FOMC Minutes: April 24-25 Meeting

Minutes for the last FOMC meeting are posted here. There are some interesting things here. The first is a discussion of how the FOMC might make its communications with the public even more complicated and confusing than they already are:

A staff presentation provided an overview of an exercise that explored individual participants' views on appropriate monetary policy responses under alternative economic scenarios. Committee participants discussed the potential value and drawbacks of this type of exercise for both internal deliberations and external communications about monetary policy. Possible benefits include helping to clarify the factors that individual participants judge most important in forming their views about the economic outlook and their assessments of appropriate monetary policy. Two potential limitations of this approach are that the scenario descriptions must by necessity be incomplete, and the practical range of scenarios that can be examined may be insufficient to be informative, given the degree of uncertainty surrounding possible outcomes. Some participants stated that exercises using alternative scenarios, with appropriate adjustments, could potentially be helpful for internal deliberations and, thus, should be explored further. However, no decision was made at this meeting regarding future exercises along these lines.

The idea seems to be to construct some "alternative economic scenarios." Who gets to choose those scenarios? How do we know that these scenarios are even consistent, i.e. how do we know that there is positive probability that such data could be generated by the US economy in the future? How do we know that the alternative scenarios cover the bases? What about big surprises? Would another financial crisis in the next year be a surprise?

Once the alternative scenarios have been laid out, each FOMC participant would presumably put his or her research staff to work evaluating what an optimal monetary policy response would be under each. Then we somehow aggregate this information and report it. Could this exercise actually be helpful? I doubt it, and apparently most of the committee seems to feel the same way.

Here's something I did not know:

With Mr. Lacker dissenting, the Committee agreed to extend the reciprocal currency (swap) arrangements with the Bank of Canada and the Banco de México for an additional year beginning in mid-December 2012; these arrangements are associated with the Federal Reserve's participation in the North American Framework Agreement of 1994. The arrangement with the Bank of Canada allows for cumulative drawings of up to $2 billion equivalent, and the arrangement with the Banco de México allows for cumulative drawings of up to $3 billion equivalent. The vote to renew the System's participation in these swap arrangements was taken at this meeting because a provision in the Framework Agreement requires each party to provide six months' prior notice of an intention to terminate its participation. Mr. Lacker dissented because of his opposition, as indicated at the January meeting, to foreign exchange market intervention by the Federal Reserve, which such swap arrangements might facilitate, and because of his opposition to direct lending to foreign central banks.

There is a special "North American Framework Agreement of 1994," governing swap arrangements with among North American central banks? What exactly did the signatories to this agreement have in mind? Have any swaps actually occurred under the agreement? Why does Lacker even care enough to dissent?

On forward guidance:

While almost all of the members agreed that the change in the outlook over the intermeeting period was insufficient to warrant an adjustment to the Committee's forward guidance, particularly given the uncertainty surrounding economic forecasts, it was noted that the forward guidance is conditional on economic developments and that the date given in the statement would be subject to revision should there be a significant change in the economic outlook.

This makes it clear, in line with what Fed officials have been telling us, that the forward guidance in the FOMC statement ("...likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.") can change. It is not a commitment. The interpretation is that, if the Fed's forecast changes, so will its forward guidance. Then, if we want to understand the Fed's policy rule, we need to have a view on what the Fed's forecast means. Is it objective, or just wishful thinking? What exactly will the Fed do if it gets a surprise? How much will the forward guidance change, and in response to what? How is the current forward guidance language somehow superior to the old language ("...low levels for the federal funds rate for an extended period.")?

FOMC members still believe that they have plenty of tools at their disposal:

The Committee also stated that it will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability. Several members indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough.

To my dismay, these folks are convinced that quantitative easing actually does something. With the stock market going south, Europe in disarray, and a little less inflation, look for more QE at the next meeting, June 19-20.

Bad Ideas?

Two reactions to this piece by Paul Krugman:

1. If Krugman believes that disinflation is "incredibly expensive," then he should be more wary of exploiting the Phillips curve tradeoff that he imagines exists.

2. Krugman should do some research on the debate about disinflation that occurred circa 1980. At the time, various "gradualists" thought that the sacrifice that would have to be made in reducing inflation would be very much larger than it actually turned out to be. People like Tom Sargent (see "The Ends of Four Big Inflations" and this paper) had a better grip on what was going on than the adaptive expectationistas.

Sectoral Reallocation and the Labor Market

The topic for discussion today is the state of the US labor market: how we got here and why. I'm going to take a longer-term view, examining data from 2000 on, and using Canada as a benchmark.

First, let's look at private sector employment by sector in the US economy, in the first chart.

The chart shows employment across four sectors: services, manufacturing, mining and logging, and construction. Clearly, over the period from 2000 to 2012, there was a significant sectoral shift in the composition of employment. Employment grew in services and mining and loggging, and shrank in construction and manufacturing. There was a huge drop in construction employment from the peak of the housing boom in 2006. From the trough in the recent recession, employment in services and manufacturing has grown sluggishly, employment in mining and logging has grown at a high rate, and construction employment has been essentially unchanged.

Of course, it is also important to take account of the employment shares for each of the four sectors in the chart. The majority of employment throughout the period in question was in services, with services employment increasing from 65% of total employment in January 2000 to 70% in April 2012. Over the same period, employment in manufacturing fell from 13.2% to 9.0%, employment in construction fell from 5.2% to 4.2%, and employment in mining and logging rose from 0.5% to 0.6%.

If we were to try to explain what is going on in the first chart, what would leap to mind? First, the secular shift from manufacturing to services employment is well-known. Part of this is due to changes in demand - preferences have shifted from tangibles to intangibles. Some of it is due to changes in technology - there seem to have been significant productivity gains in manufacturing relative to services, although productivity in the services sector (e.g. financial services) is notoriously hard to measure. Second, the behavior of construction employment sticks out like a sore thumb. The increase in construction employment from 2000 to 2006 and the subsequent crash were driven by well-known incentive problems in the market for asset-backed securities, followed by the collective realization that asset-backed securities were not so well-backed.

The second chart shows employment for the same four sectors, except for Canada instead of the United States.

In this chart, the pattern of growth in employment in services and manufacturing looks very similar to the US. The share of services employment increases from 70.8%% in 2000 to 74.1% in 2012, with the manufacturing share falling from 16.5% to 10.2%. Construction employment looks much different in Canada though, with very strong trend growth throughout the sample period, and a quick recovery from the trough of the recent recession. Employment in mining and logging may look different in Canada and the US, but if we separate mining from logging, Canada and the US look similar, though Canada has a larger share of total employment in mining and logging than does the US.

The North American economy is highly integrated. Aggregate economic behavior in Canada and the United States has followed a similar trend, and business cycles in the two countries have been highly synchronized. The Great Depression was similar in Canada and the United States with regard to the behavior of real GDP, as was the case in the recent recession. However, the above two charts tell us that it may be difficult to reconcile the behavior of sectoral employment in the two countries with some conventional aggregate-shock model of the recent recession. How could such a model explain the differences in the behavior of construction employment in Canada vs. the US?

The aggregate labor market data for Canada and the US is especially interesting. The third chart shows total employment (from the household surveys now) for Canada and the US.

Over the 12-year period in the chart, Canadian employment grew by about 19%, while US employment grew by about 3%. The drop in employment in Canada during the recent recession is quite modest relative to the drop in the US. The fourth chart depicts labor force participation rates in the two countries.

This one is quite remarkable. First, the decline in the participation rate in the US that began with the recent recession is just part of a trend decline since 2000, which was interrupted for the period from the end of 2004 to the beginning of 2008. While the US participation rate declined by about 3.5 percentage points from 2000 to 2012, the Canadian participation rate actually increased by a percentage point.

The fifth chart shows unemployment rates in Canada and the US.

Historically, the Canadian unemployment rate was typically higher than the US unemployment rate, due to more generous unemployment insurance system in Canada, and sectoral and geographical differences. During the recent recession, however, the unemployment rate in the US rose by about double the increase (in percentage points) in Canada. If we took account of measurement differences in Canada and the US, the current difference between unemployment rates would be even larger than it is in the chart.

In the sixth chart, we show real GDP in the US and Canada.

In this chart, a key observation is that the recent recession was of similar depth and duration in Canada and the US. However, the recovery in Canada has been somewhat stronger, and at the end of the sample period real GDP was 3.8% higher relative to US GDP than it was in 2000.

Putting together real GDP and employment paths, we get the final chart, which shows average labor productivity in Canada and the US.

Here, a large gap had already opened up between US and Canadian productivity, and that gap increased significantly during the recession.

What are we to make of all this? I don't know about you, but the Keynesian narrative does not help me to make sense of what I'm seeing. If employment and labor force participation are so low in the US because wages and prices have been stuck for the last four years, and aggregate demand is insufficient, then we should be seeing the same phenomena in Canada. Canadian wages and prices can't be any less screwed up than are US wages and prices and, if anything, fiscal and monetary policies have been more "stimulative" in the US than in Canada. Further, according to Keynesian logic, it's essentially the same aggregate demand north and south of the 49th parallel. So why are the Canadians working so much more than the Americans?

Before the financial crisis, some of us liked to pay attention to financial factors, credit, banking, monetary economics, etc. Now we all know that those things are important, right? If you think about them, you can indeed begin to make sense out of the data above. The Canadian financial system essentially sailed through the financial crisis unscathed, save for a few bruises perhaps. The problems in US mortgage markets, which acted to foul up financial exchange and credit in general, are reflected in the performance of the US construction sector, and in US labor market performance, in ways that we have not yet been able to successfully quantify. There may be inefficiencies associated with these phenomena that can be corrected through the better design of fiscal and monetary policies, but it is far from obvious what the inefficiencies are, or what the correct policies are. Anyone who tells you they are sure of the answers is fooling themselves, or fooling you.

"Groupthink," and the FOMC

I have been on something of a blog vacation (and about time, you might say), though I can assure you there has been nothing relaxing about it. I was reading Laurence Ball's paper on "Ben Bernanke and the Zero Bound, I think that it raises some interesting questions, and I would like to relate this to current thinking (and current thinkers) on the FOMC.

Ball wants to have us think that the pre-2003 Ben Bernanke was a sensible person who argued that, in the context of the zero lower bound on the overnight nominal interest rate, a central bank is not powerless. According to Ball, pre-2003 Bernanke thought, first, that forward guidance (announcements about future monetary policy actions) and quantitative easing (large-scale asset purchases) at the zero bound are a good idea. Those policy options are indeed reflected in post-financial crisis monetary policy in the United States. Second, and more importantly, Ball argues that pre-2003 Bernanke advocated another set of zero-bound accommodative policies, which are:
(i) exchange rate depreciation
(ii) targets for long-term nominal interest rates
(iii) money-financed tax cuts
(iv) higher inflation targets

Ball is bothered by the fact that such policies have not been pursued by the current incarnation of the FOMC, as he appears to think that those policies would be appropriate at the current time. Ball has little to say - explicitly - about the science of monetary policy. He's thinking about a model of Ben Bernanke, not a macroeconomic model designed to evaluate and guide monetary policymakers.

Ball's premise is that pre-2003 Bernanke was right, and post-2003 Bernanke was wrong. What could have made Ben do such stupid things? Did he fall and hit his head? Not at all. The answer is "groupthink," and what Ball calls "personality." You have all probably heard about groupthink, which has entered the realm of pop psychology. The idea seems to be that a group may not be greater than the sum of its parts. Group members may interact in a way that produces bad results, if an urge to cooperate and forge consensus overwhelms good ideas. There's a long Wikipedia entry where you can read all about it. On the personality front, Ball characterizes Bernanke as "shy," and provides plenty of supporting evidence.

Actually, the general thrust of the paper can be summarized by: "Ben Bernanke is a wimp." I may be wrong, but I don't think he is. Economists are tough. We cannot survive as academics without being willing to defend our ideas. Bernanke flourished as an academic, and worked at Princeton, which of course is no slouch institution. He survived a period as department chair there, a position in which I'm sure he developed considerable skills in forging consensus. There is nothing wrong with consensus. Many healthy decision-making bodies thrive on it.

The key question, which I'm sure you are asking, is: What do we think of those zero bound accommodative policies - (i) through (iv) above - anyway? First, it's important to understand that a Central Bank is just that. It is a special kind of bank - a financial intermediary with some unique powers. In the United States, the unique powers of the Fed are its ability to issue currency (actually an implicit special power, but I don't want to elaborate on that here) and its ability to issue reserves which are used in intraday payments and settlement. Unless the Fed is exploiting those special powers, it really cannot influence anything.

What can the Fed do under current circumstances? It can change the interest rate on reserves (IROR). That's a decision that can only be made by the Board of Governors - not the FOMC. We're currently operating under a floor system (for a brief rundown read this post by Todd Keister) under which, roughly, the interest rate on reserves governs the behavior of the fed funds rate, with some slippage due to the idiosyncrasies of the US financial institutional setup. The Fed can also buy and sell assets - quantitative easing (QE). Finally, the Fed can resort to forward guidance - it can tell us about its intentions for future policy.

Everyone agrees, I think, that changing the IROR matters in the current context. Not everyone agrees that QE does what the Fed thinks it does. My view is, that with a large stock of excess reserves outstanding overnight, QE is irrelevant. Basically, that's a neutrality theorem. Under current circumstances, the Fed has no advantage over the private sector in turning long-maturity assets (Treasury bonds or mortgage-backed securities, for example) into overnight assets, so QE cannot matter. To my knowledge, no FOMC member agrees with me, and blog commenters tend to call me an idiot whenever I mention this. Watch.

Finally, what about forward guidance? When the Fed first "committed" to its forward guidance policy in August 2011, I stated that I thought this was bad commitment, and would create more confusion rather than less. That initial forward guidance policy has since been extended, and now reads like this:

...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

But, the minutes of the March 13 meeting state:

It was noted that the Committee's forward guidance is conditional on economic developments, and members concurred that the date given in the statement would be subject to revision in response to significant changes in the economic outlook. While recent employment data had been encouraging, a number of members perceived a nonnegligible risk that improvements in employment could diminish as the year progressed, as had occurred in 2010 and 2011, and saw this risk as reinforcing the case for leaving the forward guidance unchanged at this meeting. In contrast, one member judged that maintaining the current degree of policy accommodation much beyond this year would likely be inappropriate; that member anticipated that a tightening of monetary policy would be necessary well before the end of 2014 in order to keep inflation close to the Committee's 2 percent objective.

So what are we to make of that? Does the forward guidance mean anything at all? I don't know about you, but I'm confused.

So, what of policies (i)-(iv) above? First, exchange rate depreciaton and higher inflation targets are not explicit policies. Exchange rate deprecation and higher inflation can be the result of policy actions by the Fed, but we can't just wish for these things and expect them to happen. Indeed, under current circumstances, the Fed simply cannot engineer a currency depreciation, or a a higher inflation rate, on its own. The IROR is not going lower. Ben Bernanke himself has stated that there are technical reasons why the IROR cannot go below 0.25%, and we're not going to get much from a quarter-point reduction anyway. Further, as I stated, asset purchases are irrelevant under current circumstances. Finally, there is enough noise in the forward guidance signal now to make that signal uninformative. Thus, exchange rate depreciaton and higher inflation are not happening, at least as the result of anything the Fed does currently.

What about targets for long-term nominal interest rates? Not happening. The Fed should not be setting a target for something it cannot control. What about money-financed tax policy? Not happening. That's the province of the Congress. Maybe you think Ben Bernanke can influence those crackpots, but you're wishing for a lot in that case.

So much for Ball's paper. But here's something interesting, which is related. Read this speech by Narayana Kocherlakota, President of the Minneapolis Fed. Speaking of turnarounds in thinking, I would not have predicted a few years ago that stuff like this would come out of Narayana's mouth.

What's Kocherlakota's view of policy under the current circumstances? He thinks that changes in the IROR matter, he thinks QE matters, and he thinks forward guidance matters. What's the model that helps him think about how to formulate policy? It seems to be some some kind of 1974-ish expectations-augmented Phillips curve. The inflation rate is determined by the output gap and the anticipated rate of inflation, and the anticipated rate of inflation in turn seems to be determined (in Kocherlakota's mind) by what the Fed says. What does the Fed care about? The output gap and the inflation rate. As is usual given this type of thinking, the idea is that we can get more output if we are willing to sacrifice by accepting a higher inflation rate.

What's wrong with that view of the world? (i) Where's the money? Inflation is always and everywhere a monetary phenomenon. Milton Friedman's quantity-theory view of the world was in several ways wrongheaded, but we can't escape the idea that the prices of goods and services are in fact the prices at which particular liabilities (public and private) are exchanged for those goods and services. The quantities of the particular liabilities in question have to be important for determining the prices. (ii) Phillips curve thinking got us into trouble before - in the 1970s - and it can do so again. (iii) If people on the FOMC think that QE and forward guidance work, those things should be in the model, so we can understand exactly how these things are supposed to work, and can evaluate the Fed's policy actions accordingly.

It's quite possible that Kocherlakota does not even believe in the model in the speech I linked to above, or in the model in this talk, for that matter. Here's a possible explanation for what is going on. Kocherlakota may think that if he stuck to what he actually knows about modern monetary economics - which is a lot - in framing arguments at FOMC meetings, that the other participants would not get it. After all, even some of the more sophisticated economists on the FOMC - John Williams and Charles Evans, for example - are Phillips curve guys. But maybe those people can be educated. I think it's worth a shot.

I think that Kocherlakota basically arrives at the correct conclusion about Fed policy here:

I would say that it would be appropriate to change the Fed’s current forward guidance to the public about the future course of interest rates. Currently, the FOMC statement reads that the Committee believes that conditions will warrant extraordinarily low interest rates through late 2014. My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.

It's the right conclusion, but it's actually inconsistent with what he's said in the rest of the speech. If he thinks that QE works, he should just want to do everything in reverse - sell the assets until excess reserves are down to zero, then start increasing the fed funds target, which will at that point in time be the policy rate. Some people on the FOMC might think this policy - reverse QE followed by increases in the target policy rate - would in fact be appropriate. What they need to understand is that QE doesn't work right now, and bad things can happen while they are learning by doing.

Lazy Macroeconomics

I wish I didn't have to do it, but it's time - once again - to stick up for economic science. Krugman has crossed the line (I know it when I see it) here. If it offends you that he offends me, then stop reading. You're not allowed to whine about Krugman-bashing. The guy deserves it, after all.

Here's Krugman's assessment of the state of modern macro:

...my sense is that a lot of younger economists are aware, even if they don’t dare say so, that freshwater macro has been a great embarrassment these past four years, and that liquidity-trap Keynesianism has done very well. This will affect future research; it will, over time, break the stranglehold of decadent Lucasian doctrine on the journals.

How would Krugman have a "sense" for what younger economists are thinking? He has little interaction with them. He does not go to conferences with them; he doesn't read their papers; he spends little time at Princeton. Mostly, he lives in Manhattan and writes a blog. The finger is far from the pulse, I'm afraid.

What is "liquidity-trap Keynesianism?" In case you have not figured that out, it's Hicksian IS/LM. That's been "successful?" How could it be? It's not structural.

What is "decadent Lucasian doctrine," and why the heck is it so decadent? Good questions. You'll have to grill Krugman on that. As far as I can tell, we are all "Lucasians" now, and that includes Krugman, who uses many "Lucasian" principles. Complaining about Lucas is something like complaining about the other Bob - Bob Dylan. The revolution happened long ago, and now everyone loves Bob and his influences are everywhere. Krugman might like it if the Bob "stranglehold" somehow let go of the profession. Too bad, Krugman, that's not happening.

Here are the last two paragraphs of Krugman's post:

And the giggles and whispers thing — in which anything resembling non-microfounded Keynesian analysis was the subject of automatic ridicule — is already, I think, over. Look at Delong/Summers on fiscal policy: the analytical core is, yes, the IS-LM model.

In a better world, Brad and I and our fellow-travelers would have achieved an immediate transformation of both policy and doctrine. We don’t live in that world. But I think we are winning the argument, in ways that will make a difference.

I don't think this is about giggles and whispers any more. We're all guffawing out loud, I'm afraid. I looked at the the DeLong/Summers paper, and you really should not waste time on that piece of trash. The analytical core is, yes, an IS-LM model. Yikes. Again, there are many reasons why we don't want to go there any more, including the ones I articulated here, and here.

In the better world I'm thinking about, we would not have to put up with arrogant loud-mouths like Paul, Brad, and their "fellow-travelers." The world these people envision is one where lazy macroeconomics has free-rein. We would forget everything we have learned in the last 40 years or so. Better still, we could set the way-back machine to 1937. Why fuss with all those bothersome details? IS-LM is so easy - and so right. If you believe that, I have a bridge to sell you.

Inflation

Now would be as a good a time as any to take stock of current monetary policy, commitments by the FOMC, whether existing policy commitments make sense given our recent inflation experience, and what we might expect for the future.

At this week's FOMC meeting, policy remained essentially unchanged. Recall that, at the January FOMC meeting, the Committee essentially committed to holding the policy rate - the key rate is the interest rate on reserves - at 0.25% through late 2014, at least. Jeff Lacker dissented again on this round, as he did at the January meeting.

The FOMC told us at the January policy round that the inflation rate it cares about is the rate of increase in the raw PCE deflator. At the most recent meeting, the Committee continued to be very optimistic about the future path for the PCE deflator, apparently. From the March 13 policy statement:

The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.

And:

...the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Further, my guess is that the FOMC thinks that, even if we start to see inflation rates that are somewhat alarming, it that it can control this inflation through the use of "reserve-draining" tools - term deposits and reverse repurchase agreements. The FOMC thinks it can have its cake and eat it too - without selling assets or going back on its "extended period" language. As well, the inflation forecasts the FOMC gave us here are very optimistic - PCE inflation rates of 1.4% to 2% going out to 2014.

So, the key messages from the Fed's current policy stance are:

1. Don't worry about the possibility of more inflation coming from oil price increases, or other commodity price inflation. That's only temporary. Just like last year.
2. We believe in the Phillips curve. Not to worry. Plenty of excess capacity out there.
3. FOMC forecasts tell us that inflation is going to remain well below the inflation target of 2%. Trust the FOMC.
4. Even if inflation starts looking pretty bad, the Fed can control it, without raising the policy rate.

Well, if I were Ben Bernanke, I would now be seriously worried. But I'm not Ben Bernanke, and I can buy TIPS, so I'm not worried, as I'm insured.

What would I be worried about, if I were Ben? After our 1970s experience, and a reading of Atkeson and Ohanian, I'm not sure why anyone thinks of inflation forecasting in terms of Phillips curves. As well, even if I were to swallow the Phillips curve - hook, line, and sinker - there are good reasons to think that there may not be any excess capacity out there. Further, in the data I'm looking at, I see plenty of reasons to think that we are in for more inflation, and one of those reasons has to do with the Fed's wishful thinking about the power of reserve-draining tools.

The first chart shows you what our recent inflation experience is. I'm showing you raw pce inflation, and core pce inflation (year-over-year % rates of change). Though raw pce inflation is coming down, it is currently above the Fed's (now explicit) 2% target. Of course, the Fed takes its dual mandate seriously, but for an inflation rate of 2.5% to 3% to be acceptable, we have to think that we are currently well below capacity. That's not clear.

In terms of conventional monetary aggregates (not including the monetary base - we know why swaps of reserves for T-bills are currently irrelevant), what we see is in the second chart. This would certainly alarm an Old Monetarist. Year-over-year percentage rates of increase in currency, M1, and M2, have been increasing since early 2010. The rate of growth in M2 is close to 20% per annum, and for currency and M1, it is close to 10%. A quantity theorist would not think of those numbers as commensurate with 2% inflation.

Of course, we're not Old Monetarists, are we? A New Monetarist thinks that, under current circumstances (a large stock of excess reserves, and the interest rate on reserves - IROR - determining short nominal rates) the inflation rate is determined by the demand for and supply of the whole gamut of intermediated liquid assets - including Treasury debt of all maturities and asset-backed securities. We can't even measure everything we want to in that respect, including shadow-banking activity. For all we know, there may be a lot of substitution going on between observed and unobserved intermediation activities. Still, the second chart does not make me optimistic about inflation.

What about measures of anticipated inflation? The next chart shows the breakeven rates implicit in 5-year and 10-year Treasury bond yields and TIPS yields. There's nothing much alarming in there, though there has been a modest increase recently in these breakeven rates, which are close to where they were pre-financial crisis. Keep in mind, though, that in early 2007 the fed funds rate was at 5.25%. It's now below 0.25% (with the IROR at 0.25%), so if we really think that we have to adjust downward our notion of current capacity in the US economy, this would tell us that the policy rate should be higher. This reasoning is of course predicated on pre-crisis policy being optimal. That's a leap, but you have to start somewhere.

Finally, I think that, in line with this idea, reverse repos and term deposits at the Fed are irrelevant currently. If quantitative easing (QE) is irrelevant at the margin, reverse repos and term deposits cannot make any difference either, at the margin. If the Fed does enough of those things, of course, that will make a difference. But we're talking about $1.6 trillion worth.

Bottom line: I think some serious inflation is coming, maybe sooner than later. The Fed thinks it can control this with reverse repos and term deposits at the Fed. No way. When will the inflation happen? In line with this post, look out for increases in house prices. The higher house prices will support more credit, both at the consumer level, and in higher-level financial arrangements. The "bubble" will grow, and support the creation of more private liquid assets, which will in turn substitute for publicly-issued liquid assets, causing the price level to rise. The Fed can control the inflation, if they want to, but only if they increase the IROR, which they are loathe to do.

Structure and Microfoundations: What We Learned in the 1970s (and before)

Noah Smith provides a convenient summary of a blogospheric conversation on "microfoundations." This illustrates a key principle, which I think we should all take to heart. If one's goal is to learn macroeconomics, one's time would be much better-spent, say, by spending a year participating in Tom Sargent's NYU macro reading group than by spending a year reading the macro blogospherians.

Some of the ideas in this post can also be found in this extended piece, if you want more detail. The term "microfoundations" comes from the Phelps volume, Microeconomic foundations of employment and inflation theory (1970), which, along with Lucas's 1972 JET paper, represents the watershed in modern macroeconomics. I have never been too fond of the term "microfoundations," as this gives you the impression that the theory is somehow hidden from view - its in the foundation, and the working parts you are seeing are some kind of reduced form. For me, the theory is not just the foundation, but the walls, the roof, the plumbing, the electrical work, etc. A macroeconomic model is a coherent whole built up from all the useful economic theory we have available. The bits and pieces are the preferences, endowments, technology, and information structure, and we tie those bits and pieces together with optimizing behavior and an equilibrium concept.

Optimization is pretty weak. It's just some notion that the people living in the fictional world we have constructed are doing the best they can under the circumstances. The circumstances could be pretty bad, in that these people may not know a lot about what is going on. They may not know things about the people they are supposed to be trading with, and/or they may not be able to observe some aggregate variables, for example. There are many equilibrium concepts - standard competitive equilibrium, Nash equilibrium, pricing using bargaining solutions, competitive search, etc. All that we require from the equilibrium concept is that it coherently yields consistency among the decisions made by individuals.

Why do we do it this way? There are two reasons. First, from the point of view of doing pencil-and-paper economics, we are going to learn a lot more. Given the structure of the model, we can evaluate how changes in the technology affect the trading arrangements among economic agents, and we can evaluate how these changes affect economic welfare in a well-defined way. We can also evaluate the effects of government policies sensibly. We have been explicit about preferences in the model, so we can theoretically determine what optimal policies look like.

Second, from the point of view of practical policy evaluation - what working economists are doing - or should be doing - in the Federal Reserve System and at the U.S. Treasury, we want models that are structurally invariant to the policies that we have constructed the model to evaluate. That's what the Lucas critique is all about, though earlier writers understood what "structure" meant. That's part of what the early work (and later work too) of the Cowles Foundation was about. See in particular the 1947 quote from Koopmans here.

Structural models are useful in other fields of economics as well - not just in macro problems. A lazy econometrician would like the data to do the work for him/her, or to design the perfect experiment that he/she can run to test a particular theory, or to evaluate a particular government policy. But the value of experimental work is debatable, and much experimental work would benefit if more weight were put on the theoretical input. Oftentimes, in any field, and particularly in macroeconomics (where experiments are typically impractical and natural experiments hard to find), researchers and policy evaluators have to invest in serious theoretical and empirical tools in order to make any progress.

But how do we differentiate between what is structural and what is not? That's very subtle. We know that any model is an abstraction, and will therefore be wrong - literally. But the art of building a good model is to make it less wrong on the dimensions we are going to use it for than on the dimensions we will not use it for. Here, we need examples to show how, if we use the structural model, we are going to do "pretty well" in terms of policy evaluation, but taking the astructural approach will give us really stupid policy. The standard example, which Lucas used in his critique paper, is the Phillips curve. Following the astructural approach, I stare at the data, and observe that the unemployment rate and the inflation rate are negatively correlated. I infer that there is a tradeoff between inflation and unemployment - I can get less unemployment if the central bank acts in a way that increases the inflation rate. Central banks in the 1970s actually acted on that advice, in spite of what Milton Friedman had said in 1968, and Lucas had written down in his 1972 structural model. Friedman and Lucas advised that no long-run Phillips curve tradeoff existed, and that exploiting any short-run Phillips curve tradeoff would be the wrong thing to do. Policymakers did not listen, and then had to spend the early 1980s correcting the inflation problem they created in the 1970s.

The Phillips curve example makes Friedman and Lucas look good, but another example makes that pair look bad. Central to Old Monetarism - the Quantity Theory of Money - is the idea that we can define some subset of assets to be "money". Money, according to an Old Monetarist, is the stuff that is used as a medium of exchange, and could include public liabilities (currency and bank reserves) as well as private ones (transactions deposits at financial institutions). Further, Friedman in particular argued that one could find a stable, and simple, demand function for this "money," and estimate its parameters. Lucas does that exercise here, and then uses the estimated money demand function parameters to measure the costs of inflation.

What's wrong with that? The key problem, of course, is that the money demand function is not a structural object. Some central bankers, including Charles Goodhart, figured that out. Goodhart's idea is a bit subtle, but there are more straighforward reasons to think that the parameters we estimate as "money demand" parameters are not structural. First, all assets are to some extent useful in exchange, or as collateral. "Moneyness" is a matter of degree, and it is silly to draw a line between some assets that we call money and others which are not-money. Second, the technology determines how different assets are used in exchange. Financial innovations made asset backed securities very useful as collateral, and in financial market exchange. Those innovations changed the relationships among what we measure as monetary aggregates, inflation, asset prices, and aggregate activity. Third, regulations matter for how assets are used in exchange. Paying interest on reserves matters; paying interest on transactions deposits at banks matters; reserve requirements matter; deposit insurance matters; moral hazard problems and how they are regulated matter.

But how structural do we want to get? More structure in our models means more detail, but more detail increases technical complexity, and we want our models to be simple. The model can't be a literal description of the world, as then it would fail to be a model, which simplifies the world so we can understand it. Nevertheless, economists sometimes pay lip service to structure while writing down models that have astructural features. If you have read Woodford's Interest and Prices, you know that he cares about structure. There are plenty of references in Woodford's book to Lucas's critique paper. But some of Woodford's work looks very astructural. Some New Keynesian analysis is done in linearized models with quadratic loss functions that capture the "preferences" of policymakers. That all looks very astructural 1975, in spite of the excuses that are typically given for taking that type of approach.

Astructural stuff is all around us - habit persistence, adjustment costs, cash-in-advance constraints, money-in-the-utility-function. Sometimes those things can be convenient short-cuts, but they have to make you suspicious. In some cases, they help you fit the data - as Larry Christiano well knows - but are not well-rooted in structure.

One thing we know from long ago is that the structural approach is completely unneceessary if all we want to do is forecast the future paths of macroeconomic variables. At the Minneapolis Fed in the late 1970s and early 1980s, Neil Wallace and Tom Sargent understood the Lucas critique and why structure was important for evaluating alternative economic policies. But no one objected to what Robert Litterman was doing, which was conducting forecasts using an astructural Bayesian Vector Autoregression. Indeed, one could argue that the behemoth Keynesian macroeconometric models developed at the Fed, MIT, and Penn in the 1960s and 1970s, and their modern counterparts are perfectly acceptable forecasting tools, though no one in their right mind would use those models to evaluate policy.