Wednesday, January 27, 2016

Downside Inflation Risk

Earlier this month, New York Federal Reserve President William Dudley gave a speech on "The U.S. Economic Outlook and Implications for Monetary Policy." Like other Fed officials, Dudley expressed concern about falling inflation expectations:
With respect to the risks to the inflation outlook, the most concerning is the possibility that inflation expectations become unanchored to the downside. This would be problematic were it to occur because inflation expectations are an important driver of actual inflation. If inflation expectations become unanchored to the downside, it would become much more difficult to push inflation back up to the central bank’s objective.
Dudley, perhaps because of his New York Fed affiliation, pointed to the New York Fed’s Survey of Consumer Expectations as his preferred indicator of inflation expectations. He noted that on this survey, "The median of 3-year inflation expectations has declined over the past year, falling by 22 basis points to 2.8 percent. While the magnitude of this decline is small, I think it is noteworthy because the current reading is below where we have been during the survey history."

The 22 basis-points decline in 3-year inflation expectations that Dudley referred to is the median for all consumers. If you look at the table below, the decline is more than twice as large for consumers with income above $50,000 per year.
Source: Data from Survey of Consumer Expectations, © 2013-2015 Federal Reserve Bank of New York (FRBNY). Calculations by Carola Binder.
This might be important since high-income consumers' expectations appear to be a stronger driver of actual inflation dynamics than the median consumer's expectations, probably because they are a better proxy for price-setters' expectations. These higher-income consumers' inflation expectations were at or above 3% from the start of the survey in 2013 through mid-2014, and are now at their lowest recorded level. Lower-income consumers' expectations have risen slightly from a low of 2.72% in September 2015. We need a few more months of data to separate trend from noise, but if anything this should strengthen Dudley's concern about downside risks to inflation.

Tuesday, January 12, 2016

Long-Run Monetary Policy and Inequality

The following is a draft of my remarks from my meeting this afternoon with Philadelphia Federal Reserve President Patrick Harker and a group from Action United.

I appreciate and admire the Fed staff and officials who have done an excellent job in the very difficult economic environment of the past decade. I do not consider myself a highly political person, and as an academic, I am much more interested in trying to contribute to a better objective understanding of monetary policy than in involving myself in monetary politics. The idea of a politically independent Fed is so comforting to economists like me, within and outside of the Fed, who idealize technocratic merit and objective policymaking. But monetary policy has inescapable distributional implications, some real and some perceived, many of which are not fully understood in theory or empirically. And because monetary policy affects distribution, there are always going to be interest groups with a stake in the conduct of policy. The Fed cannot and need not hope to please every person all the time, but the democratic legitimacy of the institution requires that it make a real effort to understand the disparate impacts of its policies on different groups and to communicate with all segments of the public about the issues that concern them most.

So how does monetary policy affect inequality and the lives of low- to middle-income households? Since the employment, hours, and wages of low-to-middle-income workers are most sensitive to business cycle conditions, I think it is generally accepted that lower interest rates and higher employment reduce inequality in the short run.[1] Of course, monetary policy cannot be permanently expansionary; we can’t arrive at and stay permanently above full employment just by allowing slightly higher inflation. Economists who understand this distinction between the short-run and long-run Phillips Curve might then conclude that monetary policy has only cyclical effects on inequality.[2]

In the long-run, as John Taylor noted in 1979,[3] there is no long-run tradeoff between the level of output and the level of inflation, but, there is a tradeoff between output stability and inflation stability. If you think of the long-run monetary policy tradeoff as a production possibilities frontier showing different combinations of output and inflation stability that are possible, then the two big issues are (1) choosing which point on the frontier we want, in other words what relative value to place on output stability versus inflation stability, and (2) achieving a point on the frontier, rather than inside of it. These are the issues I use to frame my thinking on monetary policy and inequality, and I would like to talk about each of these issues for the next few minutes.

Regarding the first issue, Stephen G. Cecchetti and Michael Ehrmann show that since the rise of inflation targeting around the world in the 1990s, policymakers’ aversion to inflation volatility has risen in both inflation targeting and non-inflation targeting countries, with a resultant increase in output volatility.[4] In evaluating the relative emphasis to place on output stability versus inflation stability, it is worth trying to understand how this long-run tradeoff affects workers across the income distribution. If the relative harm of output volatility vs. inflation volatility is greater for low than for high-income households, than monetary policy could have lasting effects on inequality. This seems likely, given differences in savings and credit constraints that make it more difficult for lower-income households to smooth fluctuations in income. Output volatility could be especially harmful in the presence of scarring effects of unemployment, which mean that the harmful effects of downward fluctuations are not fully offset in upturns.
The long-run monetary policy tradeoff between output stability and inflation stability, may not only affect inequality, but also be affected by it. High inequality can impact the Federal Reserve’s ability to conduct monetary policy, for example through differences in interest rate sensitivity across the income distribution. This can worsen the sacrifice ratio, effectively moving the frontier inward.
Regarding the second issue, achieving some point on the frontier of output stability and inflation stability requires good credibility and also requires that monetary policy fully offset aggregate demand shocks, avoiding short-run errors.[5] Otherwise, both output volatility and inflation volatility will be unnecessarily high. Financial crises and the zero lower bound impede the ability to offset negative demand shocks, so preserving financial stability through regulatory and supervisory policy is especially important.
Offsetting fluctuations in aggregate demand is easier said than done, especially because monetary policy works with lags and because there are so many indicators to consider. Currently, the labor market shows signs that it is beginning to tighten. Even though inflation is below target, the FOMC chose to raise the federal funds rate, presumably to fend off any inflationary pressures that might begin to build. In considering the pace of future rate hikes, the Fed should keep in mind that the positive effects of a tighter labor market for reducing inequality are just beginning to appear. The unemployment rate for white men fell from 4.4 %to 4.2%.over the past year, and for black men fell from 11% to 8.7%,[6] so you can see the tighter labor market beginning to benefit African Americans, with plenty of room for further improvement.
Hourly pay grew 2.5% in 2015, compared to 1.8% in 2014. That is definitely an improvement, but it will take continued and stronger nominal wage growth to see the labor share of income regain lost ground and to get a real rise in living standards for the majority of households. Even as wages begin to rise more rapidly, I do not think that there should be too much concern that this will lead to strong inflationary pressures. Research by Federal Reserve Board economists Ekaterina Peneva and Jeremy Rudd, for example, points to a much weakened transmission from labor costs to price inflation.[7]

There are also several indications that labor markets still have room to tighten further. The number of persons employed part time for economic reasons hovers at 6 million, and the U-6 unemployment rate was unchanged at 9.9% in the latest jobs report. Labor force participation, at 62.6%, also has room to grow. Overall, to me it appears wise, given uncertainty about the global economy and inflation dynamics, to act cautiously, erring on the slow side for raising rates.[8]

[1] See, for example, Coibion, Olivier, Yuriy Gorodnichenko, Lorenz Kueng, and John Silvia. 2012. “Innocent Bystanders? Monetary Policy and Inequality in the U.S.” IMF Working Paper 199.
[2] . As Romer and Romer (1998) explain, “Because of the short-run cyclicality of poverty, some authors have concluded that compassionate monetary policy is loose or expansionary policy…[T]his view misses the crucial fact that the cyclical effects of monetary policy on unemployment are inherently temporary. Monetary policy can generate a temporary boom, and hence a temporary reduction in poverty. But, as unemployment returns to the natural rate, poverty rises again.”
[3] Taylor, John. 1979. “Estimation and Control of a Macroeconomic Model with Rational Expectations.” Econometrica 47(5): 1267-1286.
[4] Cecchetti, S. G. and Ehrmann, M. 2002. “Does Inflation Targeting Increase Output Volatility? An International Comparison of Policymakers' Preferences and Outcomes,” in N. Loayza and K. Schmidt-Hebbel (eds), Monetary Policy: Rules and Transmission Mechanisms, Proceedings of the 4th Annual Conference of the Central Bank of Chile, Santiago, Central Bank of Chile, pp. 247-274.
[5] See Cecchetti, Stephen. 1998. “Policy Rules and Targets: Framing the Central Banker’s Problem.” Economic Policy Review. Federal Reserve Bank of New York.
[6] BLS January 8, 2016 Employment Situation Summary
[7]Peneva, Ekaterina and Jeremy B. Rudd. 2015. "The Passthrough of Labor Costs to Price Inflation."
[8] See Brainard 1967 "Uncertainty and the Effectiveness of Policy," American Economic Review Papers and Proceedings 57(2); and Blinder, Alan. 1999. "Critical Issues for Modern Major Central Bankers."

Sunday, January 10, 2016

Household Inflation Uncertainty Update

In my job market paper last year, I constructed a new measure of households' inflation uncertainty based on people's tendency to use round numbers when they report their inflation expectations on the Michigan Survey of Consumers. The monthly consumer inflation uncertainty index is available at a short horizon (one-year-ahead) and a long horizon (five-to-ten-years ahead). I explain the construction of the indices in more detail, and update them periodically, at the Inflation Uncertainty website, where you can also download the indices.

I recently updated the indices through November 2015. As the figure below shows, short-horizon inflation uncertainty reached a historical maximum in February 2009, but has since fallen and remained relatively steady in the last two years. Consumers are less uncertain about longer-run than shorter- run inflation since around 1990. This makes sense if at least some consumers have anchored expectations, i.e. they are fairly certain about what will happen with inflation over the longer run, even if they expect it to fluctuate in the shorter run.

In my paper, I interpreted the decline of long-run consumer inflation uncertainty over the 1980s as a result of improved anchoring during and following the Volcker disinflation, but noted the apparent lack of improvement since the mid-90s, despite the Fed's efforts to improve its communication strategy and better anchor expectations. With an extra year of data, it looks like long-run inflation uncertainty may have actually declined, if only slightly, in the last few years. Still, that doesn't mean that consumers' expectations are strongly anchored, as I show in another working paper (which Kumar et al. follow up for New Zealand with similar results).

Wednesday, December 30, 2015

Did Main Street Expect the Rate Hike?

Over a year ago, I looked at data from the Michigan Survey of Consumers to see whether most households were expecting interest rates to rise. I saw that, as of May 2014, about 63% of consumers expected interest rates to rise within the year (i.e. by May 2015). This was considerably higher than the approximately 40% of consumers who expected rates to rise within the year in 2012.

Of course, the Federal Reserve did not end up raising rates until December 2015. Did a greater fraction of consumers anticipate a rise in rates leading up to the hike? Based on the updated Michigan Survey data, it appears not. As Figure 1 below shows, the share of consumers expecting higher rates actually dropped slightly, to just above half, in late 2014 and early 2015. By the most recent available survey date, November 2015, 61% expected rates to rise within the year.

Figure 1: Data from Michigan Survey of Consumers. Analysis by Binder.
Figure 2 zooms in on just the last three years. You can see that there does not appear to be any real resolution in uncertainty leading up to the rate hike. Consistently between half and two thirds of consumers have expected rates to rise within the year every month since late 2013.

Figure 2: Data from Michigan Survey of Consumers. Analysis by Binder.

Wednesday, November 18, 2015

Fed's New Community Advisory Council to Meet on Friday

The Federal Reserve Board’s newly-established Community Advisory Council (CAC) will meet for the first time on Friday, November 20. The solicitation for statements of interest for membership on the CAC, released earlier this year, describes the council as follows:
“The Board created the Community Advisory Council (CAC) as an advisory committee to the Board on issues affecting consumers and communities. The CAC will comprise a diverse group of experts and representatives of consumer and community development organizations and interests, including from such fields as affordable housing, community and economic development, small business, and asset and wealth building. CAC members will meet semiannually with the members of the Board in Washington, DC to provide a range of perspectives on the economic circumstances and financial services needs of consumers and communities, with a particular focus on the concerns of low- and moderate-income consumers and communities. The CAC will complement two of the Board's other advisory councils--the Community Depository Institutions Advisory Council (CDIAC) and the Federal Advisory Council (FAC)--whose members represent depository institutions. The CAC will serve as a mechanism to gather feedback and perspectives on a wide range of policy matters and emerging issues of interest to the Board of Governors and aligns with the Federal Reserve's mission and current responsibilities. These responsibilities include, but are not limited to, banking supervision and regulatory compliance (including the enforcement of consumer protection laws), systemic risk oversight and monetary policy decision-making, and, in conjunction with the Office of the Comptroller of the Currency (OCC) and Federal Deposit Insurance Corporation (FDIC), responsibility for implementation of the Community Reinvestment Act (CRA).”
The fifteen council members will serve staggered three-year terms and meet semi-annually. Members include the President of the Greater Kansas City AFL-CIO, executive director of the Association for Neighborhood and Housing Development, and law professor Catherine Lee Wilson, who teaches courses including bankruptcy and economic justice at University of Nebraska-Lincoln.

The Board website notes that a summary will be posted following the meeting. I do wonder why only a summary, and not a transcript or video, will be released. While the Board is not obligated to act on the CAC's advise, in the interest of transparency, I would like full documentation of the concerns and suggestions brought forth by the CAC. That way we can at least observe what the Board decides to address or not.

Friday, October 30, 2015

Did the Natural Rate Fall***?

Paul Krugman describes the natural rate of interest as "a standard economic concept dating back a century; it’s the rate of interest at which the economy is neither depressed and deflating nor overheated and inflating. And it’s therefore the rate monetary policy is supposed to achieve."

The reason he brings it up-- aside from obvious interest in what the Fed should do about interest rates-- is because a recent paper by Thomas Laubach of Federal Reserve and San Francisco Fed President John Williams has just provided updated estimates of the natural rate for the U.S. Laubach and Williams estimate that the natural rate has fallen to around 0% in the past few years.

The authors' estimates come from a methodology they developed in 2001 (published 2003). The earlier paper noted the imprecision of estimates of the natural rate. The solid line in the figure below presents their estimates of the natural real interest rate, while the dashed line is the real federal funds rate. The green shaded region is the 70% confidence interval around the estimates of the natural rate. (Technical aside: Since the estimation procedure uses the Kalman filter, they compute these confidence intervals using Monte Carlo methods from Hamilton (1986) that account for both filter and parameter uncertainty.) The more commonly reported 90% or 95% confidence interval would of course be even wider, and would certainly include both 0% and 6% in 2000.
Source: Laubach and Williams 2001
The newer paper does not appear to provide confidence intervals or standard errors for the estimates of the natural rate. As the figure below shows, the decline in the point estimate is pretty steep, and this decline is robust to alternative assumptions made in the computation, but robustness and precision are not equivalent.
Source: Laubach and Williams 2015

Note the difference in y-axes on the two preceding figures. If you were to draw those green confidence bands from the older paper on the updated figure from the newer paper, they would basically cover the whole figure. In a "statistical significance" sense (three stars***!), we might not be able to say that the natural rate has fallen. (I can't be sure without knowing the standard errors of the updated estimates, but that's my guess given the width of the 70% confidence intervals on the earlier estimates, and my hunch that the confidence intervals for the newer estimates are even wider, because lots of confidence intervals got wider around 2008.)

I point this out not to say that these findings are insignificant. Quite the opposite, in fact. The economic significance of a decline in the natural rate is so large, in terms of policy implications and what it says about the underlying growth potential of the economy, that this result merits a lot of attention even if it lacks p<0.05 statistical significance. I think it is more common in the profession to overemphasize statistical significance over economic significance.

Tuesday, October 13, 2015

Desire to Serve, Ability to Perform, and Courage to Act

Ben Bernanke’s new book, “The Courage to Act: A Memoir of a Crisis and its Aftermath,” was released on October 5. When the title of the book was revealed in April, it apparently hit a few nerves. Market Watch reported that “Not everyone has been enamored with either Bernanke or his book-titling skills,” listing representative negative reactions to the title from Twitter.

On October 7, Stephen Colbert began an interview of Bernanke by asking about his choice of title for the book, to which Bernanke responded, “I totally blame my wife, it was entirely her idea.”

I hope to comment more substantively on the book after I get a chance to read it, but for now, I just wanted to point out a fun fact about the title. The phrase “courage to act” is the third of three parts of the U.S. Air Force Fire Protection motto: “the desire to serve, the ability to perform, and the courage to act.”

Bernanke has made an explicit analogy between monetary policymakers in the crisis and fire fighters before. In a speech at Princeton in April 2014, he said, “In the middle of a big fire, you don’t start worrying about the fire laws. You try to get the fire out.” On his blog, Bernanke described a bill proposed by Senators Elizabeth Warren and David Vitter as “roughly equivalent to shutting down the fire department to encourage fire safety.” The appeal of the fire fighter analogy to technocratic policymakers with academic backgrounds must be huge. How many nerds’ dreams can be summed up by the notion of saving people from fire…with your brain!

Do we want our policymakers “playing fire fighter”? Ideally, we would be better off if they were more like Smoky the Bear, preventing rather than responding to emergencies. Anat Admati, among others, makes this point in her piece “Where’s the Courage to Act on Banks?” in which she argues that “banks need much more capital, specifically in the form of equity. In this area, the reforms engendered by the crisis have fallen far short.”

Air Force Fire Protection selected its motto by popular vote in 1980. The nominator of the motto was Sargent William J. Sawyers. A discussion of the new motto in the 1980 Fire Protection Newsletter reveals additional dimensions of the analogy, as well as its limits: 
The motto signifies that the first prerequisite of a fire fighter is "the desire to serve." The fire fighter must understand that he is "serving" the public and there is no compensation which is adequate to reward the fire fighter for what they may ultimately give - their life. The second part of the motto is absolutely necessary if the fire fighter is to do the job and do it safely. "The ability to perform" signifies not only a physical and mental ability but also that knowledge is possessed which enables the fire fighter to accomplish the task. The final segment of the motto indicates that fire fighters must have an underlying "courage to act" even when they know what's at stake. To enter a smoke filled building not knowing what's in it or where the fire is, or whether the building is about to collapse requires "courage." To fight an aircraft fire involving munitions, pressure cylinders, volatile fuels, fuel tanks, and just about anything else imaginable requires "courage."
The tripartite Air Force Fire Protection motto emphasizes intrinsic motivation for public service and personal competence as prerequisites to courage. Indeed, in the Roman Catholic tradition, courage, or fortitude, is a cardinal virtue. But as St. Thomas Aquinas explains, fortitude ranks third among the cardinal virtues, behind prudence and justice. He writes that “prudence, since it is a perfection of reason, has the good essentially: while justice effects this good, since it belongs to justice to establish the order of reason in all human affairs: whereas the other virtues safeguard this good, inasmuch as they moderate the passions, lest they lead man away from reason's good. As to the order of the latter, fortitude holds the first place, because fear of dangers of death has the greatest power to make man recede from the good of reason.”

Courage alone, without prudence and justice, is akin to running into a burning building, literally or metaphorically. It may either be commendable or the height of recklessness. As we evaluate Bernanke’s legacy at the Fed, and the role of the Fed more generally, any appraisal of courage should be preceded by consideration of the prudence and justice of Fed actions.

Other mottos that were nominated for the Air Force Fire Protection motto are also interesting to consider in light of the Fed-as-fire-fighter analogy. Which others could Bernanke have considered as book titles? The proposed mottos include:
  • Let us know to let you know we care. 
  • Wherever flames may rage, we are there. 
  • Duty bound. 
  • To serve and preserve. 
  • To intercede in time of need. 
  • When no one else can do. 
  • Duty bound when the chips are down. 
  • For those special times. 
  • Forever vigilant
  • Honor through compassion and bravery.
  • To care to be there. 
  • Prepared for the challenge. 
  • Readiness is our profession.
  • To protect - to serve
  • Without fear and without reproach.
  • Fire prevention - our job is everyone's business
  • Support your fire fighters, we can't do the job alone.