Economics One

In my article on British monetary policy in yesterday’s Financial Times, I suggested (recommendation 5) that as the Bank of England seeks a way to implement forward guidance it might want to consider a “rule for all seasons” as a guideline.   This rule would allow for the possibility that bank rate would be extra low in periods following a stint at the zero lower bound, but by a measurable rules-based amount that depends in a consistent way on the degree to which the desired bank rate has fallen below zero bound.

The idea comes from a very early paper (perhaps the first) on using forward guidance to deal with the zero bound. It was presented at a conference in Woodstock, Vermont more than a decade ago and published  by David Reifschneider and John Williams (now president of the San Francisco Fed).   I used the term “rule for all seasons” in the FT to convey the idea that it is a kind of meta-rule which would apply consistently whether or not the zero bound was constraining.  In principle, it thereby mitigates the time inconsistency problems that the Fed’s current forward guidance has created.

As Reifschneider and Williams explained: “What we seek is a policy that deviates from the Taylor rule in a negative direction at times when interest rates are unconstrained and there is a ‘backlog’ of past deviations—i. e. immediately following episodes of zero interest rates….”

The specific policy they propose can be written down algebraically (see equation 4 in their paper), so technically speaking it is a rule.  It would require keeping track of the backlog by summing up all the past deviations, as explained in the following example.  Suppose that the zero bound was not constraining, according to the basic Taylor rule, in the years up to 2008.  Suppose also that in the years from 2009 to 2016 the basic rule algebraically called for the interest rate shown in the first column of the table, labeled “basic rule”. The resulting 4-year backlog and the interest rate implied by the meta-rule, which is the maximum of (1) zero and (2) the basic rate minus the backlog, are shown in  second and third columns:

Notice that even though the basic rule calls for 1% in 2013, the actual rate would still be zero due to the backlog correction in the meta-rule.  The actual rate is lower than the basic rule in 2014 and by 2015 the meta-rule is back to the basic rule.

The following chart copied from the Reifschneider-Williams paper illustrates how such a path for the short rate could affect a longer rate using an expectations theory of the term structure.

With Mervyn King stepping down as head of the Bank of England this weekend there are many good things that can be said and have been said about his public service.  (Here is what I said at the conference in his honor.)

But we economists should be very grateful to him for his decision to put Adam Smith on the £20 note along with an illustration of the pin factory in Smith’s famous story from the Wealth of Nations. Here is what the £20 note looks like

and here is a close up of the pin factory.

For many years Adam Smith has visited  my Economics 1 class to talk about the pin factory.  Here is an excerpt from a recording  Smith2 where he tells the students how: one man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper.  It is actually hard to see all these activities in the drawing on the note. Perhaps this is because it is not the same pin factory but rather this drawing from a French reference book 

Épinglier (Pin-Maker) III, L’Encyclopédie (1760s)

Many agree that the provision of liquidity by the Fed during the panic period in the fall of 2008 was helpful in alleviating severe stress in the markets and rebuilding confidence. Most criticism of the Fed pertains to the period before and after the panic, which, in my view, helped cause the crisis and the slow recovery.  In several recent posts I have given examples of the growing criticism of post-panic monetary policy including by Paul Volcker and Raghu Rajan.  Criticism of policy leading up to the crisis seems to be growing too.

For example, a new book by Justin Lin, former chief economist at the World Bank, was just reviewed by Howard Davies (former deputy governor of the Bank of England) in the Financial Times.  Lin argues that the very low interest rates during the recovery from the 2001 recession were a cause of the housing boom and thus the bust which led to the crisis.  As quoted in the Davies review, Lin says:   “The loose monetary policy introduced in 2001 in response to the bursting of the dotcom bubble, magnified by financial deregulation and innovations in financial instruments, resulted in a boom in the US housing market.”  My 2007 Jackson Hole paper endeavored to show this using a simple model to measure how “loose” monetary policy was and to run a counterfactual simulation showing how that was a factor in the boom and bust.

I listened to Raghu Rajan deliver the first Andrew Crockett Memorial Lecture at the BIS last Sunday (written version here).  Raghu’s lecture followed several moving tributes to Andrew’s remarkable contributions to policy at the IMF, the Bank of England, the BIS, and the Financial Stability Forum. During the past several years until he died last September, Andrew was an active member in the Working Group on Economic Policy at Stanford’s Hoover Institution and contributed to our most recent book in Bankruptcy Not Bailout.  Andrew always conveyed clear sensible messages in a diplomatic style that made people listen.

Raghu’s message in the Crockett lecture was also clear and sensible. The title “A Step in the Dark: Unconventional Monetary Policy After the Crisis” conveyed his main message that unconventional monetary policy—such as quantitative easing in the United States—has not worked to help the economy grow during the past four years.  Though his style was polite and respectful of the central bankers present, he did not mince words. For example, he paraphrased Churchill near the end of his talk to describe the unconventional policies: “Never in the field of economic policy has so much been spent, with so little evidence, by so few”

I have been critical of the Fed’s quantitative easing for quite a while now. In September 9, 2010 I wrote in the Wall Street Journal that the last thing we needed as “another large dose of quantitative easing in which the Fed’s balance sheet explodes even further, raising more uncertainty about how it will ever be unwound.”  So I largely agree with Raghu about the ineffectiveness. Moreover, I would say that the list of people in agreement is getting longer and  longer, though some of the central bankers who responded to Raghu, such as Bill Dudley (remarks here),  do not yet agree.

The most frequently asked question by central bankers at the various gatherings at the BIS annual general meeting in Basel was:

Q: What do you think caused the market turbulence last week?

And there were nearly as many answers as central bankers. Here are a few:

A: It was very temporary and will disappear soon. Don’t worry.

A: Traders were surprised that the Fed’s forecast for growth was higher than the consensus of private forecasters, so they guessed the zero interest rate would not last so long.

A: It was a cynical response of major investors who think the Fed should do more

A: Poor communications. Ben should not have given a 7% threshold

A: No, it was not poor communications. People recognize the normalization will take more than simply unwinding QE. The normalization process will involve many other changes which we are uncertain about including exchange rate realignments.

A: The effect of QE is not well understood.  Exit causes as much uncertainty as entry.

A: It is just the inevitable downside effects following any earlier positive upside.

A: Japan and the US are going in opposite directions, so it is very confusing to traders

When I was asked here was my answer:

A: I’ve been warning for quite a while that a big risk of QE would be the exit strategy. So what you are seeing is that risk being realized.

Q (a typical follow-up): But the FOMC or press conference announcement was small in terms of the change in the stock of assets that will be purchased.

A:  No, it was actually quite large.  Before announcement, the peak level of reserve balances could have reached $4.2 trillion. With Wednesday’s announcement, it will reasonably be expected to reach $2.8 trillion. That’s a cut in the expected stock of $1.4 trillion—about the same as the increase that will have occurred since the QE3 announcement last year: $2.8T – $1.4T (in Sept 2012) = $1.4T).  So the effect should be big.  (See here for calculations.)

The Bank for International Settlements (BIS) held its annual monetary conference in Luzern Switzerland over the past two days. I presented a paper on cross-border monetary policy spillovers, which was unexpectedly and vividly brought to life by the turmoil in financial markets following last Wednesday’s FOMC meeting and its global impact. Many central bank governors from emerging market countries who attended the conference had to spend a lot of time on cell phones and Blackberry’s monitoring the financial market situation back home. Others had to cancel their trip.

Though their views might have understandably been overly influenced by the recent turmoil, I noticed several interesting areas of agreement among the central bankers and others who spoke at the conference. First, many longed for a return to the type of rules-based monetary policy associated with the so-called great moderation of the 1980s, 1990s, and until recently.  Second, they agreed that monetary policy has become overburdened with too many tasks far removed from the traditional monetary policy objectives. Third, they admitted that there were significant monetary policy spillovers on emerging market countries of the current unconventional policies in advanced countries.  Fourth, they lamented that it would be a long uncertain road back to normalization.

In my paper I argued that deviations from rules-based policy at several central banks, including the Fed in recent years, created incentives for other central banks to deviate from such policies and that this had created the current Global Great Deviation.  Another view—which I reviewed in the paper—is that the global state of monetary policy is either not a deviation from good policy or that such deviations are benign and appropriate.  I was surprised that there was considerable support for the first view rather than the alternative at the conference, though there was by no means a consensus and probably not a majority. I had thought that there would be more support for the alternative view and for unconventional monetary policies.

Eventually all the papers and comments by the discussants will be posted on the BIS website as with last last year’s conference papers. (My discussants were Arminio Fraga and Ken Rogoff). In the meantime I am off to Basle for the Annual General Meeting of the BIS which many more of the world’s central bankers will attend.

Today’s FOMC meeting and press conference clarified to some degree how large the Fed intends to let its balance sheet grow under quantitative easing.   Under the FOMC’s current economic outlook, the Fed intends to slow, before the end of the year, the pace of bond purchases from $85 billion per month and stop the purchases by the middle of next year.  With the FOMC’s forecast for the unemployment rate around 7% in the middle of 2014, this also clarifies that the criterion for ending QE is explicitly different from the 6.5% unemployment criterion for the commitment to the zero interest rate policy.

The impact of this new view can be assessed with the following chart of reserve balances (which I have used on this blog and in congressional testimony).  To finance large-scale bond purchases, the Fed credits banks with these reserve balances (deposits at the Fed), so they closely track purchases under QE. The chart illustrates how unprecedented the Fed’s recent policy has been, not only compared with the response to the physical damage in 9/11/2001 but also in comparison with the liquidity provisions during the panic of 2008.

The red line shows a projection consistent with the assumption that the $85 billion would continue until the unemployment rate hit 6.5 % (which until today was one interpretation of the “substantial labor market improvement” criterion) in which case tapering would have started in mid-2015.  Note that this is essentially a continuation of the recent history (blue line).

The black line shows a projection consistent with the new view that was expressed today. Although we still do not know what the degree of slowing will be, the chart assumes that the pace is cut in half (to $42.5 billion per month) in October and then to zero in the summer of 2014.  If this is what actually transpires, reserve balances will peak around $2.8 trillion rather than $4.2 trillion under the previous projection. That’s a big revision.  Markets likely had already been assuming (at least since Bernanke’s Joint Economic Committee hearing a month ago) a tapering before the middle of 2015.  Still that downward revision is larger than the total increase in reserve balances under QE3.

Ever since QE3 began I have been giving lectures pointing to the red line, hoping it would not happen, and asking, as in the story of Scrooge, “Are these the shadows of the things that will be…. . . or are they the shadows of things that may be, only?”  The new projection is less scary, and that is something to be grateful for.  Still even though the peak is lower than one might have feared, exit from that peak will be very difficult for the Fed as the market volatility for the past month has shown as various Fed officials have endeavored to broach the subject. Unfortunately, Fed policy makers are still not clear about the exit and they are far from what Justin Wolfers recommends that they: “Tell us what they are going to do, then follow through by doing it.”