Single mandate or fear of inflation demons

During the Boston Federal Reserve conference on Fulfilling the Full Employment Mandate, there was a panel discussion on the importance of the dual mandate for the US Federal Reserve. The panelists were two of the Presidents of the Federal Reserve System (Kocherlakota and Evans), a member of the monetary policy of the Bank of England (David Miles) and Lars Svensson from the Riksbank (Swedish Central Bank). The four panelists presented complementary views on how central banks manage the trade off between inflation and unemployment under different mandates: an explicit dual mandate for the US Federal Reserve and a single mandate for the Bank of England or the Riksbank (same as the ECB).

Despite the differences in the way their mandates are written, the panelists stressed the similarities in actions of the three central banks and they also expressed support for aggressive monetary policy given the current circumstances.

What I found shocking in the presentations is how the panelists felt the need to explain the obvious. Both in Sweden and the US (as well as in the Euro area), inflation is and has been below the target for the recent past. Even if one thought of these central banks as being responsible for just inflation (single mandate), it is clear that they are failing to keep inflation from reaching that target. As Svensson made explicit, in the case of Sweden, inflation has now been below 2% for a significant period of time and it is unclear how the Riksbank will manage to produce an average around 2% over a medium-term horizon.

In addition, if one takes seriously the notion of a dual mandate, then there is a much stronger justification for current central bank actions. Both Evans and Kocherlakota showed very simple charts about the trade off between unemployment and inflation to support the notion that given the level of unemployment, having inflation be slightly above the target in the short run to accelerate the transition of unemployment towards what we consider normal is consistent with the dual mandate of the US Federal Reserve. Below is one of the slides used by Kocherlakota to explain this logic (full presentation can be found here).

Given the simplicity of the argument, the real questions is who they are trying to convince or, to put it differently, who are the ones who have opposing views on the inflation / unemployment outlook and monetary policy. I see two set of voices that are critical of the current central bank actions. First, there are those scared of inflation, or as Evanst put it, those who are afraid of "unlocking the long-ago-vanquished inflation demons from the dungeon". Given how low inflation has now be for decades and how anchored inflation expectations are, it is difficult to understand where those fears are coming from. The second argument might sound more rational:  if you want inflation to be around 2% in the long-term and given that we know that inflation will be higher one day when the recovery gets stronger, it might be ok to see inflation below target for a significant period of time (while the recovery is weak). But this argument depends on the slope of the Philips Curve. In a world where the Philips Curve is very flat (as it is for all these countries), it is very unlike that any fast reduction in unemployment will bring any significant inflation in the future. Therefore the fear of inflation when the recovery is strong, is not supported by the data either.

The panel discussion left me with a sense that over the years we have developed an unfounded fear of inflation and a very asymmetric view on what is admissible: being below the target is ok, being above cannot even be discussed as an option. And it was refreshing to see voting members of the monetary policy committees of the US Fed, Bank of England and Riksbank saying this explicitly -- it was just the ECB that was missing.

Antonio Fatás

Targeting the Price Level?

Eric Rosengren, president and CEO of the Boston Fed, opened today the conference I am attending with his views on the challenges of monetary policy in the current environment. Here is a slide that I found interesting: if you plot the level of prices for the Fed and the ECB since 1993 and compare it to a line that represents a 2% growth (inflation), the three lines almost look identical.

Temporary deviations from the 2% path seem to be corrected over time as if these central banks were targeting a certain path of the price level and not just inflation -- i.e. when inflation is higher than the target it is followed by a period of lower inflation so that the price level returns towards its trend. This is not completely surprising given how anchored inflation and inflation expectations have been in these 20 years but it is interesting how tight the fit is. Of course, this is not the case in Japan where prices have been flat over the same period.

The whole set of slides as well as the transcript of his speech can be found at the conference web site.

Antonio Fatás

Savings Glut meets the Great Recession

Ken Rogoff writes a very interesting article on the mystery of low interest rates. He starts by going back to 2005 when Ben Bernanke blamed the "Global Savings Glut" for the unusually low (by historical standards) real interest rates in the world economy. His comment was a reaction to the conventional assumption that interest rates are determined by central banks. As Ken Rogoff correctly argues,

"I share Bernanke’s instinct that, while central banks do set very short-term interest rates, they have virtually no influence over long-term real (inflation-adjusted) rates, other than a modest effect through portfolio management policies (for example, “quantitative easing”)"

Interest rates should be seen as the price that clears a market where the supply of funds (saving) meets the demand for funds (investment). A shift in the global supply of funds through a combination of the aftermath of the Asian crisis, the reaction of oil-producing countries as the oil price was increasing as well as the increasing savings from Germany and Japan (a result of low growth and contained domestic spending) led to falling interest rates in the period 1998-2005.

What has happened after 2005? Interest rates stabilized for a few years but then during and after the financial crisis we have seen a further decrease in the real interest rates to levels close to zero or negative. Ken Rogoff argues that this is more of a mystery, that the behavior we have seen in saving and investment during these years cannot justify a further decline in interest rates. I am not sure this is the case. A slowdown is likely to reduce interest rates. Yes, China's investment stayed strong but so did its savings. And in advanced economies we witnessed a collapse of private investment as well as a large increase in private savings (partly compensated in the early years by government spending but not so much since austerity has kicked in). So we have all the conditions to see a further decrease in interest rates during the period 2008-2013.

In particular, what has happened to saving in emerging markets since 2005? Rogoff argues that

"A related theory is that emerging economies’ citizens find it difficult to diversify the huge risk inherent in their fast-growing but volatile environments, and feel particularly vulnerable as a result of weak social safety nets. So they save massively. These explanations have some merit, but one should recognize that central banks and sovereign wealth funds, not private citizens, are the players most directly responsible for the big savings surpluses. It is a strain to think that governments have the same motivations as private citizens."

I am not sure I share Rogoff's views. Central banks or sovereign wealth funds cannot save, they can at most be managing the savings that either the private sector or the government have generated. Let's take an extreme example: a country with a current account surplus where private citizens are not allowed to invest in foreign assets. In this environment, private savings will always show up in the form of an increase in foreign reserves at the central bank as private citizens redeem the foreign currencies that they earned from exports at the central bank in exchange for the local currency. The central bank is not saving, it is simply the destination of all foreign earned income (and not spent). This story fits well with the accumulation of foreign reserves in China and other emerging markets that we have witnessed in recent years. A similar story holds for sovereign wealth funds, they are simply the vehicle through which savings (private or public) are channeled into foreign assets.

There are other factors that have possibly influenced real interest rates in recent years: from the flight the quality as a result of the crisis, or the potential influence on portfolio allocations of quantitative easing, but it seems to me that an explanation as simple as demand and supply shifts represented by savings and investment in global financial markets still can produce a reasonable story that explains most of the evolution of interest rates since 1998.


Antonio Fatás

Gross Mistake

In a couple of recent posts Paul Krugman reminds us that interpreting data on debt as a sign of excessive spending and living beyond our means is incorrect. I have made this point before when looking at government debt.

The first flaw in the logic is that while it is correct to argue that if someone lives beyond his or her means we will see their debt increasing, it is not correct to argue that every time we see debt increasing it means that someone is living beyond his or her means. The reason is that we need to consider assets and not just liabilities. This argument becomes even more relevant when you go from an individual to a country as what is debt for a person is likely to be an asset for someone else. In other words, for an individual you want to look at the balance sheet (and not just debt), for a country we need to look at the consolidated balance sheets of all economic actors.

As Krugman argues in his blog post, the main reason why we see debt increasing in the US (and other advanced economies) during the years that preceded the global financial crisis was an increase in leverage and not overspending. I borrow to invest in someone else's business or idea who is borrowing from me to invest in someone else's asset, etc. In this scenario, the collective level of debt keeps increasing even if no one is living beyond their means; our balance sheets look fine with assets matching liabilities. It can, of course, be the case that we are creating a risk in the system by this increasing lending with leverage that could itself become an amplification mechanism to any future disturbance to the economy (so maybe increasing debt as a result of increasing leverage is bad after all) but this has nothing to do with the level of spending (no spending spree here).

One way to provide an additional perspective on this issue is to realize that as countries develop we expect their level of debt to increase relative to their GDP. There is a measure that economists use all the time called financial deepeness that captures the development of financial markets which is directly related to the size of the balance sheet of financial institutions. In advanced economies these balance sheets are bigger in size so any measure of the liabilities as a % of GDP will be higher than in developing countries. So higher debt is a sign of development in this context.

There are indicators that aggregate all the balance sheets of all economic actors that give us the true measure of imbalances in spending and income. We can do it by sectors (the government, the private sector, households,..) or we can do it for the whole country. When we do it for the whole country what we measure is the Net International Investment Position (NIIP). This is the difference between all foreign assets and foreign liabilities. This is the true measure of how much the country is borrowing from the rest of the world (in net terms). How does it compare to measure of gross debt? For a start it is smaller for most countries but, more interestingly, it can give you a very different perspective on a country if you just compare it to a partial measure of indebtedness.

As an example, let's compare government debt with the NIIP for some selected countries.

The figure above shows the (gross) government debt as % of GDP and it compares it to the NIIP (also as a % of GDP). In the case of the US, gross government debt is around 100% but the NIIP position is much smaller (around 25%). In other words, some of the debt that the US government issues is held by US citizens, we owe money to ourselves and it is wrong to think that we are passing all the government debt to the next generation because we are also passing the asset that goes with it (a point made many times by Paul Krugman).

In the case of Japan or Germany, government debt is high (very high in the case of Japan). But that debt is more than compensated by the assets that both the government and the private sector hold so both countries have large net international investment positions.

We have other countries like Australia where the government debt is small relative to the NIIP. This is a sign that the private sector has been borrowing (in net terms).

There are lots of interesting questions about the meaning and risk of gross versus net debt but answering those questions requires an understanding of how gross positions create risk to the financial system and more generally to the macroeconomy. Simple and misleading statements that link debt to overspending are not helpful in understanding the potential risks and can be completely off when it comes to suggesting solutions for the economic crisis.

Antonio Fatás

Cyprus: between hope and panic

The Eurogroup announcement on Saturday of an agreement with the Cypriot authorities for a macroeconomic adjustment program came with a big surprise. The agreement involves a controversial "one-time-tax" on bank deposits. The tax is progressive starting with a lower level for bank deposits below 100k Euros. While the authorities are trying to sell this measure as a tax, it is clearly going to be read as a statement that regardless of any deposit insurance mechanism (which is in place in Cyprus for deposits below 100k), bank deposits might now be considered risky. As much as the Eurogroup and the Cypriot authorities will do their best to minimize this interpretation, there is the possibility that it spreads to other countries and that we see bank runs at a significant scale in some of them.

The reaction to the announcement has either been of hope or panic. My reaction is somewhere in between the two.

When it comes to the government of Cyprus, they are hopeful that everyone will understand that this was a one-time event and that the country can now move forward. From CNBC here is a quote from the Cyprus finance minister Michael Sarris:

"Absolutely, there is no capital restrictions, people can move. We hope people will believe us, believe the collective leadership of the European Union, that this was a necessary step, but a single shot at the problem, and that from now on they can be very confident that nothing will happen to their savings."

This will not happen, people will not believe them (not to mention the fact that the parliament has postponed the approval of the agreement that was scheduled to happen on Sunday). Prepared for several rounds of panic. I doubt the banking system will be able to operate without some capital restrictions over the coming days.

On the other side, there are those who panic that this is the prelude of bank runs in Greece, Spain, Portugal or Italy. This is certainly a possibility and we have already seen withdrawals of deposits in some of these countries during this crisis, but it will take a lot of panic to produce a significant bank run. The reason is that there are still costs or barriers to produce a widespread bank run in these countries. The assumption that all the depositors in these banks will immediately open an account in Germany and transfer all their funds is (fortunately) not obvious. There are significant restrictions in opening of bank accounts even within the Euro area if depositors do not have residence in the country where the bank is established. Of course, there is always the option of hiding all your deposits under your mattress (or a cash vault) but both they represent a risk or they simply are not practical enough. Having said that, in the event where there is a strong perception that a similar "one-time-tax" is about to happen in other countries, these barriers will not be enough, so a bank run cannot be ruled out either.

The next days are going to test the ability of European authorities to convince the public that what has happened in Cyprus will not happen in other countries. Is it possible? Yes, this is what to some extent happened after the agreed default on Greek government debt. The fact that interest rates on government debt of other countries in the periphery has come down significantly over the last months is a proof that you can credibly claim that certain events are exceptional and will not spread. Contagion is always possible when we see default but it is not always necessary. Let's see how good European authorities are this time to ensure that hope defeats panic.

Antonio Fatás

Bill Gross on the Big Mac and QE

These are good days for someone who teaches macroeconomics, because it is easy to find articles that misrepresent the basic concepts we teach in class - this always motivates our students who now feel that they can make better arguments than those writing in the financial press.

Bill Gross, founder and co-chief investment of Pimco is back in the Financial Times. This time he is not trying to explain why higher interest rates are good for investment and growth, but instead he is trying to help investors make decisions on foreign exchange markets. His argument is that the traditional theories of exchange rates (Purchasing Power Parity = Big Mac Index) do not matter much today, what matters is the behavior of central banks when it comes to quantitative easing.

The first thing that is odd in the article is that he misses the connection between the different theories he discusses. Someone making an argument that quantitative easing leads to inflation and a depreciation of a currency is implicitly using Purchasing Power Parity as an argument to talk about exchange rates. That argument is standard in any macroeconomics textbook.

What is not standard and where, in my view, he is not being accurate is the way he describes quantitative easing and its implications on exchange rates. First, there is the constant reference to "money being printed". This is wrong. Most of the increases in the monetary base (the size of the balance sheet of central banks) do not correspond to increases in the amount of currency in circulation but to increases in the deposits that commercial banks hold at the central bank (reserves). This increase in the monetary base do not always lead to an increase in the money supply or inflation. Or you can put it in a different way: the increase in liquidity is matching the demand for liquidity by the financial system. If demand and supply are balanced, prices do not change (exchange rates do not change).

When it comes to the exchange rate he cites Japan as an example where his theory is working (the Yen has depreciated because of quantitative easing). Correct, but only up to a point: it is not because the balance sheet of the central bank is increasing, it is because there is the perception that the central bank is finally committed to deliver high inflation and if this is the case, PPP tells us that a currency will get weaker.

His advice: to pick winners and losers (in terms of currencies) by looking at the size of the central bank balance sheet. Way too simplistic and possibly wrong. It sounds more as one additional attempt to criticize central banks for what they have been doing (QE). If anyone had followed that advice during the crisis years, they would have gotten their bets on currencies wrong several times (same for those who followed his earlier advice that inflation was around the corner and interest rates would increase fast).

Yes, monetary policy matters for the exchange rate because it affects all nominal variables: prices, inflation and the nominal exchange rate. But mislabeling quantitative easing as "printing money" and call it a sure bet to increase inflation in future years has proven to be wrong enough times in the last years that one would think that the argument would not be repeated again. But I should not complain, I have to teach a few more sessions on monetary policy in about three weeks, so these articles are making my search for interesting readings much easier.

Antonio Fatás

Dove or Hawk? Bernanke's record

In yesterday's testimony at the U.S. Senate Ben Bernanke was accused of policies that could potentially generate high inflation. Senator Corker accused the Fed Chairman of nor being concerned enough about inflation by saying "I don't think there's any question that you would be the biggest dove since World War II". The term "dove" in the context of central banks is used to describe policies that put more weight on unemployment and less on inflation (as opposed to "hawks" who do the opposite). Ben Bernanke defended himself by mentioning that he has one of the strongest records in terms of inflation of any previous Chairman.

Below is a quick check on both the inflation as well as the unemployment record of the last six chairmen of the US Fed. Ben Bernanke has so far produced one of the lowest inflation rates since the 1950s. When it comes to unemployment, his record is not that positive, only second to Paul Volcker in terms of high unemployment rates.

Comparing performance of central banks without controlling for other factors (such as the depth and frequency of economic crisis or shocks during their mandates) is not fair but at a minimum it provides some basic facts to back the statement by Ben Bernanke that it is difficult to see his record as someone who put too much weight on unemployment and too little on inflation.

Antonio Fatás