The Fed Should be a Day Trader

According to  Philadelphia Federal Reserve President Charles Plosser, the economy is "immune" to the Fed's stimulus efforts. Therefore we shouldn't even try to ease. I think Matt Yglesias does a very good job with responding to this argument, so in this post I want to draw attention to another fallacy Plosser makes that, as a result, makes the shift to a forward looking monetary regime even more important.

From a Thursday morning interview, the WSJ represents Plosser's views as:

“Monetary policy shouldn’t be a day trader,” Plosser said Thursday morning in an interview with Dow Jones Newswires and The Wall Street Journal. “I don’t think that’s a healthy focus for central banks…Policy making is too focused on short-term and not long-term views.”

On face, it seems sensible. Of course the Federal Reserve shouldn't act in an erratic manner like a day trader, and of course it should focus on long-term views. But does one imply the other? I would say no -- to focus on long-term views, it makes sense to act like a day traders and look at real time market expectations of the long term.

Specifically, it should make sense for the Federal Reserve to worry about long-term inflation expectations, as they, by definition, represent the long-term views of the market. Given that the 5-year breakeven is barely above 2%, this means that, given what the market perceives of the economy and policy interventions, annual inflation is forecasted to be around 2% for 5 years. Given that inflation since the 2008 peak has been around 1.1%, a period of higher than average inflation should not be problematic. By the premise of efficient markets, the relatively low breakeven suggests that the Fed should take additional action. Perhaps there is some argument for why the breakeven is skewed, but traditional deviations from efficient markets, such as momentum trading, does not seems to form the basis of any of Plosser's arguments.

Plosser's comments also point out a more glaring hole: if the Federal Reserve isn't going to use indicies looking forward to guide monetary policy, what should it do instead? If we aren't allowed to forecast using the knowledge of the market, then the Fed is left to waiting for the data to come in and then to adjust economic policy many quarters after the original shock. This is actually worse for long-term views, as it opens the possibilities for downside for the financial market that isn't controlled for with policy.

To improve on the current situation, we could subsidize and construct an NGDP futures market in order to measure market expectations of future NGDP growth, and then the Federal Reserve can use those futures as a leading indicator on whether they should ease or tighten. These futures can even help in the unwinding process, as it lets the Fed know when the money supply has increased too quickly even before the actual numbers come in. Acting like a day trader is not inconsistent with an appreciation for long term fundamentals - the trick is to find a day-to-day measure and then use it to put the economy on stable, long run foundation.

Never Reason from a Price Change: Commodity Price Edition

The Federal Reserve's historic announcement of open ended QE3 has sent the stock markets soaring, both at home and abroad. However, there's a persistent concern that QE3 will hurt the economy through higher commodity prices. However, this view is misplaced and violates a fundamental rule of macroeconomic analysis: never reason from a price change.

Consider the following news article:

WASHINGTON (AP) — Higher gas prices are crimping consumer spending and slowing the already-weak U.S. economy. And they could get worse in the coming months. 

The Federal Reserve this week took steps to boost economic growth. But those stimulus measures are also pushing oil prices up. If gas prices follow, consumers will have less money to spend elsewhere. 

The impact of the Fed's actions "is likely to weigh on the value of the U.S. dollar and lift commodity prices," said Joseph Carson, U.S. economist at AllianceBernstein. "We would not be surprised if (it) fueled more inflation in coming months, squeezing the real income of U.S. workers."

Given that the argument is that more spending on fuel causes less spending on other goods, purchases of durable goods should go down in response to an oil price spike. However, a quick look at the time series suggests otherwise.

As noted by Ritwik, we need to look at durable goods spending in contrast to the amount fuel inflation exceeded regular inflation. So in the graph, blue is the real level of PCE on durable goods, while red is the fuel/oil component of the CPI divided by the part of the CPI less food and energy. From this we do see that although there are some times where oil prices go in the opposite direction of real purchases of durable goods, in general they move together. We can get a more precise image of this by looking at year over year growth rates:

As well as a running correlation of the two graphs. The correlation at any given time looks at the 12 months before the given month including the given month as well as the twelve months after. The thick lines are the thresholds for statistical significance.

This suggests that while rising oil prices sometimes hurt the economy, such as in early 2004 or early 2008, rising oil prices can also be a sign of a recovery, such as in 2009 and 2010.

The mistake the news article makes is that it starts from the price change in oil and then tries to figure out what happens to demand in other goods. Instead, one should proceed from demand and derive the change in price. If the factor pushing up fuel prices is a general increase in income and aggregate demand, that means the gas price rise is a part of a general rise in the price level, meaning purchases of other goods actually increases with the rise in gas prices. However, if the reason gas prices rise is because oil refineries in the Middle East are shut down, crimping aggregate supply, then the rise in the relative gas price would reduce demand for other goods, lowering the overall standard of living in the economy.

This kind of analysis is also powerful in microeconomics when answering the classic question of "what happens to consumer expenditure on other goods if the price of gas rises?" To give a full answer, we have to know what causes the price increase. If the reason gas prices rise is because supply contracts and lowers the equilibrium quantity transacted, then people will buy fewer other consumer goods. But if the reason gas prices rise is because higher incomes push up demand, then we should expect people to buy more consumer goods.

In Econ 101, one could possibly get around the problem by pointing out that a rise in income would cause a general rise in the price level, not the relative rise that is important in microeconomics. However, this does not mean we can reason from a price change in microeconomics.

First, sticky prices for durable goods means that a rise in income will directly increase the relative price of fuel, but this change will still predict an increase in durable goods purchases.

Second, a change in preferences towards something that requires large amounts of gas, such as roadtrips, would increase the relative value of gas while also increasing demand for restaurant food and hotel rooms.

The problem is that price changes are not exogenous; they happen as the result of changes in supply and demand. Outside of corner cases*, there is no such thing as "ceteris paribus, the gas becomes relatively more expensive." Quantity changes always accompany price changes, and supply and demand determine the two. In the case of monetary policy, we should look towards the recent rise in commodity prices with approval, as it is a sign that policy is working by increasing demand and stabilizing nominal GDP.

Never Reason from a Price Change

In introductory microeconomics, professors introduce the concepts of substitute and complement goods. In my Econ 101 class at the University of Michigan, the professor stated the concept as:

If two goods are substitute goods, an increase in the price of one increases the demand of the other.

If two goods are complementary goods, an increase in the price of one decreases the demand of the other.

This might make sense in most situations, but my Sumnerian senses are tingling -- why are we reasoning from a price change? What is causing the price of one good to increase, and how does this change whether the demand of the other good to increase or decrease?

Let us first consider the case of substitute goods. If two goods are substitutes for each other, it seems logical to consider that if supply in the second good contracted, pushing prices up, then people would substitute out of that second good and increase demand for the first good. If cars become harder to produce and become more expensive, it's logical that the demand for bicycles will increase. However, does this hold up if the price change was because of a demand shock? If cars became more expensive because demand increased, it seems peculiar to think that the demand for bicycles also increases. Just because it's a price change doesn't mean it's the price change you were looking for.

A similar scenario plays out in the case of complement goods. If two goods are complements, it seems logical to consider that if the supply for one good increases, then the price decrease would increase the demand for the second good. If tortilla chips become easier to make, we can expect the demand for salsa to increase. But does the same hold true if it was a demand shock that caused the price change? If people start demanding more potato chips, pushing up the price, what do we expect will happen to the demand for chip dip?  We would expect it to increase -- directly contrary to what the definition suggests.

Reasoning from a price change fails because it neglects whether the price change in one good is from a change in production technologies or from a change in preferences. If it's a change in technology, the standard analysis applies. However, if it's a change in preferences, we need a more nuanced view that encompasses both modes of analysis.

If two goods are substitute goods, an increase in the equilibrium quantity of one decreases the demand of the other.

If two goods are complementary goods, an increase in the equilibrium quantity of one increases the demand of the other.

So in the market for cars and bicycles, if the equilibrium quantity of cars increases, whether from a supply expansion or a demand contraction, then the demand for bicycles will decrease. This is true regardless of what happens to the price of cars. Similarly, if the equilibrium quantity of potato chips increases, then the demand for chip dip increases -- regardless of where the price for potato chips go. This makes sense because it encompasses the lay person view of substitutes and complements. If I ride my bike more, I drive less. If I eat more chips, I buy more salsa.

The fact that this isn't taught on the first pass around is understandable -- you don't want to confuse the auditorium of 300+ students with a model of both supply and demand when you're introducing the demand curve. But it does pose a problem when there are exam questions such as "Does an increase in price of a complement good raise the demand of the original good?" To which I have to say, "it might". A possible solution is to ask "Holding the demand of a complement good constant, does raising its price raise the demand of the original good?" This would be more comprehensive, and those who understand can better answer the question, while those who don't understand can forget about the first clause and just answer the second question.

Cochrane: "Woodford Needs to Fight Harder!"

When reading John Cochrane's critique of Woodford's call for NGDP targeting, I felt it was actually a great justification for why Woodford needed to write that paper, and for why the market monetarist project is something that we need to continue to fight for.

Cochrane's largest argument rests on a credibility argument -- that there's no way for the Federal Reserve to credibly commit to a permanent expansion of the monetary base, because the market expects that the Fed will tighten to reach 2% inflation in the future. As a result, because there's no way to effectively change expectations of the future monetary base, there's no way to change the level of present NGDP.  In the words of Cochrane:

How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise?  More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

Cochrane must know that hose are two very different questions! When we call for a 5% NGDP target, we're not calling for the path of the 1970's -- to say so is a complete straw man. Thus, the real question is how do we convince people that the Fed won't tighten in response to mild inflation. And to me, the answer is simple: declare that the Fed is targeting NGDP.

Why? Because all of the current analysis on credibility and promises implicitly assumes that the Fed is targeting inflation! Of course, an inflation targeting Fed's promise to hold rates low until an NGDP target is hit is not credible because everybody knows the Fed will tighten in response to the higher level of inflation. If, on the other hand, if people know that the Fed is willing to tolerate higher levels of inflation because it is in their mandate, the credibility problem will go away.

The problem is that everybody is looking at the standard loss function for inflation and arguing that NGDP targeting doesn't minimize the function. If you're just trying to minimize the squared deviations from 2% inflation, of course an NGDP target is nonsensical; an NGDP target actively encourages deviations from 2% inflation to correct for past mistakes. However, if the loss function is seen as the squared deviation of actual NGDP from trend NGDP, then the promise to target NGDP is much more logical.

Formally, if the Fed's optimal policy is described by minimizing this:

(π - 2)²

Of course the Fed won't manage to minimize this:

(Y-Ytrend)²

This is why Woodford's paper is so important. It's the first step towards convincing economists and market participants that the Fed's loss function is changing. Given that Woodford presented the paper at Jackson Hole, the premier meeting on monetary policy, the paper is a key step in signalling that NGDP targeting is gaining legitimacy.  If successful, people will realize that the Fed's new policy will tolerate a temporary inflation increase in order to bring NGDP back to trend. No longer does the Fed have to "credibly promise to be irresponsible", it can just change the definition of responsibility. 

So when Cochrane argues that NGDP targeting is flawed because the Fed can just go back to inflation targeting, what he's actually saying is that academics should fight extremely hard to legitimize NGDP targeting. When a monetary policy that targets NGDP becomes as self-evident as one that targets inflation, it will be no difficulty to credibly commit to a new monetary regime.

Chinese Housing: A Reply

This post is meant to be a reply to Scott Sumner and Matt Yglesias' thoughtful points on the Chinese housing market and what China could be building besides housing. Reading their responses, it seems that a large part of the debate is about whether China needs more housing right now, and if the current explosion in housing construction is in-line with long term fundamentals.

Yet this debate about fundamentals seems to neglect the most important part about housing in China: the role of housing as a savings vehicle. What I think is sometimes forgotten is that Chinese citizens face a severe shortage of effective ways to save money to 保值, or preserve value. Bank deposit rates consistently run below the rate of inflation. When better investment opportunities come along, those deposit rates don't necessarily rise. There are securities companies, but it's very difficult for the people to trust them. Moreover, given the recent explosion in these companies, it's not hard to imagine that any risk-adjusted excess returns on securities should quickly go to zero. The stock market is seen as a capricious creature, and given past stock crazes involving nannies and farmers, people are right to be suspicious of investing in stocks as a way to secure wealth.

Therefore, housing is special because it is much more concrete than other investments. It depreciates relatively slowly and is easy to verify; this is unlike many other investment opportunities such as equities or securities. It is useful, because you can immediately start to live in it or rent it out. Also, because of rising incomes across China, it seems very reasonable that demand for housing will increase and therefore building a house will have a high return. Urbanization and demographics are sometimes used by Shanghai residents to justify that housing prices “will never fall,” or that if they do, the drop will be minor. As a result, Shanghai residents view houses as an incredibly important way to save money. This past summer, I had the opportunity to work with a Chinese instructor on my language skills. She was a middle-class Chinese citizen and often mentioned that, although housing wealth was rising, she and her family didn't feel much richer. This was because, for them, the houses were seen as a savings vehicle, much too important to be sold on a whim.

Under such conditions, large scale housing investment is not necessarily a neutral “revealed preference”. Rather it can be a dangerous “constrained preference”. Given the option between negative real rates in a bank account or housing, Chinese citizens choose housing. But if they had the option of higher deposit rates, we might have seen a shift away from housing towards regular bank deposits. This is very similar to the problem developmental economists face when discussing whether people in poor countries have too many children. While parents might prefer to take care of fewer children, they choose to have more children so that enough of them survive to take care of their elderly parents. So similarly, poor people choose to have a lot of children given their constraints, but with enough financial innovation they would consider having fewer children.

Applied back to housing, these dynamics result in a world where the statements “there are too many houses” and “housing prices are too high” can both be true. Chinese people want housing, but they would prefer an alternative savings mechanism. Therefore, houses are built because there is the demand for the savings vehicle. But there are “too many” houses because the demand doesn't have to be this high. The high demand pushes up prices, pushing those who need the a roof over their heads into cold or other cramped conditions.

From an empirical standpoint, this story should manifest itself in a rising price to rent ratio as well as a lower housing yield. This is because if the house is seen mostly as a savings vehicle, those who own houses would be willing to take a lower rental rate, as their income growth is not dependent upon the flow of rental fees but rather on the growth in the value of the underlying asset. And as seen on page 12 of a 2010 IMF working paper, housing markets in cities such as Shanghai, Beijing, and Senzhen were “overvalued” in 2010 by this metric. More recent data on rental yields also supports this hypothesis, as rental yields in Beijing have fallen to around 2.2% while yields in Shanghai are around 2.8%, much reduced from above 9% and around 6% when the data was first collected.

This has serious implications for policy. First, housing controls such as one-house per family or severe taxes against house-flipping may not be very effective in stanching the speculative demand. The speculative demand is not from, as it was in the US, large banks trying to manufacture subprime mortgages to sell CDS. Rather, Chinese housing demand is from everyday people desperately trying to stretch their savings so that they have something solid to own many years from now. These “mom and pop” speculators are sometimes even willing to go through sham divorces to get around housing restrictions to make this saving method work. As the ant colonies of everyday workers get richer, they too will try to invest in housing for the purpose of saving money, only compounding this problem. This is all a natural outgrowth, and not some nefarious plot by one financial firm. In some ways, larger scale speculation may even be beneficial as it would encourage firms with enough capital to point out the lack of fundamentals in certain areas and help moderate prices.

Second, the question of housing investment is intimately related to efficient resource allocation. Because state-owned enterprises depend on low deposit yields to make a profit, they are a critical structural driver of continued housing price growth. We can't just write off billions of dollars of malinvestments and non-performing loans just because China is quickly growing. The continued support of enterprises that make those kinds of investments is a large reason why there is such excessive growth in housing. Moreover, these malinvestments prevent the necessary structural adjustment that Matt talks about. So unless we can address the problem of providing average Chinese citizens with more savings vehicles, we're not going to be able to address excessive growth in housing construction.

This is the reason why I believe that, besides housing, there are many things China could be building right now. I don't mean to deny the fundamentals story advocated by Scott and Matt, but while China does need a lot of housing to keep up with rapid urbanization, it does not mean that all the housing investment that is occurring at the margin is beneficial. In fact, the same IMF paper does point out that a change in the interest rate would have dramatic effect on price to rent ratios, highlighting the point that the Chinese could be pouring their resources into a lot of other places. Yet, if these places are not immediately obvious to us, it does not mean the market cannot use the higher price of credit to create more productive enterprise.

Third, demand for housing can be highly capricious, creating a dangerous situation for private companies and government alike. To play with expectations is to play with fire, and warning flags are popping up that investment demand for housingis running out. The worst case scenario would be some massive loss of confidence as people pull out of housing as it suddenly has lower yield than other wealth-preserving investments such as gold or jade. Such a drop in prices could shift expectations, driving yields lower. While the probability is uncertain, the fragility is certainly there. When I read stories about entire credit chains dependent on house sales, I have to wonder how severe the problem is. The fear is not about demographics or the fundamentals, it's the possibility of a market that, all of a sudden, falls apart. Perhaps this is yet another reason why there's too much housing; it fragilizes society to be dependent on houses for credit, revenue, and cash flow. And when the music finally stops, we all fall down.