Friday, February 24, 2017

Macro Musings Podcast: Hester Peirce

My latest Macro Musings podcast is with Hester Peirce. Hestor is a Senior Research Fellow and director of the Financial Markets Working Group at the Mercatus Center. She previously served on Senator Richard Shelby’s staff on the Senate Committee on Banking, Housing, and Urban Affairs. In that position, she worked on financial regulatory reform following the financial crisis of 2008 as well as oversight of the regulatory implementation of the Dodd-Frank Act. Hester also served at the Securities and Exchange Commission as a staff attorney and as counsel to Commissioner Paul S. Atkins.  Hester was also nominated by President Obama to be an SEC Commisioner.

Hester joined me to discuss a new book she co-edited with Ben Klutsey titled “Reframing Financial Regulation: Enhancing Stability and Protecting Consumers” This book covers a lot of topics on how to better regulate the financial system. 

We spent most of our time talking about how to improve the stability of the financial system. The laws and regulations emanating from Dodd-Frank (DF) were supposed to make the financial system safer, but a number of recent papers--Nissim and Calormiris (2014)Sarin and Summers (2016)Chousaks and Gorton (2017)--find the banking system weaker now and not meaningfully safer than pre-2008. Others, like Minneapolis Fed President Neel Kashkari, are worried about financial institution that remain too big to fail (TBTF) since they still fund with too much debt. Moreover, it is not clear if the reforms made in DF, like living wills and the Financial Stability Oversight Council, will actually make much difference should the TBTF institutions get in trouble again. President Kashkari, consequently, has proposed a number of reforms to end TBTF.

Hester and I discussed these concerns as well as the possibility that DF has actually increased the fragility of the financial system. One area, in particular, that is creating new potential problems for financial stability is the new DF central clearinghouse utility for derivatives. These central clearinghouses or CCPs were created as a way to improve transparency about derivatives so that regulators and other observer would know what is happening in this part of the financial system. Ironically, however, they appear to be making the financial system more fragile. This is because the CCPs concentrate all the risk from formerly bilateral relationships into one financial firm, making it another TBTF institution. Put differently, DF has inadvertently created more Lehmans or AIGs. 

Now some of the clearinghouse existed before DF, but they have grown and absorbed more risk since DF. In fact, the Financial Stability Oversight Board has designated some of the CCPs as TBTF institutions that need to be monitored. Other reports have come out saying "clearing house push has created unforeseen systemic risk" or "U.S. Treasury warns clearinghouses could spread risk". So it is not clear whether DF on balance has increased the safety of the financial system.

Hester and I do discuss other issues that are covered in the book, but I wanted to highlight here what I see as one of the bigger issues still facing us eight years after the crisis.

If you are interested in the book, you can download it or individual chapters from here. This is a great resource to have as the new President and Congress consider revamping financial regulation.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Related Links
Macro Musings podcast with Anat Admati (similar these covered).

Friday, February 17, 2017

Macro Musings Podcast: Sebastian Mallaby

My latest Macro Musings podcast is with Sebastian Mallaby. Sebastian is a senior fellow at the Council on Foreign Relations and a contributing columnist to the Washington Post. Previously, he worked with the Financial Times and the Economist magazine and is the author of several books. He joined me to talk about his latest book “The Man Who Knew: The Life and Times of Alan Greenspan”.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Monday, February 13, 2017

The Monetary Superpower: As Strong As Ever

In a forthcoming paper, Chris Crowe and I argue the Fed is a monetary superpower:
[A] defining feature of the US financial system is that its central bank, the Federal Reserve, has inordinate influence over global monetary conditions. Because of this influence, it shapes the growth path of global aggregate demand more than any other central bank does. This global reach of the Federal Reserve arises for three reasons. 
First, many emerging and some advanced economies either explicitly or implicitly peg their currency to the US dollar given its reserve currency status. Doing so, as first noted by Mundell (1963), implies these countries have delegated their monetary policy to the Federal Reserve as they have moved towards open capital markets over the past few decades. 
These “dollar bloc” countries, in other words, have effectively set their monetary policies on autopilot, exposed to the machinations of US monetary policy. Consequently, when the Federal Reserve adjusts its target interest rate or engages in quantitative easing, the periphery economies pegging to the dollar mostly follow suit with similar adjustments to their own monetary conditions.  
The second reason for the global reach of US monetary policy is that a large and growing share of global credit is denominated in dollars. That means the Federal Reserve’s influence over the dollar’s value gives it influence over the external debt burdens of many countries.  
The third reason for the extended reach of US monetary policy is that other  advanced- economy central banks are likely to be mindful of, and respond to, Federal Reserve policy given the large size of the dollar bloc...  These  findings imply that even  inflation- targeting central banks in advanced economies with developed financial markets are not immune from the influence of Federal Reserve policy. This has led Rey (2013, 2015) to argue that the standard macroeconomic trilemma view is incomplete. 
There is more in our article, but I wanted to share this excerpt because a new working paper from Ethan Ilzetzki, Carmen Reinhart, and Kenneth Rogoff sheds light on our claim that Fed is a monetary superpower. 

Specifically, this new paper shows that contrary to conventional wisdom exchange rate regimes across the world have not become significantly more flexible since the end of the Bretton Woods System. This surprising finding is backed up by a large cross-country data set that spans the period 1946-2015. Moreover, they show that the limited exchange rate flexibility has coincided with an expanding reach of the dollar. From their abstract:
Our central finding is that the US dollar scores (by a wide margin) as the world’s dominant anchor currency and, by some metrics, its use is far wider today than 70 years ago. 
Here is the key chart from their paper as it relates the monetary superpower argument. It shows the share of world GDP that has the dollar as its anchor currency:

What this graph implies is that about 70 percent of world GDP has its monetary policy effectively set by the FOMC! Given the size of the dollar bloc and its spillover effects, it is likely the Fed's total influence on global monetary conditions is even larger. 

This is staggering. It means that twelve Fed officials that meet in Washington D.C. largely determine global monetary conditions. The Fed is truly a monetary superpower. 

Related Links

Friday, February 10, 2017

Macro Musings Podcast: Eswar Prasad

My latest Macro Musings podcast is with Eswar Prasad. Eswar is a professor of economics at Cornell University and a senior fellow at Brookings Institution. He joined me to talk about his new book, Gaining Currency: the Rise of the Renminbi

We began by reviewing the history of money in China. Many people know that China had the first paper currency, but few appreciate that China had the first debates over monetary theory and role of the state in money creation. China also had the first currency war--literally a physical war between two competing central banks in China--as well as its own interesting monetary history during the Great Depression of the 1930s. 

We then moved to China's exchange rate regime and the thorny question of whether China's currency being undervalued in the past and whether it was now overvalued. We also discussed how consequential was the past undervaluation of China's currency to the huge trade surplus it ran with the United States. Our conversation also covered the role the Fed played in setting monetary conditions in China via its currency peg to the dollar. 

The interview wrapped up by considering the prospects of the Renminbi becoming a truly important currency. This was a fascinating conversation throughout.

You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Friday, February 3, 2017

Macro Musings Podcast: Jesus Fernandez-Villaverde

My latest Macro Musing podcast is with Jesus Fernandez-Villaverde.  Jesus is a professor of economics the University of Pennsylvania, a research associate with the National Bureau of Economic Research, and a research affiliate with the Centre for Economic Policy Research. 

Jesus does theoretical macroeconomic modeling, econometrics, and economic history. He has several books coming out on those topics and recently coauthored a chapter in the Handbook of Macroeconomics titled "Solution and Estimation Methods for DSGE Models". He joined me to talk about European economic history and macroeconomic modeling on the show. 

Most of our conversation focused on German monetary history in the 20th century since it has been so consequential for the rest of the Europe. We began by discussing the Weimar hyperinflation of the early-to-mid 1920s and the Great Depression of the late 1920s-early 1930s. It is hard to appreciate the fact that Germany went from hyperinflation to painful deflation in a decade. Several interesting questions come out this experience. First, which is worse: hyperinflation or depression? Second, why do the Germans seem to remember the former more than the later? Third, is it true that the Great Depression brought the Nazis to power? Jesus provides good answers to these in the interview. We also touch on Bretton Woods, the EMS crisis in 1992, the advent of the Eurozone, and the best path forward for this currency union.

Jesus and I then turn to the current debate over DSGE  modeling in macroeconomics. He responds to recent criticism of this approach and also considers the the future of monetary search models in this field.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Update: Since we talked about it in the podcast, here is a chart I created some time ago on the EMS crisis in 1992 . It shows Germany's tightening of monetary policy pulling down (via the peg) nominal demand in other European countries.  It is also shows a recovery in UK nominal spending once the peg was broken.

Related Links
Jesus Fernandez-Villaverde's home page

Tuesday, January 24, 2017

Macro Musings Podcast: Gauti Eggertsson

My latest Macro Musings is with Gauti Eggertson. Gauti is a professor of economics at Brown University and formerly worked in the research departments of the International Monetary Fund and the Federal Reserve Bank of New York. He has written widely on liquidity traps, deflation, and the zero lower bound (ZLB) and joined me to talk about these issues.

This was a fun conversation and a good look back at the challenges and shortcomings of macroeconomic policy since the crisis in 2008. One of the big takeaways from our conversation, at least for me, is that central banks during this time ignored many of the key findings in the literature when it comes to best practices at the ZLB.

Before getting to these missed opportunities, it is worth recalling the nature of the ZLB problem. It emerges when there has been a severe recession that forces down the 'natural' or market-clearing level of short-term interest rates to a level well below 0%. The Fed's normal response, lowering interest rates to the level of the natural interest rate, does not work here because the Fed will run up against a lower bound where people would rather hold cash than earn a negative interest rate on their deposits. This lower bound is effectively a price floor that prevents the economy from properly healing and quickly returning to full employment. 

So what can policymakers do? Gauti's work gives an answer. Specifically, his 2003 paper with Michael Woodford (which builds upon Paul Krugman's 1998 paper) shows that policymakers need to credibly commit to an expected path of interest rates that will restore the pre-crisis path of the price level. Put differently, Gauti's work implies the best defense against and escape from a depressed economy is some kind of level targeting. Gauti favors an output-gap adjusted price level target. As Michael Woodford noted in his 2011 talk, this effectively amounts to a nominal GDP level target or restoring the growth path of nominal spending. 

One implication of this understanding is that if there is any disinflation or deflation from a collapse in aggregate demand during a recession there needs to be an offsetting period of reflation to restore the aggregate demand growth path. This did not happen after 2008 and implies aggregate demand growth was persistently weak. This was a missed opportunity by the Fed.

The Fed, instead, tried various rounds of QE. And it did so in exactly the manner that Eggertson and Woodford (2003) and Krugman (1998) said would lead to the famous  'irrelevance results'. That is, the Fed did these programs using temporary monetary base injections, whereas only permanent injections matter. 

What is truly surprising about this observation is that the permanent injections point is widely understood. For example,  here is a list of prominent New Keynesians who acknowledge it (including former Fed chair Ben Bernanke). And here is a list of quantity theory advocates making the same point.

To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment. 

So why did the Fed ignore the literature and fall right into the irrelevance results trap? I have a working paper that takes a stab at this question. I argue there were both external forces (public's fear of inflation vented via Congress) as well as internal ones (Fed still fighting the last battle and suffering from loss aversion) that kept the Fed timid. In our interview, Gauti made an interesting observation related to this point. The Fed seemed okay being aggressive with QE, but not with reflation. It is a bit of puzzle why it was so bold in the former but timid in the later. 

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

Gauti and I also touched on how best to sell level targeting to policymakers and the public. Here is a recent Bloomberg article that looks at Gauti's innovative attempt to do so at the New York Fed in 2010 using 'Inflation Budget Accounting". Below is an excerpt:
We suggest that the FOMC keeps track of the extent to which it has "missed" its inflation target. Let us call these accumulated misses "inflation debt". Hence if the inflation target is 2 percent, and inflation is at 1 percent for two years in a row, then the accumulated "inflation debt" is 2 percent. 
The FOMC would then announce an "easing bias" until the inflation debt accumulated in the current recession has been extinguished. If this is credible, a deflationary reading of the data would signal a larger "easing bias" going forward.
As I note in my working paper mentioned above, the Fed has been explicit about its plan to eventually shrink its balance sheet. It said so in its exit strategy plans reported in the June 2011 and September 2014 FOMC meetings. Janet Yellen recently reiterated those plans in her August 2016 Jackson Hole speech (see footnote 13). More recently, the Federal Reserve updated its basic guidebook to monetary policy in October 2016. Here too it stresses the balance sheet will be reduced:
As the policy normalization process proceeds, the Federal Reserve’s securities holdings—and the supply of reserve balances—will be reduced in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the portfolio...
The FOMC intends that the Federal Reserve will, over the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities (p.52)
And if there were any questions about what this means, the Fed later notes that "no more securities than necessary" means doing away with the overnight  reverse repurchase facility:
During normalization, the Committee is using an overnight reverse repurchase (ON RRP) facility as a supplementary tool as needed to help control the federal funds rate... The FOMC plans to use the ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate (p.51).
I would also add from a political economy perspective that the balance sheet will have to be reduced given IOR. The increasingly bad optics of the Fed paying banks larger interest payments as interest rates go up  will force the Fed's hands on reducing its balance sheet.

Sunday, January 22, 2017

Note to President Trump: It's Policy Divergence, Not China, Driving the Dollar

President Trump is worried about the strong dollar:
In his interview with the Journal on Friday, Mr. Trump said the U.S. dollar was already “too strong” in part because China holds down its currency, the yuan. “Our companies can’t compete with them now because our currency is too strong. And it’s killing us.”
The real issue is not China but the diverging of the current and expected paths of monetary policy among the major advanced economies, particularly the United States and Europe. The Fed has been tightening and is expected to continue do so with further rate hikes in 2017. The ECB, on the other hand, is still running its QE program and is keeping it short-term policy rates pegged close to zero. 

This policy divergence can be seen in the figure below. It shows the 6-month interest rate, 6 months ahead for the United States minus the same measure for the Eurozone (blue line).1 Ever since mid-2014 this spread has been rising--with a brief plateauing in 2016--and the trade weighted dollar (red line) has closely followed it.

Part of the divergence between the expected paths of monetary policy comes from the belief that Trump's policies will spur robust growth. This belief may prove premature, but if it does come to fruition it will only reinforce the policy divergence by pushing interest rates higher.  Going after China will not change this policy divergence. 

The surging dollar, if anything, creates more problems for the rest of the world than for the U.S. economy.  It is something to worry about, as I have noted before, because there is a lot of foreign debt denominated in dollars and because other currencies tied to the dollar will also strengthen.  But this is a very different problem than the one President Trump sees with the strong dollar. 

1 I calculate this 6 month interest rate, 6 months ahead as follows.