Why El-Erian should be reading Steve Williamson

You have likely heard of Mohamed El-Erian, one of the heads at PIMCO. Let's just say that El-Erian and other major bond investors pay a lot of attention to the conduct of Fed policy and how it's likely to evolve over time.

Here is what El-Erian has to say about the Fed's most recent (Dec 12, 2012) policy statement: How Risky is the Fed's Major Move?

Wow! That is what I suspect many investors said when they heard Wednesday's policy announcement from the Federal Reserve.
...
The Fed took two major steps on Wednesday, one expected and one less so. 

First, it added to its expected purchases of market securities, doubling the dollar amount to $1 trillion for 2013 -- a very large number by any measure. Second, the Fed shifted to quantitative (unemployment and inflation) targets for forward policy guidance, and it did so earlier than most expected given theoretical and practical complexities.

Maybe a lot of investors, including El-Erian (and myself, for that matter), were surprised by the Fed's move. But I can point to at least one economist who hit the nail right on the head; see, Steve Williamson. 

First, in terms of the "less surprising" announcement of what was to follow the termination of the MEP, Steve writes:

What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month.

And what we got:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month.

Second, in terms of "more surprising" move of replacing the forward guidance language with a state-contingent rule, Steve writes:

This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. ...  

The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0.

The x in part (i) turned out to be 2.5%, which fell within his predicted range of 2.5-3.0; and the y in part (ii) turned out to be 6.5%, which fell within his predicted range of 5.5-7.0.

Steve didn't quite nail it exactly, however (as he explains in his follow up piece here). In particular, note that the y = 6.5% is not really a "trigger,"--it is just a necessary (but not sufficient) condition for raising the federal funds rate target. What it really means is that the Fed does not plan to "tighten" as long as unemployment remains above 6.5% (and as long as forecast inflation remains below 2.5%). But the Fed may wish to keep the federal funds rate low even if unemployment falls below that threshold. 

  

(By the way, note that this "trigger" language only applies to the federal funds rate target, not to the Fed's asset purchase programs.)

In any case, I just thought I'd point this out for those people interested in following the Fed: Steve Williamson is your man. Spread the word.

Losing it, with Paul and Brad

The demand for senior economists willing to lose their marbles in public seems insatiable. Thankfully, we have Paul and Brad to make sure supply equals demand (see example 1 and example 2).

Oooo...they are so angry! But maybe they can get angrier yet! For a lesson, they should look at the classic "getting angry" performance by Ren Hoek, the asthmatic chihuahua with the Peter Lorre voice losing it when Stimpy the cat (and his pal) thoughtlessly destroy Ren's most treasured collections. Here, I imagine our heroes playing the role of Ren, with the incredibly stupid Stimpy and his equally dense pal playing the role of Bob Lucas and John Cochrane (or take your pick).

Enjoy! Greatest cartoon performance ever: Ren Hoek

Merry Christmas everyone.

Update: I see that the tireless Steve Williamson has taken the time to craft a more thoughtful reply to the Krugman piece cited above; see here. 

Shadow Banking

The Arrow-Debreu model provides the foundation for modern macroeconomic theory and the theory of finance. This is probably as it should be. But like most foundations, it is just a place to start. As John Geanakoplos explains here, the AD model is "relentlessly neoclassical." And what this means, among other things, is that the basic AD model offers no explanation for phenomena related to money, liquidity, banking, and corporate finance (just to offer a partial list). 

 

To make sense of phenomena like money, liquidity, and collateral, we need to model the "frictions" that make intertemporal trade difficult. Frictions like private information, limited commitment, and limited communication. Absent such frictions, debtors could spend their promises easily. Creditors would not not have to worry about promises being broken. Such a world is not likely be free of the business cycle. But business cycles would likely be muted (small shocks would not be magnified as much, or propagated throughout the economy to the same extent). 

 

Of course, economists throughout the ages have thought about these sort of frictions. And there is a substantial body of modern macroeconomic theory that attempts to formalize these notions. A heretofore neglected area of research, however, is what economists have come to call the "shadow banking" sector (see here, here and here). Some recent theoretical work can be found here: 

A Model of Shadow Banking, Gennaioli, Shleifer, Vishny
Shadow Banks and Macroeconomic Instability, Meeks, Nelson, Allesandri

The shadow banking sector is still very large--take a look at this recent news story: Shadow Banking Still Thrives. According to Gary Gorton (Shadow Banking Must not be Left in the Shadows) the shadow banking sector needs to be regulated...somehow. It seems like we're still not exactly sure how this should be done or, indeed, if it is even feasible. 

 

What I mean about "feasibility" is the observation that private agents, particularly those in the financial industry, seem to be extremely good at innovating their way around existing bank legislation. Shedding light on one dark place in the room just causes the little critters to find other shadows. Who knows, maybe that's even a good thing. But I haven't really seen any theoretical papers on the subject (please send if you have). 

Here is Ken Rogoff on the subject: Ending the Financial Arms Race. Here is an excerpt:

Legislative complexity is growing exponentially in parallel. In the United States, the Glass-Steagall Act of 1933 was just 37 pages and helped to produce financial stability for the greater part of seven decades. The recent Dodd-Frank Wall Street Reform and Consumer Protection Act is 848 pages, and requires regulatory agencies to produce several hundred additional documents giving even more detailed rules. Combined, the legislation appears on track to run 30,000 pages. 

As Haldane notes, even the celebrated “Volcker rule,” intended to build a better wall between more mundane commercial banking and riskier proprietary bank trading, has been hugely watered down as it grinds through the legislative process. The former Federal Reserve chairman’s simple idea has been co-opted and diluted through hundreds of pages of legalese. 

The problem, at least, is simple: As finance has become more complicated, regulators have tried to keep up by adopting ever more complicated rules. It is an arms race that underfunded government agencies have no chance to win.

No more bubble talk (please!)

I am currently at the Institute of Advanced Studies in Vienna, which hosts one of the best little macro conference in Europe: The Vienna Macro Cafe. Excellent papers, lively discussions, wonderful camaraderie, and an unbeatable location. (Let me know if you'd like to be placed on our mailing list.) 
  
After this uplifting experience, I made the mistake of checking the econ blogosphere. Blah. 

I guess it all started with Paul Krugman (who else?), who goes off here in his usual assertive style: Bubble, Bubble, Conceptual Trouble. Steve Williamson takes issue with some of the claims that Krugman makes here: The State of the World. And then Noah Smith steps in to attack one part of Williamson's post here: Money Is Just Little Green Bits of Paper! Noah gets it all wrong, but that doesn't stop both Krugman and DeLong in congratulating him for an argument that even they apparently do not understand. And so it goes. 

Let me now explain why I think Noah gets the "bubble" issue wrong. Here is how Noah starts off. 

Have you ever heard people say that "money is just little green pieces of paper"? Well, that is exactly what Steve Williamson claims in this post.

Um, no...Steve never said that "money is just little green pieces of paper." So right away, we're off to a bad start.
To understand what Steve meant, we have to start with Krugman's own "definition" of a bubble:

Over and over again one hears that we can’t expect to return to 2007 levels of employment, because there was a bubble back then. But what is a bubble? It’s a situation in which some people are spending too much.

It's a situation in which some people are spending too much? Thanks for that, Paul. To which Steve replies:

What is a bubble? You certainly can't know it's a bubble by just looking at it. You need a model. (i) Write down a model that determines asset prices. (ii) Determine what the actual underlying payoffs are on each asset. (iii) Calculate each asset's "fundamental," which is the expected present value of these underlying payoffs, using the appropriate discount factors. (iv) The difference between the asset's actual price and the fundamental is the bubble. Money, for example, is a pure bubble, as its fundamental is zero. There is a bubble component to government debt, due to the fact that it is used in financial transactions (just as money is used in retail transactions) and as collateral. Thus bubbles can be a good thing. We would not compare an economy with money to one without money and argue that the people in the monetary economy are "spending too much," would we?

The only quibble I have with this reply is Steve's use of the word "bubble." Bubbles mean different things to different people. As Steve emphasizes, the definition should be made relative to a specific model. "Bubbles" are not something you can actually "see" in the data -- "bubble dynamics" are an interpretation of the data. 

In any case, what word might Steve have used instead of "bubble?" While less colorful, I think that the label "liquidity premium" is more accurate. It is the market price of an asset above it's "fundamental" value. The distinction here seems similar to the one that Marx made between "use value" and "exchange value;" see here.

Here is how I like to think about it. Imagine an economy with just one person, as in Robinson Crusoe. Crusoe likes to eat coconuts. So he values coconuts. And he values the trees that produce coconut dividends. One way to measure value here is to ask "how many coconuts would Crusoe be willing to give up to have one more coconut tree?" The answer to this question will provide a measure of the tree's "fundamental" value. Because there are no other people on the island (prior to Friday), there is no exchange value associated with tree ownership. There is no "bubble" in a Robinson Crusoe economy.

The situation can be quite different, however, in an economy consisting of more than one person wanting to trade intertemporally in credit markets. One friction that hampers intertemporal trade is what economists call a lack of commitment. Essentially, people cannot be relied upon to keep their promises. Monetary theorists have shown that in this type of world, various objects may be employed to enhance the volume of intertemporal trade. These objects are called exchange media.

Exchange media may take the form objects that are commonly viewed as "money"--objects that circulate widely from hand to hand, or from account to account. They may also take the form of collateral objects, like the senior tranches of MBS that (until recently) circulated widely in the repo market. Because U.S. treasuries are used widely to facilitate financial transactions, they too constitute an important medium of exchange.

Abstracting from risk, the market price of an exchange medium can be broken down into two components: fundamental value and market value. We can estimate the fundamental value of an asset by assessing its value under the assumption that it is illiquid (i.e., does not circulate as an exchange medium). The difference between market price and fundamental value is a measure of liquidity value. Because an asset may be priced above its fundamental value, there is a sense in which the asset price embeds a "bubble" component according to many popular definitions. But the word is more trouble that it's worth--our discussions might be clearer and more productive if we avoided the term entirely.

Aside: Steve's point is that in a world of financial frictions, exchange media and their associated "bubble" prices may be useful for increasing the level of spending closer to socially optimal levels. If so, then how does Krugman's definition of a bubble--a situation where people are spending too much--make any sense? There may be bubbles that have this property. But then there may be bubbles that do not. Williamson is telling Krugman that he needs to be more careful. The message, unfortunately, seems hopelessly lost. 

  

Alright then, back to Noah, whose whole column is based on Steve's throwaway comment: 

Money, for example, is a pure bubble, as its fundamental is zero.

To which Noah replies:

Can this be true? Is money fundamentally worth nothing more than the paper it's printed on (or the bytes that keep track of it in a hard drive)? It's an interesting and deep question. But my answer is: No. 

First, consider the following: If money is a pure bubble, than nearly every financial asset is a pure bubble. Why? Simple: because most financial assets entitle you only to a stream of money. A bond entitles you to coupons and/or a redemption value, both of which are paid in money. Equity entitles you to dividends (money), and a share of the (money) proceeds from a sale of the company's assets. If money has a fundamental value of zero, and a bond or a share of stock does nothing but spit out money, the fundamental value of every bond or stock in existence is precisely zero.

While it may not have been clear to the average reader, I happen to know that Steve was referring to a special kind of monetary object: a pure "fiat" currency. "Fiat" in the modern sense of the word means "intrinsically useless" or "zero use value."The USD issued by the Fed may not fit this description exactly because, as others have pointed out, government money does have the power to discharge a real tax obligation. On the other hand, pure fiat money does seem exist; see my post: Fiat Money in Theory and in Somalia. The point is that even fiat money can have exchange value, and if it does, then its value is entirely a liquidity premium or "bubble" and that, moreover, it is probably a "good" bubble to the extent that fiat money facilitates trade. 

What of Noah's claim that if money is a bubble, then nearly every financial asset is a bubble? This just seems plain wrong to me. Financial assets are typically backed by physical assets. For example, the banknotes issued by private banks in the U.S. free-banking era (1836-63) were not only redeemable in specie, but they constituted senior claims against the bank's physical assets in the event of bankruptcy. Mortgages are backed by real estate, etc.

Of course, there is the problem of dividing up the physical assets, but at some level, someone ends up with property rights in the physical asset--and it is this property right that gives most assets a "fundamental" value.

Note: I see that Steve Williamson has his own reply here: Money and Bubbles. 

How Canada Saved Its Bacon

Interesting to see that Canada's former finance minister (and prime minister) Paul Martin issuing a "stern warning" to U.S. policymakers; see here.

The similarity between the current U.S. slump and what happened to Canada in the 1990s is quite interesting, and I've written about it here: The Great Canadian Slump: Can it Happen in the U.S.?
 
I know that economists like Tiff Macklem and Pierre Fortin debated the issue some time in the mid 1990s, but I haven't really seen any work on the subject since then. If I recall correctly, I believe that Fortin was ascribing blame to the Bank of Canada, and possibly Paul Martin's "austerity" measures. Macklem (and coauthors) did not share the same view.

If you know of any more recent work that investigates the great Canadian slump, please pass it along.

Is the Fed missing on both sides of its dual mandate?

With the unemployment rate still above 8% and some inflation measures below 2%, many people argue that the Fed is "missing on both sides of its dual mandate;" see, for example, Fed Harms Itself By Missing Goals.

Jim Bullard, president of the St. Louis Fed, has a different view, which he just published here: Patience Needed for Fed's Dual Mandate.

My interpretation of  his critique is as follows.

People who make this critique invariably organize their macroeconomic thinking along "Keynesian" (or New Keynesian) lines. An important pillar of this way of thinking is some version of the Phillips Curve (see here for Mike Bryan's humorous critique of the concept). Here is what a Phillips curve is supposed to look like:

Now, imagine that the economy is hit by a large negative "aggregate demand shock." Unemployment rises, and inflation falls--there is a movement along the PC, downward, from left to right (see diagram above).

Next, suppose that the Fed has the power to exploit the PC relationship (this is a questionable supposition, in my view, but it's what people like to believe, so let's run with it). What would the unemployment-inflation dynamic look like in response to such a shock under an optimal (or near optimal) monetary policy? (Bullard references the Smets and Wouters NK model: Shocks and Frictions in U.S. Business Cycles: A Bayesian DSGE Approach.)

Bullard's suggests that a non-monotonic transition path for inflation is unlikely to be part of any optimal policy in a NK type model. The optimal transition dynamics are typically monotonic--think of the optimal transition path as a movement back up the PC in the diagram above. If this is true, then the optimal transition path  necessarily has the Fed missing on both sides of its dual mandate.

Of course, conventional NK models frequently abstract from a lot of considerations that many people feel are important for understanding the recent recession and sluggish recovery. The optimal monetary policy may indeed dictate "inflation overshooting" in a different class of models. Please feel free to put forth your favorite candidate. Tell me why you think Bullard is wrong. 

QE3 and Inflation Expectations

Some interesting data here on the TIPS measure of expected inflation following the Fed's QE3 announcement (courtesy of my colleague, Kevin Kliesen).

The first chart shows that the announcement had a significant impact on inflation expectations at short and long horizons.

Here's the same data, together with the 10-year inflation forecast, and for a longer sample period.

The impact on real yields, especially at the short end, seems significant (but let's see how long this lasts). 

 
Here's the same data over an even longer sample period.

 
And here's a truly remarkable graph...

Notes: Inflation-Indexed Treasury Yield Spreads are a measure of inflation compensation at those horizons, and it is simply the nominal constant maturity yield less the real constant maturity yield. Daily data and descriptions are available at research.stlouisfed.org/fred2/. See also Statistical Supplement to the Federal Reserve Bulletin, table 1.35. The URL for MT is: http://research.stlouisfed.org/publications/mt/