Europeans' Biggest Problem

The European Commission's Eurobarometer survey monitors public opinion on a variety of political and economic issues across European Union member states. One question on the Eurobarometer survey asks:

Personally, what are the two most important issues you are facing at the moment? 

This question was only asked in May 2012. For the EU as a whole, by far the most common response was rising prices/inflation. In fact, 45% of people in 2012 said that inflation was one of the top two most important issues they were facing. The pie graph below shows, for the EU as a whole, the responses people chose. Only 15% of people chose the financial situation of their household as a top issue. Health and social security also had a mere 15%. I was stunned that three times as many people consider inflation a top issue as consider health and social security a top issue.

In the graphs below, the results are broken down by country. First I show the percent of respondents in each country who choose inflation as a top-two issue. Then for a few countries, I show the percent who choose inflation and the percent who choose unemployment. In twelve countries (including Austria, France, and Germany), at least half of respondents say that inflation is a top-two issue. Sweden is a major outlier-- only 5% think that inflation is a top-two issue. The next lowest is Greece, at 26%. Sweden and Greece did have the lowest inflation in the EU in May 2012, but really just about ALL countries in the EU had (and still have) low or reasonable inflation.

Half of Germans and French thought that rising prices were a top issue, even when inflation was just 2.5%. The EC Consumer Survey, asks people how much they think prices have risen in the past 12 months. In May 2012, 28% of German, 36% of French, and 40% of Austrians thought that prices had risen "a lot."

Neil Irwin recently wrote that "The leading economies of the industrialized nations may not have a lot in common, but they are all afflicted by this: Inflation is too low." Even though inflation is too low, a lot of people think it is high-- and think that rising prices personally affect them more than unemployment. Public opinion is a powerful force, so we see policymakers being more reluctant to raise inflation when it it too low, than to lower it when it is too high.

Monetary Policy and Equity Prices at the Zero Lower Bound

A recent Wall Street Journal article by Jon Hilsenrath raises the question of what will happen to stock and bond prices when the Fed ends its bond-buying program. Tim Duy responds that "Fears of an imminent policy-driven collapse in equity prices are likely greatly over-exaggerated." Duy plots time series of the S&P500 alongside time series of the fed funds rate, noting "it strikes me that previous instances of tighter monetary policy did not trigger immediate widespread declines in equities."

Of course, these previous instances of tighter monetary policy occurred away from the zero lower bound (ZLB), with the target fed funds rate well above zero. Since the end of 2008, with the target fed funds rate at effectively zero, the Fed has attempted to influence interest rates through non-traditional actions such as forward guidance and balance sheet expansion aimed at altering long-term interest rates. If non-traditional expansionary monetary policy has a different effect on equity prices than traditional policy, than non-traditional contractionary monetary policy (i.e. and end to bond-buying) could have a different effect on equity prices than raising the fed funds rate.

How do equity prices react to monetary policy at the ZLB? This is the subject of a Federal Reserve Discussion Series paper by Michael Kiley, "The Response of Equity Prices to Movements in Long-term Interest Rates Associated With Monetary Policy Statements: Before and After the Zero Lower Bound." Kiley studies the impact on equity prices (S&P500) of a monetary policy action that would reduce the 10-year Treasury yield by 100 basis points, both before and during the ZLB era. The key finding is:

Implementation of our identification strategy suggests that, prior to 2009, monetary policy actions that would reduce the 10-year Treasury yield by 100 basis points were associated with a 6- to 9-percent increase in equity prices. In contrast, similar-sized declines in the 10-year Treasury yield associated with monetary policy actions since the end of 2008 have been accompanied by increases in equity prices of 1-½ to 3-percent - a notably smaller association.

The identification strategy is an event-study combined with instrumental variables, focusing on changes in interest rates and equity prices in 30-minute windows around FOMC announcements. The results suggest that non-traditional monetary policy has substantially different--less intense--effects on equity prices than traditional monetary policy. The study only focuses on expansionary actions at the ZLB, by necessity, but if expansionary policy at the ZLB does not cause equity prices to rise as much, then maybe contractionary policy at the ZLB will not cause equity prices to fall as much.
Kiley adds this note:

It is possible that FOMC announcements in the ZLB period have communicated more information about the economic outlook than about the policy stance: If FOMC communications provided previously unappreciated information about the outlook, then it is possible that such information would attenuate the response of equity prices to a policy announcement (because, for example, announcements communicating an easing in policy also communicated a worse economic outlook, with the former factor boosting equity prices and the latter factor depressing equity prices.)

Correspondingly, when the FOMC announces the end of its bond-buying program, that could communicate both a tightening in policy and a better economic outlook. If the announcement makes market participants realize that the economic outlook is better than they thought, that would help boost equity prices. The big question is how much tightening it will indicate. Scaling back asset purchases is tightening in and of itself, but probably not enough to cause a collapse in equity prices. But if the announcement also makes market participants expect a series of interest rate hikes to soon follow, then the depressing effect on equity prices will be much greater. Tim Duy adds in another post that "A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases."

Treasury and MBS Markets as QE Continues

Today the Fed announced that "To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month."

In February, in response to questions by the House Financial Services Committee, Fed Chairman Ben Bernanke said that the asset purchase programs have not disrupted the markets for longer-term Treasuries or for mortgage-backed securities. The New York Fed followed up on this in the latest Survey of Primary Dealers, from March 2013. Primary dealers are trading counterparties of the New York Fed, and play an important role in implementing the asset purchase program. They are obligated to participate in open market operations and to provide the New York Fed's trading desk with market information and analysis. The primary dealers are surveyed each month to help the FOMC evaluate market expectations about the outlook for the economic and financial conditions and monetary policy.

One question from the survey asked: How would you rate market functioning in longer-term Treasury and agency MBS securities markets today relative to the worst and best conditions you have seen since the beginning of 2009? 

Here is a tabulation of the responses:

Most of the dealers agree that conditions in the Treasury market are relatively good. Fifteen out of the 21 dealers rate conditions at 4 or 5 on a five-point scale. In the agency MBS market, conditions are a bit more iffy, though 4 is still the modal response. It looks like most of the dealers agree with Bernanke.

The survey also asked about expectations for the change in the amount of domestic securities held in the System Open Market Account (SOMA) portfolio over the next few years. I plotted the 25th, 50th, and 75th percentiles for expected cumulative changes in treasury holdings and in agency debt and MBS holdings below. Both types of asset holdings are expected to level off in the second half of 2014. But agency debt and MBS holdings are expected to start declining more quickly and rapidly than treasury holdings, which are expected to hold steady through the end of 2015 before beginning to decline.

Respondents were allowed to give written comments on their predictions:

"Some dealers assumed that future declines in the SOMA portfolio would be due to halting reinvestments only, while some dealers assumed halting reinvestments combined with sales. Several dealers expected such declines in the SOMA portfolio to occur at a fixed time before or after the first interest rate increase. Several dealers mentioned their views were based on the June 2011 exit principles while several others mentioned the FOMC will likely review its exit strategy, citing recent communication from Federal Reserve officials...
Some dealers expected sales of agency MBS securities to be a part of the exit strategy from accommodative policy. Some others thought that sales are unlikely or do not expect them to occur, with several mentioning that sufficient tightening could be brought about through other tools, including raising the interest rate paid on excess reserves (IOER) as well as temporary reserve draining."

Expected SOMA holdings at the end of 2014 are contingent on the level of unemployment by the end of this year. The blue bars show the probability distribution over holdings if the unemployment rate is less than 7.4% by the end of 2013. The red bars are if the unemployment rate is between 7.4 and 7.7%, and the green bars are if the unemployment rate is above 7.7%.

Services and the Slow Economic Recovery

The Berkeley Economic History Laboratory (BEHL) launched a series of working papers earlier this year. The BEHL website notes that "These papers are preliminary works, and their circulation is intended to stimulate discussion and comment." To further that goal, as I mentioned in an earlier post, I'll be spotlighting these working papers on the blog. Three new papers are out; the one I'd like to write about today is called "Goods, Services, and the Pace of Economic Recovery," by Martha Olney and Aaron Pacitti.

The authors cite Lazear and Spletzer's argument that “the problem [with the U.S. economy now] is not that the labor market is underperforming; it is that the recovery has been very slow” (2012 pg. 35). Olney and Pacitti offer an explanation for the slow recovery based on a hypothesis that recoveries from downturns should be slower when services are a larger share of the economy. This comes from the simple idea that goods, and not services, can be produced ahead of an anticipated increase in demand, because only goods can be inventoried. Here is the abstract:

Do service-based economies experience slower economic recoveries than goods-based economies? We argue they do. An economy recovers from a downturn when businesses increase production. Both goods and services can be produced in response to actual demand. But only goods—and not services—can be produced in response to anticipated increases in demand, allowing optimistic forward-looking producers to inventory goods until anticipated buyers appear. Services can’t be inventoried. The more services an economy produces relative to goods, the more production is dependent upon only actual increases in demand, and the slower the recovery. We exploit variation across time and states in the share of services in output. Controlling for the depth of the downturn, the higher is the share of services, the longer is the recovery. Extending our results to the current downturn, given the depth of the downturn, the rise in services alone will make the post-2009 recovery last about 1 year longer than it would have a half-century ago.

The authors use national data for the 10 recessions in the United States from 1948 to 2001, and a panel of state data for 50 states and 5 recessions from 1969 to 2001. They use the depth of each recession as a control variable. Getting the state-level data on service sector shares and business cycles was not an easy feat, and is an important contribution of this research. They are able to document interesting, and changing, variation in the share of services by state. My home state, Kentucky, had the second lowest share of services (39%) in the nation in 1967-1969; the share has risen to 50%. Now oil-rich states Wyoming, Alaska, and Louisiana have the lowest share of services. (Take a look at figure 6 and very cool figure 7 in the paper.)

I am left wondering about the other side of the business cycle. The story in this paper is that businesses can anticipate an increase in demand and build up an inventory. What happens when a decrease in demand is anticipated? Wouldn't goods-producing businesses decrease production and start using up their inventory? This would lengthen the downturn part of the cycle by making it start sooner. If this is the case, service-oriented economies would have longer recoveries and shorter downturns. I don't know if the effect would be asymmetrical. For the state-level data, the authors measure recovery as the length of time from one peak to the next peak of the business cycle. This actually captures the length of the downturn plus recovery. I think it would be preferable to use trough-to-peak length instead of peak-to-peak length if the data allowed it, since share of services could plausibly effect peak-to-trough length and trough-to-peak length in different ways.


Overall, I think this working paper documents an intriguing empirical fact. Has anyone out there read (or written) a macro model with two firms with heterogeneous inventory costs? Please comment or send it my way if you have.Setting the inventory costs of one of the firms to infinity could represent the service sector. I think it would be useful to have a model to go along with this paper-- both to help think about my point in the last paragraph and because I am having trouble thinking about GE implications for relative prices and wages in the goods and services sectors and what role that could play. Any other comments or suggestions on the paper are of course welcome, and I will pass them along to the authors.

Trust and the Future of the Euro

Last week I attended the Future of the Euro conference at UC Berkeley. The conference was cosponsored by the Institute of European Studies, the EU Center of Excellence, the Austrian Marshall Plan Foundation, and the Austrian National Bank. The conference was structured around four panels on political, banking, fiscal, and monetary union. On each panel, several panelists--mostly economic historians-- gave brief presentations of about 20 minutes. In each case, I wished I could hear longer presentations to get more details. This was particularly true of the presentation by Lars Jonung from the monetary union panel, in part because he gave a critique of modern macro which I hadn't heard before.

Jonung is a senior professor in economics at Lund University, Chairman of the Swedish Fiscal Policy Council, and Research Adviser at DG ECFIN at the European Commission. Jonung says that when applying macroeconomic models, we need to keep in mind economic political culture, which he claims can be summarized as “trust.” The indirect cause of the euro crisis, he argues, was lack of trust by the public in the political system in certain parts of the Eurozone, especially Greece, Spain, and Cyprus. He describes the “vicious trust circle” in those areas, whereby weak performance leads to low trust, which leads to more weak performance, and so on. In other parts of the Eurozone, such as Germany and the Nordic countries, a “virtuous trust circle” is in place.

Jonung uses the Eurobarometer dataset as an indicator of trust. He says that the Eurobarometer ought to be a gold mine for researchers, but is rarely used because modern macro models include no role for trust. From his own analysis of the Eurobarometer, he finds that trust in national governments, the European Parliament, and the European Central Bank have fallen over the 1999-2012 period, but support for the euro has not. Jonung remarked, “People trust the euro, but they don’t trust the institution behind the euro.”

His proposed long-run cure for the euro area is to foster trust in national governments and the EU system via decentralized fiscal policy. For starters, this would entail fiscal policy councils in every member country, as well as Eurostat offices in every member country. (See a paper by Jenny E. Ligthart and Peter van Oudheusden on the role of fiscal decentralization on trust in government.) If the recovery continues to be slow, so that trust cannot be restored across the Eurozone, he thinks that one possibility is to have a “high trust monetary union” in the North and a “low trust monetary union” in the South, with flexible exchange rate between the two. Then, when trust is equalized, they could fix the exchange rate.

As I mentioned, I wished Jonung’s talk could have been longer, because it left a lot of missing details. First, I would have liked to hear more about his high trust and low trust monetary unions idea, particularly, how trust would eventually be equalized between the two unions. Much more fundamentally, I’m not sure exactly how Jonung interprets the concept of trust. The Eurobarometer survey asks respondents a large number of questions about their trust in, and support for, the euro and various institutions. But what do respondents mean when they say that they trust a currency or institution? Does trust in a government mean confidence that the government is not corrupt? Does it mean approval of government’s policies toward people in their situation, or in all situations? Does it mean optimism that the government will be successful in preventing hyperinflation or recession? Does it imply that the government is credible, or something else? What about trust in the euro? Does it simply measure the subjective probability that the euro will persist? Is it a sense of European identity? On the one hand, I am sympathetic to the argument that macroeconomic models do not incorporate political cultural factors like trust. On the other hand, depending on what exactly is meant by trust, it may be reflected in interest rates, exchange rates, and other features of the asset market which are to some degree built into macro models.

Jonung's recent working paper with Felix Roth and Felicitas Nowak-Lehmann D. notes that when respondents are asked about "trust" in the euro, "It seems reasonable to interpret 'trust' in the euro as `trust' in the purchasing power of this type of money," but this is not what the authors mean by trust. Instead they focus on the question about "support" for the euro, which "would then mean support for the idea of a single European currency while not necessarily meaning that the respondent expects the euro to deliver a stable purchasing power." This is more what the authors mean by trust. 

The first figure below comes from the Roth, Jonung, and Nowak-Lehmann's paper showing support for the euro in the EA-12 countries (where support is their indicator for trust.) I made the second figure at the Eurobarometer website (European Commission Public Opinion). It shows, for Greece only, the percent of respondents that tend to trust or not trust in the European Union. You can see trust in the EU fall drastically around crisis time. But I'm not sure exactly what this tells us, since respondents could interpret the question about trust in a variety of ways that would all show a decline in trust following a crisis. The fact that trust continues to fall, and hasn't leveled off, does seem interesting.

You can play around on the Eurobarometer site and see how trust in the EU and ECB changes in different countries with different country-specific or Europe-wide events. Roth, Jonung, and Nowak-Lehmann "interpret the fall in trust in the ECB to imply that citizens blame the ECB for not preventing the economic, financial and political turmoil during the crisis and suspect that the crisis measures taken by the ECB and other European institutions have had an inflationary effect," while at the same time, "respondents support the euro as their currency and...do not blame the euro for the crisis." 

When Economists Have an Auction

I just got back from the Berkeley Economics annual skit party. The skit party is combined with an auction to raise money for the Graduate Economics Association. Professor Yuriy Gorodnichenko contributed a very interesting auction item: a promise to pay $500 if Christina Romer or Janet Yellen becomes Fed chair at any time in the future.

The bidding started at $50, and quickly jumped up to $200. I was bidding against Gabriel Chodorow-Reich, a fellow macro student. I chickened out and went silent after he bid $220, so he won. Immediately after, I was kicking myself for not sticking in a little longer. I think Gabe got a heck of a deal-- plus I would just love to be able to say that I had bought this unique asset.

Professor Gorodnichenko (who also swept the awards ceremony tonight, winning the Best Professor and Best Adviser awards) donated another auction item-- a check with the amount drawn from a beta distribution with parameters alpha=3 and beta=2, multiplied by $100. The beta distribution is only nonzero on the unit interval, so the check will have value between $0 and $100. The mean of the beta distribution is alpha/(alpha+beta), so the expected value should be $100 (3/5)=$60. The item went for $50 -- so everyone in the audience must have been risk averse, loss averse, financially illiterate, or liquidity constrained (or some combination, like me.) A bottle of wine from Professor David Card's vineyard was the highest-priced item, going for $240.

The most creative item was donated by grad student Kaushik Krishnan. He collected and printed all of Brad DeLong's "Liveblogging World War II" blog posts and put them into a binder, which he promises to get signed by DeLong next time he's in Berkeley. If I remember right, that went for around $40.

Operationalizing the Dual Mandate

In January 2012, the Federal open Market Committee put out a principles statement describing its longer-run goals and policy strategy. On April 13, Narayana Kocherlakota, President Federal Reserve Bank of Minneapolis, gave a speech on the "operational implications" of the principles statement. He focused in particular on paragraph 5 of the statement, which says the following:

The Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

If the Fed's only mandate were to mitigate deviations of inflation from its longer- run goal, Kocherlakota explains, then the Fed would aim for the green line, rather than the red line, in the graph below (from his slides.) He is confident that monetary policy works in one to two years, so reaching the inflation target of 2% (indicated by pi* in the graph) in two years would be both feasible and consistent with the mandate concerning inflation, if that were the only mandate.

Since the Fed has not one but two mandates, Kocherlakota explains, they must "balance" the inflation objective and the employment objective. He uses the graphs below to explain how he interprets "balance."

He says that the red line is "not balanced" because unemployment returns too slowly to its objective level u* (he does not specify its value.) The green line, on the other hand, he calls "balanced." It is more accomodative, with inflation rising faster and unemployment falling faster. The key point he makes is that inflation is allowed to rise temporarily above target, for a time, to help bring unemployment down.

A word I kept waiting for him to use is "symmetric." Last year, Mark Thoma noted that "the projections from members of the FOMC looked more like a ceiling than a central point," and thought that comments made by some officials could indicate that the Fed viewed the costs of overshooting and undershooting its target as asymmetric. If the objective were treated as a ceiling, then policymakers would choose the red line. Kocherlakota's  preference for the green line in the graph indicates that he does not view 2% as an upper bound on inflation, but is willing to allow inflation to go above 2%.

Thoma also wrote a fake interview with Kocherlakota in September asking him about the symmetry of the inflation target, and whether there is in fact an upper threshold on inflation. This fake interview was based on Kocherlakota's speech "Planning for Liftoff" in which he said 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." There is no scale on the graph to tell us whether that green line, at its maximum, is "allowed" to go above 2.25%. 

Though the speech is called "Operational Implications of the FOMC's Principles Statement," I'm not entirely sure how those green lines are intended to be operationalized. Until somewhere around quarter 7 on his graph, the two mandates are actually complementary; accommodative policy brings both inflation and unemployment closer to target. Then it looks like accommodation continues until around quarter 10-- inflation keeps rising, unemployment falling. But what does the Fed do from quarter 10 onward to get inflation to fall and keep unemployment moving steadily downward? The reason the two objectives are sometimes called "not complementary" is because in previous experience it has been hard to achieve the kind of outcome he plots starting in quarter 10. So if I were fake-interviewing Kocherlakota, that is what I would ask him about.

In the graphs below, I replicated Kocherlakota's "Dual Mandate Outlook" graphs using data from the U.S. Survey of Professional Forecasters. The red lines show the mean forecasts for inflation and unemployment made in 2013Q1 for various time horizons. The dashed lines are pi* and u*, where for u* I used the forecasters' latest mean "natural rate of unemployment." The forecasters do expect something qualitatively similar to Kocherlakota's green "balanced" lines at first: they expect inflation to exceed the 2% target in sometime sooner than 8 quarters, and for unemployment to continue falling. But while Kocherlakota hopes inflation will peak in 10 quarters, the forecasters expect inflation to peak in 12 quarters (at 2.27%). And while he hopes inflation will fall back to target by around 16 quarters from now, the forecasters expect it to still be up at 2.24% even  in 20 quarters.