The Fed will be purchasing $600 billion of long term Treasury bonds. This is a 30% increase in the monetary base. For money expenditures to return to the growth path of the Great Moderation over the next year, the increase in Final Sales of Domestic Product must be 21 percent.
At first pass, then, the amount of quantitative easing looks excessive--about 50 percent too high. However, it is possible that the expansion in the monetary base will not result in a proportional increase in money expenditures--that the real demand for the monetary base will grow faster than real income. There is no guarantee that the demand for the money base will remain proportional to money expenditures over the next year.
Unfortunately, the Fed doesn't target a growth path of money expenditures. Much of the discussion of the Fed's policy, including much of what the Fed itself says, suggests that the purpose of the policy is to lower long term interest rates. The Fed will buy long term bonds, raising their prices, and lowering their nominal yields. The lower nominal interest rates, given expected inflation, will result in lower real interest rates. The lower real interest rates are supposed to encourage additional borrowing. How does that work?
Apparently, the idea is that those who sell the government bonds to the Fed will use the funds they receive to purchase privately issued financial assets, bidding up their prices and lowering their yields as well. Because of the lower interest rates, firms will issue more such bonds--borrow more. These could be firms issuing new corporate bonds. Or perhaps more mortgate backed securities would be issued, allowing for lower mortgate rates. Perhaps other asset backed securities could be issued, allowing banks to take credit card debt off their balance sheets. Perhaps finance companies could issue more bonds, and make more loans to small business. Regardless, those directly or indirectly borrowing the money will spend at least some of it on consumer and capital goods. The firms producing the consumer and capital goods will obtain additional sales. As firms see expanded sales, they will expand production and hire workers.
It is very likely that firms have been limiting price increases because of slow sales. If sales pick up as planned, then firms will raise their prices more quickly. The inflation rate will rise. The Fed says that current levels of inflation are too low. This pick up in inflation will move it closer to what the Fed thinks is the right level. While the Fed continues to be less than perfectly clear, a 2 percent inflation rate appears to be what is being proposed.
To the degree the Fed's policy is expected to slightly increase inflation, this will reinforce the effect of the lower nominal interest rates and further reduce real interest rates. This entices more borrowing and more spending, more sales and more production.
Maybe.. but not necessarily.
I favor targeting a growth path for Final Sales of Domestic Product. I favor some opportunistic disinflation, with a shift in the growth path to one increasing 3 percent per year from the old growth path for the third quarter of 2008. I believe the Fed should commit to hitting that adjusted growth one year in the future--a 13 percent increase.
Given the current unsettled conditions, I think the Fed should purchase $260 billion of Treasury bonds. This is a 13 percent increase in the monetary base, which is currently approximatly $2 trillion.
They should buy bonds that have yields greater than the interest rate the Fed is paying on reserve balances (.25 percent.) Currently, Treasuries with maturities 2 and 3 years into the future meet that criterion. However, if the Fed's purchases push down those yields, to .25 percent or below, the Fed should purchase longer term Treasury bills as needed. Of course, the Fed can and should reduce the interest rate it pays reserve balances. I believe it should be reduced to slightly less than zero, which would allow the Fed to purchase shorter term Treasuries again.
The implied target for the monetary base, of $2,260 billion should remain tentative. The "policy" should be to buy (or sell) whatever amount and maturities of Treasury bonds needed to reach the target for money expenditures-- $16,415 billion, in my view. In particular, if $260 billion of bonds is not enough, then the Fed should commit to buying more. But, of course, if money expenditures are above target, then the Fed should be committed to selling off whatever amount is necessary.
What of the transmission mechanism? Should the goal be to lower interest rates on long term Treasury bonds? Should the goal be to raise inflation expectations so that these lower nominal interest rates entail an even lower real interest rate? More importantly, should the goal be to encourage more borrowing?
My answer is no.
Clearly, as an advocate of money expenditure targeting, I believe the goal should be to increase both expected and actual money expenditures. However, what happens to short term or long term, nominal or real interest rates is not important. Whether borrowing increases or deceases is not important.
In my view, the ideal response to quantitative easing is for households and firms to sell off already existing bonds that they currently hold and use the funds they receive to purchase consumer goods or capital goods. This is not an increase in borrowing, but rather a decrease in lending. While not directly a decrease in the flow of new lending, those who end up with the already existing bonds won't be purchasing newly issued bonds. The sale of existing bonds quickly translates into a contraction in the flow of new lending.
Unfortunately, bad macroeconomic analysis is common. Decreased lending is nearly always associated with reduced expenditures on goods and services. Less lending implies higher interest rates, less borrowing, and less spending on goods and services. While plausible enough, the implicit assumption is that the alternative to lending is to hold money. Less lending is implicitly assumed to be an increase in the demand to hold money. Or, perhaps, the assumption is that the quantity of money drops because any lending is funded by newly created money.
However, if the alternative to lending is spending on goods and services, then less lending does not entail less spending. Less lending is more spending.
How can quantitative easing result in less lending and more spending? One possible pathway would be lower nominal interest rates. The Fed buys bonds, raising their prices and lowering their yields. The lower nominal interest rate reduces the quantity of bonds demanded, and rather than hold the money they receive, the previous bond holders purchase consumer goods or capital goods.
As explained above, the increased spending on consumer or capital goods will make firms less restrained in raising prices. The result should be higher inflation, and expecting this, the policy should raise expected inflation. This higher expected inflation could add to the effect of lower nominal interest rates to further lower real interest rates, and so, further reduce the real quantity of bonds demanded, and spur a larger increase in spending.
However, it is possible that existing bonds holders could sell even more bonds than the Fed is purchasing, resulting in higher nominal interest rates, yet because of the higher expected inflation, the result is lower real interest rates. That is what is motivating the decrease in the real quantity of bonds demanded, and so, the decrease in lending and an increase in the demand for consumer goods and capital goods.
This pathway also provides an incentive for those holding short term bonds, including various bank deposits, whose yields are already very low, to sell them off and use the proceeds to purchase consumer and capital goods. Again, this involves no increase in borrowing, but rather a decrease in short term lending. While the nominal yields on these short term securities are unlikely to fall much, an increase in expected inflation will reduce the real interest rates on them and so motivate a decrease in the quantity of short bonds demanded and an increase in spending on consumer and capital goods. Further, as explained above, it is possible that higher expected inflation could result in higher nominal interest rates for short term bonds and deposits, but still allow for lower real rates, and so motivate the reduced quantity of bonds demanded, and increase in the demand for consumer goods and capital goods.
Finally, and most importantly, the expectations of future inflation are not the only pathway by which the impact of quantitative easing could raise interest rates. The expected increase in sales provides an incentive for firms to sell off their existing holdings of long and short term bonds and use the proceeds to purchase capital goods to be able to expand capacity. The expected increase in production, real income, and employment provide an incentive for households to sell off existing holdings of bonds to fund the purchase of consumer goods.
Consider a well off household that is refraining from purchasing a new sailboat, instead holding on to T-bills, because of fear that poor business performance is going to result in a reorganization and an extended period of unemployment. Finding a new, high paying VP job may take some time with the slow economy. Turn expectations around, and the household sells off the T-bills to fund a purchase of the sailboat.
Expectations of higher real sales, real income and real output, and higher employment could motivate more sales of bonds than the amount purchased by the Fed, and so higher nominal interest rates on the long(er) term bonds the Fed purchases as well as the shorter term ones that have yields already at or below the interest rate the Fed pays on bank reserves. What is interesting, however, is that the reduced demand for those bonds (and increased demand for consumer and capital goods,) could result in higher real interest rates as well.
It is possible, and perhaps in some way desirable, that quantitative easing result in higher nominal and real interest rates and less lending--but still more spending. Aside from that final impact, the result is almost the opposite of the conventional account of its effect. Not lower nominal interest rates, lower real interest rates, more borrowing and so, more spending. But rather, higher nominal interest rates, higher real interest rates, less lending, and more spending.
If the Fed were to return to the growth path of money expenditures from the Great Moderation, the most likely result would be for the price level to return to its growth path. This would involve higher than 2 percent inflation during the adjustment period, and to the degree inflation has been less than 2 percent during the Great Recession, a higher inflation rate in the long run.
My preferred noninflationary growth path is a bit more complicated. My judgement is that the result of a prompt move to that growth path would involve an increase in the price level, and so some inflation during the adjustment period, but the lower growth rate of money expenditures would result in lower--actually zero--trend inflation in the long run.
Finally, I am not really opposed to real interest rates falling. And higher expected sales, real output, and employment would certainly motivate increased borrowing--a higher supply of bonds. I am not opposed to increased borrowing. There are financially sound households and firms that might benefit by borrowing and would be good credit risks for lenders. But increased borrowing is not necessary. And most importantly, imagining that quantitative easing is about (too) low interest rates and already (excessively) indebted households and firms borrowing more, and so increasing spending is WRONG!
So, it looks to me that the Fed's quantitative easing is excessive and its explanation of what it is trying to do is mistaken. But most importantly, the Fed needs to start targeting money expenditures and stop thinking about interest rates--short term or long term.
Friday, November 5, 2010
Monday, November 1, 2010
Final Sales for the Third Quarter
The new GDP report has come out, and there is both good news and bad news. Final Sales of Domestic Product was $14,600 billion in the third quarter of 2010, which has finally passed its previous peak of $14,514 billion in the third quarter of 2008, what I count as the end of the Great Moderation and the beginning of the Great Recession. Money expenditures have finally "recovered."
Unfortunately, the growth of of Final Sales of Domestic Product was only 2.8 percent, and so continued to fall further behind the growth path of the Great Moderation. If money expenditures had continued to grow at the 5.4 percent growth path of the Great Moderation, the value in the third quarter of 2010 would have been $16,721 billion. The current value of money expenditures is 13 percent below the growth path of the Great Moderation, and the gap continues to grow.
A 13.8 percent growth rate for money expenditures is quite rapid. After one year, the growth rate would return to the noninflationary 3 percent rate.
Unfortunately, the growth of of Final Sales of Domestic Product was only 2.8 percent, and so continued to fall further behind the growth path of the Great Moderation. If money expenditures had continued to grow at the 5.4 percent growth path of the Great Moderation, the value in the third quarter of 2010 would have been $16,721 billion. The current value of money expenditures is 13 percent below the growth path of the Great Moderation, and the gap continues to grow.
For money expenditures to return to the growth path of the Great Moderation by the third quarter of 2011, an annual growth rate of 21 percent would be necessary. The target for the third quarter of 2011 would $17,652 billion.
I have long favored moderate disinflation. In my view, a 5 percent growth path for money expenditures is too inflationary. Rather than planning on a 2 percent inflation rate, a zero inflation trend would be better. While I would not have picked the Fall of 2008 as a time to change the monetary regime to a slower growth path of money expenditures, now that money expenditures have fallen so far from the previous 5 percent growth path, I support some opportunistic disinflation.
Below is Final Sales of Domestic Product since 1984, the 5 percent trend growth path from 1984 to the fall of 2008, and projected through 2012, and my preferred adjusted growth path that shifts to a 3 percent growth path in the Fall of 2008.
With the adjusted growth path for money expenditures, the gap between its current value and target value is smaller. It is now 8.4 percent. To return to the adjusted growth path, it would
would need to increase by 13.8%. The target for the third quarter of 2011 would be $16,415 billion.
A 13.8 percent growth rate for money expenditures is quite rapid. After one year, the growth rate would return to the noninflationary 3 percent rate.
Saturday, October 16, 2010
QE2 and Fixed Exchange Rates
One avenue by which quantitative easing could raise money expenditures on domestic product is through a lower exchange rate. The lower exchange rate will tend to result in an expansion of exports and a decrease in imports. The decrease imports should be associated with an expansion in the demand for the products of import competing industries.
If the foreigners respond to the quantitative easing with their own quantitative easing, then exchange rates will not change. Quantitative easing will still raise purchases in each and every country, including purchases of foreign products. Both imports and exports would rise as real output and real income recover. (This, of course, assumes that real expenditures is less than the productive capacity of the economy, which is the primary reason to undertake quantitative easing. If real expenditures are equal to the productive capacity of the economy, then money expenditures are at the appropriate level.)
Suppose that rather than responding with their own quantitative easing, foreign central banks prevent their exchange rates from rising by accumulating assets denonominated in the currency issued by the central bank underaking the quantitative easing, while selling off other types of assets. F or example, imagine that China restricts new loans to Chinese firms, and as old loans are repaid, purchases U.S. Treasury securities. In other words, China generates whatever net capital outflow is needed to avoid any increase in its exchange rate.
Unlike the scenario where competitive quantitive easing expands demand all over, and so results in expansions in both exports and imports for each country, here the pathway by which a lower exchange rate expands demand is closed, and there is no foreign quantitative easing to expand exports. The only pathway by which quantitative easing expands money expenditures is domestic purchases on domestic product. This simply means that more quantitative easing--a larger expansion in the quantity of money--is necessary to return money expenditures to the desired level.
Another way to see the "problem," is that the efforts of the foreign countries to avoid exchage rate appreciation without expanding money expenditures in their own countries--that is, sterilization--involves a decrease in the natural interest rate for the country undertaking the quantitative easing. The net capital inflow generated by the foreign central bank(s) is an addition to saving, and requires a lower level of interest rates for total saving to be balanced with investment.
My view is that a clear committment to a prompt return to a reasonble growth path for money expenditures will raise the natural interest rate. Any increase in expected inflation would further raise the nominal interest rate consistent with any natural interest rate. And so, the most likely scenario is that efforts by foreign central banks to keep their currencies from appreciating would simply dampen the increase in the nominal market interest rates consistent with money expenditures returning to and then remaining on the targetted growth path.
However, if those effects are ignored, so that the additional quantity of money simultaneously involves an expansion in the total demand for bonds, then an alternative perspective would be that a larger increase in the quantity of money also entails a larger decrease in some type of nominal interest rate. If it is assumed that quantitative easing involves the central bank purchasing short and safe assets, such as T-bills, and further, that the foreign central banks are also purchasing T-bills to keep their currencies from appreciating, and still further, that the yield on those T-bills has been driven to approximately zero, then perhaps the foreign central banks might be blamed for the failure of quantitative easing. If only the foreign central banks didn't purchase all of those T-bills, then their yield would be above zero and quantitative easing would work. Of course, so would conventional interest rate targeting.
But proposals for quantitative easing usually involve the purchase of assets that are not so so short or safe, in particular, longer term government bonds whose yields are not close to zero. And so, the bottom line is that the efforts of the foreign central banks to keep their currencies from appreciating by purchasing some kind of assets requires that the central bank undertaking the quantitative easing purchase a larger quantity of longer term or riskier assets than otherwise would be needed. With longer term assets, like 10 year government bonds, at the very least bearing more interest rate risk, the efforts of the foreign central banks are requiring the central bank undertaking quantitative easing to bear more risk than would otherwise be necessary.
To me, the obvious solution is for the yield on money to fall, and if necessary, to become negative. Since I strongly favor a growth path for money expenditures consistent with a stable price level on average, negative nominal interest rates on money is the obvious answer. If foreign central banks want to accumulate large amounts of safe and short assets, then the nominal yield on such assets should perhaps be negative. And, of course, that creates problems with the issue of zero-interest hand-to-hand currency.
To put it simply, if the central bank promises to issue zero-interest hand-to-hand currency on demand, and it is committed to a rule for noninflationary growth of money expenditures, then, it is possible that it will have to bear, at the very least, interest rate risk by borrowing short (issuing zero interest currency) and lending long. If foreign central banks accumulate assets, then this problem is exacerbated. If they can be brow-beaten into allowing their currencies to appreciate, then this "problem" is less severe.
If the foreigners respond to the quantitative easing with their own quantitative easing, then exchange rates will not change. Quantitative easing will still raise purchases in each and every country, including purchases of foreign products. Both imports and exports would rise as real output and real income recover. (This, of course, assumes that real expenditures is less than the productive capacity of the economy, which is the primary reason to undertake quantitative easing. If real expenditures are equal to the productive capacity of the economy, then money expenditures are at the appropriate level.)
Suppose that rather than responding with their own quantitative easing, foreign central banks prevent their exchange rates from rising by accumulating assets denonominated in the currency issued by the central bank underaking the quantitative easing, while selling off other types of assets. F or example, imagine that China restricts new loans to Chinese firms, and as old loans are repaid, purchases U.S. Treasury securities. In other words, China generates whatever net capital outflow is needed to avoid any increase in its exchange rate.
Unlike the scenario where competitive quantitive easing expands demand all over, and so results in expansions in both exports and imports for each country, here the pathway by which a lower exchange rate expands demand is closed, and there is no foreign quantitative easing to expand exports. The only pathway by which quantitative easing expands money expenditures is domestic purchases on domestic product. This simply means that more quantitative easing--a larger expansion in the quantity of money--is necessary to return money expenditures to the desired level.
Another way to see the "problem," is that the efforts of the foreign countries to avoid exchage rate appreciation without expanding money expenditures in their own countries--that is, sterilization--involves a decrease in the natural interest rate for the country undertaking the quantitative easing. The net capital inflow generated by the foreign central bank(s) is an addition to saving, and requires a lower level of interest rates for total saving to be balanced with investment.
My view is that a clear committment to a prompt return to a reasonble growth path for money expenditures will raise the natural interest rate. Any increase in expected inflation would further raise the nominal interest rate consistent with any natural interest rate. And so, the most likely scenario is that efforts by foreign central banks to keep their currencies from appreciating would simply dampen the increase in the nominal market interest rates consistent with money expenditures returning to and then remaining on the targetted growth path.
However, if those effects are ignored, so that the additional quantity of money simultaneously involves an expansion in the total demand for bonds, then an alternative perspective would be that a larger increase in the quantity of money also entails a larger decrease in some type of nominal interest rate. If it is assumed that quantitative easing involves the central bank purchasing short and safe assets, such as T-bills, and further, that the foreign central banks are also purchasing T-bills to keep their currencies from appreciating, and still further, that the yield on those T-bills has been driven to approximately zero, then perhaps the foreign central banks might be blamed for the failure of quantitative easing. If only the foreign central banks didn't purchase all of those T-bills, then their yield would be above zero and quantitative easing would work. Of course, so would conventional interest rate targeting.
But proposals for quantitative easing usually involve the purchase of assets that are not so so short or safe, in particular, longer term government bonds whose yields are not close to zero. And so, the bottom line is that the efforts of the foreign central banks to keep their currencies from appreciating by purchasing some kind of assets requires that the central bank undertaking the quantitative easing purchase a larger quantity of longer term or riskier assets than otherwise would be needed. With longer term assets, like 10 year government bonds, at the very least bearing more interest rate risk, the efforts of the foreign central banks are requiring the central bank undertaking quantitative easing to bear more risk than would otherwise be necessary.
To me, the obvious solution is for the yield on money to fall, and if necessary, to become negative. Since I strongly favor a growth path for money expenditures consistent with a stable price level on average, negative nominal interest rates on money is the obvious answer. If foreign central banks want to accumulate large amounts of safe and short assets, then the nominal yield on such assets should perhaps be negative. And, of course, that creates problems with the issue of zero-interest hand-to-hand currency.
To put it simply, if the central bank promises to issue zero-interest hand-to-hand currency on demand, and it is committed to a rule for noninflationary growth of money expenditures, then, it is possible that it will have to bear, at the very least, interest rate risk by borrowing short (issuing zero interest currency) and lending long. If foreign central banks accumulate assets, then this problem is exacerbated. If they can be brow-beaten into allowing their currencies to appreciate, then this "problem" is less severe.
Friday, October 15, 2010
QE2 and Begger Your Neighbor
I favor quantitative easing combined with a target for the growth path of money expenditures, in particular, final sales of domestic product. The Fed has seemed poised to undertake some quantitative easing along with an at least temporarily higher target for inflation. While I oppose having any target for inflation, it seems likely to me that a prompt return to any reasonable growth path for money expenditures would be associated with a temporary increase in inflation.
It is also likely that quantitative easing and these expectations of inflation (or greater real growth) will cause a depreciation of the dollar on foreign exchange markets. That the dollar did depreciate in response to Federal Reserve discussions of quantitative easing and inflation targets is no surprise.
Ceteris paribus, one of the pathways by which quantitative easing can result in an increase in money expenditures on domestic product is through a decrease in the exchange rate. Imports become more expensive, which tends to raise domestic demand for import-competing goods and services. Exports become cheaper to foreigners, raising their demand for domestically -produced goods and services. The "cost of living" is likely to increase, since that includes the prices of imported goods, but the rate of inflation on domestically produced goods will only rise due to anticipated excess demands for those products. That, of course, is the possible unfortunate side effect of returning money expenditures to a target growth path.
Again, ceteris paribus, this pathway for expanding money expenditures on domestic product has an adverse impact on money expenditures on foreign goods and services. As foreign products become more expensive in dollar terms, fewer of them are purchased. The foreigners export less. Similarly, as exports expand due to lower prices in terms of foreign currencies, at least some of those sales come at the expense of foreign producers.
Suppose the foreigners "retaliate" by their own quantitative easing. The exchange rates don't change after all, and so the "ceteris paribus" condition doesn't hold. Changes in the prices of imports and exports, and decreased imports and expanded exports are not a means by which money expenditures rise in any country. Instead, excess money balances are spent on all goods and services (domestic and foreign) and so every country would tend to both import more as its residents spend on foreign goods as well as domestically produced goods, and export more as foreigners spend more too.
Now, if there are some countries that already have sufficient money expenditures, then they should not undertake quantitative easing to keep their exchange rate from rising. No, they should only do what is needed to keep their money expenditures on target. An increase in their exchange rate, resulting in reduced exports and greater imports would help prevent the development of excess money expenditures in their economy. It would help relieve inflationary pressures.
So, why the worries about "beggar your neighbor?" Suppose it is 100 years ago, and the typical country is on the gold standard and small relative to the world economy. The key goal of monetary policy is to keep the domestic paper money redeemable for gold. If gold is flowing into a country, there is no problem in maintaining currency at par. The only "problem" that might develop (keeping in mind that inflation, unemployment and everything else is irrelevant to the one golden goal of monetary policy,) is that gold may flow out of the country, gold reserves may disappear, and then redeeming paper money with gold may become impossible.
If this sad state of affairs should develop, then the obvious and practical response is raise interest rates. These higher interest rates should attract foreign short term investment (a net capital inflow) which will slow, stop, or reverse the outflow of gold. The goal of monetary policy can be maintained.
Of course, using monetary policy to raise interest rates tends to slow the economy and perhaps results in a recession--money expenditures grow more slowly or shirk, sales fall, and production and employment fall. This unfortunate side effect of the policy to maintain redeemability can help, because by slowing real growth, the demand for foreign goods will tend to fall and so reduce the gold outflow.
The long run solution to the problem however, is for money incomes, particularly wages, to grow more slowly, or perhaps even shrink. This will improve the competitiveness of domestic industry. The result is an export led recovery, because unit costs for export industries are lower compared to the rest of the world, and further, as economic recovery leads to growing demand, less of that demand will be for imported goods because, again, the lower unit costs provides domestic producers with an improved competitive edge.
Now, rather than go through this painful approach described above, suppose a country decides to give its domestic industries the desired competitive edge by devaluation--raising the price of gold in terms of the domestic currency. Of course, this sacrifices the core goal of monetary policy--keeping the currency tied to gold at par. But will it provide the improved competitiveness?
By devaluing the currency, imports become more expensive and, from the point of view of foreigners, exported goods become cheaper. Domestic industries are given a competitive edge without slowing the growth of wages or reducing them. There is no need to raise interest rates and attract foreign investment. There is no need for the economy to slow.
Obviously, there are complications. With less gold being received for exports and more gold being paid for imports, it is possible that the gold outflow would accelerate. There is the J curve. And, of course, expectations of a devaluation will result in a gold outflow. But leave these issues aside for a moment.
What if other countries retaliate? Suppose they devalue their currencies as well? Then this competitive edge created by devaluation does not materialize. And so, devaluation does not result in the gold outflow being slowed, stopped, or reversed. The exchange rates between countries don't change, and so nothing much happens.
Ah.. but the "goal" of monetary policy, keeping the paper money on par has been violated, with no good purpose. Right? The world has fallen into a "beggar your neighbor" policy seeking to develop a favorable balance of trade (and nongold capital flows,) to build gold reserves at the rest of the world's expense, and it doesn't work. And each currency is devalued more and more. The horror!
But suppose there is no gold standard. And there is no goal of maintaining the gold redeemablity of paper money. If an exchange rate depreciates, there is no goal of obtaining gold or other foreign exchange to maintain redeemability. No, the goal is to maintain money expenditures on domestic product. In that world--the real world of today--there is no reason to worry that other countries might retaliate to quantitative easing by doing some themselves. Their quantitive easing helps by increasing their domestic purchases, at least some of which are your exported goods.
P.S. Later I will discuss the possibility that trading partners keep their currencies from appreciating by increasing their rate of accumulation of short term debt. (In other words, China responds to U.S. quantitative easing by accelerating their rate of purchase of U.S. Treasury bills.)
It is also likely that quantitative easing and these expectations of inflation (or greater real growth) will cause a depreciation of the dollar on foreign exchange markets. That the dollar did depreciate in response to Federal Reserve discussions of quantitative easing and inflation targets is no surprise.
Ceteris paribus, one of the pathways by which quantitative easing can result in an increase in money expenditures on domestic product is through a decrease in the exchange rate. Imports become more expensive, which tends to raise domestic demand for import-competing goods and services. Exports become cheaper to foreigners, raising their demand for domestically -produced goods and services. The "cost of living" is likely to increase, since that includes the prices of imported goods, but the rate of inflation on domestically produced goods will only rise due to anticipated excess demands for those products. That, of course, is the possible unfortunate side effect of returning money expenditures to a target growth path.
Again, ceteris paribus, this pathway for expanding money expenditures on domestic product has an adverse impact on money expenditures on foreign goods and services. As foreign products become more expensive in dollar terms, fewer of them are purchased. The foreigners export less. Similarly, as exports expand due to lower prices in terms of foreign currencies, at least some of those sales come at the expense of foreign producers.
Suppose the foreigners "retaliate" by their own quantitative easing. The exchange rates don't change after all, and so the "ceteris paribus" condition doesn't hold. Changes in the prices of imports and exports, and decreased imports and expanded exports are not a means by which money expenditures rise in any country. Instead, excess money balances are spent on all goods and services (domestic and foreign) and so every country would tend to both import more as its residents spend on foreign goods as well as domestically produced goods, and export more as foreigners spend more too.
Now, if there are some countries that already have sufficient money expenditures, then they should not undertake quantitative easing to keep their exchange rate from rising. No, they should only do what is needed to keep their money expenditures on target. An increase in their exchange rate, resulting in reduced exports and greater imports would help prevent the development of excess money expenditures in their economy. It would help relieve inflationary pressures.
So, why the worries about "beggar your neighbor?" Suppose it is 100 years ago, and the typical country is on the gold standard and small relative to the world economy. The key goal of monetary policy is to keep the domestic paper money redeemable for gold. If gold is flowing into a country, there is no problem in maintaining currency at par. The only "problem" that might develop (keeping in mind that inflation, unemployment and everything else is irrelevant to the one golden goal of monetary policy,) is that gold may flow out of the country, gold reserves may disappear, and then redeeming paper money with gold may become impossible.
If this sad state of affairs should develop, then the obvious and practical response is raise interest rates. These higher interest rates should attract foreign short term investment (a net capital inflow) which will slow, stop, or reverse the outflow of gold. The goal of monetary policy can be maintained.
Of course, using monetary policy to raise interest rates tends to slow the economy and perhaps results in a recession--money expenditures grow more slowly or shirk, sales fall, and production and employment fall. This unfortunate side effect of the policy to maintain redeemability can help, because by slowing real growth, the demand for foreign goods will tend to fall and so reduce the gold outflow.
The long run solution to the problem however, is for money incomes, particularly wages, to grow more slowly, or perhaps even shrink. This will improve the competitiveness of domestic industry. The result is an export led recovery, because unit costs for export industries are lower compared to the rest of the world, and further, as economic recovery leads to growing demand, less of that demand will be for imported goods because, again, the lower unit costs provides domestic producers with an improved competitive edge.
Now, rather than go through this painful approach described above, suppose a country decides to give its domestic industries the desired competitive edge by devaluation--raising the price of gold in terms of the domestic currency. Of course, this sacrifices the core goal of monetary policy--keeping the currency tied to gold at par. But will it provide the improved competitiveness?
By devaluing the currency, imports become more expensive and, from the point of view of foreigners, exported goods become cheaper. Domestic industries are given a competitive edge without slowing the growth of wages or reducing them. There is no need to raise interest rates and attract foreign investment. There is no need for the economy to slow.
Obviously, there are complications. With less gold being received for exports and more gold being paid for imports, it is possible that the gold outflow would accelerate. There is the J curve. And, of course, expectations of a devaluation will result in a gold outflow. But leave these issues aside for a moment.
What if other countries retaliate? Suppose they devalue their currencies as well? Then this competitive edge created by devaluation does not materialize. And so, devaluation does not result in the gold outflow being slowed, stopped, or reversed. The exchange rates between countries don't change, and so nothing much happens.
Ah.. but the "goal" of monetary policy, keeping the paper money on par has been violated, with no good purpose. Right? The world has fallen into a "beggar your neighbor" policy seeking to develop a favorable balance of trade (and nongold capital flows,) to build gold reserves at the rest of the world's expense, and it doesn't work. And each currency is devalued more and more. The horror!
But suppose there is no gold standard. And there is no goal of maintaining the gold redeemablity of paper money. If an exchange rate depreciates, there is no goal of obtaining gold or other foreign exchange to maintain redeemability. No, the goal is to maintain money expenditures on domestic product. In that world--the real world of today--there is no reason to worry that other countries might retaliate to quantitative easing by doing some themselves. Their quantitive easing helps by increasing their domestic purchases, at least some of which are your exported goods.
P.S. Later I will discuss the possibility that trading partners keep their currencies from appreciating by increasing their rate of accumulation of short term debt. (In other words, China responds to U.S. quantitative easing by accelerating their rate of purchase of U.S. Treasury bills.)
Wednesday, October 13, 2010
Please! Professor Meltzer!
Allan Meltzer has criticized the Fed's proposal for a new round of quantitative easing.
He claimed that the Great Inflation was caused by the Fed choosing to target higher inflation in order to reduce unemployment.
Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman's analysis is now a standard teaching of economics. Surely Fed economists understand this.
That isn't the way I understand the history. On the contrary, the Fed targeted short term interest rates in order to lower unemployment, or at least to prevent it from rising, and claimed that inflation was caused by "cost push" factors. So, for example, the Fed would observe rising inflation, and refrain from raising short term interest rates because unemployment was too high, or at least, wasn't too low.
The implicit model was that the Fed controls the short term nominal interest rate, which impacts real expenditure. Real expenditure impacts real output, employment, and unemployment. Inflation depends on "cost push" factors. If the Fed's target for the unemployment rate is too low, then this "model" can easily result in progressively worsening inflation--something like the Great Inflation.
I am no fan of the "new Keynesian" approach, but the model today would be that higher expected inflation reduces real interest rates on short term, safe assets that already have nominal yields near zero. This directly raises real expenditure, but also creates a shift towards riskier and longer term securities that have higher real yields, lowering those real yields as well. This also results in greater real expenditures. The higher real expenditures raises real output and employment and lowers the unemployment rate. Inflation rises consistent with the higher expectations of inflation.
While this approach does imply a higher inflation rate, and perhaps it won't work to reduce unemployment, there seems to be little danger of a return to the Great Inflation of progressively worsening inflation. If inflation rises "too much" then the new Keynesian approach calls for an increase in short term, low risk, nominal interest rates by more than the increase in expected inflation.
While the Fed and the new Keynesians remain wedded to interest rate targets, Milton Friedman won the war about the Fed's responsibility for inflation. Treating a target for unemployment as a goal of monetary policy (say, keep unemployment at 4%,) has next to no support.
Some of Meltzer's other comments are even more disappointing. He claims that there is plenty of liquidity. However, the proper standard isn't how much was apparently needed in the past, but rather relative to the current demand to hold liquid assets. With money expenditures well below their trend from the Great Moderation, it is apparent that there isn't enough to meet the demand.
Surely Meltzer hasn't adopted the "market clearing" approach which implies that the current level of prices and wages must be at the level that keeps the real quantity of money equal to the real demand for money, and simultaneously, the flow of real expenditures equal to the productive capacity of the economy. Sure, there is always enough liquidity to meet the demand if that is true, but how realistic is that?
Similarly, real interest rates, especially on short and safe assets, are very low by historical standards, but apparently they are not low enough to coordinate saving and investment. Perhaps the Obama administrations policy of green jobs, health care reform, and making the rich pay their "fair" share of taxes to fund out of control spending depresses investment. But real interest rates should coordinate saving and investment given expectations of future profitability, not only if business people feel comfortable with the current political leadership.
I am very puzzled by Meltzer's concern that the Fed cannot reduce the excess reserves in the banking system when the demand for credit recovers. The Fed gets weekly data on bank deposits and loans. While the Fed would probably need to raise its target for the Federal Funds rate in the face of growing loan demand, the quantity of credit offered by the banking system doesn't have to shrink, but could even grow. The notion that they must passively allow the quantity of money to expand enough so that all of the excess reserves in the banking system today become required, or perhaps, drained off into currency holdings, is absurd.
Of course, to the degree the Fed holds bad securities (say, mortgage backed securities that are claims to lots of mortgages in default,) the Fed might run into problems. Further, their failed new Keynesian approach of dealing with the zero bound on short term and safe assets by promising to keep interest rates low for a good long time, is a bit of a problem.
Meltzer really does seem to remain committed to some kind of quantity of money rule. And if the demand to hold money rises, so that a quantity of money rule results in monetary disequilibrium, and reduced money expenditures, then the problem is the economy. They shouldn't demand so much money.
No! The quantity of money should adjust to accommodate the demand to hold money, with a nominal anchor of a stable growth path for money expenditures. With such a policy, real output, employment, unemployment, the price level, and inflation all depend on market forces. Still, there is no way that such a policy would result in another Great Inflation. Well, unless the the target for the growth path of money expenditures is in double digits.
Like Meltzer, I am a critic of the Fed. But I think QE2 (another round of quantitative easing) is appropriate because money expenditures are far below any reasonable trend.
I agree with Meltzer that a higher target for the inflation rate is a mistake, but not because I think the current target of 2 percent is optimal. On the contrary, inflation targeting should be replaced by a target for the growth path of money expenditures consistent with zero inflation in the long run.
And what I would like to see from Meltzer is evidence that he remembers the distinction between money and credit and doesn't consider the Federal Funds rate, or any other interest rate, as providing any clear signal of the stance of monetary policy.
Can the Fed come to its Senses?
At the last Fed meeting, somebody mentioned a target for the growth path of money expenditures.....
Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.Last but not least?
I might also complain a bit about seeing money expenditure targeting as a means to raise short term inflation expectations (and so, lower real short term interest rates and the output gap.) The actual point would be to raise expectations of real sales, and so increased investment at any level of real interest rate as well raise expectations of employment, and real consumption expenditure. The increase in real expenditures should increase real output (reduce the output gap) and employment. That this might result in higher inflation is an undesirable side effect. While people expecting this unfortunate side-effect shouldn't count as a cost, generating such an expectation is hardly the point.
More importantly, a target for the growth path of money expenditures--if it is permanent--protects against any temporary inflationary impact from creating expectations of permanently higher inflation. Once money expenditures return to an appropriate target, persistently higher inflation would involve firms pricing themselves out of sales. Since firms would be motivated to avoid that sort of suboptimal behavior, expecting such inflation would not be rational.
Most fundamentally, the reason for targeting the growth path of money expenditure is that it provides the least bad macroeconomic environment for microeconomic coordination. Memoryless inflation targeting has proven a failure in the face of a large negative shock to monetary expenditures. Price level targeting would surely be a disaster in the face of any significant adverse supply shock and perhaps bubble prone if there were a favorable aggregate supply shock. Short term interest rate targeting has failed, once again, this time in the face of a severe financial shock that involved a shift away from holding more risky assets to holding safer assets.
It is time for something new.
Well, at least it is on the Fed's radar now.
HT to David Beckworth
P.S. OK, so Scott gets to be Frodo. I have always liked Pippin, and I am clearly not the faithful follower type, but Sam did become Mayor.
Monday, October 11, 2010
Money Expenditures in Japan
What was up with Japan's "lost decade?" Will the U.S. suffer a similar fate?
The monetarists look at some measure of the quantity of money. The neo-Keynesians look at expected inflation and short term interest rates. And what about monetary disequilibriumites? (O.K. As bad as quasi-monetarist sounds, perhaps it is the least bad option.)
I date the "Great Moderation" from 1984 to the third quarter of 2008. I measure money expenditures using Final Sales of Domestic Product. For Japan, I am instead using GDP (which is nominal GDP. Later, I will try to construct Final Sales of Domestic Product for Japan.)
From 1984 to 1990, money expenditures in Japan remained very close to a growth path that increased at a 6 percent annual rate. From the perspective of a "quasi-monetarist," there was a regime change at that time, and a shift to a much lower .12 percent growth path.
There were substantial fluctuations around that trend, rising to as much as 6 percent above trend in 1997 and 3 percent below trend in 2003.
In 2008, the "Great Recession" hit early in Japan, with money expenditures shrinking at a 5 percent annual rate in the second quarter, and then continuing to shrink at that rate until the first quarter of 2009, when they dropped at the remarkable 18 percent annual rate.
Money expenditures remain about 8 percent below the growth path of 1990-2008. (If you look at the 6 percent growth path from early in the Great Moderation, money expentures are 65 percent below that trend. )
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