Monday, December 5, 2016

Macro Musings Podcast: Peter Conti-Brown

My latest Macro Musings podcast is with Peter Conti-Brown. Peter is a financial historian and legal scholar at the University of Pennsylvania. He is also the author of a new book The Power and Independence of the Federal Reserve and joined me on the show to discuss it.

Our conversation begins with what Peter calls the three foundings of the Fed: 1913, 1935, and 1951. These were the pivotal dates where major changes were made in the legal structure of the Fed. These changes, however, only changed the legal infrastructure to the Fed. Important personalities continued to transform the institution. Peter points specifically to three Fed chairs for making the Fed what it is today: William McChesney Martin, Paul Volker, and Allan Greenspan.

We also cover the important role the staff plays at the Fed. In particular, the discuss the inordinate influence the head of the international finance division and the general counsel play in shaping international and domestic policy. That they have so much power, but are not appointed creates legal issues according to Peter. Similarly, regional bank presidents are FOMC members who set national policy but not appointed by the President. Peter believes a reexamination of how they are appointed is warranted too.

We then discuss some more recent issues such as the debate over whether the Fed was really constrained by law when it came to bailing out  Lehman. Peter, a lawyer, provides a discussion of this legal claim made by Fed officials and does not find it convincing. 

Finally, we talk about the future of the Fed under President Trump. One question we consider is whether the President can fire a Fed chair. President Truman fired Thomas McCabe and there enough legal ambiguity that it could be done again. But it would be politically costly. We also discuss who would be on the shortlist for the board of governor positions for Donald Trump.

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

Related Links
Peter Conti-Brown's home page
Peter Conti-Brown's twitter account

Friday, December 2, 2016

Can the Global Economy Survive a Stronger Dollar?

One of the big questions going into 2017 is how resilient the global economy will be to a further strengthening of the dollar. The Trump shock and the Fed's desire to raise interest rates almost guarantee a strengthening of the dollar next year. Unfortunately, this is not the best time for a surging dollar since the global economy is ripe with dollar-denominated debt and anemic growth. 

The dollar's initial surge took place between mid-2014 and late 2015 when it grew over 20 percent. This sharp rise was tied to the Fed talking up interest rate hikes while the ECB signaled lower future interest rates. The figure above shows this by reporting the spread between the U.S. and Eurozone 6-month interest rate, 6 months ahead along with the trade-weighted dollar. The figure shows that after plateauing for much of 2016--with some bumps along the way--the dollar has recently started strengthening again as the spread has started to widen. My concern is that this will continue into 2017.

It is instructive to look closer at the dollar surge in 2014-2015 to get  sense of what could happen in 2017. For this initial dollar growth explains a lot of developments in the global economy over the past couple of years. 

First, it explains the timing of the financial stress of late 2015 and early 2016. By that period the value of the dollar had reached a point where it caused the financial imbalances in China to start cracking. Those financial stresses temporarily spread to stock markets around the globe. 

Second, it also explains why China allowed its currency to devalue, as I suscepted would happen. China was violating the macroeconomic trilemma and could only do so for so long. The stronger dollar forced the hand of the Chinese monetary authorities who have been allowing a moderate devaluation of their currency this year. Now that the dollar is strengthening even more, the capital outflows are increasing in anticipation of further devaluation of the renminbi. And no, I do not think capital controls will solve the problem.

Third, it explains why the Fed has been stuck in a seemingly endless rate-hike-talk-loop-cycle in 2016. The cycle goes something like this: the Fed talks up interest rate hikes → dollar begins to strengthen → bad economic news emerges → the Fed dials down its rate hike talk → dollar pressures ease → good economic news emerges → repeat cycle. This cycle occurs because one, there is approximately $10 trillion in dollar-denominated debt outside the United States per the BIS and two, because many countries still peg to the dollar. A strengthening dollar is a problem for the former since implies a higher debt burden while for the latter it means pegging countries have to import the Fed's tightening of monetary policy. Most Fed officials, other than Governor Lael Brainard, fail to fully appreciate this loop. 

Fourth, it explains a sizable part of oil's decline since 2014. Both Ben Bernanke and Jim Hamilton estimated that about 40-45 percent of oil's decline this time is because of weakened global demand. Following similar methods, I estimated it to be about 50 percent. Of course, this begs the question as to what caused global demand to weaken. The obvious candidate was the strengthening dollar putting a chokehold on global economic growth.

Going into 2017 these same dynamics are likely to intensify if market forecasts are correct. Both the stock market and bond market see improved economic growth ahead from the Trump shock. Along with this growth, however, will come higher interest rates and a stronger dollar. So while the U.S. economy seems geared to take off in 2017, the global economy seems positioned to sputter as it faces a stronger dollar. If that sputtering turns into an outright stall then all bets are off for the Fed tightening next year. 

Related Links
Edna Curran and Craig Torres--'Trump Tower Accord' Mooted to ease Dollar Pains 

Tuesday, November 29, 2016

What Goes Down Must Come Up

The Mercatus Center is running a colloquium on the low interest rate environment and its implications for the economy. The colloquium runs twelve days and each day a new essay will be published. Since this is leading up to the holidays, some are calling it the "twelve days of interest".

Today the colloquium ran my essay in which I make the case that the 10-year treasury interest rate will return to the range of 4.0 to 4.5 percent. This definitely goes against the conventional view that the natural interest rate or "r-star" has permanently fallen and will keep treasury yields depressed. This view is evident, for example, in the FOMC's summary of economic projections (SEP) where members expect the long-run value of the federal funds rate to land near 3 percent. So why my contrarian claim?

My answer, as laid out in the piece, is that much of decline in the 10-year real interest rate is due to a temporary decline in the natural interest rate. In my view, this decline is tied to business cycle forces rather than structural ones. As evidence for my view, I provide Figure 5 which shows a strong relationship between the natural interest rate--the 10-year, risk-free, real interest rate in the article--and the CBO's output gap. Here is the same data plotted in a scatter plot:

And here is the output from running a regression on these two series:

As I note in the piece, these results imply that if the output gap eventually closes (i.e. goes to zero) the natural interest rate will hit 1.65 percent. Add in 2 percent for inflation and a modest amount for the term premium and one easily breaks the 4.0 percent barrier. 

I may be proved wrong, but the early bounce from the Trump shock is pushing in my direction. To be upfront, though, I was making a similar argument in 2014 when the economy early on appeared to be taking off. I still think my call was reasonable given robust growth in early 2014, but the growth quickly got snuffed out. It did so, in my view, because the Fed began talking up interest rate hikes and effectively tightening policy in mid-2014. Throw in some strains on the term premium from problems in China, Eurozone, new regulatory burdens and you get the low treasury yields since 2014. This seems to be changing now with the Trump shock but we will have to wait to know for sure. 

I encourage you to keep following the colloquium. Other contributors, often with less sanguine views about future interest rates, will follow. The next one, for example, is from Joe Gagnon who does not share my outlook on interest rates. Also, the other pieces that follow will get more into the implications of the low interest rate environment. So stay tuned!

Monday, November 28, 2016

Macro Musings Podcast: JP Koning

My latest Macro Musings Podcast is with JP Koning. JP is an economist who works in the Canadian financial industry and is a walking encyclopedia on the institutional details of central banks and money. He runs a fantastic blog called Moneyness--a must read for anyone serious about understanding money and its history. JP joined me to talk about some of the more interesting institutional arrangements for central banks and money today.

We began our conversation by talking about central banks of Switzerland, Japan, South Africa, Belgium, and Greece. They are unique in that they have stocks that are traded on the stock market. As JP notes, however, these stocks function more like a perpetual bond than an actual stock.

Another fascinating central bank story is that the Bank of England in that it used to allow personal checking. It no longer does this, but it demonstrates that the current restrictions on access to central bank balance sheets has not always been in place. And there are many advocates who would like to see a further openness of central bank balance sheets as a way to stem financial crisis. We discuss the implications of going down this path.

What happens when a central bank has internal divisions and various branches compete against each other? This happened recently in Libya and JP gives us the details. Our conversation then turned to the dollarization of the Zimbabwe economy following its bout of hyperinflation in 2008. We discuss how it happened and the influence U.S. monetary policy has on dollarized economies. We also discuss what appears to new monetary mischief being done by the government of Zimbabwe.

We also briefly touch on the latest case of hyperinflation in Venezuela. The Wall Street Journal had an interesting piece on a man who is considered by the number one nemesis of the Venezuela government for publishing black-market exchange rate of the Bolivar currency.

Our talk ends with a discussion on the Fedwire and the potential for a Fedcoin.

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

P.S. Here is a slide show on the evolution of Zimbabwe's currency leading up to the hyperinflation in 2008.

Friday, November 25, 2016

Macro Musings Podcast: Mark Calabria

My latest Macro Musings podcast is with Mark Calabria of the Cato Institute. We discussed his time doing financial regulation and Fed policy as a senior staffer on the U.S. Senate Committee on Banking, Housing, and Urban Affairs. We also spent some time discussing his new paper on applying behavioral economics to Fed policy.

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

Related Links
Mark Calabria's Home Page
Mark Calabria's Twitter Account
Mark Calabria's New Paper

Tuesday, November 15, 2016

Macro Musings Podcast: Roger Farmer

My latest Macro Musings podcast is with Roger Farmer. Roger is a Professor of Economics at UCLA. He joined me to discuss his latest book, Prosperity for All: How to Prevent Financial Crises

This was a very fascinating conversation. Roger makes the case that modern macroeconomics as it is formally practiced has gone down the wrong path with the New Keynesian paradigm. He considers it a degenerative research agenda for several reasons. First, it is premised on the natural rate hypothesis (NRH) which he sees as incorrect. He uses the analogy of a child hitting a rocking horse to describe the NRH. The child hitting the horse will cause it to rock, but eventually it will come to rest. Likewise an economy buffeted by shocks will cause fluctuations but eventually the economy will return to its full employment level. Roger sees this view as fundamentally wrong

Roger contends a more accurate analogy would be a rudderless boat blown by various winds to new locations and staying there until new winds come along. Put differently, Roger believes in multiple equilibria for the economy that arise because of various shocks--the winds--pushing the economy to new points. The economy may stay at these equilibria for some time. Some equilibria may be good, some bad. One of the important shocks that determine these equilibria are peoples beliefs or confidence. In his work he has formally modeled this through a 'belief function' that replaces the Philips Curve in the standard New Keynesian model. This was a key theme running throughout our conversation.

Other problems Roger sees with the New Keynesian paradigm include prices being implausibly sticky, the absence of involuntary unemployment, small welfare costs to business cycles, and the inability to explain bubbles and crashes. His modeling approach aims to fix these problems and bring back the original animal spirit theme of Keynes in a formal rational expectations framework. 

Moving beyond modeling issues, Roger also believes the reason for economic volatility is not sticky prices but incomplete markets. Specifically, incomplete labor and financial markets. This was interesting because it implies price signals are not working properly and preventing markets from doing their magic. His solution is to have the government stabilize the growth of a stock market index via purchases of ETFs.

This was a fun conversation throughout. And his book is highly recommend. It really gets into the philosophy of science and its implications for the macroeconomic discipline. 

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

Related Links
Roger Farmer's Home Page
Roger Farmer's Books

Tuesday, November 8, 2016

Monetary Policy Rules Conference: Presentation and Paper

Back in September I was part of the Monetary Policy Rules for a Post-Crisis World conference. It was jointly hosted by the Mercatus Center and the Cato Institute. There were many interesting presentations from folks like David Laidler, Perry Merhling, Robert Hetzel, Miles Kimball, Peter Ireland, John Taylor, and Scott Sumner. The panel moderators--Ylan Q. Mui, Ryan Avent, Cardiff Garcia, and Greg Ip--were great too!

I wanted to share the working paper I presented at the conference. It was titled The Fed's Dirty Little Secret and now is posted online. This paper had its origins in an earlier blog post of mine. It was fun taking an idea sketched out on this blog and turning into a paper. Below is the paper's abstract:
Despite the Federal Reserve’s use of QE programs, the U.S. economy experienced one of the weakest recoveries on record following the Great Recession. Not only was real growth disappointingly low, but even nominal growth over which monetary policy has more control was feeble. Why did QE fail to stimulate robust aggregate demand growth? This paper argues the answer is that the Federal Reserve could not credibly commit to a permanent expansion of the monetary base under QE. Both the quantity theory of money and New Keynesian theory show, however, that a permanent expansion of the monetary base is needed to spur aggregate demand growth at the ZLB. The Federal Reserve’s inability to do so meant its QE program got consigned to ‘irrelevance results’ of Krugman (1998) and Eggertson and Woodford (2003) and were never going to spark a strong a recovery. This is the Fed’s dirty little secret. Moving forward, this inability to commit to permanent expansions of the monetary base at the ZLB will continue to weigh down on the effectiveness of Fed policy. As a result, this paper calls for a new monetary policy regime of a NGDP level target that is backstopped by the U.S. Treasury Department.  
Please take a look and feel free to provide feedback.

For those interested, the video presentation my panel at the conference is below.  As you can see, my panel consisted of Miles Kimball, Peter Ireland, and myself. Greg Ip was the panel moderator.