points lower—a much smaller impact than implied by previous analyses, and that the long-term unemployment rate would have been even lower. He finds that half or more of these impacts are due to the unemployed remaining in the labor force rather than reductions in the chances of finding employment. As a result, Rothstein suggests that a generous extension of UI benefit in deep recessions should last until the labor market is strong again, thus giving displaced workers a realistic chance of finding new employment before their benefits expire.
In The Effects of Quantitative Easing on Interest Rates, Arvind Krishnamurthy and Annette Vissing-Jorgensen of Northwestern University show that the Federal Reserve’s recent quantitative easing (QE) programs (“QE1” and “QE2”) did in fact significantly lower interest rates on Treasury securities, as well as GSE bonds and highly rated corporate bonds. They also find that such programs affect interest rates differently depending on which assets are purchased: QE1, which involved the purchase of mortgage-backed securities (MBS) in addition to Treasury securities, significantly lowered MBS rates, whereas QE2, which focused exclusively on Treasury securities, had little effect on MBS rates. The authors identify several channels through which QE affects interest rates: first, QE increases the premium paid for assets with low-default risk (and thus lowers rates on these assets), by reducing the supply of such assets available to investors; second, QE drives down interest rates broadly by signaling a commitment by the Federal Reserve to keep interest rates low for a long period; and third, when QE involves purchases of mortgage-related assets, it lowers rates on such assets by affecting the price of mortgage-specific risk. Because QE does not affect all long-term interest rates equally, examining the impact of a QE policy that focuses on purchases of Treasury securities on long-term Treasury rates is likely to overstate the program’s impact on the long-term corporate and mortgage interest rates that all relevant to investment and housing demand. Interestingly, the results about having the Fed use its communication channel alone – that is, signaling its intentions – might be having a significant impact on rates without having the Fed actually take on the risks associated with increasing its balance sheet. The authors also conclude that expected inflation increased substantially due to QE1 and modestly due to QE2, implying that reductions in real rates were larger than reductions in nominal rates.
In Practical Monetary Policy: Examples from Sweden and the United States, Lars E.O. Svensson, the Deputy Governor of the Swedish Central Bank (Sveriges Riksbank) analyzes the actions of the U.S. Federal Reserve and the Swedish Riksbank during and after the summer of 2010, looking for evidence that perhaps central banks make mistakes. In that time period, both the Fed and Riksbank forecasts for inflation were below their target and their forecasts for unemployment were above the sustainable unemployment rate, suggesting that more expansionary policy was warranted. However, the Riksbank tightened policy while the Federal Reserve held rates steady. Although the Swedish economy developed better than expected, and the U.S. economy developed worse than anticipated, Svensson argues that these developments were the result of external factors — not, in fact, the nations’ respective monetary policies. The Riksbank benefited from higher-than-anticipated domestic and export demand, upward revisions of GDP data, and a lack of structural problems. On the other hand, the Fed had to contend with fiscal policy problems, a slower housing market recovery, and substantial downward revisions of GDP data. The author concludes that the Riksbank’s decision to tighten policy is difficult to justify, while the Federal Reserve’s decision not to tighten was appropriate, although there is also a case to be made that they should have eased more.
In case you haven’t heard of him, let me introduce Brian Sack. As Executive Vice President at the New York Fed, he’s the guy in charge of implementing the Federal Reserves’s monetary policy efforts including all the purchases of agency securities and Treasury bonds in QE1 and QE2 (LSAP1 and LSAP2 in Fedspeak, where they are known as large-scale asset purchases).
Sack gave an interesting speech last week on the Fed’s $2.654 trillion portfolio. Among other things, he reiterated the Fed view that the impact of the portfolio comes from the owning, not just the buying:
Lastly, I should note that the market seems to have adjusted fairly well so far to the end of the purchase program. The pace of the Desk’s purchases fell back sharply at the end of June, as we moved from expanding the portfolio to simply reinvesting principal payments. In particular, our purchases slowed from an average pace of about $100 billion per month through June to an anticipated pace of about $15 billion per month going forward. We do not expect this adjustment to our purchases to produce significant upward pressure on interest rates or a tightening of broader financial conditions, given our view that the effects of the program arise primarily from the stock of our holdings rather than the flow of our purchases. While there has been considerable volatility in Treasury yields over the past several weeks, we attribute those movements primarily to incoming economic data and to broader risk events. However, we will continue to watch the markets and assess their adjustment to the end of the purchase program.
As noted earlier, the current directive from the FOMC is to reinvest principal payments on the securities we hold in order to maintain the level of domestic assets in the SOMA portfolio. This approach can be interpreted as keeping monetary policy on hold. Indeed, one can generally think of the stance of monetary policy in terms of two tools—the level of the federal funds rate, and the amount and type of assets held on the Federal Reserve’s balance sheet. The FOMC has decided to keep both of these tools basically unchanged for now. (Emphasis added)
In short, quantitative easing is over, but quantitative accommodation is still boosting the economy.
Sack also offered a rule of thumb equating each $250 billion in asset purchases to a 25 basis point reduction in the federal funds rate. By that metric, the $1.6 trillion in asset purchases has been the equivalent of lowering short-term rates by about 1.6 percentage points. (Over at Econbrowser, however, James Hamilton suggests that impact may be significantly smaller.)
Everyone has been writing epitaphs for the “end” of QE2, the Federal Reserve’s program to buy $600 billion in Treasury bonds.
In a narrow sense, they are right: the Fed just completed those purchases. What most coverage misses, however, is that the effects of “quantitive easing” depend at least as much on the Fed’s owning the bonds as buying them. The stock matters at least as much as the flow.*
The epitaphs apply only to the buying. The stock–Fed ownership of $600 billion in Treasury bonds–is still with us.
Which brings us to today’s question: What should we call that? To say that QE2 is over leaves the impression that the program is over. It’s not.
One answer would be to expand the definition of QE2 to include the owning as well as the buying. In that case, we’d simply say that QE2 is still in place.
That strikes me as the cleanest solution except for one thing: almost everyone seems to want to believe that QE2 is over. So we need a new name.
To get some inspiration, consider the three stages of traditional monetary policy. You know, the kind where the Federal Reserve moves short-term interest rates up and down:
Stage 1, quantitative easing, just ended. When the Fed someday starts selling, that will clearly be quantitative tightening.
But what about stage 2? The best I can come up with is quantitative accommodation, QA for short.
That doesn’t really flow off the tongue, and better suggestions would be welcome.
For now, though, here’s my recommendation: If you insist on saying that QE2 is over, you should also be saying that QA2 just began.
* For example, here’s Chairman Bernanke discussing stocks and flows at his inaugural press conferencein April:
[W]e subscribe generally to what we call here the stock view of the effects of securities purchases, which—by which I mean that what matters primarily for interest rates, stock prices, and so on is not the pace of ongoing purchase, but rather the size of the portfolio that the Federal Reserve holds. And so, when we complete the program, as you noted, we are going to continue to reinvest maturing securities, both Treasuries and MBS, and so the amount of securities that we hold will remain approximately constant. Therefore, we shouldn’t expect any major effect of that. Put another way, the amount of ease, monetary policy easing, should essentially remain constant going forward from—from June.