June 19, 2011
Monetary policy since 2000
I just returned from the annual conference of the Society for Financial Econometrics hosted by the University of Chicago. One of the many interesting papers described changes in Federal Reserve policy over time.
One formulation commonly used to summarize Fed policy is the Taylor Rule , which calls for the Fed to choose a higher interest rate when inflation is high and a lower interest rate when there is a big gap between the level of GDP and estimate of what the economy could produce at full potential. The Taylor Principle suggests that in response to a 1 percentage point increase in inflation, the Fed needs to increase the short-term interest rate by more than 1 percentage point in order to keep the economy on a stable path. A paper by Li, Li, and Yu presented at the SoFiE conference proposed that perhaps the Fed has been using different coefficients for this rule at different points in time. They estimated a regime-switching model that allows for such shifts. They identified some periods in which the Taylor Principle was adhered to (with a 1% increase in inflation leading the Fed to increase the interest rate by 1.5%), and others in which it was not (with a 1% increase in inflation leading the Fed to increase the interest rate by only 0.86%). The graph below plots their inferred probability that the Fed was in the accommodative regime at different historical dates. Their conclusion is that the Fed was not adhering to the Taylor Principle in the 1960s and 1970s, and returned to that accommodative regime again over the last decade.
It's interesting to look in detail at their description of the most recent decade. The red line in the graph below denotes the actual 3-month T-bill rate over 2000-2007. The blue line indicates the interest rate the Fed would have set if it were following the historical pro-active rule, and fuchsia indicates the predicted rate under the accommodative rule. The Fed seemed to start out the decade following the pro-active rule and then switched to an interest rate even below the accommodative rule.
This provides an interesting confirmation of the theme of a talk by Stanford Professor John Taylor also given at the conference. Taylor argued that a shift away from the policies followed in the 1990s was one factor contributing to the excessive housing boom and subsequent problems. My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem.
Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake.
Posted by James Hamilton at June 19, 2011 06:55 AMdigg this | reddit
My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem.
Wouldn't it be more accurate, based on the horrible results we are being forced to deal with, to say that bad regulation, whether anchored in law or simply dreamed up by regulatory agencies, is worse than allowing the markets to regulate adn discipline themselves?
Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake.
I assume then that you would not support another term for Mr. Accomodation, helicopter Ben?
Posted by: Ricardo at June 19, 2011 07:28 AM
Recall what happened in the '90s with the changes to the requirements for bank reserves and sweep accounts and how these changes encouraged an increase in banking and financial system leverage.
And then the dismantling of Glass-Steagall over time ensured that debt would eventually grow at a cumulatively faster-than-exponential growth differential to GDP, inevitably leading to an unsustainable debt load, a financial system implosion, and ensuing debt-deflationary regime.
Despite (or because of) the bailout of financial institutions and the Fed's reliquifying the US and EU banking system (US banks now have $1.9 trillion in cash assets, up from less than $300 billion in '08), household and corporate debt has barely declined, whereas US public debt has grown 8-9%/yr. since '00 (TWICE the rate of nominal GDP) and 17-18% since '07-'08 (EIGHT TIMES the rate of nominal GDP), doubling during the period.
Were the differential rates of US gov't debt and GDP to maintain since '07, US gov't debt held by the public will reach 200% of GDP by no later than '19-'20, with public debt outstanding/GDP approaching 250%.
Further, at the differential rates of US gov't spending and receipts since '00 (onset of the secular slow-motion depression), the US will run a fiscal deficit of $2 trillion in '15 and nearly $4 trillion in '20.
At the differential trend rates of GDP and total gov't spending, including personal transfers, total gov't spending will reach 100% of GDP by the mid- to late '20s.
The figures above are not difficult to calculate and extrapolate, but the sheer scale of implications will likely mean most readers will be utterly incredulous and dismiss the figures outright, no doubt.
Irrespective, the data are clear enough evidence that the auto-, oil-, and debt-based economic model of perpetual growth of population and resource consumption on a finite planet is no longer viable; however, we have no viable alternatives to which any conventional economist would subscribe and thus advocate in order to mitigate the worst effects from Peak Oil, population overshoot, and the end of growth.
Sadly, we will continue doing what we have done for 30-40 years that have gotten us where we are, only we will do more of what will not work until global systemic crises prevent further folly and force us to face the inevitable.
Posted by: Bruce at June 19, 2011 08:15 AM
Li, Li and Yu estimate their model using an outcomes based Taylor Rule and the GDP deflator for the inflation rate. Poole (2007) estimated an outcomes based Taylor Rule using headline CPI and found that the Fed was unusually accomodative from about 2000 on. Orphanides and Wieland (2007) on the other hand estimated an expectations based Taylor Rule that used the the inflation measures that the Fed has actually been targeting and found no deviation during the 2000s.
The Fed switched from GDP deflator to headline CPI in 1988 and then to headline PCE in 2000 and finally core PCE in 2004. So the regime change that Li, Li and Yu are detecting in 2000 is most likely a combination of the fact that the Fed's behavior seems better modeled by an expectations based Taylor Rule and that the Fed switched it's measure of inflation in the 2000s.
On the question of whether policy was too accomodative one has too look at the results. If you believe that core inflation is a better measure of inflation inertia as I do then you'll note that core PCE stayed within a narrow range of 1.5%-2.4% throughout 2000-2008. And GDP only went above potential in 2006-2007 and then only by a very modest amount. Similarly unemployment was below the natural rate only from March 2006 through November 2007 and never by more than 0.4 points. So, no I don't think Fed policy was excessively accomodative during the 2000s.
In the final analysis monetary policy should not have been held hostage to policing an asset bubble, even if it did contribute, which I sincerely doubt.
Posted by: Mark A. Sadowski at June 19, 2011 10:04 AM
While I agree with your diagnosis of the cause of the current economic crisis and the unsustainability of continual logarithmic growth... I disagree that US government debt will approach 200% of GDP by the end of the decade.
I believe that most viable candidates for the
2012 Presidency are running on planks of fiscal responsibility. I don't believe the finance industry can shell out enough money to get their shill (Obama) re-elected.
Posted by: MarkS at June 19, 2011 10:30 AM
Please may I mention other recent scandals as part of the general context, and the disastrous role of deregulation in generating the mortgage catastrophe?
I may? Thanks!
Posted by: stunney at June 19, 2011 10:33 AM
You are forgetting about one BIG thing: China's entrance into the WTO in 2001 and the upping of tax breaks for companies to offshore.
So what happens? While traditional capital investments domestically dropped as capital either went overseas or sat on the shelf looking for saftey, investers had to find a "safe" place for it.
So what safe asset was there that ALWAYS produced? Real Estate. Especially home building. So in late 2001 some investers began moving into RE. At this point there was no financial bubble in RE. But the stage was being set. With offshoring going accordingly to plan, the animal spirits took over. The investing class followed the heard. Home building detached from the recession and became everybodies safe domestic investment vehicle. While the economy sputtered overall, home building served as a money maker and helped end boost the economy out of recession by 2003.
But the end results were ugly. Due to the general recession in the economy from the lack of demand, long term interest rates didn't rise. This was more important than supposed Chinease buying of US treasuries. Lack of demand and a weak economy, those rates are not going to rise. This also led the FFR to be lower than usual as well, longer than wanted.
Thus, we see the beginnings of the financial bubble in 2003. With homebuilding booming, they were going to get some of the easy money. Expand mortgage products and detach those products interest rates from long term rates. Then the "flipping" art that has always been around became a pop culture trend. Driving up home prices even more.
Artifically higher FFR or tighter regulation(aka capital controls) may have stopped the bubble, but it would have weakened the US economy as investment ceased and driven "other" financial problems outside of the looking glass as well. The major problem was the misallocation of capital by the capitalists themselves. To much domestic investment went overseas and into real estate as a flight to saftey intially. We got NOTHING back for this policy as well, I mean nothing.
This problem is outside the review of regulation or the federal reserve. This goes right back to corporate america and their lovies inside the beltway. They live a decadent lifestyle of glamour and glitz beyond the "ordinary" person can even think about. Then we have the ones making 150,000 a year who think they belong there with them. This type of attitude needs to change or the consenquences will be grave.
Posted by: The Rage at June 19, 2011 02:25 PM
What is actually going on if an economy is getting a negative interest rate from the taylor rule?
"One formulation commonly used to summarize Fed policy is the Taylor Rule , which calls for the Fed to choose a higher interest rate when inflation is high and a lower interest rate when there is a big gap between the level of GDP and estimate of what the economy could produce at full potential."
Why should real GDP grow by what AS grows instead of AD? It seems to me you are assuming real aggregate demand is unlimited or real aggregate supply can never reach real aggregate demand.
"My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem."
BOTH of those seem necessary for too much debt, the real problem.
"Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake."
So, what would have happened if not enough debt was produced to prevent price deflation from positive productivity growth and cheap labor?
Posted by: Get Rid of the Fed at June 19, 2011 03:38 PM
Both regulatory failures and loose Fed policy contributed to the housing bubble and subsequent crash, but they both sidestep the heart of the matter. The real failure has been the push by progressives to increase the rate of home ownership among low-income households. The simple fact of the matter is that if a family doesn't have the money for a 20% down payment and cannot find a house for less than 2 or 2.5 times their annual income, they shouldn't buy a house. If homes in an area are unaffordable to the vast majority of residents, then that just says that housing is still overpriced. Many government and non-profit programs tried to increase home ownership among low-income people and minorities, yet they are precisely the people who have gotten burned the most throughout this crisis.
Posted by: Brian at June 20, 2011 05:46 AM
Very good econ stats site (via Marg. Revolution):
Posted by: Steven Kopits at June 20, 2011 07:12 AM
The Rage, Get Rid, and Brian, all valid points. But most of our current situation goes back to the fact that the US reached peak domestic crude oil production in 1970 and a secondary peak in 1985, after which crude production has fallen 62% per capita since. Since then, it has been effectively unaffordable/unprofitable in the US to be an oil-based industrial economy and expect real per capita domestic demand to grow sustainably without an equivalent differential amount of debt-money to sustain final demand.
In fact, during the past 26-41 years as US domestic crude production fell over 2.5-3%/yr. and the US economy was deindustrialization, financialized, and feminized, debt-money grew at 4-5%/yr. per capita and a net ~7-8%/yr. vs. the decline in per capita US crude production.
In cumulative nominal debt-money US$ terms today, the US has ~6 times more debt-money "assets"/debts than value-add physical capital and plant in order to sustain the necessary nominal per capita growth of demand to service the gargantuan debt service costs.
IOW, private per capita debt and debt/GDP can no longer grow; therefore, per capita GDP cannot grow, implying further that falling per capita crude production (and falling net energy) will now exert an even larger net cumulative drag on the secular trend of US investment, production, gov't receipts, and overall economic activity approximately at the net of the decline in US crude production to oil consumption/GDP plus the net loss of per capita GDP from the decline in private bank lending.
That there is a limit to which the US gov't can borrow and spend to make up for the loss of per capita GDP from falling oil production and bank lending, the only mathematical solution, whether we like it or not, is a net consumption of financial (liquidation to maintain final demand) and physical (depreciation) assets accumulated since the 1980s reflationary period. This is bearish for corporate equity prices for the indefinite future.
Posted by: Bruce at June 20, 2011 08:19 AM
The Taylor rule doesn't measure anything. The formula uses yesterday's variables which have no future nexus. It's useless.
Posted by: flow5 at June 20, 2011 08:33 AM
The US economy could recover reasonably quickly if the subsidies and supports were removed from the financial system, letting non-performing loans go belly-up... Credit market debt has to be significantly reduced. Current policy does so very slowly, sentencing generations of our youth to bleak opportunities and unproductive lives.
Declining domestic oil production IS NOT the reason for America's industrial decline. Our problem is political and institutional. We've blown our wealth on a ponderous military for 65 years, and erected a legal and tax system that rewards incumbents rather than innovators. Imported oil should be heavily taxed, both to reduce trade deficits and to facilitate domestically produced substitution.
Posted by: MarkS at June 20, 2011 09:40 AM
"Declining domestic oil production IS NOT the reason for America's industrial decline. Our problem is political and institutional. We've blown our wealth on a ponderous military for 65 years, and erected a legal and tax system that rewards incumbents rather than innovators. Imported oil should be heavily taxed, both to reduce trade deficits and to facilitate domestically produced substitution."
MarkS, the primary reason we are now spending $1 trillion/yr. on imperial wars is that it is imperative that we protect and maintain the oil production and shipping lanes in the Middle East (and Central Asia) to ensure what remains of any marginal oil supply from the region is not disrupted to the point that the global imperial trade regime collapses along with western civilization (such as it is).
Moreover, the Anglo-American imperial military is occupying Central Asia and the Middle East (and agitating in North Africa) as a forward military position against any designs by Russia and China to gain control of the primary and marginal oil supplies in the region.
Finally, there will never be "democracy" in the Middle East and North Africa, as Anglo-American empire would be thrown out of the region by the masses, and groups hostile to Anglo-American oil empire would take control of the oil production and revenues for themselves, bringing down Imperium Americanum in short order.
Were the US to be forced to adapt to economic conditions based on our domestic oil supplies and what we could trade of value-add for the oil of Mexico and Canada, 80-90% of American households would be at a per capita standard of material consumption of late 1940s to mid-1950s.
Now, one could make the case that a reduction of private debt/income, debt/GDP, and gov't/GDP to sustainable levels would allow for most working-class Americans to sustain a socially desirable standard of material consumption of the 1940s-50s, which conceivably many Americans could adapt to without a catastrophic decline in well-being; but it will require the majority of Americans to triple up for housing, auto transport, utilities, etc., and getting there from here won't be fun for most of us dependent upon the oil- and auto-based suburban/exurban division of labor and system of income distribution and resource allocation.
Needless to say, no political leader can be selected who will tell us the truth about Peak Oil, falling net energy, population overshoot, and the grim implications of the end of growth and "the American way of life"; therefore, the information, policies, and necessary means to adapt will not come from the established political order, Wall St., Ivy League (or state university) intelligentsia, and vested corporate-statist interests.
IOW, there is no political solution (to quote The Police from "Spirits in the Material World").
Posted by: Bruce at June 20, 2011 05:07 PM
Complete OT: The Princeton Housing Market
After holding out for two seasons, Princeton real estate sellers are beginning to throw in the towel. Princeton has long been an aspirational location for regional residents to purchase a home, primarily due to the influence of the university there. As a result, home prices typically exceed those of the surrounding suburbs by 15-20% for comparable homes. This has tended to create inflated expectations on the part of sellers regarding home prices and the balance of negotiating power with buyers.
However, this began to change in late winter this year, as sellers began to perceive that the terrible 2009 and 2010 real estate markets were not a glitch, but part of a sustained downward trend. Indeed, 2011 is turning out even worse than the disastrous 2010 season. Sellers are visibly beginning to panic, with price reductions in some cases coming every couple of weeks.
But there are no buyers. Why not is an interesting question. It may be that banks have tightened standards, and a 20% down payment is now more typical, knocking many potential buyers out of the market. I personally think, however, that a key issue is that current homeowners cannot sell their houses, and therefore cannot appear as buyers. This leaves first-time homeowners and renters as the market. Princeton is too pricey for the former (assuming new household formation) and the latter market is thin.
As a result, a number of good homes in Princeton have received no offers at all, not even bad ones. Sellers are beginning to panic, with a visible unraveling of price expectations within the community. Even six months ago, sellers would establish minimum (and high) expectations, saying, "Well, I won't sell my house for less than X." Now, sellers are searching for a price to clear the market. After three years on the sidelines, a number of sellers are under pressure to move their properties, in some cases because they are seeking to move to low-cost Pennsylvania, just twenty minutes away. Some can hold out no longer.
From an economics perspective, it's interesting to see what a "sticky" market looks like, and how expectations are formed and undermined. For example, many of the sellers know each other (Princeton being Princeton), and therefore a change of opinion of just a few sellers can influence attitudes throughout the community.
For now, I think the market continues to unwind. I would guess next spring would be a good time to buy, when the current cohort of sellers crashes the market, each trying to find a clearing price. But don't expect a rebound any time soon. The market is backed up with homes for sale but not on the market--I personally know of at least three. When the market strengthens even a bit, these sellers will jump back into the market, restraining price appreciation.
Posted by: Steven Kopits at June 21, 2011 05:29 AM
I see a similar kind of situation in my town in Northern NJ. I know someone who bought a smaller house in town and is having little luck selling a house that was originally listed at $1MM +. It's now down to $945k. Eventually, people are going to conclude that they aren't going to get what they thought their house was worth and get realistic. Our market peaked around the beginning of 2006.
Posted by: Rich Berger at June 21, 2011 08:04 AM
Steven, Kuznets cycle busts last 6-7 years. Higher-end house prices remain higher longer but fall at a faster rate during the final phase of the price decline. We are about 1-3 years from the nominal price lows for median prices, whereas the final inflation-adjusted lows might not occur until the end of the decade or as late as the early '20s.
The next secular real estate buy-up phase will not begin until no earlier than '16-'19.
However, "it's different this time" in that the unprecedented effects on real estate prices from the rate of growth of Baby Boomer household formation, divorce and reconstituted households, and female single heads of households, etc., since the '70s will not be repeated hereafter. US household formation will be the slowest on record as US population growth slows from the 50- to 100-year rate of 1.25-1.5% trend to 0.6-0.7%, with the increasing likelihood that we will see persons per household rise as there emerges a trend of an increasing number of multi-generational households (with the US housing profile converging with that of Asia and Latin American in the long run).
Moreover, we are witnessing the early stages of a epochal shift in the composition of US household spending, which most economists have yet to discern. Secular growth of spending on high-GDP-multiplier housing, autos, and child rearing will give way to low-multiplier spending per household on property taxes, house maintenance, insurance premia, and out-of-pocket costs for medical services and medications.
Americans will pay less for housing-related costs per capita and as a share of household spending and increasingly more for energy, food, and medical services.
We will witness a steady decline in household spending on meals out, travel, toys, entertainment, a wide variety of discretionary purchases in general, and even for "higher education", as a growing share of high school graduates will no longer be able to afford, or perceive the merit of, borrowing tens of thousands of dollars for a post-secondary credential that no longer provides a payoff in occupational advantage and lifetime earnings.
And these trend effects will coincide (are coinciding) with the global structural effects of peak global crude oil production and falling net energy returns per capita, which will combine to end real per capita growth.
Posted by: Bruce at June 21, 2011 08:22 AM
There's no crank like a Peak Oil crank.
Posted by: Rich Berger at June 21, 2011 08:39 AM
Rich, there are many more "Peak Oil cranks" in the highest levels of corporations and gov'ts, including the Pentagon and German military, than you might know, or be willing to admit.
The US reached peak crude oil production in 1970 and a secondary peak in 1985, after which production has declined 40-45% and 62% per capita. The world is now 3-6 years into "global" peak crude production, approximately where the US was in 1973-76 and 1988-91. The US has effectively deindustrialized and financialized the economy ever since.
China's crude oil consumption is on track to reach parity with US oil imports by no later than 2015-16, and China's oil consumption and oil imports will reach parity with the US by the early 2020s, with the US and China consuming as much as 60-65% of total global crude oil production by then, leaving the rest of the planet to maintain will about half of what is available to consume today.
Were China's crude oil consumption to continue growing at the trend rate of the past 10-30 years, China will consume the entire world's crude oil production by mid-century or sooner.
By definition, for China-Asia to continue to grow economic activity at peak global crude oil production and peak or falling global real per capita GDP, the rest of the world will have to consume significantly less oil and thus contract in real per capita GDP terms.
China-Asia's continuing 8-10% (even 2-3%) growth creates a growing national security to the US and EU.
To describe those who research and are concerned about the global structural effects of peak global crude oil production as "cranks" poisons the well for serious discussion and encourages being in denial about the very real effects manifesting today.
Posted by: Bruce at June 22, 2011 10:16 AM
Why do I think PO proponents are cranks? First, they seem to revel in apocalytic forecasts and I have found these forecasts to be mistaken in the past (think Club of Rome, Paul Ehrlich). Second, they tend to focus strictly on technological issues and ignore the more important economic dimension. As a resource grows scarce relative to demand, its price rises, which leads to economization and a search for alternatives. I don't think the world will ever run out of oil; it will be replaced by a reasonable substitute well before that. Jerry Pournelle, the noted science fiction and computer tech writer published a collection of essays, mostly in the 1970's, which has been reissued as "A Step Further Out", which includes a very useful summary of current and future energy sources. Although these essays go back 30-40 years and some of his predictions have not been born out, they remain interesting and thought-provoking.
Finally, I am an optimist and have great faith in human ingenuity, liberty and its offspring, the free market, while understanding the dangers that always exist (the current regime being an example of such dangers).
Posted by: Rich Berger at June 23, 2011 05:42 AM