President Obama's Big, Frothy Hint

President Obama, in an interview with the New York Times, said a few sentences about what he's looking for in the next Fed chair. A few newspapers, including the Washington Post, have already exclaimed that "President Barack Obama says his next Fed chairman should take ordinary people into account when setting monetary policy."

President Obama indeed mentions "the lives of ordinary Americans getting better." But taken in context, his remarks are surprisingly inflation-hawkish and relatively unconcerned with unemployment. He says:

And what I’m looking for is somebody who understands the Fed has a dual mandate, that that’s not just lip service; that it is very important to keep inflation in check, to keep our dollar sound, and to ensure stability in the markets. But the idea is not just to promote those things in the abstract. The idea is to promote those things in service of the lives of ordinary Americans getting better. And when unemployment is still too high, and long-term unemployment is still too high, and there’s still weak demand in a lot of industries, I want a Fed chairman that can step back and look at that objectively and say, let’s make sure that we’re growing the economy, but let’s also keep an eye on inflation, and if it starts eating up, if the markets start frothing up, let’s make sure that we’re not creating new bubbles.

When he says "The idea is to promote those things in service of the lives of ordinary Americans getting better," those things refers to keeping inflation in check, keeping the dollar sound, and ensuring stability in the markets. He's emphasizing the price stability part of the dual mandate much more than the maximum employment part. When he then goes on to mention high unemployment (a much bigger impediment to the lives of ordinary Americans getting better, in my opinion), he is remarkably quick to mention keeping an eye on inflation in the very same sentence.

The President says he wants "somebody who understands the Fed has a dual mandate," but somebody who truly understood this would recognize that the Fed's efforts in this economic environment should be focused on restoring full employment.

And then there are the remarks about frothing markets and bubbles. Now, President Obama refused to answer the NYT reporter's question about who he was considering for chairman--in particular, he refused to say whether he was planning to appoint Larry Summers--but this is a pretty big hint. Fed officials are split over the appropriate role of the Fed in trying to identify and constrain asset bubbles. The so-called "Bernanke doctrine" holds that monetary policy should be used to deal with normal macroeconomic concerns, while regulatory policies should be used to try to alleviate financial imbalances. Ben Bernanke, of course, is a follower of the Bernanke doctrine, as are, among others, Governor Sarah Raskin and Vice Chairwoman Janet Yellen. Yellen, a top contender for the next Fed chair, has said, "I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense."

Governors Jeremy Stein and James Bullard are among the group who don't buy the Bernanke doctrine; they believe that monetary policy (i.e. higher interest rates) should be used to "fight financial excess a little more than we have in the last few years." Larry Summers, also considered a top contender, fits more into this group, expressing concerns that the Fed's monetary policy of recent years creates "an environment that’s going to increase the risk of – going to increase the risk of bubbles."

So I think President Obama's comment, "if the markets start frothing up, let’s make sure that we’re not creating new bubbles," reveals who has his ear, and maybe whom he has in mind: Summers.

But returning to "the lives of ordinary Americans getting better," here's Janet Yellen in 1995:

"I began by asking myself the question, what is it that the public cares about? The answer seems straightforward to me. It is not just high and variable inflation; that is not the only aspect of economic performance people care about. The public also cares about real outcomes. Households and businesses very much dislike fluctuations in output and employment, for good reasons. Quite naturally, they prefer higher average output and lower average unemployment. I consider these goals eminently sensible, not foolish nor irrational. 

Then I ask myself, what is it that the Fed can accomplish? I conclude that the actions of this Committee affect not just the level and variability of inflation but also at a minimum the variability of output and employment. I know that some people would argue against our trying to reduce the variability of output on the grounds that economic forecasting is so uncertain and that there are long and variable lags in monetary policy, so maybe all we would do is to destabilize the economy rather than stabilize it. But when I look at the record, I just do not agree. It seems to me the record shows that within limits, tuning works even if it is not "fine."... 

The moral I draw is simply that the Fed should pursue multiple goals. It follows almost automatically that when the American people have sensible multiple goals and the Federal Reserve affects multiple dimensions of economic performance, that the Federal Reserve Act should enshrine all of those goals and we should do our best to honor them... I understand that the mandate of the Federal Reserve Act to pursue multiple goals is pretty vague. There really is no guidance in the Act as to how to call the tough trade-offs. But I see the objectives as fundamentally sound, and I think this Fed, in pursuing those goals, has enhanced social welfare...I want at least to mention that if this Committee were to decide that it really wanted a quantitative monetary policy rule incorporating a numerical inflation target--for example, because it was thought to be important to have a nominal anchor for monetary policy--we should not go with the type of rule embodied in the Neal amendment, which is a pure inflation targeting scheme. Why? Because there clearly are better rules. We could talk about those at length but a simple approach, not necessarily the best, that dominates inflation targeting would be a hybrid rule that would adjust monetary policy--and this could be a mechanical rule if it were so desired--on the basis of two gaps, not one. These would be the gap between actual and target inflation and also the gap between actual and potential output...Uncertainty about sales impedes business planning and could harm capital formation just as much as uncertainty about inflation can create uncertainty about relative prices and harm business planning."

She got it then and she gets it now. I could say more about her remarkable credentials, but plenty of people have already jumped in to do so in the last week. I can only echo that she is the best choice to replace Chairman Ben Bernanke at the Fed.

***Fun fact: My high school, like most high schools, voted on "senior superlatives" (most likely to succeed, best athlete, etc.) Oddly, I was given "Most likely to be the next Alan Greenspan." I say oddly because I had no interest in economics at the time, and still didn't for another few years after that. Obviously, I did not become the next Alan Greenspan. Ben Bernanke beat me to it! But I was still tickled by Binyamin Appelbaum and Annie Lowrey's remark that "President Obama’s choice of a replacement for the Federal Reserve chairman, Ben S. Bernanke, is coming down to a battle between the California girls and the Rubin boys," and to have the great pleasure of being associated with the California girls!

Three Thought-Provoking Central Banking Reads

I have three recommendations for readers interested in central banks and monetary policy. First, my classmate Jeremie Cohen-Setton has started a new blog (together with Tishani Dorfmeister) called ECB Watchers. This blog is great for anyone who watches the Fed too, because the comparative analyses of ECB and Fed policies are quite illuminating. In particular, they have good insights into why the ECB and the Fed will each face serious but different challenges with forward guidance. They explain how the differences stem in part from the Trichet doctrine, which basically holds that non-standard monetary policy measures can “be determined largely independently” from conventional measures. They add:

The intellectual case for such a separation became more fragile, however, as the ECB introduced another set of non-standard measures (LTROs, covered bond programme, Securities Markets Programme and, should it be implemented, the Outright Markets Transactions), which implicitly addressed the second category of problems. By and large, the ECB has remained very shy with measures affecting the structure and risk premia problems (which it consistently saw as bordering fiscal policy) in comparison to the Fed and other central banks.

This relative timidity for touching the risk and term premia can be understood in a multi-country context where monetary policy would inevitably have important distributional consequences. But ECB officials often overplay this aspect. The ECB has eventually been forced to venture in this field and is nervously attempting to rationalize and justify these interventions ex post by explaining that the specific set up of the euro area and in particular the risks of financial fragmentation justified such an approach (see speech by Benoit Coeure at the Banque de France). But this argument is anachronic, because the ECB’s non-standard measures largely predates the financial fragmentation along national boundaries or redenomination risks (covered bond programme, SMP) and because the institutional set up cannot be a sufficiently good reason for the ECB not to undertake what its mandate and its fiduciary duty towards European citizens call for.

My second recommendation is a speech by Fed Governor Sarah Bloom Raskin called "Beyond Capital: The Case for a Harmonized Response to Asset Bubbles." Unfortunately, since she gave the speech on the same day as Chairman Ben Bernanke's testimony on July 17, the speech was under-covered. The bit of coverage that the speech has had mostly just notes that she thinks regulation can stem asset bubbles. But it actually has quite a bit more content. The mechanics of asset bubbles-- why and how they form and grow-- is not clearly understood. But Governor Raskin provides a much clearer and more coherent discussion than I have seen in any previous central banker speech (and I have read quite a lot of them!) Here's a long excerpt-- I'm thrilled to see a central banker actually putting this many words into explaining precisely what they mean by an asset bubble before saying what they want to do about it.

It used to be believed that asset bubbles emerged spontaneously, or perhaps came from sunspots or other mysterious causes. Now we know more and we know better, and, while we may not be able to predict bubbles, we understand them to be a product of particular actions and choices by financial institutions and their regulators.

Here is one way a bubble might start. And, to approximate current economic conditions, we'll assume an environment of interest rates that have been low, and continue to be low, for a long time. To start, retail investors may become dissatisfied with their low yields and begin to seek higher yields by purchasing some specific higher-yielding asset. If investors have access to credit, they might try to raise the return on their money by funding a greater portion of their purchases with debt. The asset purchased could serve to collateralize their loan. If many investors employ this strategy and they borrow to invest in the same asset, the price of that asset, and perhaps the prices of closely related assets as well, will increase noticeably faster than the historical trend.

At the same time, increased demand for credit to finance these asset purchases could lead lenders to increase their reliance on less expensive, unstable short-term funding, such as uninsured deposits, commercial paper, or repo transactions, in order to fund the loans.

Besides meeting customers' growing demands for credit, financial intermediaries may themselves decide to "reach for yield" and take on additional risk in a low interest-rate environment. Banks suffering compressed net interest margins because of low long-term interest rates, money market funds facing an earnings squeeze, insurance companies that had promised minimum rates of return on their products, and others may all begin to take on higher interest rate risk, market risk, liquidity risk, or credit risk in search of higher returns.

If these conditions seem likely to continue, an initial rise in the asset's price leads to expectations of further increases, which adds to investor demand, spurring further borrowing and credit growth and increased household and financial sector leverage, which, in turn, could drive asset prices still higher. Rising asset prices, in turn, would increase the value of borrowers' collateral, allowing still further borrowing.

For loans collateralized by an asset whose price is rising, lenders believe they can rely for repayment more on the appreciation of the asset and collateral and less on the borrower's repayment ability. Lenders relax their underwriting standards, such as minimum requirements for borrower down payments, credit scores and credit history, or required maximum debt-to-income ratios. To compete for loans to buy or to hold the appreciating asset, or financial assets related to it, financial institutions could also decrease the margins and haircuts that usually protect them from asset price declines.

Financial institution decisions to relax underwriting and impose less-stringent margins and haircuts will further increase the pool of potential borrowers and their borrowing capacity, further increasing credit growth and supporting still higher asset prices, but, at the same time, will also increase lenders' credit risks and exposure--as secured creditors--to a decline in the asset's price. Ultimately, the asset becomes severely overvalued, with its price untethered from economic fundamentals. We would then have on our hands a full-blown, credit-fueled asset bubble.

And, as we experienced in the financial crisis, when a bubble involving a widely-held asset bursts, the consequent plunge in asset prices can seriously impair the balance sheets of households and firms. Indeed, a dramatic decline in the price of a significant asset can reduce household wealth, spending, and aggregate demand. When such effects on wealth, credit availability, and aggregate demand are large enough, the real economy can suffer a significant recession. And, of course, lower employment and incomes further depress asset prices and borrowers' ability to repay loans, with further adverse effects on financial institutions and their ability to extend credit.

At this point, some financial institutions may have become nearly insolvent. And this, coupled with their increased reliance on potentially unstable short-term funding, could make them more vulnerable to sudden losses of public confidence.

Such a loss of confidence, in turn, makes it impossible for affected institutions to roll over existing debts or extend new credit, and may force deleveraging that requires selling illiquid assets quickly and cheaply in asset fire sales, resulting in further declines in asset prices. Such developments further threaten the solvency of financial institutions and intensify credit contraction, depriving households and businesses of financing. A loss of confidence that is institution-specific could spread, causing other institutions to experience their own heightened solvency risks, liquidity problems, and need to de-lever through asset sales.

My third recommendation is an old (in blogosphere terms) post by Nick Rowe called "Is money a liability?" I came across it because I'm teaching undergrads about the central bank balance sheet this week (as Rowe was too when he wrote the post.)

Let's Not Invent New Ways to Measure Higher Inflation

Matthew Klein of Bloomberg View has just posted an interesting article called "A Better Way to Measure Inflation." He writes:

Sooner or later, most people end up retiring. You may not be working, but you still need money to eat and live. In the U.S., retirees get some income from Social Security, while Medicare covers their healthcare expenses. These programs by themselves aren't enough for most people, which is why it's a good idea to take some of the money you earn during your working life and use it to buy assets that can be consumed later. 

The amount of money you need to spend on assets to guarantee a given standard of living in retirement is determined by your assets' average yield. The higher the yield on your assets, the less money you need to spend today to get an equivalent amount of money in retirement. Falling yields therefore mean you need to spend more money today to guarantee the same amount of money in the future. In other words, the price of retirement, which is a price almost everyone is exposed to, goes up when yields go down.

The Consumer Price Index calculates inflation as the percent change in the price of a "market basket" of goods and services. Klein implies that the Consumer Price Index understates inflation because retirement is left out of the market basket.

"Consumption smoothing" is the usual name for the fact that people want to spread their consumption across their lifetime more smoothly than their income. For example, when people retire and have little or no income, they still want to consume around the same amount as they did before, as Klein describes. So over the lifecycle, a typical person will try to borrow (reduce their net assets) when their income is low and save (increase their net assets) when their income is high. Interest rates, and correspondingly, yields, figure prominently in the analysis of lifetime consumption.

I am a teaching assistant for undergraduate macroeconomics this summer, and we have been teaching the students a variety of different ways to think about interest rates. One way we explain is that interest rates are like a "price" in the market for loanable funds. They are familiar with supply and demand curves from their prerequisite course, so we show them a graph like this:

Klein, I think, is implying that Fed policy has shifted the supply curve to the right, lowering the real interest rate, making the price of loanable funds lower and in turn making the cost of saving for retirement higher. He pays attention to the second part (the higher price of saving), but not the first part (the lower cost of borrowing.) He says that:

People who already own a lot of assets tend to see things differently. For them, falling yields are great because it means that the value of their savings is rising relative to their other expenses. By contrast, workers struggling to save for retirement have to cut back on current purchases of goods and services in order to cover the added cost of their future liabilities. Rising yields have the opposite effect: it makes the asset-rich feel poorer and makes the asset-poor freer to spend more today.

Monetary policy does have different effects on different people, for a variety of reasons, but not really in the way Klein describes. He is considering only people who are currently increasing their net assets. In terms of lifetime consumption models, these are people who are in a part of their lifecycle when their current income is higher than their expected average future income. (These people have earnings above the red line in the figure below.) What he calls the "asset-rich" and the "asset-poor" do not together make up the entire population-- and a lot of "struggling workers" would not accurately fit into his characterization of the "asset-poor."

Especially when unemployment and underemployment are high, a lot of people's current income is lower than their expected average future income. (Somewhere around the blue star in the figure below.) These people are quite rational to want to spend more than their current income. Rising yields would certainly not make them "freer to spend more today." Klein's "asset-poor" leaves out the people with falling (and in many cases also negative) net assets.  In short, Klein argues that our measured inflation leaves out the price of consumption smoothing, but he only considers the saving part of consumption smoothing, and not the borrowing part.

Image Source: Kotlikoff and Burns (not including blue star)

I hope the Fed does not start finding inflation where it doesn't exist as an excuse to raise rates.

Divided Fed, Broken Models

This week, it has become abundantly clear that the Fed is "deeply divided." In speeches and public communications, FOMC committee members and  Fed Chairman Ben Bernanke have revealed significant differences in their outlooks and intentions for the economy. Tim Duy writes that "The growing division makes it increasingly difficult to think of "the Fed" as a single entity with regards to policy intentions." This is an extremely important point, because most macroeconomic models do consider the Fed as a single entity, and would have different implications if they did not.

Monetary policy is often modeled as a dynamic game in which the two players are the central banker and the public. Typically, the central banker can choose what private information to reveal to the public. Monetary policymakers' preferences and reputational concerns determine their optimal communication strategy in the equilibrium of this dynamic credibility game (see for example Faust and Svensson 2001). Depending on the exact "rules of the game," the optimal strategy turns out to be something less than full information revelation. This game-theoretic political economy paradigm for thinking about monetary policy became hugely influential after seminal papers by Kydland and Prescott in 1977 and Barro in 1986, and has shaped the way economists think about the merits of central bank independence, rules versus discretion, transparency, and explicit inflation targets, with. Insights from this huge literature have been thoroughly integrated into the policymaking sphere.


In reality, of course, in almost every country, monetary policy is not made by a single representative agent, but rather by a committee of very non-representative agents, each with their own, sometimes conflicting, preferences and reputational concerns. With multiple central bankers, monetary policy is a dynamic game between more than two players-- which makes computing optimal strategies dauntingly complex. Strategic behavior between members of the committee will influence each member's communication strategy with the public and with each other. And the public, aware of these strategic interactions, will have quite a complex task computing their best response.

I'm not quite sure where we go from here. One of the most brilliant and famous game theorists, John Nash, proved that non-cooperative games with an arbitrary finite number of players have a Nash equilibrium. But actually finding such an equilibrium is a huge challenge (plus, the non-cooperative assumption is kind of restrictive.) A pair of computer scientists at Berkeley and Stanford note that "even less is known about computing equilibria in multi-player games than in the (still mysterious) special case of two-player games." Even more telling is the title of another paper by Berkeley computer scientists: "Three-Player Games are Hard."

Stein, Thoma, and Hamilton on Fed Communication

Mark Thoma describes four ways the Fed is creating harmful uncertainty that could block the economic recovery. A June 28 speech by Jeremy Stein, a member of the Board of Governors, describes Stein's opinions on how the Fed should address two out of the four.

Thoma says that the Fed is creating harmful uncertainty through a botched communication policy concerning when quantitative easing will begin tapering off. "The Fed does not seem to understand how anxious it has appeared to return policy to normal over the last several years," he writes. "Any sign of `Green Shoots,' such as the supposed sighting in 2009 by Chairman Bernanke, prompts the Fed to announce that it is developing an exit strategy. With that background, combined with the public perception that the Fed is itching to reverse course and get back to normal, members of the Fed should not be surprised when markets “misread” talk about when the Fed is planning to reverse course. When Fed communication is adding uncertainty instead of reducing it, that’s a big problem."

Another, related way the Fed is creating uncertainty, Thoma notes, is through its consistently overly-optimistic forecasts: "When things turn out much worse than forecast, the Fed has to reverse itself. It has eased policy after these episodes in some cases and that creates quite a bit of uncertainty over Fed policy."

Stein asserts that both the labor market and the general economic outlook have improved since the start of this round of asset purchases nine months ago, but adds that "this very progress has brought communications challenges to the fore, since the further down the road we get, the more information the market demands about the conditions that would lead us to reduce and eventually end our purchases." In other words, "as we get closer to our goals, the balance sheet uncertainty becomes more manageable – at the same time that the
market’s demand for specificity goes up." This seems roughly true, although I would add that it is not balance sheet uncertainty per se that is the most impactful. I think market participants, in contrast to the consensus among Fed officials, generally care more about the flow of asset purchases than the stock on the balance sheet. In other words, while the Fed believes that tapering is not tightening, since it still expands the balance sheet, if at a slower rate, the markets interpret the slower rate as tightening. So the fact that "balance sheet uncertainty" becomes more manageable does not do much to alleviate uncertainty in the financial market.

Stein makes a suggestion that might go some ways towards addressing Thoma's concern about consistently overly-optimistic forecasts:

"A key point is that as we approach an FOMC meeting where an adjustment decision looms, it is appropriate to give relatively heavy weight to the accumulated stock of progress toward our labor market objective and to not be excessively sensitive to the sort of near-term momentum captured by, for example, the last payroll number that comes in just before the meeting...Not only do FOMC actions shape market expectations, but the converse is true as well: Market expectations influence FOMC actions. It is difficult for the Committee to take an action at any meeting that is wholly unanticipated because we don’t want to create undue market volatility. However, when there is a two-way feedback between financial conditions and FOMC actions, an initial perception that noisy recent data play a central role in the policy process can become somewhat self-fulfilling and can itself be the cause of extraneous volatility in asset prices. 

Thus both in an effort to make reliable judgments about the state of the economy, as well as to reduce the possibility of an undesirable feedback loop, the best approach is for the Committee to be clear that in making a decision in, say, September, it will give primary weight to the large stock of news that has accumulated since the inception of the program and will not be unduly influenced by whatever data releases arrive in the few weeks before the meeting – as salient as these releases may appear to be to market participants. I should emphasize that this would not mean abandoning the premise that the program as a whole should be both data-dependent and forward looking. Even if a data release from early September does not exert a strong influence on the decision to make an adjustment at the September meeting, that release will remain relevant for future decisions. If the news is bad, and it is confirmed by further bad news in October and November, this would suggest that the 7 percent unemployment goal is likely to be further away, and the remainder of the program would be extended accordingly."

The question is whether such a commitment would be credible. Market participants might believe that the Fed would treat September near-term news asymmetrically. Participants might (reasonably) believe that a data release from early September may not exert a strong influence on September decisionmaking if it were bad news, whereas if it were good news, the Fed would choose to use it to justify a return to normal.

While Stein recognizes the need to improve the Fed's communication strategy, he also points out that "there are limits to how much even good communication can do to limit market volatility, especially at times like these." In this respect his view is quite similar to that of James Hamilton, who questions the omnipotence sometimes ascribed to the Fed's communication, reminding us that the Fed's communication strategy is not the only determinant of long-term yields.

"Prior to the Great Recession, I thought we had all agreed on the practical limits on the Fed's capabilities. We understood that to some extent the Fed could control the short-term interest rate by changing the supply of reserves available to the banking system. But we also understood that the Fed's influence over longer-term interest rates was much less immediate and direct. The Fed can communicate its long-run inflation objectives, and certainly the 10-year inflation rate is a very important determinant of long-term yields. But regardless of what the Fed may say about its 10-year inflation goals, the market would form its own view of whether the Fed could or would achieve those. Other determinants of long-term yields, such as the term premium, long-run economic growth rate, and global saving and investment decisions were understood to be even farther beyond those things that the Fed can hope to control."

Stein puts it very similarly:

"At best, we can help market participants to understand how we will make decisions about the policy fundamentals that the FOMC controls – the path of future short-term policy rates and the total stock of long-term securities that we ultimately plan to accumulate via our asset purchases. Yet as research has repeatedly demonstrated, these sorts of fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well – and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics...So while we have seen very significant increases in long-term Treasury yields since the FOMC meeting, I think it is a mistake to infer from these movements that there must have been an equivalently big change in monetary policy fundamentals."