Regime Change From Roosevelt to Rousseff

I've written another post for the Berkeley Center for Latin American Studies blog:

President Franklin Delano Roosevelt was elected in October 1932, in the midst of the Great Depression. High unemployment, severely depressed spending, and double-digit deflation plagued the economy. Shortly after his inauguration in March 1933, a dramatic turnaround occurred. Positive inflation was restored, and 1933 to 1937 was the fastest four-year period of output growth in peacetime in United States history. 

How did such a transformation occur? Economists Peter Temin and Barrie Wigmore attribute the recovery to a “regime change.” In the economics literature, regime change refers to the idea that a set of new policies can have major effects by rapidly and sharply changing expectations. A regime change can occur when a policymaker credibly commits to a new set of policies and goals.... 

In short, Roosevelt stated and proved that he was willing to do whatever it would take to end deflation and restore economic growth. As Roosevelt proclaimed on October 22, 1933: “If we cannot do this one way, we will do it another. Do it, we will.” 

Almost all politicians promise change but few manage such drastic transformation. In Brazil’s closely contested presidential election this October, incumbent President Dilma Rousseff won reelection with a three-point margin over centrist candidate Aecio Neves. Rouseff told supporters, “I know that I am being sent back to the presidency to make the big changes that Brazilian society demands. I want to be a much better president than I have been until now.” 

Rousseff’s rhetoric of “big changes” refers in large part to the Brazilian economy, which is plagued with stagnant growth, high inflation, and a strained federal budget. Brazil’s currency, the real, hit a nine-year low following Rousseff’s victory, and the stock market also tumbled. This market tumult reflects investors’ doubts about the Rousseff administration’s intention and ability to enact effective reforms. Investors viewed Neves as the pro-business, anti-interventionist candidate and are unconvinced that Rousseff will act decisively to restore fiscal discipline and rein in inflation. In other words, Rousseff’s talk of change is not fully credible in the way that Roosevelt’s was... 

Though Rousseff is taking some actions to improve business conditions, restore fiscal discipline, and reduce inflation, the problem is that they are being enacted quietly and reluctantly rather than being trumpeted as part of a broader vision of reform. The key to regime change is that the effects of policy changes depend crucially on how the changes are presented and perceived. Economic policies work not only through direct channels but also through signaling and expectations. For example, a small rise in fuel prices and a reduction in state bank subsidized lending may have small direct effects, but if they are viewed as signals that the president is wholeheartedly embracing market-friendly reforms, the effects will be much greater. So far, despite Rousseff’s campaign slogan — “new government, new ideas” — she hasn’t credibly committed to a new regime.

Read the complete article and my pre-election Brazil article at the CLAS blog.

Reading Keynes at the Zero Lower Bound

The Berkeley Economic History Lab working paper series has recently put up a new paper by Richard Sutch, "The Liquidity Trap, the Great Depression, and Unconventional Policy: Reading Keynes at the Zero Lower Bound." From the abstract:

The developed economies of Japan, the United States, and the Eurozone are currently experiencing very low short-term rates, so low that they are considered to be at the “zero lower bound” of possibility. This effectively paralyzes conventional monetary policy. As a consequence, monetary authorities have turned to unconventional and controversial policies such as “Quantitative Easing,” “Maturity Extension,” and “Low for Long Forward Guidance.” John Maynard Keynes in The General Theory offered a rich analysis of the problems that appear at the zero lower bound and advocated the very same unconventional policies that are now being pursued. Keynes’s comments on these issues are rarely mentioned in the current discussions because the subsequent simplifications and the bowdlerization of his model obliterated this detail. It was only later that his characterization of a lower bound to interest rates would be dubbed a “Liquidity Trap.” This essay employs Keynes’s analysis to retell the economic history of the Great Depression in the United States. Keynes’s rationale for unconventional policies and his expectations of their effect remain surprisingly relevant today. I suggest that in both the Depression and the Great Recession the primary impact on interest rates was produced by lowering expectations about the future path of rates rather than by changing the risk premiums that attach to yields of different maturities. The long sustained period when short term rates were at the lower bound convinced investors that rates were likely to remain near zero for several more years. In both cases the treatment proved to be very slow to produce a significant response, requiring a sustained zero-rate policy for four years or longer.

Sutch notes that "the General Theory is a notoriously unreadable book, one that required others to interpret and popularize its message." Since Keynes did not use the phrase "liquidity trap"--it was coined by Dennis Robertson in 1940--interpreting Keynes' policy prescriptions in a liquidity trap is contentious. Sutch reinterprets the theory of the liquidity trap from the General Theory, then examines the impact of Federal Reserve and Treasury policies during the Great Depression in light of his interpretation.

Sutch outlines Keynes' three theoretical reasons why an effective floor to long-term interest rates might be encountered at the depth of a depression:

(1) Since the term structure of interest rates will rise with maturity when short-term rates are low, a point might be reached where continued open-market purchases of shortterm government debt would reduce the short-term rate to zero before producing a sufficient decline in the risk-free long-term rate [Keynes 1936: 201-204 and 233]. 

(2) It is, at least theoretically, possible that the demand for money (called “liquidity preference” by Keynes) could become “virtually absolute” at a sufficiently low longterm interest rate and, if so, then increases in the money supply would be absorbed completely by hoarding [Keynes 1936: 172 and 207-208]. 

(3) The default premiums included as a portion of the interest charged on business loans and on the return to corporate securities could become so great that it would prove impossible to bring down the long-term rate of interest relevant for business decisions even though the risk-free long-term rate was being reduced by monetary policy [Keynes 1936: 144-145].

The first two reasons, Sutch notes, are often conflated  because of a tendency in the post-Keynesian literature to drop short-term assets from the model. The third reason, called "lender's risk," is typically neglected in textbooks and empirical studies.

In Keynes' view, the Great Depression was triggered by a collapse in investment in 1929, prior to the Wall Street crash in the fall, as “experience was beginning to show that borrowers could not really hope to earn on new investment the rates which they had been paying” and “even if some new investment could earn these high rates, in the course of time all the best propositions had got taken up, and the cream was off the business.” Keynes maintained that a reduction in the long-term borrowing rate, to low levels would be required to stimulate investment after the collapse of the demand curve for investment. He suggested that the long-term borrowing rate has three components: (1) the pure expectations component, (2) the risk premium, and (3) the default premium.

Sutch goes on to interpret the zero lower bound episodes of 1932, April 1934-December 1936 and April 1938-December 1939 according to Keynes' theory. He concludes that the primary impact of unconventional monetary policy on interest rates was through lowering expectations about the future path of rates rather than by changing the risk premiums on yields of different maturities---but this impact was very slow. Sutch also concludes that a similar interpretation of recent unconventional monetary policy is appropriate. He notes four main similarities between the Great Depression and the Great Recession:

...the collapse of demand for new fixed investment, the role of the zero lower bound in hampering conventional monetary policy, the multi-year period of near-zero short term rates, and the protracted period of subnormal prosperity during the respective recoveries. A major difference between then and now is that in the current situation the monetary authorities are actively pursuing large-scale purchases of long-term government securities and mortgage-backed assets. This is the primary monetary policy that Keynes advocated for a depressed economy at the zero lower bound. This policy was not attempted during the Great Depression and it is unclear whether the backdoor QE engineered by the Treasury was an adequate substitute. 

While the current monetary activism is to be welcomed, Quantitative Easing then and now appears to be slow acting. In both regimes recovery came only after multiple painful years during which uncertainly damped optimism. Improvement came only after multiple years during which many lives were seriously marred by unemployment and many businesses experienced or were threatened with bankruptcy...Keynes opened his series of Chicago lectures in 1931 expressing the fear that, just possibly, "… when this crisis is looked back upon by the economic historian of the future it will be seen to mark one of the major turning-points. For it is a possibility that the duration of the slump may be much more prolonged than most people are expecting and that much will be changed, both in our ideas and in our methods, before we emerge. Not, of course, the duration of the acute phase of the slump, but that of the long, dragging conditions of semislump, or at least subnormal prosperity which may be expected to succeed the acute phase." [Keynes 1931: 344]

If you are interested in reading narrative evidence from Keynes' writing, the entire working paper is worth your time.

Guest Post: Estimating Monetary Policy Rules Around The Zero Lower Bound

I hope you enjoy this guest post contributed by Jon Hartley. 

As the Federal Reserve moves closer to normalizing monetary policy and moving toward a federal funds rate “lift-off” date, I’ve created MonetaryPolicyRules.org, a new website that provides up-to-date interactive graphs of popular monetary policy rules.

Since the federal funds rate has hit the zero lower bound, Taylor rules have received a lot of criticism in large part because many Taylor rules have prescribed negative nominal interest rates during and after the global financial crisis. Chicago Fed President (and prominent monetary policy scholar) Charles Evans stated about the Taylor Rule that “The rule completely breaks down during the Great Recession and its aftermath”.

The discretionary versus rules-based monetary policy debate endures, most recently with the Federal Reserve Accountability and Transparency Act being introduced in Congress, followed by a series of dueling Wall Street Journal op-eds by John Taylor and Alan Blinder. Rather than thinking about Taylor rules as a prescription for monetary policy (in a normative economics sense), what has been left out of the discussion is how Taylor rules can accurately be a description of monetary policy regimes (in a positive economics sense) even if the central bank does not explicitly follow a stated rule.

Tim Duy has accurately pointed out in a recent post that using the GDP and inflation forecasts also provided by the FOMC for 2014 through 2017 (and beyond), no traditional monetary policy rule captures the median of the current fed fund rate forecasts (commonly known as the “dot plots” released by the Federal Reserve on a quarterly basis as part of their Delphic forward guidance) which are considerably lower than either the Taylor (1993), Taylor (1999), Mankiw (2001), or Rudebusch (2009) rules would estimate.

What’s also worth noting is that in the early to mid-2000’s the federal funds rate was considerably lower than what any of the above classic monetary policy rules would estimate. This in large part is because all of these rules were estimated using data from the “Great Moderation” of the 1990’s, which was then led by a very different Federal Reserve than we have today (note those rules fit the federal funds effective rate data very accurately during the 1990’s).

Source: Tim Duy

The real question is how can we estimate a monetary policy rule that describes the Bernanke-Yellen Fed, while also addressing the problem of the zero lower bound for nominal interest rates?

One interesting idea that has gained some popularity recently is the idea of measuring a “shadow federal funds rate” (originally hypothesized by Fisher Black in a 1995 paper, published just before his death, which uses fed funds futures rates and an affine term structure model to back out a negative spot rate). The idea nicely estimates the potential effects of quantitative easing on long-term rates  while the federal funds rate is at the zero lower bound (and for that reason I’ve included the Wu-Xia (2014) shadow fed funds rate on the site). With the shadow fed funds rate in hand, one can now estimate a monetary policy rule with a standard OLS regression. One issue with this methodology is how there is a lack of consensus around what to use as input data for a shadow rate which can give you very different results (Khan and Hakkio (2014) observed that the Wu-Xia (2014) shadow fed funds rate looks remarkably different from the rate calculated by Krippner (2014)).

Wu-Xia (2014) and Krippner (2014) Shadow Federal Funds Rates (in %)Source: Khan and Hakkio (2014), Federal Reserve Board of Governors, Krippner (2014), Wu-Xia (2014)

One other solution to the problem of estimating a monetary policy rule at the zero lower bound is an econometric one. Fortunately, we have Tobit regressions in our econometric toolbox (originally developed by James Tobin (1958)) which allow us to estimate Taylor rules while censoring data at the zero lower bound.

In my Taylor rule that is estimated with federal funds rate from the Bernanke-Yellen period, censoring data at the zero lower bound using a Tobit regression, I use both y/y core CPI inflation and unemployment. In another version, I use the Fed’s new Labor Market Conditions Index (LMCI) as a labor market indicator though both yield relatively similar results*. Importantly, these estimates indicate that the Bernanke-Yellen Fed puts a much higher weight on the output/unemployment gap than the Mankiw (2001) rule estimated with data from the Greenspan period.

Tobit Taylor Rule Using Unemployment Rate and Core CPI as Inputs:

Federal Funds Target Rate = max{0, -0.43 + 1.2*(Core CPI y/y %) – 2.6*(Unemployment Rate-5.6)}

Using unemployment and inflation forecast data from the latest Federal Reserve FOMC meeting’s Survey of Economic Projections, I input these data as inputs into the Tobit Rule and Mankiw (2001) Rule. Matching these federal funds rate targets implied by the rules with the median federal funds forecasts provided by both the Federal Reserve “dot plots” and the Survey of Primary Dealers (note: the expected Fed Funds rate path from Survey of Primary Dealers has significantly fallen below the Fed dot plot Fed Funds rate path as noted by Christensen (2014)). Unfortunately, we do not have precise data on which dots belong to which Fed officials (otherwise, we could try to construct a Taylor rule for each Fed president and board member). Compared to the Mankiw (2001) rule, the estimated Tobit rule much better matches the median forecasts provided by the dot plots and the Survey of Primary Dealers.

Federal Reserve Forward Guidance/Survey of Primary Dealers Fed Funds Rate Forecasts versus Tobit Rule and Mankiw (2001) Rule Using Fed Unemployment and CPI Forecasts

Janet Yellen has spoken fondly of the Taylor (1999) rule in the past as she has previously stated in a 2012 speech that “[John] Taylor himself continues to prefer his original rule, which I will refer to as the Taylor (1993) rule. In my view, however, the later variant--which I will refer to as the Taylor (1999) rule--is more consistent with following a balanced approach to promoting our dual mandate.”

It is no surprise that the Tobit rule estimated with more recent data comes much closer to accurately describing the Fed’s forward guidance than the Taylor (1993) rule. However, what is really interesting is that the Tobit Rule is also much closer to describing the Fed’s current forward guidance than the Taylor (1999) rule, which remains far off.

Footnote:

*An important issue which has been addressed recently with the introduction of the Fed’s new Labor Market Conditions Index (LMCI) is how do we measure improvement (or lack thereof) in the labor market? While the U.S. unemployment rate for September was 5.9% (the lowest level since July 2008), the figure fails to capture a number of fractures in the economy remain which are not reflected in the unemployment rate. One item included in the LMCI (but not reflected in the unemployment rate) is the high U-6 unemployment rate (which factors in individuals who are underemployed, working part-time for economic reasons and would rather have full-time jobs) currently at 11.8%. Another is subdued wage growth that is not commensurate with drops in the unemployment rate as history would suggest. The labor force participation rate is at historical lows of 62% (in large part due to the number of retirements (a secular demographic trend) and to some extent due to discouraged workers (a cyclical trend) according to a recent Philly Fed study).

A previous post on this blog astutely points out that correlation of 12-month changes in LMCI with 12-month changes in the unemployment rate is -0.96, suggesting that “the LMCI doesn’t tell you anything that the unemployment rate wouldn’t already tell you”. While the economists who developed the LMCI list on the Fed’s website the correlations of 12-month changes (which tell you the tendency of large 12-month figures moving together), I would argue that this is accurate of long-term labor market trends, while the correlations of monthly changes with the LMCI is a more accurate representation of the extent the measures move together in small short-term labor market movements. Doing so indicates that the monthly level of the LMCI has a -0.82 correlation with the unemployment rate, suggesting that the LMCI is not completely redundant in short-term labor market movements, incorporating some parts of the mixed economic narrative told by dampening wage growth, low labor force participation, and high amount of underemployed part-timers.