"I still hold out some hope": James Bullard on the U.S. becoming Japan

Refreshingly outspoken James Bullard, from the St. Louis Fed, gives an interview to the New York Times. Some great quotes (emphasis mine):

"The general rule of thumb within the Fed is that labor market data trumps G.D.P. data." 

"Once major central banks hit the zero lower bound, the key issue was whether central banks would be able to keep inflation expectations consistent with inflation targets." 

"I think the Brexit vote, there are a couple of aspects of this that make it much less of an international macroeconomic event. It’s a scheduled event; you can track which way the vote is going to go by looking at polling; and it’s a long-term strategic vote on the part of the U.K. The day after Brexit — even if they vote to leave — nothing would actually change in terms of the trade arrangements. Those would continue for at least two years." 

"The norm in central banking, away from the zero bound, is to say, “We have set the policy rate exactly where we think it should be for today, given everything that’s going on in the economy, and in the future we’ll look at the data.” You didn’t do this kind of dot-plot thing. [...] I’ve wondered if we should get back to something that’s more akin to that. We don’t want to give unintentional commitments." 

"I’ve actually argued that unconventional policy works reasonably well. But it’s far less clear how it works, or how effective it is." 

"I’ve always been worried that the long run here is the Japanese outcome. I still hold out hope that that’s not the case, but I am worried about it, and it’s been going on for a very long time. If you talk to people in Tokyo, they say, 'Well, we’ve been through this and tried all these things, and you guys are just following us.' I hope that’s not exactly true. [...] I still hold out some hope." 

"I’m not as big an advocate of fiscal policy as some other people. It’s very hard to do very much on a business cycle time scale, given the fact that you’ve got to work with Congress." 

"At some point something will happen and we’ll be back in recession, and by almost any reckoning we will not have much that we can do in the way of lowering our policy rate."

The hawkish shift of monetary policy recommendations

A recent poll by Chicago Booth (thanks, Tyler!) asked a panel of economists in early December to agree or disagree with the following statement

The Fed should raise its target interest rate when it meets in mid-December.

The respondents (all of whom are "senior faculty at the most elite research universities in the United States") were largely in favor of a hike. Forty-eight percent either agreed or strongly agreed; and 19% disagreed. Nobody disagreed strongly.

Digging through previous questions to the same panel, I found a puzzling result from early April. The question then was:

The Fed should wait until its preferred measure of inflation (Core PCE) is clearly rising — and not just forecast to rise — before it begins hiking interest rates.

Here's how the results of the two polls compare:

April

December

The hawkish swing is dramatic. In April 40% of respondents thought the Fed should wait for core inflation to rise. In December, even though core inflation had not risen at all, only 19% didn't think the Fed should raise immediately. What's going on? (Remember, both statements were about what respondents thought the Fed should do, not predictions of what the Fed would do.)

1) Unemployment went down. But I find this hard to believe, because the unemployment rate fell just 0.5% between March and November, and the consensus forecast in March was already that unemployment would go down.

2) Despite the wording of the April question, respondents did have in mind forecast inflation, not just actual inflation. But forecasts of core inflation barely changed between April and December. If anything, medium-term forecasts went down slightly.

3) There is a third (fourth, fifth?) variable in the respondents' mental Taylor rule. However, this additional variable would have to produce a hawkish leaning by December. Output didn't grow particularly fast, in the U.S. or globally. Perhaps a heightened awareness that low interest rates are destabilizing the global financial system? I'm not convinced because, if anything, the consensus is probably that the system is more fragile now than in April. An interest rate hike, at the wrong time, could trigger the crisis.

4) Respondents are concerned about the Fed's credibility. The Fed had been beating the hiking drum from October through December. Doing nothing in December would have undermined the effectiveness of future Fed communications.

5) The respondents, by December, believed that the December hike was largely testimonial, a mere assertion that the Fed is still "in charge," and the hike is to be followed by a gentle tightening cycle. This was not the consensus in April yet.

6) The poll statements are poorly written, because they fail to account for a behavioral bias that makes respondents more likely to agree than disagree with whatever statement they face.

7) Respondents are unconsciously conflating the normative statement with predictions of what the Fed will do. (The consensus prediction shifted dramatically between April and December, mostly because the Fed itself gave strong guidance of an interest rate hike in October and November.)

8) Tyler is right, and economists don't know what they're talking about. Moreover, their ignorant self-confidence produces time-varying biases.

I think a combination of #3, #4, and #5 is most likely, but (as a respondent to opinion polls myself) I can't completely dismiss behavioral biases of the respondents.

QE: What if investors don't buy it?

John Authers has written another good column. It's about "what happens if rates never rise." Among many interesting things, he reminds us to watch profits (payrolls and GDP are secondary, really). He also walks us through the (increasingly plausible) scenario where the Fed doesn't raise rates at all, and  the central bank needs to resort to QE to counter an economic slowdown.

He writes, in passing, something with disturbing implications:

The risk continues to be that investors at some point give up on monetary policy and its power to make a difference — and that would be bad for stocks. So rather than plan for a continued indiscriminate rally in US stocks, it is probably better to focus on those that can show some sustained pricing power, and on those that pay a decent yield.

That first sentence (emphasis mine) entails a mind-blowing possibility. What it the emperor has no clothes?  What if the main (only?) effect of QE is through higher asset valuations? What if QE works because investors think it works and nothing else? What if investors wake up and decide that QE doesn't work?

Sundry links

No time for writing this week, so I'm listing blog posts and articles that caught my eye recently:

1. Liftoff levers. John Cochrane is doing a fantastic job explaining how the Fed's reverse repo operations are supposed to work. Start with this post, and then read this other one.

2. A "new" working paper, by Katharina Knoll, Mortiz Schularick, and Thomas Steger, looks at global house prices in the really long run (1870-2012). From the abstract:

...house prices in most industrial economies stayed constant in real terms from the 19th to the mid-20th century, but rose sharply in recent decades. Land prices, not construction costs, hold the key to understanding the trajectory of house prices in the long-run. Residential land prices have surged in the second half of the 20th century, but did not increase meaningfully before. We argue that before World War II dramatic reductions in transport costs expanded the supply of land and suppressed land prices. Since the mid-20th century, comparably large land-augmenting reductions in transport costs no longer occurred. Increased regulations on land use further inhibited the utilization of additional land...

3. An Icelander goes to Cyprus and tells us why Cypriots keep cash worth 6% of GDP under the mattress.--Sigrún Davíðsdótti at A Fistful of Euros.

4. China's monetary and exchange rate framework under pressure.

           4.1 Huge FX inflows turn into small outflows, and the PBoC switches from draining renminbis to injecting them. To keep base money growing, the central bank has introduced new tools. By Gabriel Wildau for the Financial Times.

           4.2 Time to ditch the renminbi-dollar peg? The Chinese currency has depreciated and is hitting the central bank's target band.

           4.3 On the internationalization of the RMB, a colleague forwards several papers and reports
                 Paths to a reserve currency, at the Asian Development Bank Institute.
                 The rise of the redback, by HSBC.
                 Yuan is fifth world's payments currency, at the WSJ.
               
An important event to keep in mind is that the IMF is reviewing the SDR basket in 2015. China is under pressure to step up the internationalization of the renminbi, ahead of the basket review.

5. Dani Rodrik summarizes the results of his latest paper on de-industrialization.

Premature deindustrialization is not good news for developing nations. It blocks off the main avenue of rapid economic convergence in low‐income settings, the shift of workers from the countryside to urban factories where their productivity tends to be much higher.

Industrialization contributes to growth both because of this reallocation effect and because manufacturing tends to experience relatively stronger productivity growth over the medium to longer term. In fact, organized, formal manufacturing appears to exhibit unconditional convergence (Rodrik 2013), which makes it special and an engine of growth. Since low‐income countries tend to start with small manufacturing sectors, the dynamic within manufacturing initially plays a small role, overshadowed by the reallocation effect. But over time, the within‐manufacturing effect becomes a more potent force as the manufacturing sector becomes larger.Premature deindustrialization throws sand in the wheels of both engines (Rodrik 2013, 2014).

The consequences are already visible in the developing world. In Latin America, as manufacturing has shrunk informality has grown and economy‐wide productivity has suffered. In Africa, urban migrants are crowding into petty services instead of manufacturing, and despite growing Chinese investment there are as yet few signs of a real resurgence in industry. Where growth occurs, it is driven largely by capital inflows, transfers, or commodity booms, raising questions about its sustainability.  

In the absence of sizable manufacturing industries, these economies will need to discover new growth models. One possibility is services‐led growth. Many services, such as IT and finance, are high productivity and tradable, and could play the escalator role that manufacturing has traditionally played. However, these service industries are typically highly skill‐intensive, and do not have the capacity to absorb – as manufacturing did – the type of labor that low‐ and middle‐income economies have in abundance. The bulk of other services suffer from two shortcomings. Either they are technologically not very dynamic. Or they are non‐tradable, which means that their ability to expand rapidly is constrained by incomes (and hence productivity) in the rest of the economy.

I couldn't help but tie Rodrik's paper to that other paper by Pritchett and Summers, the one about regression to the mean of long-term growth rates. Growth is far from a uniform process. It tends to happen in fits and starts. Those who are projecting high growth rates of developing economies, based on past high growth rates, which in turn hinged on industralization, are probably going to be disappointed.

6. The translation industry.The Economist opines that translation is very hard for machines. Humans will need to stay involved, but technology will improve productivity.

A different question: Do improvements in translation bode well for language diversity in the world? How about the language learning industry? I see this as a race between technologies that allow machines to translate better, and technologies that allow humans to learn languages faster. The machines are winning, by a long shot. We're clearly on a path to better simultaneous translation capabilities. Soon we'll be able to listen to anything, anywhere in our native tongue, in real time. That means humans won't have to know more than one language. Learning languages will become a hobby, like dancing. (Sorry, parents, but you're wasting your money on Mandarin lessons.)

As for language diversity, I think a more important force than technology is urbanization. The lion's share of the world's languages are spoken by small, rural communities in developing countries. Urbanization increases the usefulness of majority languages, killing the minority languages. And urbanization will happen faster than the spread of cheap, simultaneous translation technology. At some point, however, the trend towards fewer and fewer languages will slow down, as simultaneous translation becomes pervasive.

Anticipating the Fed's language

Tim Duy wonders whether predicting the Fed's change of language over the next six months will be as easy as looking at the statements from 2004. On Jan. 28, 2004 the FOMC statement introduced the word "patient", replacing the "considerable period" phrase. The Fed kept "patient" in the March 16 statement, and then in May 4 it replaced the key word "patient" with "measured." The first hike would come on June 30.

What did the markets do over that period?

    (Click on the chart to enlarge.)

	10y yield (b.p.)	3m yield (b.p.)	S&P 500 (%)	VIX (%)
Oct. 28, 2003-Dec. 9, 2003	+9	-3	1.28	4.82
Dec. 9, 2003-Jan. 28, 2003	-10	+1	6.15	-4.18
Jan. 28, 2003-Mar. 16, 2004	-52	+2	-1.58	21.22
Mar. 16, 2004-May 4, 2004	+86	+4	0.80	-18.63
May 4, 2004-Jun. 30, 2004	+6	+33	1.90	-13.35

In the bond market the largest yield change was between March 16 and May 4, but it appears that at least part of it was a correction of a previous 50 b.p. decline. Treasury bill yields only moved significantly between May 4 and June 30, when the Fed actually raised rates. The stock market seemed even less unfazed by the Fed's changing statement.

The bottom line is: the markets seemed to be affected by other news much more than by the change in language in the FOMC statements, perhaps because they correctly anticipated the Fed's subtle changes of stance (or lack thereof). (Of course, a better way to do this is to look at minute-by-minute market prices, before and after the FOMC announcements.)

Notable pictures: Dissent (or lack therof) within the FOMC

What explains dissent within the FOMC? Daniel Thornton and David Wheelock contribute a fascinating research note (pdf) to this quarter's issue of the Federal Reserve Bank of St. Louis Review. (A 2013 article by Mark Wynne at the Dallas Fed also touches on dissent and FOMC communications.)

A few highlights (selection and emphasis mine):

1) Ninety-four percent of all votes by FOMC members were cast in favor of the policy directive adopted by the Committee.

2) There have been relatively few dissents since the early 1990s.

3) Since 1936 overall dissents are roughly evenly split between presidents and governors (215 were issued by presidents of the regional Federal Reserve banks, and 194 by members of the Board of Governors). But since 2006, all of the dissents have been issued by presidents of the regional Federal Reserve banks, and none by governors. Moreover, since 1994, only four dissents were issued by governors, and about 70* by presidents (see chart below).

In Thornton and Wheelock's research note, the bit of statistical analysis focuses on the relationship between the dissent rate and inflation and unemployment. And in the note's introductory paragraphs, the authors say that, trying to explain the variation of dissent rates over time:

Our study suggests two main reasons for such variations: (i) differences in macroeconomic conditions and (ii) the level of disagreement among the Committee members about how to judge the stance of policy and how best to achieve the Committee’s ultimate objectives.

When I read the note, however, I get a feeling that institutional factors are behind the lion's share of those variations. The way the FOMC operates has changed dramatically over the decades. Let me show you a few examples, with quotes from the research note itself:

1930s and 1940s: The Fed cooperates with the Treasury

There were only a handful of dissents during FOMC policy votes between 1936 and 1956, all of which occurred between 1938 and 1940. 5 During World War II, the Federal Reserve pledged to cooperate fully with the Treasury Department to finance the war effort.

1950-1955: The executive committee

Federal spending and budget deficits increased when the Korean War began in 1950. Inflation began to rise and the Fed found it increasingly difficult to prevent interest rates from rising. With the support of key members of Congress, the Fed successfully negotiated an agreement with the Treasury Department, known as the Fed-Treasury Accord, in March 1951.

[...]

Differences among FOMC members soon arose over how to implement monetary policy to achieve the Committee’s macroeconomic objectives. However, until 1957, no member ever dissented on a policy vote. The absence of dissents in the early post-Accord years may have reflected, at least in part, how the Committee was organized and the nature of the policy directives issued by the Committee. The Banking Act of 1935 required the FOMC to meet at least four times per year. At that time, directives issued by the full Committee were vaguely worded statements that members may have found little to disagree with. An executive committee consisting of the Chairman and Vice Chairman and three other members met biweekly to issue operating instructions to the manager of the Open Market Desk at the New York Fed. Presumably, those instructions were in line with the desires of the full Committee.

1956-...: Full committee

FOMC procedures changed in 1955. In that year, the FOMC voted to abolish the executive committee and to meet more frequently—every three to four weeks, instead of just once per quarter. Beginning in 1956, at each meeting the full Committee voted on the operating directive to the manager of the Open Market Account, resulting in about 18 policy votes per year instead of the usual four votes in preceding years. The FOMC maintained this schedule until the early 1980s, when the number of scheduled meetings was reduced to eight per year.

1978-2000: Money stock targets

In 1977, the FOMC began to set annual targets for the growth rates of various money stock measures. Although the Committee’s operating directives continued to express policy in terms of money market conditions, they also specified the Committee’s long-run objectives and near-term expectations for growth of the monetary aggregates and an “operational objective” for the federal funds rate, which was usually a range of either 50 or 75 basis points.

[...]

The explanation given for dissenting votes in FOMC records indicates that dissenters sometimes disagreed with the Committee’s chosen growth rate targets for monetary aggregates, the tolerance range for money market conditions or the funds rate, or some other element of the broader directive.

1983-...: Forward guidance

In 1983, the FOMC began to include information in the directive about the likely direction of future changes in policy. Subsequently, some dissents were against the signaling statement rather than the current policy stance.

Unconventional policy

The frequency of dissents has at times been associated with the use of unconventional policy measures. For example, in the early 1960s, the FOMC abandoned its long-standing policy of conducting open market operations solely in Treasury bills. Some members opposed the move, as well as explicit efforts to simultaneously lower long-term interest rates while raising short-term rates—a policy sometimes referred to as “Operation Twist.”More recently, after the FOMC lowered its target for the federal funds rate to the zero lower bound in 2008, some members expressed skepticism about the use of certain unconventional policy measures, including “credit easing,” “forward guidance,” and “maturity extension programs” to ease monetary conditions further.

Explaining the break in the early 1990s

Another institutional change is the publication of the votes of the individual members of the FOMC--and this change might help explain the decline of dissent after the early 1990s, and the stark difference in the dissent rate between governors and presidents, also after the early 1990s.

I'm no expert on the institutional details of the FOMC, but I do know that the Fed started issuing statements announcing the outcomes of its meetings in February 1994. Prior to that, when the committee changed the monetary policy stance, it didn't announce it to the public. Instead, market participants had to figure out the change in stance by watching what the open markets desk did in securities markets after a meeting.

On February 4, 1994, under Greenspan, the FOMC issued its first statement. The statement consisted of three terse paragraphs, and it didn't identify who voted for or against the FOMC decision. Starting. however, with the meeting of May 17 of that year, the statement disclosed which presidents had submitted requests for a change to the discount rate, which at the time was a main operational target of the FOMC. For example, that month the statement revealed that the Board of Directors of the Cleveland Fed had not requested to raise the discount rate, whereas the other eleven regional banks had done so. That was, then, the first time the FOMC had published any hint of internal dissent immediately after a meeting.

On March 19, 2002, the FOMC started including in its immediate announcements the roll call of the vote on the FOMC decision, including the identities and preferences of dissenters, which I believe has been the custom ever since.

Could this increased transparency on the FOMC's internal disagreements explain (1) the decline of dissenting votes since the early 1990s, and (2) the almost total consensus among governors? Thornton and Wheelock themselves offer a hint to an explanation:

District Bank presidents are appointed by their local boards of directors (with approval by the Board of Governors), and Federal Reserve governors are appointed by the president of the United States and confirmed by the Senate. Some researchers argue that governors are thus more responsive to the desires of politicians (who must consider reelection)...

Thornton and Wheelock point to this institutional feature to suggest why presidents are more hawkish than governors. But I think the difference in how presidents and governors are appointed affects their incentives to dissent publicly. Governors (who face reelection by Washington) may be less willing to dissent if disagreement is frowned upon by politicians--who face an asymmetric information problem when assessing the performance of the governors. The regional presidents, on the other hand, might be closer to their boards of directors than governors are to politicians, or perhaps the regional boards of directors are more knowledgeable about monetary policy than Washington politicians are, reducing the information asymmetry between appointee and "appointer."

A second difference between governors and presidents is that the former are appointed for 14-year terms, throughout which they get to vote at the FOMC meetings. Governors have a lot at stake if they ruffle feathers often, or if they're perceived as "eccentric" or "self-centered". The regional presidents, on the other hand, vote at the meetings for just one year, after which they're replaced in the rotation by the president of a different regional bank. (Except for the New York Fed president, who always votes.)

A slightly different answer is that this consensus among governors is an endogenous response to the increased transparency about dissent: Governors not only say they agree more with each other, but genuinely agree more with each other. Fear of "sticking out one's neck" publicly might persuade governors to listen more to each other and to the chairman, which results in less dissent. This hypothesis begs the question of why the regional presidents, who aren't based in DC, don't try as hard as the governors to communicate with other FOMC members between meetings--unless you buy my previous hypotheses on varying costs of dissent.

All these hypotheses, however, require a measure of inattention, as the minutes have always disclosed dissent, but they're published weeks after the meeting.

*I don't have the dataset, so I'm reading off the charts on the research note.

What caught my eye

1. Recessions according to Hayek and Keynes;
2. Network neutrality;
3. Vaccines and autism;
4. Spain issues inflation-linked bonds;
5. The Fed was way off.

1. Reconciling Hayek's and Keynes' views on recessions (NBER working paper). I can't find an ungated version. Please email me if you do.

Abstract: Recessions often happen after periods of rapid accumulation of houses, consumer durables and business capital. This observation has led some economists, most notably Friedrich Hayek, to conclude that recessions mainly reflect periods of needed liquidation resulting from past over-investment. According to the main proponents of this view, government spending should not be used to mitigate such a liquidation process, as doing so would simply result in a needed adjustment being postponed. In contrast, ever since the work of Keynes, many economists have viewed recessions as periods of deficient demand that should be countered by activist fiscal policy. In this paper we reexamine the liquidation perspective of recessions in a setup where prices are flexible but where not all trades are coordinated by centralized markets. We show why and how liquidations can produce periods where the economy functions particularly inefficiently, with many socially desirable trades between individuals remaining unexploited when the economy inherits too many capital goods. In this sense, our model illustrates how liquidations can cause recessions characterized by deficient aggregate demand and accordingly suggests that Keynes' and Hayek's views of recessions may be much more closely linked than previously recognized. In our framework, interventions aimed at stimulating aggregate demand face the trade-off emphasized by Hayek whereby current stimulus mainly postpones the adjustment process and therefore prolongs the recessions. However, when examining this trade-off, we find that some stimulative policies may nevertheless remain desirable even if they postpone a recovery.

2. Everything you need to know about network neutrality, applied to the internet, in 17 easy-to-read cards, from vox.com.

3. Clear, eight-minute review of the evidence (or lack thereof) on the link between autism and vaccines. Thanks to audible.com and upworthy.com.


4. Spain is issuing bonds linked to eurozone inflation, for the first time ever (link to El País article in Spanish, article in English from Bloomberg). A couple of years ago PIMCO published a viewpoint on the eurozone inflation-linked bond market. Market conditions have changed dramatically since then, but it's worth keeping some of PIMCO's concerns in the backs of our minds.

5. John Cochrane re-posts a chart of the Fed's forecasts vs actual growth, by Torsten Slok at Deutsche Bank. If the Fed, employing a flock of highly qualified economists, gets the forecasts so wrong, what's the hope for any individual, somewhat-less-qualified private forecaster?