"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.)

How much slack is there in the labor market?

Economists at the Cleveland Fed compile different estimates of "labor market slack" and of the "normal unemployment rate." I think the most important sentence in their commentary is:

There is considerable uncertainty surrounding the estimates, so we cannot draw sharp conclusions about the amount of slack, or about differences between slack estimates. 

Also, look at the chart of the estimates of slack:

At least three of the metrics dip below zero during business cycle expansions (the green line, the purple line, and the blue line). That means job market slack turns negative, or that the market gets too tight. Is that something policymakers should shoot for? How about the risks associated with a monetary policy that, while it "gets more people employed," also creates distortions and imbalances elsewhere? 

The most recent data points are hard to read off the chart, but it seems to me that most measures are between 0% and 0.5%, if not below. So, whereas there is uncertainty, this evidence suggests that slack is somewhere between small and non-existent. What is the optimal monetary policy in the presence of this small but uncertain job market slack? Keep monetary conditions loose, just in case? 

More and more, it seems to me, the Fed is looking only at one side of the risk (i.e. the risk that monetary conditions are too tight).

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.

Inflation in the eurozone: goods versus services

Giulio Zanella (hat tip to John Cochrane) writes a post suggesting that Italy’s deflation is mostly imported. He supports his idea with two observations. First, the price index of goods has declined, but the price index of services has increased (coincidentally, by the same percentage). Second, among goods, those whose price has declined are: unprocessed food, energy, tobacco, and consumer durables. The first three have in common, Zanella says, that they’re traded in global commodity markets.

Assume that goods are tradable in international markets, whereas services are non-tradable—a good approximation for a country like Italy, Zanella says. Then, he concludes, the origin of Italy’s deflation is international and on the supply side, whereas the contribution of weak domestic demand is “modest.”

In this post I look at the questions of whether eurozone deflation is really “imported,” and of how big the deflation threat is.

For the currency area as a whole, disinflation is a lot faster for energy and unprocessed food than for the other components of the HICP:

Within the “core” inflation rate, durable and semi-durable non-energy goods are in outright deflation, whereas non-durable goods are not:

The identification of the tradable component of the HICP with goods, and the non-tradable component with services is not accurate, but I’ll accept it for the sake of simplicity. (After all, the main drivers of services inflation should be domestic factors.) Extending this simplification to prices, goods deflation is “imported,” whereas services deflation is “homegrown.”

The distinction is important, among other things, because the optimal monetary policy response depends on the type of deflation. If deflation is imported, the ECB should do nothing, because commodity prices and the exchange rate are outside the set of things it can (or wants to) control. Let’s look, then, at the split of the HICP between goods and services.

The sub-index for all goods was falling at an annual rate of 0.3% as of July, whereas the price index of the basket of services was increasing 1.2%:

(Goods account for about 57.2% of the eurozone-wide HICP, and services for 42.8%.) 

Services inflation appeared to be declining from 2011 up until April 2013, and since then it’s been more or less flat around 1.2% (to zoom in, adjust the dates on the chart above).

It appears, then, that a large part of the eurozone’s current disinflation might be “imported.” Another, smaller part of this disinflation is “homegrown,” but it doesn’t seem to be getting worse.

What’s the evidence across countries?

Goods inflation has declined in every single of the 15 countries I consider*. In all but two countries, prices are falling outright.

Services inflation has declined overall, but slightly (from 1.4% in July 2013 to 1.2% one year later). In five countries services inflation rose: Belgium, Ireland, France, Portugal, and Finland. In one country, Greece, deflation became less pronounced. In two countries, Germany and Austria, the services inflation rate didn’t change. And in the remaining six countries inflation declined: Estonia, Spain, Netherlands, Italy, Slovakia, and Slovenia.

So far, then, I’d say the jury is still out on whether disinflation, for services, is continuing.

Clemente De Lucia, economist at BNP Paribas, just published a research note taking a deep look at services inflation. This is what I see, from the first section of his note (“Inflation decomposition”):

1. Services inflation in core countries (Netherlands, Austria, Luxembourg, Belgium, Finland, Germany, France) is higher than in periphery countries (Greece, Spain, Portugal, Ireland, Italy). In the “core” region, services inflation shows no apparent trend since early 2011, whereas in the “periphery” services inflation has been roughly flat since late 2013:

Source: Clemente De Lucia (BNP Paribas), July-August 2014.

De Lucia mentions how, in the core, the current inflation rate is “slightly below its historical average,” and that in Germany and the Netherlands the services inflation rate is below the eurozone aggregate (although barely so):

Source: Clemente De Lucia (BNP Paribas), July-August 2014.

2. "Lowflation” is spreading across services sub-categories, but deflation is less pervasive. To gauge the diffusion of disinflation and deflation, De Lucia looks at the percentage of the 39 sub-components of the services HICP that had an inflation rate between 1% and 2%, between 0% and 1%, and below 0%.

For the eurozone as a whole, the share of services sub-categories with inflation between 1% and 2% has shot up, but the share of services in deflation has declined (from a percentage that was never higher than 20%):

Source: Clemente De Lucia (BNP Paribas), July-August 2014.

The evidence by country varies. De Lucia focuses on the total proportion of services sub-categories with inflation below 2%. That statistic is rising, De Lucia notes, in Spain, Portugal, Greece, Netherlands, and France. From that he concludes that deflationary pressure is mounting in those countries.

(Beware that, in those charts, the three categories are nested. That is, the category of "below 2% inflation" includes the category of "below 1%" inflation, and so forth. I checked.) 

De Lucia's data end in May 2014. I gathered my own data to see what's happened over the past 12 months, for the eurozone aggregate. The proportion of service categories with inflation below 2% reached a maximum in February (70%), and has declined since then. The diffusion of deflation reached 18% in December 2013, and has fallen to about 5% in July.

It will be interesting to see a breakdown by country. So far, though, I'm not convinced that "domestic deflationary pressures" are mounting.

One interpretation of the ECB’s recent policies is that the bank is not reacting to today’s decline in the price of goods. Most of that is due to past declines in commodity prices—which the ECB has no control over— and to the past rise of the exchange rate—which the ECB doesn’t target. The ECB, instead, is reacting to the disinflation of services, and the risk (or expectation?) that it might turn into outright deflation. How serious is that threat?

Based on the (admittedly backward-looking) evidence surveyed here, the risk of "homegrown" deflation is there, but it's not increasing, imminent, or pervasive across countries. (De Lucia’s note continues with a promising, long section on inflation expectations, which I haven’t had time to read yet.)

A different interpretation is that the ECB sees deflation in goods as a problem it can solve—through the exchange rate. The euro appreciated steeply, through May, and that has driven the euro price of commodities lower. The new policies might be aimed at depreciation.

But that will have to wait for another blog.

*For visual clarity, I removed from the chart the three smallest members of the eurozone: Cyprus, Malta, and Luxembourg.

Why QE might be a bad idea for the eurozone

Michael Heise, chief economist at Allianz, is against (FT) quantitative easing by the ECB. He thinks the ECB shouldn't go down the QE route, because:

First, the recent low inflation rates are in part a result of the decline in oil and other commodity prices. They also reflect necessary adjustments in the eurozone periphery. [...] There is no sign of a vicious circle of falling inflation expectations and consumer restraint. Inflation rates will gradually climb again as the economy recovers.

Second, although the ECB has several options when it comes to implementing QE, there are serious objections to all of them. Buying asset-backed securities or corporate bonds would expose the European taxpayer to credit risk.

[...]

Third, the impact of further monetary easing on output and price levels would be negligible. That is because the recession in many parts of the eurozone is caused by the hobbling effect of the unsustainable amounts of debt that were built up by public and private actors during the boom years. Over-indebted households and companies are unlikely to pile up more debt; on the contrary, they are trying to pay it down. This makes monetary policy ineffective.

Fourth, the collateral damage from ultra-loose monetary policy is accumulating. Risks to financial stability are growing as investors are piling into riskier assets in search of higher returns. Already, some assets such as junk bonds are trading at what look like inflated prices.

Fifth, further monetary easing would delay the much-needed adjustments in the balance sheets of European banks and companies. An abundance of cost-free liquidity from the central bank enables commercial lenders to continue propping up weak creditors.

Of those, I agree most with #1. A breakdown of the eurozone's consumer price index suggests that a good chunk of Europe's deflationary pressure is "imported," showing up in the price index of goods with a high component of commodities. The price index of services, on the other hand, many of which are non-tradable, doesn't indicate deflation. (More on this soon.) Yes, demand is weak, and the private sector is deleveraging, but a lot of the "deflation" problem has to do with declining prices of globally traded goods, and the appreciation of the euro between 2012 and 2014, which only started to reverse itself in May.

Of the other reasons offered by Heise, I agree with #4. I'm sympathetic with #3 (further easing will be ineffective), but I stress a different obstacle: banks are under pressure to clean up their balance sheets. In that sense, European policy is schizophrenic. On one hand, the ECB is trying to encourage more lending; on the other, regulators tell banks to improve their equity ratios.

What caught my eye

1. Global bond sales at post-2009 high (from the FT):

Banks and businesses seeking to capitalise on record low borrowing costs in the west have seen worldwide bond volumes increase by 6 per cent to $2.74tn so far this year compared with the same period in 2013. The figure is the highest since 2009, a record year for deals according to Dealogic.
[...]

The US accounts for the largest number of global bond deals, equivalent to 30 per cent of the global total, but its share has slipped by 5 percentage points from 2013 in the face of resurgent issuance elsewhere, especially in Europe.

Overall European issuance increased by 11 per cent to $1.41tn driven by a 69 per cent year-on-year rise in financial institutions’ bonds, while corporate bond issues enjoyed a single-digit rise. Sovereign bond deals decreased slightly.

Eurozone banks, especially those in the periphery countries, have been eager to cash in on investors’ hunt for higher yielding bonds while they have been under regulatory pressure to build their capital buffers.

2. A new book (free!) on the secular stagnation hypothesis. VoxEU summarizes the book. Stephen Williamson writes a critique. David Beckworth says long-term interest rates are not in secular decline.

3. Timothy Taylor (Conversable Economist) relays the conclusions of a new paper on fair trade:

a) Fair Trade and other certification programs affect a relatively small number of workers.

b) Fair Trade does seem to provide higher prices and greater financial stability, at least when farmers can sell at the minimum price.

c) Fair Trade does seem to promote improved environmental practices.

d) While Fair Trade helps producers, the effects on workers and work organizations is more mixed. 

4. Dovish Draghi. Comments by Simon Wren-Lewis and Greg Ip.

5. Home ownership for everyone, Swedish edition, from Bloomberg News:

Sweden’s Social Democratic Party, which polls show will oust Prime MinisterFredrik Reinfeldt’s ruling coalition in elections next month, is ready to relax a regulatory limit on mortgage financing.

The party says a rule that prevents Swedes getting loans worth more than 85 percent of property values hurts first-time buyers. According to Magdalena Andersson, the party’s economic spokeswoman, the Social Democrats may seek to ease the loan-to-value cap if the regulator introduces rules that force households to amortize their mortgages. Less well-off households would be exempt from any amortization requirements, she said.

[...]

The proposal, which would reverse a 2010 limit put in place during Reinfeldt’s tenure to contain record household debt, risks colliding with central bank pleas to slow credit growth. Riksbank Governor Stefan Ingves said last week failure to address consumer indebtedness could force the central bank to tighten monetary policy to protect financial health.
[...]

The government and regulator are exploring more options to address Sweden’s debt burden, which the central bank estimates is about 175 percent of disposable incomes, the highest on record. Swedes’ addiction to borrowing has intensified over the past half decade. Consumers in the AAA-rated country used record-low interest rates during Europe’s debt crisis to take on credit in a cycle that contributed to record housing prices.

6. Tyler Cowen on the interaction between macroeconomic trend and cycle:

Let’s say, as seems to be the case, that wages stagnated, labor market mobility slowed down, and non-outsourcing productivity was slow during 2000-2007 (or maybe longer).  Those are all long-term economic trends and they are all bad news.

During 2000-2007 most Americans acted as if were are on a good trend line when in fact they were on a less favorable trend line.  This influenced spending decisions, borrowing decisions, real estate decisions, and so on.  People overextended themselves and they also created unsustainable bubbles.  Sooner or later the debt cannot be rolled over, the bubbles pop, the crash ensues, AD falls, and so on.  This often takes the form of a discrete cyclical event, as indeed it did in 2008.

One point — still neglected in much of today’s macroeconomic discourse — is that the mis-estimated trend was a major factor behind the cyclical event.  But there is yet more to say about this interrelationship between cycle and trend.

The arrival of the cyclical event, in due time, makes the negative underlying trend more visible.  At first people blame everything on the cycle/crash, but a look at the slow recovery, combined with a study of pre-crash economic problems, shows more has been going on.

The cyclical event itself places greater stress on labor markets, on firm liquidity and thus on R&D, on perceived stocks of wealth, and so on.  As individuals observe the reaction of the economy to this added stress, they start seeing just how wide-ranging and deep the previously existing structural problems have been.

Those observations, and the accompanying economic responses, make the problems worse.  Forecasts become more pessimistic, investment declines, firms will be less keen to commit to workers who are less than the “sure thing,” and so on.  Sometimes this is moving along curves, other times there are shifts in multiple equilibria (“is Greece a European country or a Balkans country?”), toss in some herd behavior too.  In any case these changes are ill-served by the terminology of cyclical vs. structural.  They are cyclical and structural in an intertwined fashion.  And of course this all leads aggregate demand to fall all the more.

Keynesian Yellen vs. Wicksellian BIS

Gavyn Davies writes an excellent summary of the debate between the"mainstream-central bank-Keynesian" view of the economy and the "alternative-BIS-Wicksellian" view. (It's on the blog section of the Financial Times, but I'm not sure if it's gated.)

Davies juxtaposes a recent speech by Yellen to the BIS annual report, both of which, I'm sure, are excellent readings.

Similarities between the two views:

There is agreement that financial crashes that trigger “balance sheet recessions” lead to deeper and longer recessions than occur in a normal business cycle. There is also agreement that inflation is not likely to re-appear any time soon, and that the current recovery should be used to strengthen the balance sheets of the financial sector through regulatory and macro-prudential policy.

Wicksellians and Keynesians have radically opposed views, however, on what caused the great financial crisis:

The BIS views the crash as the culmination of successive economic cycles during which the central banks adopted an asymmetric policy stance, easing monetary policy substantially during downturns, while tightening only modestly during recoveries[...]On this view, monetary policy has been too easy on average, leading to a long term upward trend in debt and risky financial investments. The financial cycle, which extends over much longer periods than the usual business cycle in output and inflation, eventually peaked in 2008[...]In contrast, the mainstream central bank view denies that monetary policy has been biased towards accommodation over the long term. Ms Yellen’s speech claims that higher interest rates in the mid 2000s would have done little to prevent the housing and financial bubble from developing. She certainly admits that mistakes were made, but they were in the regulatory sphere, where there was insufficient understanding of the new financial instruments that would eventually exacerbate the effects of the housing crash. Higher interest rates, she says, would have led to much worse unemployment, without doing much to reduce leverage and dangerous financial innovation.

Because central banks are using the "wrong model," their policies are inadequate, and even exacerbating some problems:

[...]even now, the BIS says that the central banks are attempting to validate the long term rise in debt and leverage, instead of allowing it to correct itself. Excessive debt, it contends, is preventing the rise in capital investment needed for a healthy recovery. Financial and household balance sheets need to be repaired (ie debt needs to be reduced) before this can take place.[...]The BIS argues that zero interest rates and quantitative easing are becoming increasingly ineffective in boosting GDP growth. Instead, they are artificially inflating asset prices, and blocking a necessary correction in excessive debt. Macro-prudential and regulatory policy might be helpful here, but will not be sufficient. The main risk is that the exit from these accommodative monetary policies may come too late.
The Yellen view is in sharp contrast to this. There is no admission that quantitative easing is becoming ineffective, or that excessive debt should be reversed [3]. There is an outright rejection of the view that interest rates have been too low throughout previous cycles. If anything, the “secular stagnation” argument is adopted, suggesting that real interest rates have been and remain too high, because the zero lower bound prevents them from falling as far as would be required to reach the equilibrium real rate. On this view, the danger is that the exit from accommodative monetary policies will come too early, not too late.

One massive difference between the two views of the economy is that the BIS would prefer to see a tightening of both monetary and fiscal policies, whereas Keynesians think that neither should be tightened "too soon." On fiscal policy:

This divergence of views on economic capacity leads in turn to a major difference on appropriate fiscal policy. The BIS implies that cyclically-adjusted fiscal policy is looser than it seems, because GDP can never return to its earlier trends. The Keynesian/Yellen view is that fiscal policy should not be tightened too soon, and perhaps not at all until output has fully recovered.

What caught my eye

1. Benjamin Friedman describes the perils of downsizing the central bank's balance sheet. It wasn't my first guess, though. Friedman argues that, by holding an assortment of assets, central banks have acquired a new tool to fine-tune monetary policy.

2. A three-part essay on alternative measures of inflation, on the website of the Atlanta Fed, by Mike Bryan, the father of the trimmed CPI and the median CPI.

3. Australia proposes to raise the retirement age to... 70! (on Bloomberg)

4. Excellent review of the consensus view why the "natural" interest rate has tumbled, by Larry Summers (via John Cochrane).

5. The TIOBE index: the most popular programming languages.

6. A comparison of programming languages in economics, by Aruoba and Fernández-Villaverde, from this week's batch of NBER working papers.

7. Can productivity rise forever? A partial discussion of the main issues, by Robin Harding at the FT.

8. Repeat after me: banks do not "lend out" reserves, by Paul Sheard at S&P, via David Andolfatto. David commented on Sheard's note, and was quickly corrected by Nick Rowe. David has now written a simple model to think through the issue of excess reserves and inflation risk. Don't you love economics blogs??

Four stories of quantitative easing

I strongly recommend this paper (no math, some jargon) to those of you interested in monetary policy. Brett Fawley and Christopher Neely walk the reader through the "quantitative easing" programs of the Big Four central banks (Fed, BoE, BoJ, ECB), from 2008 through 2012. Aside from the month-by-month, bank-by-bank chronicle, this paper provides great charts, tables, and links to the sources.

For a wider cross-section of central banks that have doubled the monetary base, dating back to the early 1990s, see Anderson, Gascon, and Liu (2010).

What I got from this reading:

1) There's a difference, at least in appearance, between "quantitative easing" and "credit easing." QE has as explicit target to expand, in a pronounced and persistent way, the liabilities of the central bank (i.e. the monetary base, or M0). QE can take the form of asset purchases or lending programs. Credit easing, on the other hand, intends to improve liquidity or the cost of credit, perhaps in specific credit markets. Credit easing may lead to an enlarged balance sheet, and that's often the case, but credit easing does not target an expansion of the monetary base.

2) Only some of the BoJ's and the BoE's programs can be properly described as QE policies, because they explicitly stated the goal to enlarge the central bank's liabilities. The Fed and the ECB have not formally engaged in QE. In practice, however, just looking at balance sheets, it's difficult to tell un-sterilized credit easing from QE. Fawley and Neely seem to lean towards considering that any policy that increases the monetary base substantially and for a long period is QE, whether as a stated goal or de facto.

3) An exhaustive list of references to the QE and credit easing programs implemented by those four banks through 2012.

What caught my eye

1. Brazilians turn against the canarinha (for now).

2. Bad dreams about Russia, China, and World War.

3. What do cancer and unemployment have in common?

4. NBER papers: phasing out paper currency, and permanent changes to monetary policy.

1. "I want Brazil to lose," says a Brazilian. I seldom hear good things about the World Cup, which makes me think the event will be a positive surprise. (By the way, remember the comments in the months prior to London's Olympics?)

2. Russia strengthening ties to China. Perhaps it's WWI centennial fever, but I can't erase from my mind the idea of a China-Russia military alliance, against the "oppression," "bullying," etc. from the U.S.-Western Europe-Japan trio. Articles like this, on China supposedly following Japan's prewar blueprint, don't help put me at ease.

3. The odds of developing certain cancers decline with age, just like the odds of escaping unemployment decline with the length of the jobless spell, by Jim Hamilton.

4. Two papers from this week's NBER crop:

4.1 Costs and benefits to phasing out paper currency, by Kenneth Rogoff.

Despite advances in transactions technologies, paper currency still constitutes a notable percentage of the money supply in most countries.  For example, it constitutes roughly 10% of the US Federal Reserve's main monetary aggregate, M2.  Yet, it has important drawbacks. First, it can help facilitate activity in the underground (tax-evading) and illegal economy. Second, its existence creates the artifact of the zero bound on the nominal interest rate.  On the other hand, the enduring popularity of paper currency generates many benefits, including substantial seigniorage revenue.  This paper explores some of the issues associated with phasing out paper currency, especially large-denomination notes.

4.2 Has the financial crisis permanently changed the practice of monetary policy?, by Benjamin Friedman.

I argue in this paper that one of the two forms of hitherto unconventional monetary policy that many central banks have implemented in response to the 2007 financial crisis - large-scale asset purchases, or to put the matter more generically, use of the central bank's balance sheet as a distinct tool of monetary policy -is likely to become part of the standard toolkit of monetary policymaking in normal times as well.  As intended, these purchases have lowered long-term interest rates relative to short-term rates, and lowered interest rates on more-risky compared to less-risky obligations.  Moreover, their introduction fills a conceptual vacuum that has long stood at the heart of monetary policy analysis and implementation. By contrast, forward guidance on the future trajectory of monetary policy has been less successful.  Public statements by central banks about their actions and intentions will no doubt continue, but transparency for the sake of transparency is not the same as the deliberate attempt to shape market expectations for purposes of achieving specific monetary policy objectives. Finally, there is a conceptual component to all this as well.  In contrast to the last century or more of monetary theory, which has focused on central banks' liabilities, the basis for the effectiveness of central bank asset purchases turns on the role of the asset side of the central bank's balance sheet. The implications for monetary theory are profound.

Well worth reading

1. A scorching critique of the Fed's unconventional policies--by the president of the Philadelphia Fed. If you don't have time for the whole thing, read John Cochrane's excerpts and commentary.

2. À propos of unconventional monetary policy: how loose are monetary conditions anyway? Back in the day when "straightforward" tools were in place, the Fed funds rate was all you needed to know. These days we don't observe the "true" policy rate, because once the Fed hit the zero bound, they replaced the Fed funds rate with QE as the tool to loosen monetary conditions. The true Fed funds rate has gone underground, so we can't see it. Dora Xia and Cynthia Wu have developed an estimate of the shadow policy rate. (Hat tip to Jim Hamilton.) The authors were kind enough to make the data available online.

3. House prices in the UK: multiple estimates. And: is the UK housing market in a bubble?

4. The Canadian housing bubble.

20130603 Links

1. China's exchange rate; 2. Nigeria's banking system; 3. The Fed indirectly caused low interest rates.

1. Is the renminbi overvalued? Charles Dumas at the FT thinks so.

Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezing profit margins, and are up 20 per cent relative to the export competition since 2011.  

Adding to this problem is the sudden, related, swing into high real interest rates. In mid-2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from China’s banks has kept nominal interest rates high. The nominal interest rate is only down to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per cent. Such high real interest rates combined with squeezed profit margins have pushed China into a prolonged “investment-led” slowdown. 

China’s extravagant post-crisis recovery splurge, with capital spending raised to 48 per cent of GDP, much of it debt-financed, has left it with high prices for real estate and industrial commodities. These assets with low-to-negative yield are also the most sensitive to interest and exchange rate changes. Whether or not Chinese real estate is in a bubble, high nominal and real interest rates make these asset prices vulnerable. 

Premier Li Keqiang spoke recently of plans to remove controls on capital outflows. Any such action could release a wave of savings seeking real foreign assets. This would devalue the yuan and cushion the rebalancing of the economy away from excessive capital spending. But it would also drain away bank deposits, threatening a major domestic asset sell-off as well as bank insolvency. 

[Emphasis added.]

I am most worried about a spiral of: flight of savings away from Chinese banks, rising interest rates, a property crash, and household and bank insolvencies.

2. Nigeria's banking system has recovered. To me, not following the Nigerian economy closely, it was news that the country suffered a banking crisis in 2009. In any case, the IMF has published a report that says that banks have recovered just fine, although (of course), substantial risks remain. Selected paragraphs from the executive summary:

1. The Nigerian economy has experienced domestic and external shocks in recent years, which resulted in the 2009 banking crisis. However, the economy has continued to grow rapidly, achieving over 7 percent growth each year since 2009. The performance of financial institutions has begun to improve, though some of the emergency anti-crisis measures continue to be in place. The success in maintaining financial stability after the crisis, and in the face of major external threats, reflects the decisive and broad-based policy response by the government and the Central Bank of Nigeria (CBN).  

2. Following the crisis, the authorities took a comprehensive set of remedial measures. Substantial liquidity was injected; a blanket guarantee for depositors, as well as for interbank and foreign credit lines of banks, was provided; the Asset Management Company of Nigeria (AMCON) was established to purchase banks’ nonperforming loans (NPLs) in exchange for zero coupon bonds and inject funds to bring capital to zero; regulations and supervision were strengthened and corporate governance enhanced; and the universal banking model was abandoned and banks instructed to establish holding companies or divest their nonbank activities.  

3. As a result, Nigeria avoided economic collapse and economic growth resumed. The challenge now is to build on these achievements, so that vulnerabilities can be mitigated and growth placed on a sustainable and enduring path. 

(...) 

5. The financial system continues to suffer from weak governance, including some non-transparent ownership structures, deficiencies in financial reporting, and endemic perceptions of corruption. These weaknesses were highlighted by failures and severe undercapitalization of several banks, contributing to banking sector consolidation from 89 banks in 2005 to 20 in 2012. The federal government’s fight against corruption has resulted in an improvement in perception of the extent of corruption as indicated, for instance, by Transparency International in 2011. However, corruption continues to be a significant problem, including in the court system and other public authorities.  

6. Despite significant progress in recent years, the regulatory and supervisory framework has gaps and weaknesses: (i) Nigerian financial institutions operate under a framework of laws, regulations, circulars, and guidelines that are not all well-understood, and do not seem to provide a coherent overall framework; (ii) further enhancements are still needed in bank supervision and resolution, particularly with regards to at least one weak bank, and to cross-border supervisory practices; and (iii) the extensive agenda ahead for supervisors and regulators will pose serious capacity challenges.  

7. The development and regulation of non-bank financial institutions require further reforms. The insurance sector needs better enforcement of compulsory insurance; improvements in product disclosure standards; and resolution of small unprofitable companies. The 2004 pension sector reform was helpful, but coverage remains low. Legacy funds’ assets are yet to be transferred to Pension Fund Administrators. Although the Nigerian Securities and Exchange Commission (SEC) has made progress, more reforms are needed to further enhance oversight of the capital markets. The SEC has been without a Board since June 2012, jeopardizing its proper governance and functioning.  

(...) 

9. Access to finance is an important constraint to Nigeria’s development. There is negligible intermediation to small and medium-sized enterprises (SMEs) by the formal financial sector. While the microfinance sector has undergone significant changes, it remains characterized by numerous small, financially weak and ineffective institutions. 

3. Bringing perspective to QE. David Beckworth points out that the Fed, yes, bought a lot of government debt in 2010-11, but they also allowed their share of Treasury debt balances to drop in 2008-09. In his view, the Fed is indirectly responsible for the ultra-low interest rates. If I understand him correctly, the Fed did not respond adequately to the spike in demand for money balances in 2008-09, and that that failure is behind the low interest rates.

David asks "Why are interest rates so low?"

The most obvious answer is that the monetary policy of the Federal Reserve is keeping them low. Many observers point to the Fed’s large-scale asset-purchase programs as the reason for the low interest rates. Others point to the Fed’s forward guidance on interest rates that says the target federal-funds rate will remain in the exceptionally low 0–0.25 percent range for some time. These observations have led some to conclude that the Fed is not only creating a drag on the economy with its low-interest-rate policies, but is also making it easier for Congress and the president to avoid tough budget choices and enabling large government deficits by reducing the Treasury Department’s financing costs. 

This understanding, however, runs up against three inconvenient facts. First, the Fed has not been dominating the Treasury market. At the end of 2012, the Fed held only 15 percent of all marketable Treasury securities, roughly the same share it has held over the past decade. This means that the largest-ever run-up of public debt was financed mostly by individual investors, their financial intermediaries, and foreigners. Second, the Fed’s forward guidance on interest rates is itself shaped by the Fed’s forecast of the economy. The Fed, then, is not independently shaping the future path of interest rates, but is responding to what it thinks will happen to the economy in the future. Finally, long-term interest rates on safe government debt across the world have fallen: Very similar sustained declines in government-bond yields have occurred over the past four years in the United States, the United Kingdom, Germany, and Japan, as the graph below shows. It is far easier to explain these declines as a function of a weak global economy than to attribute them to an overactive, all-powerful Fed.

David moves on to say that

The proximate reason, then, for the low-interest-rate environment is that the ongoing weak economy has stirred investors’ appetite for safe and liquid assets. Households, for example, continue to hold an inordinately high share of money-like assets, including Treasuries, in their portfolio of assets.
Households’ high share of safe assets should not be surprising given the spate of bad economic developments over the past five years: the Great Recession, the euro-zone crisis, concerns about a China slowdown, the debt-ceiling dispute of 2011, and the more recent fiscal-cliff talks. The immediate effect of these developments was to create uncertainty about future economic growth and raise the demand for money-like assets. This elevated broad money demand not only has kept interest rates low, but also has prevented a robust recovery from taking hold.
While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?

Simplifying, the two opposing views implicit in David's discussion are: 1. The Fed bough a lot of Treasury debt, thus keeping their prices high and yields low; 2. There was an independent rise in the demand for money, motivated by expectations of slow growth and by increased risk, and the Fed failed to counter expectations of depressed nominal spending.

I admit that I have not articulated a full-fledged response to David's views, but here hare a few thoughts:

1. The Fed's balances of Treasury debt do not matter for the determination of interest rates as much as the marginal purchases of treasuries, and the announcement of (possible, not even actual) future purchases.

2. Risk perceptions and risk aversion probably played a big part in the surge of money demand in 2008-09. The Fed did step in to assuage the markets. Although the Fed did fall short of targeting nominal spending, it is not clear to me how NGDP targeting would have been more effective than the policies that the Fed actually followed in regards to mitigating the rise in risk perception and risk aversion.

3. The Fed's policies in 2008-11 did probably suffer from the "pessimism problem," and it was not until 2012 when they got around it by targeting the unemployment rate. And it might have been better if they figured that out sooner. But can the Fed, really, steer the real economy one way or another, by buying more treasuries? Why would it make any difference if the Fed targeted NGDP instead of targeting the unemployment rate? In my opinion, the announcement of an intention to keep interest rates low for a long period of time had an effect on the prices of financial assets, but it made a difference on the real economy mostly by removing some uncertainty and instilling a bit of confidence. Having an objective, well-defined target was important, but the choice of target (NGDP, unemployment, employment creation, output growth, what have you) was secondary.

Here's David's blog post, and here is his recent piece on the National Review.