A Gentler Slope for the Fiscal Cliff

Evan Soltas explains succinctly the tragic confusion in U.S. fiscal and monetary policy:

Federal Reserve Chairman Ben S. Bernanke, taking questions during a February House hearing on monetary policy, uttered two very special words: fiscal cliff.

“Under current law, on January 1, 2013,” Bernanke said, “there’s going to be a massive fiscal cliff of large spending cuts and tax increases.”


Whatever Bernanke’s intention in February, Congress now works in fear of falling off his fiscal cliff. The irony is that while economic recovery rests largely in Bernanke’s hands, the tyranny of impending austerity is leading Congress toward poor decisions about the long-term structure of public spending and tax policy. These are mistakes monetary policy could never offset.

The cause of our cliff problem rests in the commingling of responsibility between fiscal and monetary policy in managing the economic recovery. A more mature way of doing business would charge the Fed with stabilizing demand in the short run and Congress with a structural environment conducive to the social welfare and economic growth over the long run. The U.S. is doing neither well right now.


Long-term deficit reduction will also require substantial cuts to planned public spending, whether one assumes a return to the historical revenue average or something slightly higher than that to account for demographic change and health costs. This is particularly true beyond the budgetary “out-years,” or 20 to 30 years from now. At that point, federal promises on Medicare and Medicaid become unsustainable without large increases in tax revenue which raise fully a quarter of GDP. There is no reasonable scenario for sustainable public finances without deep rollbacks of spending promises beyond the out-years.

The austerity the fiscal cliff would achieve in one fell swoop would best be done gradually. Such an approach would be more in line with the real danger in our public finances, the combination of structurally low federal revenue and long-term increases in planned spending.


Are the Green Shoots for Real?

Market monetarist David Beckworth posted a cautionary reading on his favorite leading indicators (consumer sentiment and 10-year treasury yields).



This figure shows that during the Great Moderation period (1983-2007) households expected their dollar incomes to grow about 5.3% a year. This relative stability of expected nominal income growth  is a testament to the success of monetary policy during this time. However, since 2008 households have expected 1.6% dollar income growth on average.  Until this changes, there is no way a recovery will take hold.  And yes, this speaks poorly of Fed policy since 2008. (My access to this data is limited by a 6-month lag.  So if you have access to this data, please let me know the latest numbers.)

The second indicator is simply the 10-year treasury yield.  As I noted many times before, this interest rate is currently at historic lows largely because of the weak economy, not the Fed (i.e. the short-run natural interest rate is depressed due to an increase in desired savings and/or a decrease in desired investment).  If the economic outlook were to improve, then the 10-year yield would go up because of higher expected real growth as well as some higher expected inflation.  And yes, the Fed could do more here by raising  expectations of future nominal income growth.  An explicit nominal GDP target should do the trick:
So until these two forward-looking indicators meaningfully turn around, I will remain hopeful but uncertain about our recovery. 

(Via David Beckworth.)

A bottleneck in the economy

The Federal Reserve’s choice to allow only a slow recovery in NGDP has essentially created a bottleneck in the economy, behind which a large crowd of would-be workers is swelling. 

That sentence really captures the US challenge. I recommend this 27 September post by Ryan Avent at Free Exchange, where he attempts to rebut the claim that it is too late for monetary policy to be effective.

(…) Let’s look at some charts. First, here is the year-on-year change in NGDP since 1990:

So, the first thing to note is that NGDP growth is clearly not back to the trend rate for recent expansions. Nominal output routinely grew above 5% per year during the boom of the 1990s (with an average closer to 7% than 5% during the latter, stronger half of that period). Nominal growth decelerated slightly during the 2000s expansion but was clearly and persistently above 5% during the period of meaningful employment growth. Nominal output then shrank at a pace matched only in the postwar period by demobilisation before settling at a rate persistently below 5%. Average year-on-year growth over the whole of this period, including recessions, is 4.7%. Average growth since the end of this recession has been 3.1%. Average growth since the beginning of 2010 has been 3.9%.



Ryan discusses the key points, including the evidence that wages are still sticky three years after the 2008 crash. Read the whole thing.

US Fed members are shifting to consensus on “economic lift-off”

My caption probably overstates the “lift-off” consensus, but there definitely is a movement from the “hawk” to the “dove” perspective on inflation vs. economic growth. Ryan Avent examines the very significant shift of Kocherlakota to a policy square near to the “Evans Rule”.  


NARAYANA KOCHERLAKOTA, the president of the Reserve Bank of Minneapolis, has long been a member of the club of more hawkish voices within the Federal Open Market Committee (to which he’ll return as an alternate next year and a voting member in 2014). But where other hawks like Philadelphia Fed president Charles Plosser and Dallas Fed president Richard Fisher advance criticisms of expansionary Fed action that seem rooted in confusion over just how monetary policy works, Mr Kocherlakota understands monetary policy just fine. His concern has instead been that economic potential has fallen more than is appreciated, and that structural unemployment is correspondingly higher. It’s a perfectly coherent view, albeit one that has seemed to be at odds with labour-market data. 

And so a frisson of excitement ran through the economics commentariat yesterday when Mr Kocherlakota abruptly signed on to a strategy resembling the one pushed by Chicago Fed president Charles Evans, a supporter of much more aggressive action to help the economy. Speaking in Michigan, Mr Kocherlakota described a plan for ‘liftoff’:

The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate. 

Ryan has much more analysis at Free Exchange.

The Fed’s welcome shift is still not nearly as effective as NGDP-Level-Targetting.

Startup companies are sputtering

“Entrepreneurs are having a harder time starting a company today than at any time since the government began collecting data.”

Startup companies aren’t sprouting up during the economic recovery like they did before it started according to a study by Hudson Institute economist, Tim Kane. “Job creation at new firms was at an all-time low in 2009 of 2.8 million, then fell again a year later by 250,000 jobs,” writes Kane.As seen in the chart above, the rate of job creation collapse during the latest recession and hasn’t recovered. He concludes that “entrepreneurs are having a harder time starting a company today than at any time since the government began collecting data.”What makes this recovery different for startups? Kane thinks it’s an environment more “hostile to entrepreneurial employment.” He writes:

At the federal level, high taxes and higher uncertainty about taxes are undoubtedly inhibiting entrepreneurship, but to what degree is unknown. The dominant factor may be new regulations on labor. The passage of the Affordable Care Act is creating a sweeping alteration of the regulatory environment that directly changes how employers engage their workforces, and it will be some time until those changes are understood by employers or scholars. Separately, there has been a federal crackdown since 2009 by the Internal Revenue Service on U.S. employers that hire U.S. workers as independent contractors rather than employees, raising the question of mandatory benefits. New firms tend to use part-time and contract staffing rather than full-time employees during the startup stage. According to Labor Department data, the typical American today only takes home 70 percent of compensation as pay, while the rest is absorbed by the spiraling cost of benefits (e.g., health insurance). The dilemma for U.S. policy is that an American entrepreneur has zero tax or regulatory burden when hiring a consultant/contractor who resides abroad. But that same employer is subject to paperwork, taxation, and possible IRS harassment if employing U.S.-based contractors


Some of those fears are reflected in the most-recent U.S. Chamber Small Business Outlook Survey that found that 72% think the health care law will make it harder to hire more people.


How the market monetarists changed the debate

Ryan Avent at The Economist explains just how influential Scott Sumner has been:

First, Dylan Matthews has a very nice interview with Michael Woodford that I recommend reading in its entirety. As part of it, however, Mr Woodford disavows any influence from Scott Sumner in his choice to move toward a recommendation of a nominal GDP target. It is certainly correct to say that Mr Woodford has been focusing on these issues for a while and making important contributions to the literature. That, however, helps illustrate the importance of Mr Sumner and the market monetarist emergence. It seems very possible—probable even—that Mr Woodford and other prominent monetary economists would have been led by the events of the crisis and recovery to approximately the position in the debate they now occupy without Mr Sumner’s influence. But despite the fact that many of the ideas in Mr Woodford’s Jackson Hole paper were already circulating in 2009, most of the economists engaging in public debate and most of those writing about that public debate were then operating under the assumption that fiscal policy was the main if not the only game in town. Mr Sumner helped convince many of those of us with a familiarity with monetary economics to rethink the frame within which we were operating and to reconsider the conclusions we’d drawn. His work made us more receptive to research by people like Mr Woodford.

I’m also am sceptical that Mr Woodford would have included in his Jackson Hole paper a statement of support for nominal GDP targeting—rather than something a bit more obscure-sounding, like “output-gap adjusted price level targeting”—if Mr Sumner had not encouraged so many of us to think of NGDP targeting as an appropriate, viable, and relatively straightforward alternative policy to inflation-rate targeting. As Mr Woodford says in the interview, he was trying in his most recent paper “to express a more helpful proposal”. An NGDP-oriented policy fits that description largely because we’ve all been primed to think in those terms, thanks mostly to the conversation Mr Sumner initiated.



Evan Soltas: Bloomberg Endorses NGDPLT

Good news, in the “every little bit helps” department. Thanks for this Evan:

Bloomberg Endorses NGDPLT: “Bloomberg View’s editorial board endorsed using monetary policy to target the path of nominal GDP yesterday — making them, as far as I know, the first major media outlet in the United States to endorse the practice. Naturally, this is excellent news for supporters of NGDP level targeting like myself.

We suggest looking at an old idea that is again attracting attention among monetary economists. Recast the target that the Fed and other central banks are told to follow. Instead of a target for low inflation plus an additional primary or secondary target of high employment, focus on the money value of output — nominal gross domestic product unadjusted for inflation. This combines prices and output in a single number.

Suppose the target was 5 percent. Over the longer term, with the economy growing at 2 percent or a little more, inflation would be 3 percent or a little less, similar to the inflation targets most central banks (including the Fed) have adopted. Here’s the advantage: In the short term, the Fed would be on target if the economy were growing at 5 percent and inflation were zero, or if the growth were zero and inflation were 5 percent.

In other words, the system would call for faster-than- normal growth when inflation is too low, and faster-than-normal inflation when the economy is in a slump. Setting a nominal GDP target wouldn’t be telling the bank to choose between so much inflation and so many jobs, so you could still grant operational independence

We think it’s worth a careful look, and we’re convinced of one important advantage: This approach would make the bank’s actions easier to understand and explain.

As a matter of disclosure, I write for Bloomberg View but was not involved in their endorsement.

Sober Look: Risk aversion the lowest in over two years

Not surprising after the Fed QE3 announcement. The Fed definitely wants the markets to take on more risk – that is the point! Please read the full analysis at Sober Look. I’ll just skip to the very end, the CITI risk indicator:

(…) Given these subtleties in the risk indicators related to emerging markets equities, lets take a look at a third measure, the Citi Macro Risk Index, to ‘break the tie’. Here is the definition: 

The Citi Macro Risk Index measures risk aversion in global financial markets. It is an equally weighted index of emerging market sovereign spreads, US credit spreads, US swap spreads and implied FX, equity and swap rate volatility. The index is expressed in a rolling historical percentile and ranges between 0 (low risk aversion) and 1 (high risk aversion).

This measure is based on credit spreads and implied volatility indicators. Note that the index is inverted relative to the two above, indicating the perceived level of risk in the markets rather than the risk appetite.

Citi Macro Risk Index (Bloomberg)

Based on this third risk measure, the perception of risk in the system is now the lowest since early 2010, before the Greek sovereign debt issue first moved the markets in a material way.

Other than the underperformance of emerging markets equities, the overall risk aversion seems to be declining toward multi-year lows. Welcome to the new ‘new normal’, where central banks set the level of risk appetite – and right now they simply want risk to be ignored (see discussion).

The related discussion is on the Fed implicitly selling volatility. I’ve not figured out what this means to the investor:

 Fed’s selling volatility into the market will force mispricing of risk: “Credit Suisse has made an important point with respect to the Fed’s purchases of MBS. As we know, a mortgage borrower is long an option to prepay. That means a mortgage lender is short this same prepayment option. Therefore a buyer of MBS is an options seller and the Fed is in effect selling vol into the market.

CS: – It is important, in our view, that the Fed continue to sell volatility – explicitly or implicitly – into the markets. This is at the heart of its quest to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk) to the public. Extending the rate guidance to ‘mid 2015’ represents an implicit sale of volatility – the Fed is giving up the option to hike (arguments about the Fed’s ability to renege notwithstanding).

(Via Sober Look.)

Economist QE Primer July 2012

Ryan Avent linked this Economist special report – QE Primer which begins: 

THE conventional arms have run out. Central banks in America and Britain have long since pushed interest rates to close to zero. On July 5th the European Central Bank (ECB) joined them, slashing its rate on deposits to 0% and its main policy rate below 1%. A different sort of arsenal is now being deployed. Unconventional monetary policy covers everything from negative interest rates—now on offer in Denmark—to a change in inflation targets, but “quantitative easing” (QE), the creation of money to buy assets, has proved to be the most popular weapon of this crisis.

Its use is being stepped up. On July 5th the Bank of England (BoE) announced a £50 billion ($78 billion) increase in the size of its asset-purchase programme, to £375 billion in total. Speculation is growing that the Federal Reserve may launch another round of QE, its third, perhaps as soon as next month. There is pressure on the ECB to follow suit. With QE increasingly pivotal to monetary policy, how much bang for the buck (or yen or euro) does it deliver?