Empirical Evidence for the Endogeneity of the Money Supply in the United States from 1971-2008

Dear Readers,

Let me start off by sincerely apologizing for my abrupt and now lengthy absence from the blogosphere. Although I have been absent from blogging, my interest in the endogenous money hypothesis and Modern Monetary Theory (MMT) continues to grow.

This semester I have been taking a directed readings course on those topics with another GMU PhD student, Paul Mueller. As part of the course, we are co-writing two papers that will hopefully be published in an academic journal. Our first paper, “Empirical Evidence for the Endogeneity of the Money Supply in the United States from 1971-2008,” is now sufficiently complete to make publicly available.

The unique aspects of our paper are the incorporation of Divisia monetary aggregates and a focus on broader measures of the money supply (i.e. M3 and M4). While the paper remains in draft status (so please do not cite this version), we would greatly appreciate comments and suggestions for improving the paper before a final draft is submitted for publication. The paper can be downloaded at SSRN (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2355178). Here is the abstract:

“This paper demonstrates that contrary to orthodox monetary theory, fluctuations in total commercial bank loans affect the quantity of various money aggregates, including the monetary base, but not vice versa. The Granger causality tests that we run on lagged quarterly data strongly suggest that changes in the money supply depend on private demand for commercial loans, not “exogenous” changes in the monetary base. Our findings strongly contradict the notion of a fixed “money multiplier.” The theory behind endogenous money is that banks issue new loans (credit) on demand and look for reserves later. The Federal Reserve must ultimately accommodate increases in demand for reserves from the banking sector to maintain an interest rate target and, more importantly, financial stability. These findings suggest that most economists need to revise their theories about monetary policy and credit expansion.”

Thank you in advance for taking the time to help and for continuing to follow my blog. 

(Note: In the past couple days it has come to my attention that using Granger-causality tests on the first differences of variables may lead to invalid results. Apparently a separate technique, created by Toda and Yamamato, generates more valid results using extra lags of the variables in levels as exogenous variables in the regression. The preliminary results using this method don’t materially alter the paper’s conclusion. Since each technique has been used in recently published articles, we would appreciate insight from other economists on which method (or both) to include our final version.) 

"Cyprus Should Leave The Euro. Now."

Yesterday banks in Cyprus opened for the first time in a week. Markets were seemingly calmed by the absence of immediate bank runs, however the ability of depositors to actually create a bank run has been prevented by strict capital controls. The real test for Cyprus banks will come when the capital controls are finally lifted. Although the restrictions are only supposed to be in place for 7 days, recent experience in Iceland suggests the better question is not when but IF the capital controls will be lifted. Based on the IMF’s recommendation, Iceland instituted capital controls back in 2008 for what was supposed to be a few months. Five years later the capital controls remain in place and are expected to continue for at least a couple more years. As a base case we should expect an announcement next week that Cyprus’ capital controls will remain in place for a few more weeks (possibly months).

While the implementation of capital controls presents an interesting storyline, Paul Krugman has raised a much bigger question into the public spotlight. After being challenged to expand the boundaries of political possibility, Krugman offered the following recommendation (emphasis added):

So here it is: yes, Cyprus should leave the euro. Now.

The reason is straightforward: staying in the euro means an incredibly severe depression, which will last for many years while Cyprus tries to build a new export sector. Leaving the euro, and letting the new currency fall sharply, would greatly accelerate that rebuilding.

The question for Cyprus is therefore whether “internal” or “external” devaluation offers the best prospects for the future? Let’s consider both of the options...

“Internal devaluation” (i.e. income deflation) - In return for continued assistance from the Troika (EU/ECB/IMF), Cyprus has agreed to impose losses on equity and debt holders, as well as uninsured depositors, of the two largest banks (Bank of Cyprus and Laiki Bank). This marks a distinct change in policy, especially with regard to the latter two groups.* Since uninsured depositors held a majority of those banks’ liabilities, the focus has naturally been on that group. Based on recent estimates uninsured depositors in the Bank of Cyprus may lose approximately 40%, while Laiki Bank’s uninsured depositors will be entirely wiped out.

The sharp reduction in (perceived) wealth stemming from these actions will put severe downward pressure on national income. Individuals and businesses experiencing losses will try to increase saving by reducing spending. Banks fearing deposit flight and falling asset prices will try build a stronger base of capital by restricting the supply of credit and possibly selling assets. Adding to the fall, the government will be forced to accept a MoU (Memorandum of Understanding) that establishes policies to increase taxes and reduce spending. Combining these deflationary pressures, the overall economic results may rival (or exceed) Greece’s recent history.

During the past 5 years Greece’s real GDP has declined by 20%

and unemployment has nearly quadrupled from ~7% to ~27%.

To offer some historical perspective, US unemployment during the Great Depression peaked at 25% and real GDP loss only exceeded 16% for one major European nation (Austria). Perhaps even more disheartening than the current data is recognition that output and unemployment appear unlikely to improve anytime soon.

Returning to Cyprus, unemployment has already quadrupled over the past 5 years (~3.5% to ~14%; shown above). Based on current estimates of a 20-30% drop in real GDP, Cyprus’ unemployment rate could easily approach or eclipse Greece’s in the next few years.

“External devaluation” (i.e. new currency) - If Cyprus were to leave the Eurozone, one of the first actions would be re-introducing the Cypriot pound at a heavily devalued rate against the euro. Not unlike the imposed losses on uninsured depositors, currency devaluation immediately imposes significant losses on all depositors. In this sense the impact on private demand would still be extremely deflationary, perhaps even more so. Though output and employment would fall dramatically, external devaluation presents reasons for potential optimism on both the foreign trade and government fronts.

Based on the recent bank losses and capital controls, Cyprus can no longer rely on its financial sector to support exports. By heavily devaluing its currency, Cyprus would be increasing its price competitiveness on the foreign market. However, as Barkley Rosser points out:

even with large elasticities [of trade relative to the exchange rate], there is the J-curve effect. Exports do not increase immediately, whereas the value of imports tends to jump up immediately with their price increases.

Aside from these timing issues, there is also a concern regarding the certainty of each effect. A large devaluation will definitely raise the cost of living for Cypriots but as JW Mason comments, it:

might not lead to higher net exports in the next few years, or ever. That’s the question -- not how big the devaluation would be, but how strongly it will affect trade flows.

As for the government sector, returning to the Cypriot pound would remove some of the current fiscal constraints. This would permit the government to increase spending (ideally investment in a new export sector) and not raise taxes, raising private sector income. While these adjustments will not come remotely close to overcoming the other deflationary effects in the short-run, the counterbalance provided will be a significant improvement over current policy.

In asking “Why Won’t Cyprus Obey Krugman?” Rosser concludes:

While this devaluation might make it easier for Cyprus to recover several years down the road, that recovery would indeed be several years down the road, and in the meantime there would be a lot of pain for the entire citizenry that will not happen if they stay with the euro.

If Greece has taught us anything about remaining with the euro, it’s that a lot of pain for the entire citizenry will happen regardless and a recovery may be decades down the road.

Cyprus is therefore faced with a choice between two terrible outcomes:

1) Remain in the Eurozone and experience a relatively slower “internal devaluation” whereby real output and employment experience large declines spread out over several years. A potential recovery is pushed even further into the future.

2) Leave the Eurozone and experience a quick “external devaluation” whereby real output and employment fall dramatically in the next year or two, but a recovery several years down the road becomes far more probable.

Where Rosser and I find agreement:

is that the real real issue here has to do with time preferences. It may get down to hyperbolic discounting. People do not want to have pain in the near term. So, the fear by the whole population of near term pain in terms of standard of living may outweigh fear of a more gradual decline with rising unemployment, even though the shorter term sharp pain is likely to lead to a sooner turnaround to growth.

Although this psychological tendency is very normal, it can at times be detrimental to achieving longer-term goals. The cases of Greece, Spain, Italy, Portugal, Ireland, and now Cyprus are examples of such times. The severe pain of reduced standards of living and high unemployment will be felt one way or another, but the option of “external devaluation” offers potential for a better future five and ten years down the road. Therefore I concur with Krugman, “Cyprus should leave the euro. Now.”        

* From my perspective, imposing losses on debt holders should have been done from the outset in the US and Europe. The apparent change in policy may raise costs of debt financing for the largest banks, but that should be a welcome change after years of enjoying a TBTF subsidy.

Hudson, Keen, Smith and Others Explain Why Private Debt is the Problem

This past Wednesday I attended The Atlantic’s Second Annual Economy Summit featuring many previously high ranking government officials (e.g. Federal Reserve Chairman Paul Volcker, Secretary of the Treasury Robert Rubin, and FDIC Chairman Sheila Bair). Though these former public officials and many others remained focus on the issue of public debt and deficits, the conference was actually promoted on the basis of turning the focus to private debt. Since my understanding of economics suggests concerns over private debt should be the main focus of current policy, I was personally excited to hear from Steve Keen, Michael Hudson and Yves Smith.

To provide a quick gist of the discussion during these morning panels and the detrimental effects of excessive private debt, here are a few snippets from Michael Hudson’s prepared remarks:

The result of the private-sector debt overhang is a self-feeding spiral of debt deflation. Revenue earmarked to pay bankers is not available to spend on goods and services. Lower consumer spending is a major reason why firms are not investing in tangible capital to produce more output. Markets shrink, shopping malls close down, and empty stores are appearing for rent on major shopping streets from New York City to London.

Slowing employment is causing a state and local budget squeeze. Something has to give – and it is largely pension plans, infrastructure spending and social programs.

However, the one kind of debt we are not worried about is government debt. That’s because governments have little problem paying it. They do not need to balance their budget with tax revenue, because their central bank can simply print the money. On balance, the overall public debt rarely needs to be paid down. As Adam Smith noted in The Wealth of Nations, no government in history ever has paid off its public debt.

…

The policy lesson for today is that to avoid debt deflation, falling markets and unemployment, the economy needs to be revived. The way to do this is what was called for and indeed promised four years ago: a write-down of debts in keeping with the ability to pay.

Once this debt overhead is addressed, tax reform is needed to prevent a debt bubble from recurring. A tax system that favors debt financing rather than equity, and that favors asset-price “capital” gains and windfall gains over wages and industrial profits earned by producing tangible output, has been largely to blame. Also needing reform is tax favoritism for the offshore fictitious accounting that has become increasingly unrealistic in recent years.

Unless government fiscal policy addresses these issues, the U.S. economy will face the same kind of debt-deflation pressures and fiscal austerity that is now tearing the eurozone apart.

As the only two economists in attendance who predicted the financial crisis and subsequent stagnation, Hudson and Keen’s panel stood out in offering practical policy responses that will not further increase wealth inequality or the financial sector’s profits/influence:
Good Debt, Bad Debt & Real Options for Economic Growth from The Atlantic on FORA.tv

A brief detour from discussion of the conference, Professor Steve Keen has been working hard on building a computer program for building & visually simulating dynamic, monetary economics models: http://kck.st/XhKtdX
There are only 2 days left to show your support for the project on Kickstarter and help reach the secondary funding goal of $100,000. Please check out the Kickstarter page for more information and consider making a pledge to improve the future of economics:
MINSKY: Reforming economics with visual monetary modeling

Returning to the conference and giving credit where its due, The Atlantic has been working with and, in the afternoon session, featured Richard Vague’s work on “How to Deal With America’s Private Sector Debt Challenge”:
How to Deal with America's Private Sector Debt Challenge from The Atlantic on FORA.tv

Slides from the presentation and a host of other fantastic data can be found at the Debt Economics website.

Lastly I’ll recommend watching the first panel of the day which included not only Yves Smith but deficit doves Paul McCulley and Robert Kuttner:
Robert Kuttner & Others Debate U.S.'s Addiction to Debt from The Atlantic on FORA.tv

(Unfortunately the moderator was particularly determined to focus the conversation on the Ryan budget and public debt issues).

While I don’t know how many conference attendees will have been swayed by the presentations above, I think it’s a step in the right direction that these discussions are at least taking place within the mainstream community.


(Note: Although I was already a big supporter of Keen, Hudson, and Smith’s work, I should note that all three were incredibly gracious in conversation when I approached them. Separately, I apologize for the lack of blogging during the past couple weeks. My last midterm is Monday night and I hope to return to more frequent shortly thereafter.)

Targeting Nominal Wealth Leads to a Bubble Economy, Not Stabilizing the Business Cycle

Over the past few years it has become increasingly clear that the Federal Reserve and federal government are targeting rising asset prices, rather than incomes, as a way of generating economic growth. A recent post outlined some of the dangers of persistent negative real interest rates:

Households and businesses “with access to cheap borrowing” have been pouring money into stock, bond, housing and commodity markets rather than investing in tangible capital. The remarkable rise in asset prices has unfortunately not funneled down to households in the bottom four quintiles of income and wealth, only furthering the inequality gap.

Cullen Roche addressed a similar issue yesterday in a post on The Fed’s Disequilibrium Effect via Nominal Wealth Targets:

Fed policy and the monetarist perspective on much of this can be highly destabilizing by creating this sort of ponzi effect where asset prices don’t always reflect the fundamentals of the underlying corporations.  It’s not a coincidence that we’ve have 30 years of this sort of policy and also experienced the two largest nominal wealth bubbles in American history during this period.

The title of this blog is also not a coincidence, since my formative years encompassed both the dot-com and housing bubbles. My relatively limited experience with financial markets and macroeconomics (based on age) has been punctuated by financial instability. These memories are the driving factor behind my desire to study financial instability and inform policy decisions that can stabilize the business cycle.

In a recent post on The Spinning Top Economy, Matthew Berg helps further my goal with insight on measuring financial instability (my emphasis):

Now we have Government IOUs on the bottom, serving as the base of the economy. Bank and Non-Bank IOUs are leveraged on top of those IOUs – somewhat precariously.

In fact, you can think of the economy as a spinning top rather than a pyramid. Like a spinning top, the more top-heavy the economy becomes, the greater its tendency to instability, and the more readily it will topple over and collapse in a financial crisis.

Now, what happens if, as was the case during the dot-com bubble and the housing bubble, private sector net financial assets go negative but net worth continues to grow?

In fact, the difference between the measures of net financial assets and net worth provides us with a good rule of thumb for how to spot a bubble economy. If private sector net worth is growing at a greater rate than private sector net financial assets are growing, then that means that the economy – symbolized by our spinning top – is growing more top-heavy.

So, what happens if we make the spinning top more top-heavy? You can go ask your nearest Kindergartener – it becomes more likely to topple over.

Since Matthew provides the guidelines for spotting “a bubble economy,” let’s take a look at the empirical data to see how well it aligns with the story. The first chart displays the growth rates of private sector net financial assets (NFAs) and private net worth over the past 20 years*:
The negative growth rate in private NFAs corresponds with the Clinton surpluses, while the two positive surges are due to the Bush tax cuts and Bush/Obama stimulus measures. Turning to the growth in private net worth, the brief decline stems from the bursting dot-com bubble and the massive drop from cratering house prices. Combining the two measures will show when/if the economy was becoming “top-heavy” (first chart displays the past 50 years; second chart is the same data but only the past 20 years, for clarity):

Past 50 Years

Past 20 Years

Growth of private net worth began outpacing the growth of private NFAs in 1995 for the first time since 1979. The difference in growth rates then remained positive for 10 of the next 11 years. This streak is truly remarkable given that prior to 1995, the difference had only been positive in five other years dating back to 1961.** At the end of 2006, the U.S. economy was clearly more “top-heavy” than any previous time in the post-war era.

Over the past three decades, growth in private debt exceeding income and declining nominal interest rates have generated enormous returns for asset holders. Throughout the 1980’s and early 1990’s, federal deficits provided more than enough NFAs to keep pace with rising private net worth. Then, in 1995, deficits began decreasing just as the growth of net worth (and private debt-to-GDP) began accelerating higher. The unsurprising result has been more than a decade of meager asset returns, subpar economic growth and high unemployment.

The government policy of targeting nominal wealth, driven by an expansion of private debt, has failed not only at increasing net worth but also, and more importantly, at creating sustainable growth in output and employment. Going forward the focus of policy must return to promoting the growth of income and assets, which in turn will fuel higher output, employment and ultimately wealth.   


*Data for private net worth comes from the Federal Reserve’s Flow of Funds Accounts of the United States (Z.1). Data for private net financial assets (NFAs) comes from the National Income and Product Accounts (NIPA) at the BEA.

**Aside from 1979, growth of private net worth exceeded the growth of private NFAs in 1961, 1965, 1969 and 1978 (0.05%).

Related posts:
The Rise of Debt, Interest, and Inequality
Fear of Bubbles, Not Inflation, Returns to the Fed
Why the Federal Reserve Mandate Means That Bernanke Doesn't Have to Worry About Bubbles

Adaptive Inflation Expectations Hypothesis Minimizes Effectiveness of Fed Communication at ZLB

More on the adaptive inflation expectations hypothesis by Robert @ Angry Bear

My claim is that expected inflation over the next 5 (and 10 and 20) years is very similar to actual inflation over the past year.  I think the data generally fit the crudest most mechanical adaptive expectations hypothesis.

This would be interesting for two reasons.

First, the adaptive expectations hypothesis has been treated with utter contempt for roughly 4 decades.  It is considered an example of the sort of thing which economists must utterly reject.  The effort to replace it has lead to a lot of mildly interesting math and highly implausible assumptions.  

Second, there is a huge and very vigorous discussion of forward guidance by the Fed Open Market (FOMC) Committee.  It has been argued that even when the Federal Funds rate is essentially zero, the FOMC can stimulate the economy by causing higher expected inflation.  It is generally agreed that the FOMC has been convinced by this argument.  I think this implies that there should be anonalous increases in expected inflation on the dates when the FOMC began to try to cause higher expected inflation -- roughly the announcements of QE 1-4, operation twist and of forward guidance of how long it will keep the Federal Funds rate extremely low.  An excellent fit of expected inflation using only lagged inflation creates serious difficulty for those who think the FOMC always could and finally has promoted higher expected inflation.

Woj’s Thoughts - This topic is reminiscent of a chain of posts nearly six months ago that began with JW Mason’s inquiry, Does the Fed Control Interest Rates? Jazzbumpa and Art Shipman chimed in with their own opinions, the latter providing this relevant chart on the path of interest rates over time:
Responding to the others’, my view was that:

market expectations of future Fed action are sticky. During the post-war period until about 1980, inflation was consistently rising despite mainstream economic views that suggested those conditions would not persist. Following a lengthy inter-war period of near rock-bottom interest rates, market participants were slow to adjust expectations to the actual height of interest rates that would occur before sustained disinflation began. Once disinflation began in the early 1980’s, market expectations were equally slow in recognizing how long disinflation could persist and therefore how low the Fed would ultimately take rates (and hold at zero).

Returning to Robert’s claim, I suspect the recent strong correlation between the previous year’s actual inflation and inflation expectations for the next 5 or 20 years is partially due to the lengthy period of low inflation that came prior. In other words, if inflation were to start trending higher or lower over an elongated period, I predict inflation expectations would lag actual inflation while moving in the same direction. The adaptive inflation expectations hypothesis will therefore still hold, only more years of recent data will need to be incorporated into expectations formation. Validation of this hypothesis will deal a serious blow to the perception that Fed communications at the ZLB are an effective form of stimulus.

Quote of the Week...

...is from Warren Mosler’s Soft Currency Economics II (Modern Monetary Theory):

the Fed must provide enough reserves to meet the known requirements, either through open market operations or through the discount window. If banks were left on their own to obtain more reserves no amount of interbank lending would be able to create the necessary reserves. Interbank lending changes the location of the reserves but the amount of reserves in the entire banking system remains the same. For example, suppose the total reserve requirement for the banking system was $ 60 billion at the close of business today but only $ 55 billion of reserves were held by the entire banking system. Unless the Fed provides the additional $ 5 billion in reserves, at least one bank will fail to meet its reserve requirement. The Federal Reserve is, and can only be, the follower, not the leader when it adjusts reserve balances in the banking system.

Bibliography
Mosler, Warren (2012-10-25). Soft Currency Economics II (Modern Monetary Theory) (Kindle Locations 367-373).  . Kindle Edition.

Why the Federal Reserve Mandate Means That Bernanke Doesn't Have to Worry About Bubbles

Earlier this week I discussed the dangers of misunderstanding “helicopter money” and higher inflation targets. A focus of that post was the incentives stemming from negative real interest rates that will lead to greater investment in real assets, not businesses. The obvious implication is that negative real interest rates entail significant risk of spurring asset bubbles.

This discussion of asset bubbles comes on the heels of St. Louis Federal Reserve Governor Jeremy Stein’s speech that suggested the Fed was becoming increasingly concerned about bubbles, not inflation. According to a recent Bloomberg article, apparently Fed Chairman Bernanke was not onboard with the supposed shift (h/t Tim Duy):

Federal Reserve Chairman Ben S. Bernanke minimized concerns that the central bank’s easy monetary policy has spawned economically-risky asset bubbles in comments at a meeting with dealers and investors this month, according to three people with knowledge of the discussions.

Do Bernanke’s comments imply the change Stein alluded to is not really happening? Not necessarily. To understand why, one must consider the goals assigned to Bernanke or any Fed Chairman for that matter. The following is from Chapter 2 of the Federal Reserve System’s own publication, Purposes & Functions:

The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Although no explicit mention of preventing asset bubbles is made, the goal of stable prices leaves the door open for such an interpretation. Before addressing the Fed’s own interpretation of stable prices, its worth discussing the specific types of assets that are seemingly most prone to bubbles. The three major categories are commodities (e.g. oil, copper, sugar), financial assets (e.g. stocks and bonds), and housing. During the past decade real interest rates have actually been negative more often than not (Real Interest Rate = Effective Fed Funds rate - core PCE):


Unsurprisingly the past decade has also witnessed asset bubbles in commodities, stocks and housing:


Prices of these assets have clearly been anything but stable. So has the Fed failed in that aspect of its mandate? The answer is a resounding “NO.”

To remedy the cognitive dissonance readers may be experiencing, consider how the aforementioned real assets affect the FOMC’s preferred inflation measure, core Personal Consumption Expenditures (PCE). Financial assets are noteworthy in their distinct omission from the type of products making up PCE. Commodities are included in the general price measure, however core PCE is calculated by excluding a couple of the more volatile commodity components: food and energy. Housing is actually included in core PCE but is calculated using the space rent of nonfarm owner-occupied homes, not actual house prices. Focusing on core PCE thereby removes any direct concern with asset bubbles.

Bernanke has already announced his plans to step down as Fed Chairman early next year (2014). Given the Fed’s stated mandate and preferred measure of prices, it is no wonder that Bernanke is unconcerned with asset bubbles. The goals of his chair are to maximize employment and maintain stable prices. Since the types of assets prone to bubbling are not included in core PCE and appear relatively uncorrelated with that measure, to the degree that bubbles can benefit employment in the short run, they may actually be desirable.*

These institutional incentives of a Fed Chairman are unfortunately at odds with the country’s longer term economic goals. Asset bubbles created by excessive lending and/or negative real interest rates are always followed by busts. These busts are simply the recognition of malinvestment that already took place during the boom. If the booms are financed with significant leverage, the resulting deleveraging may lead to a debt deflationary spiral. Whether or not that’s the case, though it usually is, malinvestment suppresses both employment and economic growth over time.

One can argue over whether Bernanke’s views on the effectiveness of monetary policy are correct or not, but his decision to ignore asset bubbles is perfectly rational given the circumstances. Shifting the Fed’s focus from inflation to bubbles will therefore require changing the institutional incentives.


*The three major asset categories mentioned above presumably will have very different effects on employment. Among the three, commodity bubbles are least desirable from an employment perspective. Higher commodity prices generally hurt consumer spending, which may lead to a temporary decline in employment. Housing bubbles are the most desirable in these terms since the increased demand can generate a temporary employment boom in construction and housing-related services.  

Fed Puts Macho Bada$$ery At Risk

Rational nerdiness vs macho bada$$ery in monetary policy by Cardiff Garcia @ FT Alphaville

The US economy has had several false starts since 2009, and it’s likely that several tangled factors were responsible for their not lasting longer. It’s reasonable to think that one of these factors was that the initial reflationary effects of these unconventional measures faded, because of doubts about the Fed’s commitment to maintaining accomodative policy during a period of catch-up growth. If such growth threatened to generate above-target inflation, then monetary conditions could be expected to tighten.

The rational-nerdy thing to do was to soften the macho commitment to inflation and commit to a temporary period of inflation-tolerance, thereby balancing the two sides of the mandate — but to do so while retaining credibility on both. But as Harless notes, ceding a little ground on one side could be interpreted as ceding all ground. Being a “macho badass” central banker means credibly committing to never cede ground.

…

All of which has been a long windup to saying that the appeal of the Evans Rule, and if we ever get it, some variation of NGDP level targeting, is this: they institutionalise the macho badassery, which in a dual-mandate framework can only be applied to one of the two mandates.

Woj’s Thoughts - This post is reminiscent of a thread from last year involving Steve Roth and Ryan Avent on The Asymmetric Nature of Monetary Policy. In that post I made the following claim:

Whereas Roth suggests that asymmetric credibility stems from the Fed’s actions, I believe it is actually an inherent condition in our current monetary system. The Fed sets the base price for money and credit, but with private banks free to create credit, it holds relatively little control over the total amount outstanding at any time. As growth in the US has exceeded inflation for much of the past three decades, the conditions were ripe for borrowing and credit outstanding now greatly surpasses the sum of base money.

Even if the Fed promised indefinite QE, it’s hard to see the mechanism, aside from adjusting inflation expectations (wealth effects are minimal), by which this would spur real growth. Given the Fed’s skewed abilities and determination to maintain its credibility, it seems more obvious why inflation targeting remains prominent. Further, this may help explain why the Fed downplays its employment mandate (which should be removed anyways). Facing the endgame, the Fed knows it can reduce inflation (and growth) but remains unsure how successful it could be at achieving other targets.

Sucumbing to pressure, the Fed has finally decided to cede ground on its commitment to inflation. Unfortunately for the Fed, both inflation expectations and unemployment are not cooperating:


At this point I doubt whether even altering inflation expectations would provide any boost to actual inflation or employment. If fiscal policy continues to contract the budget deficit, these numbers will continue moving in the wrong direction. The Fed has taken a big risk with its established credibility. I fear the results will be very disappointing.

(Late) 2013 Predictions

Last year I took a chance and threw my own projections into the ring. Similar to Byron Wien and Edward Harrison, I mostly selected events that were widely seen as having a low probability (less than 33%) but which I believed held a greater than 50% chance of occurring. The final results were a bit disappointing, but that won’t stop me from trying again this year. Since these predictions already represent a late release, without further adieu, here are the 2013 predictions:

1) Spain requests access to ECB’s OMT - Since ECB President Mario Draghi announced the OMT program, yields on Spanish debt have fallen rather dramatically. Although this eases financing pressure, it has done little to alter the actual economy’s downward spiral. During 2012 Spain’s GDP growth became increasingly negative, falling by 1.8% year-on-year in the fourth quarter. Meanwhile unemployment continues its meteoric rise to over 26% for the general population and nearly 60% for youth. With the large banks still severely undercapitalized and households over-indebted, private sector lending continues to decline:

Seeing no recovery and potentially a worsening decline, “bond vigilantes” will eventually test Draghi’s threat. At that point Spain will be forced to accept a Memorandum of Understanding (MoU) in return for ECB bond-buying through the OMT program.

2) The Euro finishes the year above $1.30 - After falling nearly 10% during the first half of 2012, the euro has more than recouped its losses on the back of optimism and deflationary policies.

At points during 2013 the optimism is likely to fade, but I expect politicians and central bankers will take the necessary steps to quell fears for the time being. Unfortunately those steps will involve further deflationary policies that push the euro higher. These competing forces will largely cancel out, leaving the euro close to or above where it began the year.

3) The Eurozone remains in recession the entire year - Forecasters now expect euro-zone economic activity to be flat this year, down from a previous prediction of 0.3% growth made just three months ago. Last year saw practically continuous downgrades to GDP growth forecasts and I expect this year to be no different. Austerity measures are momentarily easing, but more will likely be enacted based on the outcomes of several elections. The recent appreciation of the euro against several major currencies will also dampen growth by putting pressure on net exports. With banks across Europe trying to build up capital and persistently high unemployment, the private sector will remain especially weak. Though Germany may experience a temporary rebound, the Eurozone as a whole will not register GDP growth this year.

4) The Japanese yen rises above 90 per $ - Since the election of PM Shinzo Abe, the yen has fallen fast and is down more than 20% from recent highs.

During this time the Nikkei has risen more than 20%, yet yields on Japanese sovereign debt are little changed. This suggests many foreigners may be speculating on the supposedly forthcoming monetary and fiscal stimulus. As previously stated, the fiscal stimulus will probably be small and short-term. On the monetary front, short of actually entering the foreign exchange market, the Bank of Japan (BOJ) has essentially no mechanism to spur inflation and thereby cause a sustained depreciation of the yen. When market participants recognize the inability of Japan to avoid continued deflation, the yen will return to appreciating against the dollar.

5) Gas prices will peak above $4.20 per gallon and set a new yearly record-high average above $3.75 per gallon - Gasoline prices have been on the rise for the past 31 days, currently averaging approximately $3.75 per gallon. Though this current streak will probably end soon, prices are unlikely to give back much of the gains before beginning the typical rise into summer. The ongoing potential for flare ups in the Middle East will keep prices elevated throughout the year. Higher gas prices, which already account for 4% of before-tax household income (chart below), will be a drag on consumer spending in 2013.


6) U.S. Yearly GDP growth falls below 1.5% - Forecasts of ~3% annual GDP growth over the past couple years have been overly optimistic as real growth in 2011 and 2012 was merely 1.6% and 1.9%, respectively. Apparently forecasters are being a bit tamer in their estimates this year, now expecting only 2% annual growth. Unfortunately I suspect these estimates will once again prove too optimistic. Various tax hikes and the upcoming sequester (which will go through in some respect) will reduce the budget deficit by a few percent this year. Housing is likely to remain a bright spot, but further declines in interest rates will not lead to similar magnitudes of the wealth effect. Credit remains tight for many households and small business, which should also limit private sector activity. All of these factors combined will probably not be enough to bring about a new recession but will lead to the lowest annual growth rate during this upswing.


7) U.S. Unemployment rises above 8% - Currently sitting at 7.9%, the unemployment rate is forecast to decline during 2013. Due to weaker GDP growth, corporate revenues will barely rise again this year. As companies face increasing pressure to maintain profit margins at record levels, a new wave of layoffs may occur. Separately, continuing economic growth will encourage previously discouraged workers to re-enter the job market. Both of these factors will lead to slightly higher measured unemployment.

8) Federal Reserve forecasts shift first rate hike to 2016 - After extending their forecast for the first rate hike to 2015, the Federal Reserve changed its tactics to a more rule-based monetary policy. The Fed has, in effect, promised to keep rates low until we've hit either 6.5 percent unemployment or 2.5 percent inflation. Based on the above outlook for unemployment and a continuing decline in inflation expectations (chart below), FOMC members will revise their own forecasts and push back expectations for the first rate hike.


9) U.S. Corporate Earnings (ex-Federal Reserve) finish year below 2012 peak - Meager revenue growth was not enough to prevent U.S. Corporate Profits after tax from reaching record highs in the fourth quarter of 2012 on the back of record profit margins.

US Corporate Profits After Tax data by YCharts

As global growth slows in 2013, revenues will come under further pressure. At this point the ability of firms to continue cutting costs without sacrificing output seems limited, which means margins may begin to compress. As margins revert to previous norms, earnings will register a yearly decline.

10) Bonds outperform stocks - During the first seven weeks of this year the stock market has been on fire, even though earnings estimates continue to fall.


Multiple expansion is currently being driven by the Federal Reserve’s actions despite their ineffectiveness at generating actual NGDP growth. When investors eventually turn their attention to continuing troubles in Europe, ongoing deflation in Japan, and/or weakening growth in China, U.S. earnings may once again enter the picture. Recognition that S&P 500 earnings growth has slowed substantially may cause the market to give up much of this year’s gain. These concerns combined with declining inflation expectations will result in many investors returning to the safety of U.S. Treasuries. The subsequent rise in prices (decline in rates) will generate another year of positive returns for the Treasury market.


Will my predictions prove too pessimistic once again? Only time will tell...