The Unexpected Implications of Expectations

As Market Monetarists, we always stress that expectations matter. But how can we test this hypothesis? One way we do this is to use financial evidence such as TIPS spreads to show how changes in monetary policy expectations directly affect market conditions. Evan Soltas recently tried to use a different method: surveys. He put together a series of graphs documenting changes in forecaster expectations around the time of the financial crisis, and claims that the graphs suggest that a "sudden collapse of short-to-medium expectations...could be more important than current-quarter NGDP."

But I disagree with Evan on how we should interpret such results. I took a look at the Survey of Professional forecaster data and restrict my analysis to the Great Moderation period since 1990. I also focus in on the 1 year forward NGDP forecast, as the 1 quarter forecasts give qualitatively similar results.

Like Evan, I too observe that current nominal GDP expectations are related to real variables, such as unemployment. However, the overall relationship is quite weak. NGDP expectations can only explain about 5% of the variation in unemployment. Moreover, the slope estimate is likely to be biased downwards as autocorrelation means the true slope is even closer to zero.

However, even if the correlation were stronger, it still would not say anything about the causal effect of future expectations on current conditions. Any observed correlation could simply be rational expectations at work, with causation running from unemployment to NGDP. Because unemployment is high now, it would be rational to assume that future nominal GDP will be slightly lower. Even if the Fed were more powerful, there would still be some imperfection in the implementation of monetary policy that would cause expectations to shift downwards.

To control for this, we need to look not at the change in expectations, but rather changes in surprises. A big theme in nominal GDP disucssions is that nominal prices are sticky. Therefore, when NGDP falls below trend, because past nominal contracts were set under the expectation of the higher trend, markets fail to clear and we have a fall in real growth. Therefore, if this transmission channel were true, when NGDP falls below what was expected, we should expect to see a significant impact on unemployment.

In other words, we should consider whether actual nominal GDP hit forecasts or if it fell short. This way we can construct an error index that measures to what extent forecasters over or underestimated. Positive numbers denote when actual nominal GDP outperformed the forecast, and thus the dramatic fall into negative territory during the financial crisis reflects the unexpected nature of the nominal GDP shock.

While it certainly did fall during the financial crisis, if you use ordinary least squares regression on this index against variables of interest, such as unemployment, you will not find any kind of systematic correlation. However, if you consider only the extreme cases in which the forecast undershot reality by more than 4%, then you do get a significant negative correlation:

Perhaps this evidence suggests that expectations have a nonlinear impact on unemployment, but at that point we are drawing epicycles that the regression evidence does not warrant.

Does this all mean that expectations are useless? On the contrary. When investigating these expectation surveys, I did manage to uncover the following chart comparing forecasts and actual nominal GDP growth. I lagged the actual NGDP by 1 year, so it is easier to compare how the forecast compares with actual growth.

What we can see is that the forecasters, while not perfect, still do a rather good job of identifying times of distress. Given that forecasts do carry information, then this opens up a role for policy to lean against the wind. The Fed, instead of waiting for all the data to come in, could use a joint forecast-contemporary data criterion. If the forecasters are projecting slow future growth, then the Fed could announce that it is aware of a potential problem and prepare the necessary policy machinery, conventional or otherwise, to combat that threat.

Expectations matter, but we need to be clear on why. While they may have a direct impact on growth, expectations also serve as a crucial lens into the future and can carry information content for policy makers. Armed with such tools, monetary policy can turn towards the future, lean against the wind, and in doing so remedy demand shocks before they start to hurt. 

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.

Monetary Policy: A Blunt Club or a Surgeon's Scalpel?

And a reason why NGDP futures are a critical credibility tool

Should monetary policy be viewed as a blunt club or a surgeon's scalpel? While we often discuss central banks credible actions to accurately hit a policy target, there is less discussion on whether central banks can precisely hit a target. Because while both blunt clubs and surgeons' scalpels can wound and hurt, a club "beats around the bush" while a scalpel (ideally) targets a specific, well defined area. In the language of monetary policy, we know central banks can raise the level of nominal GDP growth, but can they precisely control the magnitude of the increase? How much of a base injection does the central bank do to make the potatoes hot enough without burning our fingers? This precision problem is at least as important as the accuracy problem because it is a key reason for why explicitly declaring a five percent nominal GDP level target is not sufficient. Because there are real costs of extremely high inflation, the central bank is likely to shy away from policies that might "accidentally" lead to excessively high inflation. If economic variables become more volatile, the lack of monetary policy precision can become a major barrier to monetary policy accuracy.

The core of my argument starts from a mechanics-credibility theorem, which states that if policy does not have a concrete mechanism, it can not be credible. This theorem means raising nominal GDP can be credible. We know that central banks have an infinite number of ways to inflate: currency depreciation, asset purchases, forward guidance, nominal GDP futures targeting, among other options.

However, what does the theorem say about policies to raise nominal GDP to a specific, precise level? What do we have to guarantee this? A typical market monetarist response would be that expectations bridge the gap. Because private agents believe that the central bank will raise nominal GDP to reach trend growth, the market will do the work for the central bank. They will invest in riskier assets, hire more people, engage in more research and development projects, and other ventures up until current nominal GDP returns back to the trend line. Once we're back at trend growth, the central bank can just moderate the economy without too much work because the perfectly credible declaration will induce the market to stabilize itself. 

Although this logic is appealing, it is nonetheless circular. According to this line of argument, a precise target is credible because the central bank will inevitably hit the target, but the reason the central bank is precise is because it is credible. Before we can wave the magic wand of expectations, we need to show that there exists a vanilla, "elbow grease" monetary action that can credibly hit a target with both accuracy and precision.

In normal times, the relationship between the short term nominal interest rates is reasonably stable, and central bankers can manipulate the short term rate quite effectively to stabilize nominal GDP. This is a game that the Federal Reserve has played for the entire Great Moderation. However, once the economy is in a liquidity trap, the short term rate loses its effectiveness, and other more drastic measures are needed. Now that we're in uncharted territory, here is where the precision problem arises.

Take asset purchases for example. As noted by Miles Kimball, these asset purchases can have large effects, if implemented on a large scale. There are certain monetary frictions that allow quantitative easing to break out of the liquidity trap, but for those frictions to exert an appreciable effect quantitative easing must take place at a large magnitude. A specific friction that I see is Kiyotaki and Moore's liquidity friction, which states that the bonds central banks purchase are not as liquid as the cash that central banks dish out. Bonds cannot be sold as quickly, so the large stock of bonds represents a promise that the central bank will maintain a higher monetary base in the future. This is how the central bank gets around the Woodford, "double the monetary base in this period and all subsequent periods" credibility problem. While central bank declarations of a future elevated monetary base may not be seen as credible in light of inflation targeting, committing to large scale bond purchases commits the central bank to a brief period of above average inflation by locking in the larger monetary base. In the words of Brad DeLong:

But purchasing bonds for cash has another effect. Cash is a perfect substitute for short-term Treasury bonds now. It won't always be the case. When interest rates normalize, the price level will be roughly proportional to the high-powered money stock. Not all of today's purchases of bonds for cash will be unwound when the economy exits the zero lower bound. If we believe that the high-powered money stock will be roughly $1 trillion after exiting the zero lower bound, and if we believe that a fraction λ of marginal bond purchases won't be unwound, then an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery.

The problem with this approach is that it is not robust to shifts in expectations. Working with Brad's terminology, λ is positively correlated with the scale of bond purchases. As a result, expected inflation is non-linear with respect to bond purchases. Initial bond purchases may not raise inflation expectations by much, but past a tipping point at which λ start rising quickly, inflation expectations could drastically shift. Even if such bond purchases occur at a steady rate so as to avoid sudden changes, expectations can still suddenly shift if an unforecasted shock occurs. If key economic parameters, such as money velocity, become increasingly unstable, expectations fragility will only grow worse. An example of this kind of "expectation fragility" is with the Swiss National Bank's currency floor. While the fundamental value is below the floor, we get suppressed volatility. Once the fundamental value rises, even if it's purely because of static, there can be lots of chaos as a previously fixed price is now allowed to move. In the context of monetary policy, given the large stock of currency reserves, a slight unforecasted rise in inflation expectations can be the trigger for a massive investment reallocation.

Lars Svensson, in his paper on a "foolproof" way to leave a liquidity traps, also highlights this uncertainty:

It is difficult to determine how large an open-market operation would be needed to reduce the long interest rate, because of difficulties in estimating the determinants of the term premium of interest rates (that is, the difference between long and short interest rates and its dependence on the degree of substitutability between short and long bonds). However, Bernanke (2002) has proposed an elegant operational solution to this problem. The central bank simply announces a low (possibly zero) interest-rate ceiling for government bonds up to a particular maturity, and makes a commitment to buy an unlimited volume of those bonds (that is, potentially the whole outstanding volume) at that interest rate. This commitment by the central bank is readily verifiable – since everyone can verify that the central bank actually buys at the announced interest rates – and achieves the desired impact on the long interest rate, without a need to specify the precise magnitude of the open-market operation required. The central bank may have to buy the whole outstanding issue of the long bond, though.  

In the absence of an expectations mechanic, there is a wide range of uncertainty on the policy response. Other forms of unconventional monetary policy, including currency depreciation or forward guidance, all suffer from this "how much is too much?" problem. Once you inject a few non-linearities into the stories, and have market expectations change at unknown threshold, you realize that prospects for precision are grim.

When the monetary policy result is uncertain, central banks are less likely to use the tools to raise nominal GDP. They may fear excessively high inflation or other side-effects of over-expansionary monetary policy, and choose to be "cautious" and live with high levels of unemployment instead. This is the reason why limits in precision can become limits in the accuracy or effectiveness of monetary policy.

A historical counter-example to this theory of uncertainty would be FDR's dollar devaluation program, which Scott and Marcus Nunes have shown to be very effective in restoring both the price level and output during the Great Depression. Yet I  don't find their example to  contradict my argument about the imprecision of monetary policy at the zero lower bound. Perhaps FDR got lucky. Perhaps the price level was already so depressed that you would have needed hyperinflaiton. Perhaps, back then, finance was not as tightly coupled and the investment effects of getting out of treasuries wouldn't have been as strong. Nonetheless, in our faster, more leveraged, more volatile world, this granularity and imprecision of monetary policy is a bigger impediment.

Scott Sumner often uses Australia as another example, pointing out that their monetary base to nominal GDP ratio is much lower than that in the United States. This shows that Australia has not had to inject as much money into their banking system to stabilize nominal GDP, demonstrating that the stabilizing nominal GDP growth should not be very difficult. But Australia is unique in that it never was at risk of the zero lower bound. While part of this may have just been good monetary policy, it still leaves open the possibility of a large, unforecasted shock that puts a county at the zero lower bound.

However, one form of nominal GDP targeting seems to sidestep these problems: nominal GDP futures targeting. This would allow market participants to instantly improve estimates of future inflation by bidding on futures contracts. Their bidding one way or another would immediately translate into changes in central bank open market operations such that nominal GDP always stays on track. This approach sidesteps the non-linearity of expectations because it allows the market to aggregate all the necessary information and automatically has the central bank adapt to the new found information. Even if expectations did shift in response to unforecasted shocks, the policy response would be immediate and taken in decentralized steps as individual investors bid on futures contracts. In this case, mechanics-credibility theorem is satisfied because the mechanic by which the Fed earns its nominal GDP credibility directly interacts with market expectations while avoiding the circularity problem. Market expectations of nominal GDP feed into futures market volumes, which directly changes the monetary base. The market answers the questions of "how much" with the level it thinks is "just right".

This is one of the key advantages of an nominal GDP futures targeting regime relative to a conventional "wait-and-see" regime. It cements in credibility, and rolls with the waves of external volatility. In a sense, it floats like a butterfly and stings like a bee. It takes monetary policy from the world of "Bernanke Smash" to "Sumner Slice", and allows for greater accuracy and precision in the control of a central nominal aggregate: nominal GDP.

Monetary Axioms II: The Movement of Expectations with Respect to Shocks

Pity that these concepts are "counter-intuitive"

I quite enjoyed my last definition/proposition/lemma/theorem post, and although many of the statements were axiomatic or self-evident, they led me to an interesting realization about current nominal GDP growth, credible monetary policy, expected future nominal GDP growth,  and interest rates.

While we often talk about nominal GDP gaps, I would like to start the drawing and theorem process by looking at graphs of nominal GDP growth. Below is a graph of log nominal GDP (right) and continuously compounded annual rates of nominal GDP growth (left), both reported quarterly.

In terms of calculus, nominal GDP is the level of the variable, whereas the growth rate is the instantaneous derivative. Note that although the level falls significantly from its previous trend, the growth rate returns to a value that's similar to its pre-crisis trend. However, even a temporary shock in the growth rate can cause a permanent fall in the level if there is not a restoring amount of growth after the shock.

By looking at the growth rate, we can determine the size of the output gap by integrating, or looking at the area. The integral of the growth rate minus the integral of the trend rate is the size of the output gap, as shown in the stylized diagram below in which trend growth is simplified, without loss of generality, to 0%.

From this, we can see that growth rate targeting can leave large gaps in the actual level. Since the central bank moves the growth rate to the precrisis rate of 0, it leaves the output gap. This can be corrected by level targeting, which tries to get the level of the variable back to pre-shock trend growth. This entails a period of growth above 0 to balance the output gap. How much higher? For how long? Mathematically, the integral of the curve over this time period should be zero. Graphically, it means that the higher rate must be sustained until the blue area (positive growth) minus the red area (negative growth) equals zero. This means the red and blue areas should be the same.

By the calculus definition, the average of a function over an interval is the integral of the function over the interval divided by the size of the interval. In this context, it means that the average growth of nominal GDP over the entire period is zero, the original trend growth rate. We have therefore successfully targeted the level of nominal GDP.

To start looking at credible nominal GDP targeting in this framework, let's define some time lengths:

Definition: The crisis time (c) is the period of time starting with the formation of the output gap to the conclusion of the policy response.

Definition: The expectation horizon (e) is the period of time that economic agents forecast and use to determine their expectation of future nominal GDP growth.

For the discussion below, I will assume that before the negative shock, economic agents were unable to forecast the shock; this is the reason why the credible level targeting didn't solve the shock before it happened. However, once the shock takes place, economic agents are fully aware of the time path of nominal GDP growth that occurs as a result of the shock and policy response. Importantly, agents know that the central bank is committed to level targeting, and that this declaration is credible. This means that the private sector knows the areas, red and blue, will be the same in the end. 

In reality, these would all be expectations. But I will accept the rational expectations hypothesis that expectations match the reality for the purposes of this benchmark model.

Let us start with a special case, in which the expectation horizon is equal to the crisis time, as pictured below.

What is the expectation of economic agents of average nominal GDP growth over the expectation horizon at time to? As both areas are equal to each other, the integral over the expectation horizon is zero, so average expected nominal GDP growth is also zero. No surprise there. But what about at some time in the middle of the output gap, say at tm? The integral is then positive! The integral is represented in the graph below by the blue area minus the pink area (note that trend growth is zero after the policy response). As you can see, the blue area is larger, making the integral positive. Because  expected average nominal GDP growth is the interval divided by the expectation horizon e, the expectation of nominal GDP growth also becomes positive.

As a result, if monetary policy is perceived as credible enough to solve the shock in the same interval as the expectation horizon, a current negative nominal GDP shock manifests itself in increased expectations of nominal GDP growth over the expectation horizon. The graph would look something like this:

A similar result is obtained if the expectation horizon is greater than the crisis time (e>c). Just move to+e to the right, and both the nominal GDP growth and the expectation curves return to zero at to+c.

This result might seem puzzling, as this hardly seems like what happens in real life. To get to "real life" monetary policy, imagine a world with highly inertial policy, such that the crisis period is longer as policy takes more time to respond and the output gap lasts longer as a result. We would be in a world such as that below:

From here, the growth expectation at time to is the value of the pink area divided by e. Although e is chosen such that to+e is to the left of the policy response, as long as e is less than c, the expectation will start out negative. The expectation curve moves forward in a different manner compared to the e=c case. The expectation does become positive when the [to, to+e] interval only covers the blue portion. As a result, the expectation over the period looks like this:

Note that the exact curvature is dependent on the function for the shock and the expectation horizon. But it should be noted that the max/min of the expectation curve should not go past the max/min of the actual path for nominal GDP growth.

Flipping the directions of the output gap and policy response gives us the result for a positive aggregate demand shock, and they are, predictably, the opposites of the ones we obtain for a negative shock.

This long and winding road then allows us to conclude the following:

Theorem: Given a monetary regime that has a credible nominal GDP level targeting policy:

1. If the crisis period is greater than the expectation horizon, expectations of nominal GDP will be procyclical to current nominal GDP growth.
2. If the crisis period is less than or equal to the expectation horizon, expectations of nominal GDP with be countercyclical to current nominal GDP growth.

This gives us a yardstick to judge if a monetary policy is credibly level targeting for a variety of expectation horizons. Most importantly, if treasuries of varying maturities are correlated with expected nominal GDP growth over the treasuries' time periods, then we can look at the movement of treasuries to judge forecasts of crisis lengths in credible level targeting regimes. The treasuries with yields that rise have maturities beyond the crisis period, while the treasuries with yields that fall have maturities within the crisis period. This also solves the data problem, as we now can find out the market's observations about current GDP growth by looking at its expectations of future NGDP growth.

Although the model outlined above discusses level targeting, it can be extended to rate targeting as well. Think of rate targeting as a form of level targeting whose "policy response" is to hope a positive shock comes the other way in the future. In effect, rate targeting is level targeting with an extremely long crisis period. As a result, shocks to nominal GDP growth in a rate targeting regime almost fall into the first case of the theorem for most expectation horizons. By this theory, current yields on long term treasuries betray a very negative outlook on future nominal GDP.


As this model uses interest rates as a way of gauging expectations, they work the best when interest rates are allowed to float and communicate information. If these interest rates were targeted, the central bank would be suppressing a key source of information. This is another advantage of a NGDP futures level targeting regime versus an interest targeting regime. High interest rates won't be confused for "tight money" if the interest rate is determined by the market.


This post should remind us that Market Monetarism is a world of non-linear causality and counter-intuitive movements in both expectations and interest rates. Except they wouldn't be counter-intuitive and these arguments would be self evident if policy actually targeted the level of nominal GDP. Alas, the Fed does not. A great shame, for both both our learning of intuition and suffering in this nation.

Edit (7/13/2012): Fixed the grammar in the last three paragraphs, no substantive change in the message.

Swiss Fragility

Swiss watches aren't fragile; but can the same be said for the currency floor?

Evan recently had a post looking back on the Switzerland issue, which made me look back at our previous discussion.  In the spirit of Evan's proposition reflection, I'm also going to elaborate on a few of my arguments and look at where they're still true (often in different ways) as well as proven wrong (no surprises).

As I noted in my addition to the previous post, a lot of my previous arguments about the instabilities of a currency peg are not as relevant to the Swiss situation. The Swiss intervention is a floor on the exchange rate, and not a fixed peg. The SNB policy is to intervene on foreign exchange markets so that the Franc/Euro exchange rate can not go below 1.20. In effect, the 1.20 Franc/EUR exchange rate is the strongest the SNB will allow the Franc to be. As a result, the Swiss are not dealing with inflationary pressures as a result of the currency floor, and there's no tension between the domestic monetary policy goal of stabilizing NGDP and the external goal of limiting real appreciation.

Moreover, I do agree with Evan's broad argument that the power of expectations substantially reduces, but does not eliminate, the need for the SNB's forex interventions. However, I'm not quite as optimistic as Evan on the longer term effects of the exchange rate floor. I can't deny that the economic indicators look good: 2.8% annualized GDP growth, 3.2 percent unemployment, etc. But in spite of these positive signs, I want to make a general comment about discussions about expectations and cautionary notes on the fragility of such an arrangement.

First is that expectations cannot work in every instance. My arguments on the instability of currency pegs are a perfect example. Pegs can't function on expectations because speculators can push the bank off the edge because there's not an infinite supply of foreign reserves to defend the peg. While the SNB's policy is not a peg, this comparison leads to an important theorem for expectations arguments. Expectations can only be used as an argument if the policy would work even without expectations. In the case of the currency floor, the forex intervention would stop appreciation even if speculators didn't have expectations of future policies. The SNB could just keep on printing francs and depreciate the currency. If the speculators didn't take into account that they were overpaying for francs, they would be naturally selected out of the market by speculators who would bet that the SNB's floor will hold. Thus, if the SNB commits, they can hold the exchange rate greater than or equal to the 1.2 floor. Speculators, knowing this, would then stop speculating. In the case of unconventional monetary policy, asset purchases and lower IOR in and of itself can raise growth through portfolio balance and hot potato effects. Expectations can help augment these policies because the market would do the work for the central bank, increasing monetary policy's effectiveness. In each of these circumstances, expectations make the policy more powerful, but in and of themselves cannot make impossible policies possible. Expectations are powerful, but we need to make sure to use a rigorous set of criteria before we start applying the argument everywhere.

Second, such large scale asset purchases on the part of the SNB to maintain the peg represent an important form of instability. While I was not prescient enough to make the argument in full, I did comment on the danger of such a large balance sheet filled with foreign currency denominated assets. As Evan notes, a lot of forex intervention from the SNB is the result of absorbing demand for a safe haven currency. Thus, unless policy changes, we should expect the balance sheet to get larger and larger.

As the size of the balance sheet increases, we have to start worrying about fragility, or any ripple effects across international financial markets. To illustrate the problem, imagine a "fundamental" rate path that charts the value of the franc in the absence of a floor from the SNB. This fundamental value would also take into account the demand for a safe haven asset. Given the power of the floor, we can safely assume, currently, the fundamental value is below the floor.


However, if, for whatever reason, the fundamental value shoots above the floor (when the orange part goes above the blue), we can anticipate a sudden large amount of selling and revaluing of assets. All of a sudden, what was once at a fixed exchange rate is now moving. Because the SNB's balance sheet is so large, this shift could have massive implications for the balance sheets of other governments.

The most pernicious part of this shift would be that, given the suppressed volatility from the floor, there would be no way for the SNB to tell when we should start to get worried. Even if the fluctuation was pure static, like that shown in the graph, there would be a massive signal confusion problem. Policy makers could guess, but prediction is often quite difficult. It would also be unlikely that other indicators, such as unemployment or inflation, would be update quickly enough to keep up with changes in forex flows. This represents a key form of fragility that we need to worry about in all expectations regimes. If, for some reason, the regime changes, many arrangements that depended on the previous regimes have to be recreated, with sometimes drastic consequences.

To get around such issues, the exchange rate needs to be less about maintaining some floor and more about maintaining a favorite target, such as forecasts of NGDP growth. This way, the market is allowed a natural level of volatility, and policymakers can use this volatility to gauge the state of demand for the currency. Additionally, this natural, day to day volatility would caution those who hold the Franc from depending too much on its 1.2 floor. Alternatively, increasingly draconian capital controls could be used to change the fundamentals of holding currency in Switzerland, thereby limiting capital inflows while allowing volatility in the exchange rate. However, such an approach is subject to leaks, and given the manual smuggling of currency, is likely to fail.

Third, and as a corollary to the second point, the question we need to ask whenever we talk about regimes that fix certain values is "what are the costs?" As Miles Kimball noted, central banks can do a lot of things, so our attention needs to shift to the collateral effects of such actions. And as Bastiat reminds us, we need to look at that which is hidden in addition to the more obvious effects. While a lot of the more mainstream discussions focus on welfare costs of volatility, I worry more about fragilities in the spirit of Taleb or fault lines in the spirit of Rajan. I've commented on this line of thought in the context of NGDP targeting (here and here), and I think it has an important role in any kind of system that suppresses volatility, such as the exchange rate peg.

I can't quibble about the SNB's effective block of the Franc's appreciation, but we must qualify its success. Beware manufactured stability, especially when it creates fragilities and uncertainties that we aren't prepared for.

Can You Tell Me How to Get, How to Get to NGDPLT?

How quickly can bank reserves unravel?

Why are we always focused on the equilibrium, but not the disequilibrium dynamics that get us to that point? Noah Smith made this point in an old post about DSGE models, but it seems like there's a similar problem when it comes to an NGDP target. No doubt, in the end, an NGDP targeting regime would have incredible benefits, but how do we first get there? Specifically, how does the Fed adjust its balance sheet so that it doesn't trip on the "concrete steppes"?

Given the large expansion of the monetary base through excess reserves and IOR, the Fed cannot simply let all of the expansion become permanent. If the expansion were permanent, one would expect prices to be about four times higher than they were in the beginning of 2000. While I certainly support higher levels of inflation to support real growth in recessions, even I find that much inflation a bit unpalatable. It would certainly go beyond the 5% NGDP target that most market monetarists advocate and would result in massive political backlash. Most tragically, this would discredit the entire market monetarist enterprise, jeopardizing one of the most important revolutions in stabilization policy.

Thus, how do we control this unwinding? The typical market monetarist response is that a credible NGDP target establishes a bound on the expansion. The target can anchor market expectations to prevent inflation from getting out of control. But what happens when the policy is not fully credible? Again, I don't mean to say the central bank can not inflate. My concern is with the other side of the target and the possibility of above trend NGDP growth. When you're dealing with such a large expansion of reserves, you need to be cautious with how much is unwound as well as how quickly it takes place.

Ala Eggertsson-Woodford, we know the permanence of the monetary expansion is the critical determinant of the path of NGDP. This is confirmed in some private email correspondences, which brought up the possibility of banks paying higher dividends, or perhaps even venture capital as outlets for bank reserves. However, those options are not viable if the reserves aren't seen as permanent. A particularly striking line was:

The standard Keynesian story has been that in a zero interest-rate economy, it makes perfect sense for government to borrow a ton and invest now, because low rates don't last forever; well, guess what, it makes sense for the private sector too. Both the government and the private sector can think of ways to use more money, and if it wouldn't hurt for government to borrow and spend more, it won't hurt for business to borrow and spend more either.

While this means a credible expectations based regime can easily inflate, it should also remind us that controlling inflation and NGDP growth can be a non-linear task, subject to type-2 extremistan variation. We're not playing with bank balance sheets as much as we're playing with bank's beliefs. Beliefs can change on a whim. Once a certain threshold of expectations or interest rates are passed, banks will rapidly unwind their excess reserves and put their money to use. There is a critical level that we cannot observe, but once we pass it the monetary effects will be significant.

A possible argument out of this problem is that, if the banks knew what fraction of the reserves would be taken out of the system, they could plan ahead so that they don't expand by too much. However, the market is not a platonic game. There is no social planner that will only take a fraction from each bank; the banks have to reach a decentralized solution. Assuming each bank's reserves are small relative to the total stock of excess reserves, it would be in the interest of each bank to spend all of their excess reserves into higher yield assets or dividends so that they can take advantage of the limited permanent expansion of the base. It would be incredibly difficult on the part of the banks to coordinate, because how would they know the level of NGDP? Moreover, if the NGDP level overshot, why should private agents expect the Fed to step in? If central banks are inertial, the credibility of the NGDP target could be compromised. The FOMC only meets eight times a year, how could policy direct the path of NGDP well enough?

Fundamentally, there's two uncertainties that NGDPLT has to deal with. First is a band on the rate of NGDP growth. It can vary around the 5% goal. Second is the band on the timing of when the target is hit. If central banks are slow on adjusting policy, the market may see a bubble opportunity and jump in to make money. Timing is especially problematic because it's something that can cause bubbles even when market participants are rational about fundamentals.

To get around these problems, NGDPLT has to be implemented in a very careful fashion with strong forward guidance on what market participants should expect in terms of NGDP. Scott Sumner often discusses proposals for NGDP futures to help guide policy, but given these disequilibrium dynamics in the transition to NGDPLT, the futures markets are actually a prerequisite. Importantly, these NGDP futures should give information over a variety of time horizons, so banks, both central and private, can know more and plan for the future. With all this information, the central bank would need to be much more active in tuning the rates. While the instability of the rates might seem problematic, they would be instrumental in proving the credibility of the central bank in maintaining a smooth transition. This transition should also be slow, so that the return to trend growth is not too sudden. Thus, NGDP growth does not need to speed up too quickly before it's identified as "overshooting" the path that the Fed plans. It's not a simple act of "shooting for it". The Fed's balance sheet is incredibly large, so we need to be careful so that the easing process does not cause too many problems.

There is little doubt that a credible NGDP target regime with a small monetary base will yield incredible benefits for stabilization policy. But we can't let the perfect be the enemy of the good, and such a regime shift will require great caution.

The Whole is Greater than the Sum of its Parts: Forward Guidance and QE

Maybe interest rates aren't so useless after all

In a recent post from Stephen Williamson, he derides Christina Romer's proposal to tie new monetary expansion to objectives such as unemployment or inflation

First, I'm not sure how you announce a policy without saying what it is. Second, the last sentence in the above quote is interesting. The Fed claims that, for example, purchases of long-maturity Treasuries will lower long bond yields. If they were confident about that, the FOMC would announce targets for long bond yields rather than quantitative goals. They don't announce the targets, therefore they must not be confident that QE does what they claim.

My first reaction is the classic Market Monetarist/Friedman/Bernanke retort: interest rates aren't an indicator for the stance of monetary policy. Perhaps the Fed lowering the interest rate could be an example of loosening policy, but it would hardly qualify as loose policy. In a sense, the derivative of the interest rate time path could give information about the derivative of the policy tightness function, but the level of the interest rate tells you nothing about the tightness of policy. Low interest rates could reflect low NGDP expectation or they could reflect substantial levels of monetary easing. There's no way to actually tell.

However, some recent econometric evidence has shown the forward guidance on interest rates has some effect. In the conference paper "Macroeconomic Effects of FOMC Forward Guidance," the authors categorized two kinds of forward guidance: Odyssean and Delphic.

In Odyssean forward guidance, the interest rate path is a path that will take place in spite of elevated inflation or NGDP. The declared interest rate path is a deviation from the policy rule and is designed to "catch up" to trend growth. On the other hand, Delphic forward guidance is simply a prediction. The interest rate path is simply following the policy rule and will not make any exceptional effort to catch up growth. Thus, if the Fed's commitment to low interest rates until at least mid-2013 is Odyssean, it means that the Fed sees NGDP growth rising but it will still commit to low rates. If the guidance is merely Delphic, the guidance is merely a forecast of low NGDP growth until at least mid-2013.

(Note:  Odyssean references the scene in the Odyssey, when Odysseus commands his sailors to tie him to the mast of the boat when they travel through the land of the sirens. Odysseus committed, beforehand and contrary to what he would want at the time, to stay tied to the boat. Delphic refers to the oracle of Delphi that could tell the future.)

In the period of time before the financial crisis, research showed that the markets were listening to the Fed's declarations for a future policy path. As summarized in the Brookings paper (note, GSS is the name of the study that analyzed the data, my emphasis)

By performing a suitable rotation of the two unobserved factors, GSS show that they can be given a structural interpretation. One is a “target” factor, corresponding to surprise changes in the current federal funds target. The other is a “future path of policy,” or simply “path,” factor, corresponding to changes in futures rates that are independent of changes in the current funds rate target. The “path” factor is shown to be associated with significant changes in FOMC statement language. For example, its largest realization in absolute value occurs on January 28, 2004 when the federal funds target was not changed, but the phrase “policy accommodation can be maintained for a considerable period” was replaced with “the Committee believes it can be patient in removing its policy accommodation.” This change in language was interpreted by markets as indicating the FOMC would begin tightening policy sooner than previously expected. 

Using ordinary least squares regressions of changes in interest rates before and after the windows of time surrounding FOMC statements on the target and path factors they find that 75 to 90 percent of the explainable variation in five- and ten-year Treasury yields is due to the path factor rather than to changes in the federal funds rate target itself. Information in the statement about the future funds path that differs from prior market expectations or revelations about the FOMC’s outlook for the economy that changes private expectations of that outlook both should affect anticipated future federal funds rates. Therefore their evidence strongly suggests that forward guidance, broadly conceived, has had an impact on asset prices prior to the financial crisis.

The zero-lower bound has called into question whether interest rate guidance can still stay effective. The current literature on QE1 and QE2 both use this "future path of policy" argument. As per the paper:

This evidence is suggestive for the current situation, but not conclusive, since it covers a period before the financial crisis and the attainment of the ZLB robbed the FOMC of its principal policy tool. Research on monetary policy announcements since the onset of the crisis has focused almost exclusively on the impact of announcing large scale asset purchases (LSAPs).7There is significant evidence that LSAP policies can alter long-term interest rates. For example, Gagnon, Raskin, Remache, and Sack (2010) present an event study of QE1 that documents large reductions in interest rates on dates associated with announcements of LSAPs. Also using an event-study methodology, Krishnamurthy and Vissing-Jorgensen (2011) evaluate the impact on interest rates of announcements associated with both QE1 and QE2. They uncover several channels through which these announcements have had an impact on asset prices. With QE2 a major role is ascribed to a “signalling” channel whereby financial markets interpreted LSAPs as signalling lower federal funds rates going forward. This suggests that one feature of LSAPs resembles forward guidance and so the findings of Krishnamurthy and Vissing-Jorgensen (2011) can be interpreted as supporting the view that forward guidance has had a significant impact in the recent period. However, the impact of “pure” forward guidance, where the policy action is solely reflected in statement language, in the recent period remains unclear.

More rigorous statistical analysis finds that the path factor still exerts a large amount of impact. 

When the target and path factors are calculated using all the announcements in Table 1 except the one associated with QE1 they explain 96 percent of the total variation in the seven futures contracts we employ for their estimation. The target factor alone explains 79 percent of the variation. Table 2 reports the fraction of variation in each of the seven futures contracts explained by each of the two factors. The target factor dominates the variation in the current quarter futures rate and the one-, two- and three-quarter ahead rates, while the path factor explains the majority of variation in the three longer rates and negligible share of the two shortest contracts after the current quarter one. This pattern is broadly similar to the one obtained by GSS. The main differences are that in our case the target factor accounts for a somewhat larger share of variation at the short end, while the path factor’s explanatory power is more concentrated toward the long end. Still, the overall impression is that the impact of FOMC statements in the recent period is not very different from prior to the financial crisis. Given the disparity in the associated economic conditions this is a striking finding.

So, to quibble with Nick Rowe, the impact of the future path of interest rates is probably not 99%, but the effect is still very high.

There is also some interesting information on the safe-assets story in the paper. The authors find that expansionary forward guidance can lower corporate bond yields. Specifically:

In contrast, a one-standard deviation positive path factor realization raises the Aaa yield by 54 basis points and the Baa yield by 48 basis points.

This provides evidence of a portfolio balance effect that QE does stimulate easier credit conditions for firms. Yet this effect comes not so much from the actual asset purchases but rather from the information on the path of future policy that it yields.

As a result of this forward guidance analysis, the paper finds the Evans 7% unemployment/3% inflation joint target useful to restore aggregate demand without destabilizing inflation expectations:

Evans (2011) has proposed conditioning the FOMC's forward guidance on outcomes of un-employment and inflation expectations. His proposal involves the FOMC announcing specific conditions under which it will begin lifting its policy rate above zero: either unemployment falling below 7 percent or expected inflation over the medium term rising above 3 percent. We refer to this as the 7/3 threshold rule. It is designed to maintain low rates even as the economy begins expanding on its own (as prescribed by Eggertsson and Woodford(2003)), while providing safeguards against unexpected developments that may put the FOMCs price stability mandate in jeopardy. Our policy analysis suggests that such conditioning, if credible, could be helpful in limiting the inflationary consequences of a surge in aggregate demand arising from an early end to the post-crisis deleveraging.

Thus, the econometric evidence comes somewhere in the middle. Yes, interest rate guidance can have an effect, but asset purchases have a large impact as well on a wide variety of interest rates because the purchases substantively change the expected future path of policy. This suggests that the two policies together would have a much stronger effect than either of them apart. I see this playing out in the following manner: 

Limiting policy to a near-term interest rate commitment raises the possibility that the forward guidance describes the Fed passively tightening and keeping growth down. This forward guidance may be seen as Delphian. However, with asset purchases like QE, the Fed signals that it is committed to expansionary policy, which has first order effects on corporate bond yields and other asset prices. This additional policy action changes the original forward guidance from being Delphian to Odyssean. The Fed will be effectively saying, "We will pursue asset purchases that will push up inflation, but in spite of this inflation we will be keeping interest rates low". This would break out of the indeterminacy on whether low interest rates are expansionary or contractionary. Quantitative easing might be normally seen as just a temporary injection of money, but forward guidance cements that injection in as permanent.

This interaction effect would offer the Fed much more ammunition with its current policies. It could help alleviate the concerns of the "concrete steppes" by using not-so-unconventional policies to shape expectations. Once the expectations are settled and we escape the zero-lower-bound, forward looking monetary policy shouldn't be too difficult at all. This would be an example of the pragmatic monetary policy that could eventually transition to the end of history stabilization policy: a NGDP targeting regime.

The Danger of Promises

Promises are powerful, so don't make a promise you can't keep

Evan Soltas had an interesting post on the power of promises in the context of currency bands and monetary policy, but we should also remember that banks shouldn't try to make promises they can't keep. We all should be very worried when we see graphs that show sudden decreases in volatility, as Evan shows in his post. Whenever policymakers suppress volatility, we need to wonder where those pressures have gone, and why they have disappeared. More often then not, manufactured stability leads to calm periods punctuated by sudden change; they become Type 2 extremistan regimes, as pictured below:

So why did the currency peg work? The peg only makes sense in the context of Scott Sumner's argument that the currency peg is a form of monetary policy commitment. The undervalued currency increases aggregate demand, thereby filling the output gap. However, it should be observed that, given the undervalued currency, maintaining the peg leads eventually to above trend NGDP growth and an economy that's running "hot". However, the "hot" economy would call the currency peg into question. This is a classic example of Mundell's policy trilemma. The SNB cannot pursue an exchange rate peg, independent monetary policy, and capital mobility at the same time. Conditions are stable now only because the exchange rate peg matches the objective of an independent monetary policy. However, once the output gap starts to narrow the credibility of the exchange rate peg will be questioned.

This is where the expectations channel starts creating weird dynamics. If the market expects the SNB to pursue monetary policy that prioritizes internal conditions, then the market should expect that currency to appreciate in the future as the output gap is filled. However, because of inertial central bank policy, this will only occur when the currency is undervalued to such an extent that it is no longer feasible for the central bank to maintain the peg. At that point, we should expect to see a very sudden adjustment as the SNB comes under fire from speculators. This then creates a vicious loop, as the SNB's attempts to maintain the peg only increase the supply of currency, of which speculators buy increasing amounts as they now know that the currency will appreciate.

When the SNB is forced to rebalance the currency, it will shake up markets as it unwinds its large balance sheet of foreign assets. Since the bank would have been accumulating these assets for a long time, their sudden liquidation is likely to be a "fat tail" event, which, on one hand may not cause that much damage, but on the other hand may cause positive feedback loops to devastate markets in unknown ways.

While this analysis is in the specific context of the Swiss central bank, this argument has implications for NGDP targeting in developing countries as well. The problem with the SNB's currency peg is that it prioritizes one objective (exchange rate) over all others (including NGDP). However, when domestic politics rears its head, a internal measures such as NGDP will end up trumping external measures such as the exchange rate. The crisis arises from a sudden reversal in priorities.

This exchange rate-NGDP tension is very important for developing economies. If these countries pursue capital mobility, then they may need to compromise part of their monetary policy to maintain an exchange rate band. Thus, this is another source of possible fragility in a NGDP target, as other objectives, such as the exchange rate, suddenly come to the forefront.

Edit: Evan Soltas gave me a further explanation on how the "peg" is really a floor, as well as an explanation of the general macro conditions in Switzerland. I failed to take the time to analyze them, so the conclusions are slightly different. There's still possibilities of non-linear dynamics, and those are explained in the comment thread. I've also written a new post reflecting back of these issues here.

Capital Spillovers: Towards a New Regime

A look at the externalities from capital controls and potential effects on international finance


The focus of this post is going to be on the arguments in a recent NBER working paper on how capital controls in one country should be evaluated on an international level.

An interesting development in the analysis of capital markets in the past few years has been a changing paradigm on the use of capital controls as macroprudential policy. Through empirical analysis, we've found various channels through which capital controls function. As per the working paper:

Some economists and policymakers have recently become more supportive of controls on capital inflows, particularly if they are aimed at limiting the appreciation of overvalued currencies and reducing financial fragilities resulting from large and volatile capital flows. This support has been bolstered by theoretical work showing that taxes on capital inflows can improve a country’s welfare by reducing negative feedback effects due to capital flow volatility (Korinek, 2010 and Jeanne and Korinek, 2010) or by adjusting the terms-of-trade to shift consumption across periods (Costinot, Lorenzoni, and Werning, 2011). This theoretical work has been supported by empirical work showing that even if capital controls cannot significantly affect the total volume of capital inflows, they can improve the country’s liability structure and increase its resilience to crises (i.e., Ostry et al., 2010).1

Yet the analysis hasn't really focused on external effects of capital controls of country on others. This is an important field of study because, as the study of customs unions or financial contagion has taught us, the effect of controls or restrictions change significantly in a second-best world populated by other states with their own policy regimes. Thus, any possible externalities from one country's capital controls are extremely important in the formulation of policy.

The paper looks at 'moderate, market-based controls on capital inflows in a country which previously had a relatively open capital account." In effect, it shies away from large scale capital controlled regimes like China.  Also, these types of capital controls are unlike the command-and-control regulations that China uses in stopping capital mobility. Instead of a quota, the controls analyzed in the paper make capital harder to move on a per-unit basis. While Chinese capital controls can be represented by a levee, the capital controls analyzed in the paper are the equivalent of making the hill a bit steeper or moving to higher ground. For more rigorous empirical analysis, the paper looks at Brazilian markets, as they are relatively deep and have been subject to multiple changes in capital restrictions over the years. The authors use the Emerging Portfolio Fund Research (EPFR) to analyze changes in mutual and bond funds.  In addition, they interview investors from a variety of backgrounds to learn about how market practitioners respond to capital controls.

An interesting nugget from the empirical analysis is that a large part of the impact from Brazilian capital controls arises from the expectation about future policy. Capital controls in Brazil lower investment in Brazil, but also in other countries that have a higher risk of implementing more capital controls. The specific wording from the paper:

Given these significant portfolio effects of capital controls on investor allocations to Brazil, it is not surprising that there are externalities on portfolio allocations to other countries as well. Confirming comments in some of the investor interviews, we find that these spillovers are heterogeneous and depend on country characteristics and the fund manager’s strategy. When Brazil increases its capital controls, investors increase their portfolio allocations to other countries that are closely linked to growth in China (through commodity or regional exports). There is also mixed evidence that investors may increase their portfolio allocations to other countries in Latin America. At the same time, increased capital controls in Brazil cause investors to reduce their portfolio allocations to countries that are perceived to have a higher risk of following Brazil’s example and implementing new controls (including countries that are traditionally open but recently imposed new controls as well as countries that traditionally have extensive restrictions on capital mobility). These results confirm that much of the effect of controls is from signalling, i.e. changes in investor expectations about government policy, even for countries that are not concurrently adjusting their capital controls (6). 

This shift in expectations then has implications for whether capital controls can be targeted. If controls cause markets to judge an entire government as heterodox, then capital flows as a would reduce all forms of foreign investment. Additionally, Brazilian capital controls may change global expectations about policy for capital controls.  This may change the allocation of funds at a global level as well.


The shift towards Chinese investments in the face of Brazilian capital requirements is quite interesting. This suggests that there's something offered by investments related to China that similar to that of Brazilian investments. This relationship is probably built on the BRICs of emerging markets, but these similar flows weren't recorded as going into Russia or India. Brazil is also unique in its central placement in South America, which is probably the reason Brazilian capital controls pushed a substantial portion of the new flows into other Latin American countries. Although their development has not kept pace with Brazil, they are likely exposed to similar risks with respect to commodity price shocks on the global marketplace. As a result, an investor might decide to shift away from Brazil, which has capital controls, to another Latin American country which would offer a similar type of investment, but with a higher yield due to lower capital controls. The authors use these spillover effects of capital controls to justify more international coordination:

If capital controls shift vulnerabilities from one country to another, this “bubble thy neighbour effect” should be incorporated in any reassessment of the desirability of capital controls. Moreover, if several countries simultaneously adopted controls as part of a standard “policy toolkit”, or if a single large country adopted more stringent controls than Brazil’s small tax analyzed in this paper, the externalities could be substantial. This does not necessarily mean that capital controls will reduce global welfare and should always be avoided. Instead, these results support a role for international coordination or oversight of the use of capital controls to avoid a “bubble thy neighbor” effect which could lead to retaliation across countries and reduce global welfare (6).

The argument about "retaliation across countries" exposes an important weakness of capital controls. If capital controls function primarily by pushing hot money flows onto other countries, a global regime of capital controls is likely to have the same effect that capital controls have on a country-by-country basis. In effect, the fallacy of composition strikes again, as if every country imposed capital controls, capital controls would no longer address vulnerabilities in finance. Rather, they would just lower the global return on capital.


Section 2 of the paper moved on to investor surveys of attitudes towards capital controls. They reveal a wide diversity of views on capital flows.  While some investors were neutral (“cost of doing business”), quite a few of them interpreted capital controls as signalling something more fundamental about the country (“anti-investor bias of the country,”  “an increase in policy uncertainty in the future,” “a government that does not know what to do,” or a “lack of stability in economic policy”) that constituted "a draconian policy".  Other investors had positive views, as "controls showed the country was addressing potential vulnerabilities due to a rapid expansion of credit related to capital inflows".  If capital flows substantively affect future expectations of capital stability, these yield expectations should be integrated into the design of policy.  Yields could be used as a tool to look at market expectations of the future path of policy.

Capital controls also have heterogenous effects on different investors.  Equity investors face higher levels of volatility, so taxes on the order of a few percentage points of return were not very worrisome. On the other hand, for those who were dealing with fixed income assets or had absolute thresholds to reach, the tax on incoming capital had a major effect.

The surveys also reveal that capital controls, as currently implemented, affect the economy with long and variable lags.  This would take place in spite of advanced knowledge of when the controls would be implemented.  There were four key reasons for this:

1. Expectation lag - even though capital controls changed the expectations of future policy, any given change could only be part of a "broad assessment" of investments in a country.  As a result, one capital control would not immediately affect a change in investment strategy.
2. Institutional lag - in many institutions, fund allocations depend upon decisions of large committees that go through a "lengthy process of meetings, documentation and approvals" (10).  As a result of the internal transaction costs of making the decision, capital controls don't have immediate effects.
3. Coordination lag - the effect of capital controls extends beyond one firm.  Rather, investors require information about the actions of other agents to make a decision; they can't ex-ante coordinate to figure out how much each firm will invest.  As a result, responses to capital controls take time.

All of this shows that investors respond in very different ways to capital controls; the image of a representative investor investing symmetrically with the market is an illusion.  Policy then needs to be designed carefully to take into account these different types of investments.

Overall, this paper has notable implications for a global shift away from financial fragility through capital controls. The signalling argument means there's room for rule based policy when it comes to macroprudential regulation.  To clarify what the government wants to do with capital flows, they can create a "macroprudential regime" to try and anchor investor expectations, thereby creating an environment more conducive to growth. 

Also, the international spillovers of capital flows make the dynamics of adjustment to an international landscape dotted with capital controls unpredictable. As more and more large economies move towards capital controls, two scenarios could evolve. One is that the states without capital controls would be seen as freer to capital flows. This would create strong incentives for the remaining states to implement controls so as to prevent the new flows of hot money from coming into their polities. Even without international coordination, there would be a snowballing effect towards a new regime on capital controls. On the other hand, if the expectations channel was strong enough, the remaining states could go without controls as investors already expect them to be willing to take measures to moderate capital flows. In effect, the actions of the first movers would immunize the rest. Under this scenario, the first movers would be providing a public good with their decision to move first. As a result, there would be an inefficient level of capital controls. I'm not sure which one is more correct, but either way they make the study of international finance very exciting as development marches forward.

Complexity in Monetary Policy: The Mechanisms Do Matter

Beware manufactured stability: "expectations management" is inherently fragile

A recent working paper adds to the discussion on monetary policy and growth.  In the model, monetary policy affects growth by allowing credit-intensive industries to engage in larger projects.  It does so by easing liquidity needs and, thus, giving firms the "breathing space" to invest.  The paper finds evidence for this by looking at industry-level financial constraint variables as well as the performance of the industry in response to monetary policy.  The key finding is that countercyclical monetary policy can have a significant positive impact on long run productivity growth, especially for recessions.  This result is robust to controlling for:

...the interaction between these measures of financial constraints and country-level economic variables such as inflation, financial development, and the size of government which are likely to affect the country’s ability to pursue more countercyclical macroeconomic policies (5).

Moreover, the regressions shed light on another unique internal link from monetary policy to growth: countercyclical monetary policy promotes higher levels of R+D spending.  While the model explains it through liquidity needs, the concept of "signal-processing" causing firms to invest inefficiently likely applies.  This suggests that if we really are in a "great stagnation" of growth and innovation, a stable nominal economy vis-a-vis monetary policy will be increasingly important.

To extend the model, if monetary policy exerts a diverse range of effects on what is considered money through safe asset creation, the effect of countercyclical monetary policy is probably stronger than what the interest rate would state.  By increasing liquidity through countercyclical policy, this allows firms to invest more:

The intuition for this proposition is simple. Firms need to hoard liquidity in order to weather liquidity shocks if the aggregate state is bad. This liquidity hoarding is costly...because of the lack of commitment of consumers. Reducing interest rates in bad times lowers the amount of hoarded liquidity, by increasing the ability of firms to leverage their net worth. This effect is weaker when the aggregate state is good because in that state, short-term profits are enough to cover reinvestment needs so that no liquidity needs to be hoarded to weather liquidity shocks that occur in that aggregate state of the world. Hence a higher marginal benefit of reducing interest rates in bad times relative to good times. This effect is strong enough to overcome a countervailing effect arising from the fact that lowering interest rates in bad times leads to an implicit subsidy from consumers to entrepreneurs, explaining that optimal interest rate policy is countercyclical (14, my emphasis).

And now the Nassim Nicholas Taleb homonculus starts screaming into my ear.

To what extent does this mechanism of monetary policy just create more interlocking fragilities?  I've previously argued that one of the problems with NGDP targeting is that it hides the complexity of the ecology of markets.  In this model, the world is encouraged to increase complexity because of a monetary regime that promotes more stable growth.  The firms with "unshakeable" expectations can leverage themselves to the hilt to try to maximize future growth.  But finance is fragile; what would happen if an unseen risk arises?  More seriously, although a debt crisis would wipe these firms out, nobody would be able to tell in the short run while those debt instruments are still there.

The issue here is that "average growth" is nowhere near as important as "variant growth".  While growth is stable most of the time, the impact of tail events rises as markets become more interconnected.  Leverage is inherently dangerous in an interconnected world because it enables complex cascading effects that go beyond the ability of our models to predict.  This uncertainty is heightened by the fact that even slight miscalibration errors can cause monstruous miscalculations.  These problems aren't solved by monetary policy either because financial crises are aggregate supply problems.  If credit mediation crashes, resources are no longer allocated efficiently, raising unit costs for all factors of production.

A possible way to get around this is if we can commit to more equity instead of leverage.  From Taleb's 10 principles for a Black-Swan free society:

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

This way, the net worth of companies can be converted into equity stakes, and funding can be obtained this way.  Given the outsize role of large events, this shift to a more black swan free society should occur before the adoption of monetary policies that could increase fragility.  In this world, monetary policy would allow for increased efficiency of markets while also preventing Black Swans from coming to roost.

What is with inflation expectations? Analysis from Cleveland Fed Data

After working with TIPS data in a previous post, I became more interested in the relationship between inflation expectations and actual inflation over time.  Generally, as per a paper by Mankiw, Reis, and Wolfers, inflation expectations can be highly contentious, with uncertainty among Economists especially high in times of crisis.  However, even though the data suggests that inflation expectation are well correlated with past inflation, the hypothesis of rational expectations and inflation predictions is a bit more uncertain.  In the Mankiw et al. study, the short term predictions of the Michigan, Livingston, and Survey of Professional Forecasters seemed reasonably accurate; how does this accuracy carry over to longer term measures of inflation expectation?

However, since the TIPS data does not go back very far, I used the Cleveland Fed's inflation expectation data instead.  And as per some comparative analysis between the two measures, the Cleveland Fed data can be more descriptive in times of major change, which is when the stability of expectations is the most important.  From the CPI data, I calculated the actual inflation over the future timeframe of the expectation, and then associated this inflation rate with each month's inflation expectation data starting from January 1982.  Thus, for the 5-Year inflation expectation data for January 1982, the actual inflation was the average annual inflation from January 1982 to December 1986.  These two numbers formed a point.  I then took 60 of these points (five years), and used them to calculate a Pearson's r-value, a measure of the correlation between the two values.  For example, the set of data beginning with a point in January 1982 includes the inflation data from December 1992 to make the last calculation for actual inflation.  The movements of the different correlations are plotted below:

What is immediately apparent is that the stability of the relationship changes with time.  During the second half of the 80's, expectations matched reality quite well, with an r-value of over 0.9 for the 5 year expectation data.  This seems to match the rational expectations proposition that the expectation should be the reality.  However, beginning with the 90's, the correlation between inflation expectations and actual inflation became more negative.  What is striking is that the correlation kept on going down, reaching almost -0.8 with the 5 year expectation.  The correlation is consistent with the r value of about -0.73 with the TIPS data, lending credibility to the fact that Cleveland Fed predictions are theoretically robust.

What is more interesting than the correlations are the slopes; an increase in expected inflation predicts how much of an increase in actual inflation over the future period?  The data is graphed below.  A value of 1 means that for every percentage point increase in inflation expectations in a period, the actual inflation in the corresponding term is 1 percentage point higher.

Before looking at the actual numbers, what should we expect the slope to be?  In a world of perfect rational expectations, in which , the slope should be one.  Although there may be error, the expectation should, on average, match reality.  In the world of an inflation targeting central bank (with or without rational expectations), the slope should be 0, as actual inflation should always gravitate towards a constant.  This analysis of central banks is supported by comparisons between US (non-inflation targeting) and UK and Swedish (inflation targeting) central banks.  Below are both the time series of the slopes, as well as box and whisker plots showing the distributions of the slopes.

As can be seen from the time series, the slopes don't stay constant.  Rather, they jump around, with the 1-Year slope value substantially more volatile than the 5 or 10 year slopes.  In spite of this, the median of the slopes do lie around zero.  However, their distributions are skewed right, with the outliers mostly coming from the mid 1980's to the early 1990's time period, which was the time after the brunt of the Volcker disinflation.  The amazing convergence of measures at that time suggest it has something to do with people adjusting to a new monetary regime.  It is as if, in the transition to the fight against inflation, people were able to accurately predict the new stable regime, creating the high correlation as people lowered their expectations of inflation.  Later, as the regime became stable, the correlation became weaker as noise gained a proportionally larger effect.

But then what explains the negative slopes in more recent times?  One interpretation is that they're statistical anomalies: the 1 year data goes much farther and, while it does have a few blips into negative slope, they revert back to mildly positive relatively quickly.  Given this volatility, we will have to wait for more data to try to evaluate the impact of the regime on inflation and their expectations.