The Incredible Shifting Model

Robert Tetlow has published a fascinating research paper in the International Journal of Central Banking on policy robustness with the Fed’s FRB/US model. Perhaps the most important part of the paper is his careful documentation of the enormous shifts in the coefficients and the equations of FRB/US over time. This chart from the paper illustrates these shifts. The solid black line plots changes in the estimated sacrifice ratio of unemployment to changes in inflation implied by the model over 64 vintages.

tetlow chart 1

Given these large shifts in the model it is not surprising that monetary policy rules calculated with the model shift over time. This is why robustness studies are so important.

A typical robustness study looks at different models. It takes policy rules that work well in one model and tries them out in other models.  If the rules also work well in other models, then the rules are considered robust. Volker Wieland’s macro model data base with 61 different models is ideal for such robustness studies.

Tetlow takes a related but different approach to robustness. Rather considering different models, he looks at the different vintages of FRB/US that have been used for policy work since the mid-1990s. He then compares a bunch of different policy rules derived from each model-vintage including a model-specific Taylor rule as a “benchmark for comparison.”

For the case where the policy makers know the model and calculate the rule based on that specific model, he finds that the Taylor rule “renders a very good performance with losses that are lower than nearly all of the alternatives” or “does pretty well on average” depending on the time period examined.

But he then looks at how rules calculated for one model-vintage work in a different model-vintage. Because of the huge shifts in the model, the policy rules change a lot with vintages. This chart from the paper shows how model-specific (optimized) Taylor rule coefficients change as the model-vintage changes.

Tetlow chart 2 Tetlow finds that performance with such a model-specific Taylor rule is about in the middle of the pack in terms of robustness, but he also finds that some rules like “pure inflation-targeting rules” are not robust,” that “adding an instrument smoothing term…contributes little to the robustness,” and that “notwithstanding problems of mismeasurement of output gaps, it generally pays for policy to feedback on some measure of excess demand.”

Of course, the model-specific rules in Tetlow’s study are not designed to be robust. An important question for future research is whether rules designed with robustness in mind would be more robust than the model-specific rules that Tetlow examines.

I note that the IJCB, which is an important outlet for serious policy-relevant applied research on central banking, is having its 10th anniversary this year. John Williams is now the managing editor and before him were Ben Bernanke, Frank Smets, and me.

Posted in Monetary Policy

Seeking a Way through the Fog of a Currency War

Many have speculated on the nature of, and the reasons for, the exchange rate regime change in China last week. While the central bank has issued press statements and answered questions about it intentions, it is useful to look at the data.

First note how this change in regime compares with the regime change ten years ago when China went off the peg with the dollar. The chart below plots the percentage change in the Chinese Yuan per dollar in the two periods.  Note that both regime shifts started out exactly the same way—with a 2 percent change—appreciation in 2005 and deprecation in 2015.   But then you begin to see a real difference.  cnyusdIn 2005 there was virtually no change in the exchange rate as China began a very slow appreciation over a period of months and years with a temporary halt during the financial crisis.  This time, however, they let the rate move again on day 2 and on day 3, and they even let it appreciate a bit on day 4.  Of course the rate is still being managed—and we will learn more in upcoming days—but it is clearly more flexible and will be more flexible than in the years following the move in the summer of 2005.

I recall the first G7 meeting that the Chinese central bank governor attended.  Zhou Xiaochuan was the governor then and, of course, he is still governor now. Regarding the end of the dollar peg in 2005, Governor Zhou was asked at that G7 meeting about when China would start letting its exchange rate move. He answered “That is a difficult question…We don’t have a timetable. There is an old Chinese story about crossing a stream by walking from stone to stone. You can’t set a timeline because you don’t know which stones will be secure enough to step on.  But please believe me when I say that China is going to do this.” That answer pertains today even though he is taking bigger steps.

Why is China taking these new steps? Perhaps the IMF’s recent SDR analysis saying that the yuan needs to be more flexible and market sensitive is a factor, or perhaps it is the slowing Chinese economy. However, the most significant factor, in my view, relates to the recent large exchange rate movements around the world which appear to be largely due to unconventional monetary policy shifts in the United States, Japan and Europe, and the accompanying depreciations that have followed in many emerging market countries.

This developing story probably begins with the impact of quantitative easing in the United States on exchange rates, especially the Japanese yen. Following the financial crisis and into recovery, the yen significantly appreciated against the dollar as the Fed repeatedly extended its zero interest rate policy and its large scale asset purchases. Concerned about the adverse economic effects of the currency appreciation, the Abe government urged the Bank of Japan to implement its own massive quantitative easing, and, with a new governor at the Bank of Japan, this is exactly what happened.  As a result of this change in policy the yen fully reversed its course and has depreciated to levels before the panic of 2008.  In this way the policy of one central bank appeares to have affected the policy of another central bank.

The moves of the ECB toward quantitative easing in the past year have similar motivations. An appreciating euro was in the view of the ECB a cause of the weak economy.  The response was to shift to lower rates in the Eurozone and the initiation of quantitative easing. Indeed, the shift and initiation was followed by a dollar strengthening and a weaker euro. The taper tantrum and the reversal of capital flows led to dollar strengthening against the emerging market countries.  With all these uncertain developments in the background—call them the fog of a currency war—the recent actions of the central bank of China to let the yuan move with other currencies and away from the dollar are understandable.

Posted in International Economics

On Why The Economist Should Rule Rules In, Not Out

An old, but forever crucial, question for monetary policy is whether it should be rules-based or purely discretionary. The Economist, in a Free Exchange article this week with the title “Rule It Out,” goes all in for pure discretion, abandoning rules-based strategy. It’s a new view compared to previous articles over the years in the magazine and, more importantly, not based on any new facts.

The article’s main mode of argument is to invent and then shoot down straw men.  It argues, for example, that “Algorithms…should not supplant central bankers” even though no proposal out there suggests anything of the kind. It asserts that a rules-based policy is an “unnecessary constraint” on central bank “autonomy,” when experience shows that clear strategies and principles help defend autonomy.  Strangely, it says that sensible flexibility built into rules-based policy demonstraes its “pitfalls” which are then never even mentioned.  The article is so infatuated with unlimited distretion that it even argues that if the Congress wants oversight it would be better to designate another purely discretionary body to give opinions about monetary policy than to ask the central bank to report on and be accountable for its own policy rule or strategy.

In trying to justify discretionary policy the article discusses the Taylor rule in detail, adding a Taylor rule chart cutely labeled “Dropping Stitches;” in doing so it repeats arguments that have been refuted or discounted many times over the years.  It says that “interest rates should be lower than the Taylor rule suggests” because “many economists suspect [the long-term real interest] rate is permanently lower,” and it says that “Estimates of slack are themselves the product of qualitative judgment…” Debates over the long-term rate and the degree of slack are fine to have, but the issues create no more difficulty for rules-based policy than for pure discretion. In fact, a rules-based policy is preferable in this regard because it provides a way to consider the implications of, and to resolve disagreements about, such issues without sweeping them under the rug. A policy rule is not “a recipe for disagreement,” as the article claims, it is a reasonable way to discuss and resolve disagreements.

I got a little bit of déjà vu about the discussion of the Taylor rule in the article, and decided to look back at previous articles in the magazine. In fact, The Economist has published quite a few articles and charts about the Taylor rule over the years, but, completely unlike the article this week, those articles used the rule in a constructive way to discuss and take positions about monetary policy.

I recalled a piece published in The Economist almost two decades ago entitled “Monetary Policy, Made to Measure” (August 1996) with a chart labeled (yes, you guessed it) “Well Taylored.”  It asked if there was a rule “which will tell central bankers how to adapt their policies…” and then described the Taylor rule as “one such rule…”  It discussed the uncertainty about the “neutral” interest rate and the “output gap” in the rule and recognized that the rule “includes only part of the information available to central banks,” which meant that such a rule should not be used mechanically without central bankers exercising discretion in its implementation—a view of rules-based policy that I expressed clearly when I introduced the rule a few years earlier and continue to hold. Nevertheless, the 1996 Economist article used the rule—as many others were doing—to make the case that monetary policy was about right in several countries at the time.

Then there was the famous period when The Economist criticized the Fed for deviating from rules-based policy.  The article “Nicely Taylored?” from November 2004 used the rule to suggest that interest rates ought to have been rising faster.  Then, later looking back at that period from the vantage point of August 2007, The Economist argued that “By slashing interest rates (by more than the Taylor rule prescribed), the Fed encouraged a house-price boom.” In “Tangled Reins” (September 2007), The Economist warned that “the Fed’s efforts to exude a cowboy confidence will be undermined by the suspicion that it is dealing with the consequences of its own errors.”

And in “Fast and Loose” (October 2007) it came down very hard on the Fed for deviating from rules-based policy. The article noted that “Of course the Taylor rule is only a rough guide. The neutral rate and the output gap, in particular, cannot be measured precisely.” And it then went on to say, “But the rule can tell you whether policy is roughly right or a long way out. The Fed missed by a mile.” The article illustrated the point with this “Loose Fitting” chart.

Loose fitting

None of this history of The Economist writings on the harm caused by discretionary deviations from rules-based monetary policy is mentioned in this week’s article except to say that Taylor “thinks” such a scenario was possible. My brief review here is not meant, of course, to be a call for the magazine to be consistent over time if facts change, and besides it was fun to recall the clever titles (Monetary Policy, Made to Measure; Well Taylored; Nicely Taylored; Tangled Reins, Fast and Loose, Loose Fitting, Rule It Out, Dropped-Stitching).  But what facts have changed to lead to such a change of view?  If anything there is more evidence that departures from rules-based policy are harmful (David Papell et al) or at best useless (John Hussman).  And I note with interest that Clive Crook, who wrote and was Deputy Editor for The Economist in those earlier years, recently wrote two Bloomberg View columns “The Fed Needs Some Guidance” and “Dreaming of Normal Monetry Policy” making the case for rules-based policy.

Posted in Monetary Policy

Other Economic Lessons the US Can Learn from Greece

Last week the Senate Foreign Relations Subcommittee on Europe and Regional Security Cooperation held a hearing for which I was asked to address the lessons that the United States can learn from the Greek financial crisis.  One obvious lesson is that the United States needs to take actions to prevent its own federal debt from exploding, as is forecast by the Congressional Budget Office in their alternative fiscal scenario (See Tab 5 of CBO’s  July 2015 Release). But I chose to emphasize a broader set of economic policy issues in my testimony.

First note that while the Greek economy has been performing terribly recently (real GDP has declined by an average of 5% per year for the past five years) over the longer term economic growth has also been poor. Real GDP growth averaged only 0.9% per year and productivity growth (on a total factor basis) averaged only 0.1% per year since 1981.

Second note that Greece’s economic policies–regulatory, rule of law, budget, tax—have also been very poor according to many outside observers.  According to the Heritage Foundation’s index of economic freedom, Greece ranks 130 among the countries of the world, the worst policy performance in Europe and on a par with many poor sub-Saharan African countries.  According the World Bank’s Doing Business indicator, Greece ranks 61, which is well below Portugal, Italy, Spain, and Ireland; and on two important pro-growth measures in the World Bank’s Doing Business indicator it ranks 155 on enforcing contracts and 116 on registering property.  And, according to yet another measure, the Fraser Institute’s Index of Economic Freedom, Greece ranks 84 in the world.

These factors alone explain much of Greece’s poor economic performance and for this reason in its recent report on Greece, the IMF  concludes that “To achieve [productivity] growth that is similar to what has been achieved in other euro area countries, implementation of structural [supply side] reforms is therefore critical.” No quantitative measure is perfect and there are exceptions, but there is a general association between these economic policy measures and economic performance.

Of course, U.S. economic policy scores higher according to these quantitative measures and one must be careful in drawing analogies and lessons.  Nevertheless there is a problem:  The United States has been declining in recent years on all of these measures of good economic policy.  On the Fraser Index, the United States ranked 2 in the year 2000, and it ranks 14 today. On the Heritage Index it ranked 5 in 2008, and it ranks 12 today. On the World Bank’s Doing Business Indicator it ranked 3 in 2008, and it ranks 7 today.

I have also noticed such a deviation from good economic policy in the United States in recent years and wrote about it in my book, First Principles. I find a connection between the recent US problem of low economic growth and this deviation from sound policy principles. In the United States adherence to the principles of good economic policy has ebbed and flowed over the years, creating waves of bad economic times and good economic times.

Of course, there are implications for Greece: the best policy for Greece would be to change radically economic policy in a pro-growth direction. This would move Greece up in the economic policy indexes and, more importantly, start productivity and economic growth.

For the United States, the policy implications are similar, though their purpose is to accelerate the slow upward pace of the economy—say from a 2% growth rate to a 4% growth rate—and avoid another economic crisis, rather than to stop a precipitous downward drop in the economy and stop an ongoing crisis, as in the case of Greece.

Posted in Financial Crisis, Regulatory Policy, Slow Recovery

Make Failure Feasible and End “Too Big To Fail”

Today the Senate held a hearing on a bankruptcy reform proposal which would address the problem of too-big-to-fail head on. The reform applies to large financial firms and makes failure feasible under clear rules without systemic spillovers thereby greatly reducing the likelihood of government bailouts.  Much work has been devoted to this proposal, including at the Resolution Project directed by Ken Scott at Stanford’s Hoover Institution, where a third book on the topic is coming out with this suggestive cover (two of the co-editors, Tom Jackson and I, testified at the hearing: Tom’s testimony and my testimony).Making Failure Feasible_cover

And it is very encouraging that there are now two good reform bills, “The Taxpayer Protection and Responsible Resolution Act” in the Senate and “The Financial Institution Bankruptcy Act in the House,” which incorporate the idea.

While traditional bankruptcy has many benefits, including its basic reliance on the rule of law, it has shortcomings, perhaps the most important being that it is difficult both to resolve a failing institution and stop a run on it. To deal with the shortcoming, a new chapter is needed—it’s called Chapter 14 because there is no such chapter in the bankruptcy code now. Chapter 14 could be implemented over a weekend, and it would leave operating subsidiaries outside of bankruptcy entirely. It would do this by moving the original financial firm’s operations to a new bridge company that is not in bankruptcy.  This bridge company would be recapitalized by leaving behind long-term unsecured debt (capital structure debt).

The aim is to let a failing financial firm go through bankruptcy in a predictable, rules-based manner without spillovers while people continue to use its financial services, just as people flew on American Airlines planes, bought Kmart sundries and tried on Hartmax suits when those firms were in bankruptcy. To understand how a reformed bankruptcy code would resolve a large financial institution, Emily Kapur of Stanford has examined how it would have worked in the case of Lehman in the book Making Failure Feasible. Her summary of the analysis is attached to my testimony.

In my view Chapter 14 would work much better than Title II of Dodd-Frank where the FDIC would have to exercise considerable discretion, and the resulting uncertainty might lead nervous policy makers to resort to massive bailouts.

Chapter 14 would also facilitate resolution planning under the Dodd-Frank Act. The resolution plans submitted by the large financial firms have thus far been rejected by the Fed and FDIC as infeasible. With Chapter 14 the plans could be feasible.

In sum, reform of the bankruptcy law is essential for ending government bailouts. If accompanied by an increase in capital and capital structure debt, such a reform would go a long way toward ending too-big-too-fail.

Posted in Financial Crisis, Regulatory Policy

Does the Fed Have a Monetary Policy Strategy?

The subject of a monetary policy strategy for the Fed came up in Congressional hearings I testified at today and last week.  Today the hearing focussed on the bill to require the Fed to describe its strategy or rule for the systematic adjustment of its policy instruments. Last week the hearing was on “Fed Oversight: Lack of Transparency and Accountability,” at which members of Congress expressed concern over transparency regarding an alleged Fed leak about quantitative easing.

At both hearings I argued in favor of the Fed publicly describing a strategy or rule and explaining whenever it changed or deviated from the strategy.  In my view, research and experience over the years show that a rules-based strategy leads to better economic performance.

A rules-based strategy also leads to greater transparency and helps prevent leaks in contrast to a strategy-free policy, as the controversy over the alleged leak in October 2012 illustrates. Decisions about the timing, amount, path, or exit from quantitative easing are inherently discretionary, and inside information about each decision benefits those who can get it.  If there were a clear and publicly announced strategy for setting the policy instrument over time—as is possible in the case of a conventional instrument like the federal funds rate—then information about policy would be widely available.

Some argue, however, that the Fed already has a strategy, pointing to the Fed’s “Statement on Longer-Run Goals and Monetary Policy Strategy” posted on its web site.  If you read the statement you will find that it does set goals for inflation and employment; it says that the Fed “seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level” (goals respectively defined as an “inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption” and a “central tendency of 5.2 percent to 5.5 percent” for the unemployment rate).

But despite the appearance of the words “monetary policy strategy” in the title, the statement does not contain any strategy for the instruments of monetary policy describing how they are to be adjusted to achieve the goals. As Michael Belongia and Peter Ireland put it “For all the talk about ‘transparency,’… the process—or rule—by which the FOMC intends to defend its two-percent inflation target remains unknown.”  At the least the Fed should report on a strategy or rule it uses as a basis for policy decisions. As is well known from Fed transcripts, the Fed uses policy rules and discusses deviations from such rules, so the Fed should report them as a matter of transparency.

Posted in Monetary Policy

A Deal and a Step to International Monetary Reform

I make the case in this Wall Street Journal piece and in more detail in Congressional testimony that there’s an opportunity for a deal between the Congress and the Administration on international monetary reform.  The case starts with perhaps the most obvious lesson from the Greek crisis: The IMF should not make loans to countries with unsustainable debt. Such loans bail out banks and often worsen the situation.

The IMF learned that lesson more than a decade ago and in 2003 adopted an “exceptional access framework” enshrining the rule of no lending to countries with unsustainable debt. There were few crises in emerging markets in the years following, and it seemed to work well.

But the rule was broken in 2010 when the Greek crisis came along.  Even though Greek debt was unsustainable, the IMF lent 30 billion euros anyway.  It wrote in an exemption to the rule for systemic risk, perhaps under pressure from private holders of Greek debt.

Following this 2010 decision, the Greek economy has deteriorated sharply and many private creditors were able to get out of Greek debt leaving the public sector holding the bag, as Benn Steil has dramatically shown.

Though the framework was broken in order to make the IMF loan to Greece, it remains broken as the exemption still applies.  So it is time to restore the framework and remove the exemption. There’s a lot of support for such a reform, but the US Treasury is resisting.

There is room for a deal here: Treasury wants Congress to raise the U.S. contribution to the IMF, but Congress is reluctant to do so with no framework limiting IMF lending. If Treasury agreed to restore the framework, then Congress could provide the support . This deal would be a first step in putting America in the lead again on international monetary reform.

Posted in Financial Crisis, International Economics