Thought for the Day

The hardest part of doing research is escaping from prejudices.

TheTreasury and the Fed are at Loggerheads over QE

In my last post on QE, I quoted a paper by James Hamilton and Cynthia Wu that provides some empirical evidence for the importance of the asset composition of the Fed's balance sheet and its effect on the term structure of interest rates. They have posted their data online and it makes for interesting bedtime reading. 

Hamilton and Wu combined their data with evidence from the yield curve. They found that qualitative easing can be effective at the lower bound and that

... buying $400 billion in long-term maturities outright with newly created reserves, ... could reduce the 10-year rate by 13 basis points without raising short-term yields.

To construct these estimates, they used a theoretical model developed by Vayanos and Vila which assumes that there are investors who have a 'preferred habitat'.

The Hamilton Wu results are important. I ran some regressions of term premiums on bond supply by maturity, using their data, and I found the same orders of magnitude in the response of interest rates that they found. But there is an interesting sub-text to their analysis discussed in Section 8 of their paper. The Fed and the Treasury have been following conflicting policies. David Beckworth on his blog in 2012 makes the same point.

Quantitative Easing took place in three phases. QE1 from 11/08 to 03/10, QE2 from 11/10 to 06/11 and QE3 which is ongoing. Along with monetary expansion, the Fed attempted to refinance its portfolio by selling at the short end and buying at the long end of the yield curve. But at the same time, the Treasury was refinancing its own portfolio. The end result was that the Treasury restructuring completely swamped any effect of Fed operations at the long end of the yield curve.  

Figure 1

In Figure 1 I have broken down the System Open Market Account (SOMA) of Fed holdings of Treasuries by maturity as a percentage of all outstanding Treasuries, using the Hamilton Wu data set. The two vertical red lines are the beginning and end of the last recession and the vertical black line marks the collapse of Lehman Brothers.

The Greenspan Put and the Yellen Call

In today's Guardian, I make the case for a more aggressive financial stabilization policy,  "No more boom and bust? The financial policy committee has time on its side". I argue that the Bank of England's FPC should buy shares in the stock market when the PE ratio is low, and sell them when it is high.

Kimdriver makes the following comment.

The Greenspan put with real teeth ?

My worry is that, while CAPE has historically been a good predictor of future returns, the level that the FPC should be ready to intervene would have to be set so low that it might be fairly useless. Otherwise the safety net would just encourage increased irrational exuberance.

My response ...

I am not arguing just for a Greenspan Put: but also for a Yellen Call. It is just as dangerous to allow market bubbles as it is to allow them to crash.

Read more here...

Why Death Matters for Central Bank Policy

Noah Smith raises the question: can the Fed influence the interest rate? Although the answer may seem obvious, the question itself reflects a conundrum for neoclassical theory. It is representative of a related but more comprehensive question: does the asset composition of the central bank balance sheet matter?

Let me set aside, for now, the deep question: what is money? I will take for granted the fact that the liabilities of the central bank are special. Perhaps this is due to legal restrictions, as Neil Wallace has suggested, or perhaps it is a matter of social convention. My focus here is not on central bank liabilities; but on their assets.

A Systemic Explanation for The 2008 Financial Crisis

In September of 2013, Francis Breedon organized a Round Table discussion at the Money Macro Finance Conference held at Queen Mary College London. The session included myself, Chris Giles of the Financial Times and David Miles of the Monetary Policy Committee as speakers and Sushil Wadwhani as moderator.  Our topic: the Bank of England's remit.

Chris and David chose to speak about monetary policy and the role of the Monetary Policy Committee.  I chose, instead, to focus on the task that faces the newly formed Bank of England's  Financial Policy Committee.  This post will focus on one of the points I made in my talk, the distinction between what I call institutional and systemic explanations of the 2008 financial crisis.  My complete argument is published in a forthcoming paper "Financial Stability and the Role of the Financial Policy Committee", that will appear in The Manchester School.

Recent events have generated widespread consensus that the financial markets are not working as they should. But there is little agreement as to why. One explanation is that financial frictions can sometimes become more disruptive than usual and these frictions can be corrected by regulating financial institutions. An alternative explanation that I have promoted in my own work, is that financial markets do not allocate capital efficiently.  The failure of financial markets occurs because people who will be born in the future cannot trade in current markets. I call this the absence of prenatal financial markets.

Animal Spirits: an Empirical Test

Christian Zimmerman draws attention to a new paper by Paolo Gelain and Marco Guerrazi, "A demand-driven search model with self-fulfilling expectations: The new ‘Farmerian’ framework under scrutiny" 

Here is the abstract from the paper

In this paper, we implement Bayesian econometric techniques to analyze a theoretical framework built along the lines of Farmer’s micro-foundation of the General Theory. Specifically, we test the ability of a demand-driven search model with self-fulfilling expectations to match the behaviour of the US economy over the last thirty years. The main findings of our empirical investigation are the following. First, all over the period, our model fits data very well. Second, demand shocks are the most relevant in explaining the variability of concerned variables. In addition, our estimates reveal that a large negative demand shock caused the Great Recession via a sudden drop of confidence. Overall, those results are consistent with the main features of the New ‘Farmerian’ Economics as well as to latest demand-side explanations of the finance-induced recession.

In Christian's words...

Roger Farmer’s recent work has been causing quite a stir, especially as it seems to validate some the things that happened during the recent crisis. This paper provides an empirical test of Farmer’s theory and shows that he is indeed onto something.

Christian's website was set up to promote discussion of research on DSGE models and he invites visitors to leave comments on the papers he highlights. Thanks Christian, for drawing attention to this very interesting piece.

New Keynesian Flimflam

Simon Wren-Lewis, seeks a serious debate with our heterodox colleagues, and judging by the excellent comment thread that appears on his post, there are plenty of heterodox economists who are ready and willing to take up the challenge. This is a welcome debate.

Simon defends his view of orthodoxy, by which he means New Keynesian economics. In its simplest form, New Keynesian economics is a three-equation model that explains the behavior of the nominal interest rate, the "output gap" and the inflation rate.

I agree firmly with Simon, that from a policy perspective, we should not care one iota if NK economics has anything to do with what Keynes might or might not have thought. But from the perspective of the history of thought, we should not mislead our students with false labels. The New Keynesian model is neither new nor Keynesian. It is a beautiful formalization of David Hume's verbal argument in his 1742 essay "Of Money"; an early piece on the Quantity Theory of Money  that every macroeconomics student should read at least once.