October 20, 2014

Is the Fed Behind the Curve or Jumping the Gun? By Jon Faust

Part of my job the last three years on leave at the Fed was following public commentary on Fed policy—both expert and lay commentary. There were at least two reasons for doing so. First, lots of good ideas come in, and given the difficult times we were facing, careful consideration of all reasonable ideas was the order of the day. Second, the Fed recognized that its use of unfamiliar tools gave rise to a special responsibility to explain policy. Keeping track of public commentary was an essential part of deciding what communication should focus on.

One steady theme in the commentary over the entire period was concern that the Fed would soon “fall behind the curve” with regard to containing a burst of high inflation. This was and is a serious concern. But the opposite risk—the risk of tightening too soon and causing disinflation–is also a concern. Today’s Wall Street Journal Realtime economics blog carries a piece I wrote on this topic: Is the Fed Behind the Curve or Jumping the Gun?

Read more/comment
October 18, 2014

I’m back. Faust returns from post at the Fed By Jon Faust

This fall (2014), I returned to the CFE at JHU after nearly 3 years on leave serving as Special Adviser to the Board of Governors of the Fed. It’s great to be back. I’ve returned with a wealth of knowledge and insights that probably could not have been acquired in any other way, and I’m very excited by the prospect of incorporating these insights in my research and teaching.

Bernanke and Faust

So what did I do at the Fed? Over this period the Fed’s main policy interest rate was as low as it can go and fiscal policy was a significant drag on economic activity. There is no standard central bank playbook for times like these. Thus, with Chair Bernanke and then Chair Yellen, and with the other leadership at the Fed, I spent most days thinking about, discussing, and sometimes arguing about (but no tantrums) what was most likely to be a constructive way forward. For someone who has spent a lifetime thinking about these issues, this was incredible, fascinating, and at times frightening.

Bernanke and Yellen

How did the Fed do over this period? I tend to be a tough grader. Given what we know now, I’d say that grades of A+ and D or below are probably off the table. But with the end of this chapter not yet written, an incomplete is probably the most appropriate grade for now.

I can say that in difficult times, the policy environment can become quite corrosive. The spectacle known as Congress is a daily reminder of this. Against this backdrop, the FOMC—the main policymaking body at the Fed—performed much as one might hope. Deep differences exist in society and among experts regarding the appropriate monetary policy for this period. This broad range of views was well represented on the FOMC. Firmly held differences were vigorously, but respectfully, debated. No one seemed to lose sight of the need to form a consensus policy in the face of profound unknowns. I am honored to have served these policymakers.

Back at Hopkins, I’ll be drawing on this amazing experience in my teaching and research. And over coming months I intend share some of my experiences in informal pieces on this CFE website.

It’s great to be back.

Read more/comment
October 18, 2014

Stock market drop raises lost decade fears, JHU Experts Comment By CFEGuru

The stock-market gyrations of the past week have been driven in part by worries that a stumbling Eurozone could drag down the global economy. Unemployment stands at 11.5 percent for the bloc. The troubled Spanish and Greek economies are growing again, but face jobless rates of well over 20 percent. Meanwhile, growth is stalling in the stronger countries. France appears to have flat-lined and Germany is on the brink of recession. Fears of a deflationary spiral are rising. Is this Europe’s new normal?

In the latest installment of their roundtable discussions on the Eurozone’s woes, JHU economists Jonathan Wright and Robert Barbera and political scientist Nicolas Jabko consider the region’s prospects and how things got this bad. David Dagan, a graduate student in political science, moderated the conversation.

RB: Politicians know it rarely pays to admit you erred. But I have to believe that behind closed doors, faith in the virtues of fiscal belt-tightening has to be somewhat shaken in Europe.

Previous installments: A day late and a euro short::storm tracking in the Mediterranean::Four hard truths about the euro crisis

Is Europe’s original financial crisis solidly behind it?

JW: I think the imminent threat of the Eurozone disintegrating because of its bad equilibrium – where Italy had to pay 8 percent (interest to borrow money) because it was in danger of going broke, and it was going broke because they had to pay 8 percent – that’s behind us.

NJ: I would add that the banking union also has become a reality and that this is also a damper to the crisis, in addition to changes in monetary policy. (more…)

Read more/comment
March 2, 2014

A Consistent Set of Interest Rate and Real Growth Assumptions Suggests Stable Debt to GDP Ratios in the Out years By admin

Robert Barbera and Jonathan Wright

Larry Summers recently raised the possibility of the US economy being in danger of facing a long period of subpar growth. The fear is at least somewhat reflected in several long-run growth forecasts. Table 1 shows the most recent estimates of steady state real GDP growth from the FOMC Economic Projections, Blue Chip Economic Indicators and the Congressional Budget Office (CBO). All three are 2.3-2.4 percent, more than a full percentage point below the 1955-2005 average.

Table 1: Long-run Economic Forecasts

Blue Chip
Average 1955-2005
Real GDP
Real T Bill
Real Fed Funds
Term Premium
Notes: The FOMC real GDP growth forecast is the midpoint of the central tendency of the long-run growth forecast. The FOMC real fed funds forecast is the median of the long-run federal funds rate forecast minus the PCE inflation forecast. Blue Chip forecasts are 2020-2024 average forecasts, assuming a 40 basis point spread between CPI and PCE inflation (Blue Chip forecasts CPI, not PCE). CBO forecasts are 2018-2024 average forecasts.

Over the period from 1955-2005 the 3-month Treasury Bill rate deflated by PCE inflation has averaged 1.7 percent, while the federal funds rate deflated by PCE inflation has averaged 2.2 percent. So real short rates have averaged around 2 percent. But the dismal growth outlook that is envisioned should lower equilibrium real rates. Table 1 shows forecasts for the long-run value of real short rates from the FOMC, Blue Chip and CBO. The CBO and FOMC forecasts are both exactly 2 percent. These forecasts paint a picture for real GDP growth that is quite unlike the last 50 years, but with no effect on real rates. We believe that this growth outlook should imply a materially lower equilibrium level of real short rates. In partial defense of the FOMC forecast it should be noted that they are forecasting the real federal funds rate which ought to be a little higher than the real T Bill yield. Also, four of the respondents to the FOMC projections predict a long-run value of the real funds rate of 1.5 percent, which is at least a nod in the right direction. Still the median and modal FOMC forecast is for a real funds rate of 2 percent, which is very close to its historical mean, despite a growth outlook that is far from the historical mean. The Blue Chip forecast is 1.6 percent, which at least slightly more consistent with the growth outlook than the CBO projection.

Table 1 also shows predictions of the steady-state term premium defined as the spread between long-run forecasts of ten-year over three-month yields. The CBO and Blue Chip term premium forecasts are 1.3 and 1.1 percent, respectively (the FOMC does not predict this variable). Empirical term premium estimates have been trending down over the last twenty years, and are generally now around zero. There is a potential economic story for this. In the 1980s and 1990s, inflation was the risk that worried investors most. Inflation erodes the value of a long-term nominal bond, making these bonds risky assets. But more recently, it is financial instability and recession that worries investors more. US Treasury bonds will perform excellently in this environment, and are thus a hedge against the risks that keep investors up at night. So the term premium should be lower, or indeed negative. Robert Shiller has compiled data on one-year and long-term bond yields going back to 1871. On average from 1871 to 1960, the long-term yield was 40 basis points below the one-year yield. Outside of the Great Inflation and its aftermath, there doesn’t seem to have been much of a term premium.

Now if healthy growth resumes, 1.3 percentage points might be a reasonable calibration for the term premium. But conditional on the real GDP outlook in Table 1, investors are going to be more worried about weakness and demand deficiency than an overheating economy. If one believes this outlook for activity, the term premium should be much lower—around zero, or perhaps even negative.
The CBO forecasts are incoherent. They call for a subpar outlook for growth with little consequence for the configuration of interest rates. If this unhappy growth outlook turns out to be correct, we think that the new normal for interest rates will be much lower. The same problem arises, though to a lesser extent, with the FOMC and Blue Chip forecasts.

Implications for Budget Forecasts

What happens to budget forecasts if we pencil in both a shift down for the average real short rate and a shrinking of the average term premium? The next 5 years look somewhat better. And the crisis of the next 25 years all but disappears. CBO assumes that the real interest rate on debt is 30 basis points below the real ten-year yield. For 2018 and beyond, for CBO, this is around 3%.

If we keep CBOs real growth outlook, but imagine 1.25% as the steady-state real short rate, and compress the ten-year term premium to 50 basis points, then the real interest rate falls below 1.5%. Keeping the primary deficit unchanged from the most recent CBO extended outlook, we calculate that in 2038 (25 years hence) the ratio of debt held by the public to GDP will be 76%. This is little changed from its current level, and dramatically lower than in the CBO projection.

Read more/comment
February 28, 2014

The U.S. Budget Outlook, with Consistent Growth/Real Rate Assumptions, Looks Much Less Dire! By rbarbera

Robert J. Barbera
February 27, 2014

The CBO’s recent projection of a federal-debt disaster rests critically on the combination of two projections:

1. Real interest rates will rise substantially, increasing the cost of debt service.

2. Real GDP growth will remain tepid, resulting in tepid growth in tax receipts.

Either of these outcomes might plausibly occur. But both history and basic economic reasoning tell us that there is no basis for anticipating that they will both happen. And if only one of the two happens (either one), the long term debt problem is much more modest.

The U.S. Congressional Budget Office (CBO) in early February released its revised outlook for U.S. deficits and debt. The picture is alarming. According to CBO the gap between our revenue and spending—our primary deficit—closes rather nicely over the next 10 years. Nonetheless, CBO projects that as interest rates normalize, debt-service costs are destined to mushroom. Late in the period, our deficits and debt swell as the government is forced to pay much more to borrow. And in the long run? Deficits continue to rise as demographic forces swell the primary deficit and as debt service costs grow dramatically. In 2038, 25 years from now, CBO envisions debt at around 100% of GDP, nearly a 30 percentage point jump from its current level.

Relax. No need to buy shotguns and canned peas. For starters, take comfort by looking at previous CBO projections. A little more than a decade ago, CBO envisioned a decade of near perfection that was slated to deliver an accumulated $5 trillion surplus. Sadly for all of us, that proved to be a spectacularly incorrect projection. But it is an important reminder of just how wrong long term forecasts can turn out to be.

CBO, understandably, dares not stray too far from conventional wisdom about evolving economic circumstances. And it is easy to document that consensus thinking is strikingly predisposed to embrace the recent past as a blue print for the future. That is, unambiguously, what they did in 2001. And that, it appears to me, is precisely what they are doing today.

The CBO forecast, predictably, now envisions an extension of the terribly disappointing recovery that has plagued the U.S. since 2009. Five years is a lifetime for forecasters. Five years of Brave New World Boom was all it took to allow the conjuring of a $5 trillion surplus. And after 5 years of meager growth and shrinking labor participation, CBO now sees only little additional room for swift rebound and a tired long term trajectory thereafter. Laid alongside this tale of woe, again quite predictably, they attach a very traditional rebound for interest rates. Confronted with widespread evidence of real growth disappointment, CBO ratcheted down its expansion trajectory. But with no U.S. history of economic rebounds that don’t lift rates, CBO marries a traditional rate rise to their moribund real economy forecast.

Are we destined to suffer through an extension of timid recovery, followed by a meager trend trajectory for growth? It is certainly possible. Is it reasonable to expect real interest rates will move meaningfully higher in the years ahead? Of course. But is it likely that, simultaneously, we will see an extension of weak growth, no inflation pick-up, and the normalization of real interest rates? No. Instead, for a wide variety of more reasonable combinations of growth, inflation and interest rates, deficits and debt accumulation look to be meaningfully lower than current CBO trajectories.

Real Interest Rates in the Post-War Period

Is the CBO interest rate forecast at odds with conventional wisdom about likely prospective interest rate changes? Absolutely not. There is widespread agreement that, in the fullness of time, interest rates will return to normal. And when asked what constitutes, in normal times, a neutral real fed funds rate, 2% is answer most economists offer up. That is true among private forecasters. And that is also the view held by many Federal Reserve officials. Indeed, each of 17 Fed officials provided their opinions on the ‘longer run’ fed funds target in early February of this year. The average expectation was 1.9%, with 2% was both the median and modal value (see FRB Monetary Policy Report, February 11, 2014).

Broad sweeping comfort with 2% as the neutral real short rate is close to the reality of post war U.S. economic history (see table). But post War U.S. history was a world of a bit more than 3% real GDP growth. As the table above details, for the ten and fifty year periods ending in 2005—on the eve of the Great Recession—U.S. Real GDP growth averaged a bit more than 3%.

To belabor the point, real short rates of a bit less than 2% travel hand in hand with real GDP growth of a bit more than 3%. To state what should be obvious, if we are bound to settle into a world of limited growth and low inflation, real rates are quite unlikely to rebound to levels witnessed in the halcyon days of 3% plus economic expansions.

CBO’s Incorporates of Plunging Participation

Why capitulate to the notion that we destined to grow slowly? CBO now believes that the labor market will be moribund state for the long haul. Their major downward real GDP revision, 2014-2018, reflects their embracement of the recent plunge for the jobless rate. As we all know, a major part of the fall for unemployment reflects the striking drop for labor force participation. CBO now has joined analysts at the Bureau of Labor and Statistics, and believes this drop is permanent. Accordingly, they look upon this as evidence that much of the output gap is now filled and there is less room to grow before we run up against capacity constraints.

Labor Force Participation: 25 to 54 Year Olds

Is the decline for participation structural, a development independent of the Great Recession? It may well turn out to be structural, as a persistently lackluster economy limits job opportunities over the long haul. But as the above chart reveals, it is almost impossible to argue that the fall in participation largely reflects demographics. Around 83% prime age workers identified themselves as in the labor force, from 2003 through 2007. As the economy swooned so too did the participation of this group. To state the obvious, 25 to 54 year olds are not retiring early.

Lower Potential GDP and Less Near-Term Economic Growth

The capitulation to a much smaller labor force led CBO to dramatically cut its measure of the U.S. output gap. In turn they sharply reduced their estimate for real growth, 2015-2017, and at the same time allowed the U.S. economy to achieve full employment in 2018:

And in the end? Full Employment Translates to Normalized Interest Rates:

But look at the change in employment growth!

I spent much of my career in finance. Speculators in the U.S. bond market, over that 30 year period, revealed to me a profound interest in the pace of employment growth. Grudging increases in payrolls, in low inflation circumstances, were almost always accompanied by falling interest rates. For me, therefore, the most telling disconnect embedded in the CBO forecast, was the willingness to simultaneously slash their employment growth forecast and modestly raise their forecast for long term interest rates.

The Error That Keeps on Giving

In 2001 CBO asserted Americans were to be blessed with 10 years of strong productivity, healthy employment gains and record levels of labor force participation. Inexplicably high individual income tax payments would persist. Bear markets, recessions and wars would all stay away. Over the 2001-2011 time-frame we were set to collect trillions, ending the forecast period, in 2011, with a budget surplus of more than 5% of GDP. There were, of course, skeptics, at the time. I was one of them (see The Bubble Budgets, Financial Times 2001). But the great majority embraced the super surplus story. It didn’t require anyone to dream dreams. All you needed do, to believe in these riches, was to imagine that the next ten years would, in most respects, approximate the last five years. A steady as she goes forecast landed you in Shangri La by decade’s end.

Of course that is not exactly how things worked out. Instead we witnessed a stock market crash, wiping out the inflated individual income tax payments, a recession, ill-timed tax cuts, two wars, a spectacular financial crisis and a big recession. In short, almost everything that could drive the deficit higher came to pass. The end result? Deficits reappeared and then soared. The 2011 deficit was over 8% of GDP—quite a miss, relative to the 5% surplus expectation championed in the 2001 outlook.

The 2014 forecast, I think, suffers from the same kind of myopia that helped create the 2001 outlook. The forecast embraces a paltry growth trajectory. Why? Powerful reasons are given, but they all amount to elaborations of the same simple linkage:

               We expect a disappointing backdrop, because the backdrop for too long—five
               years—has been disappointing.

In effect, CBO is saying, that notwithstanding a 50 year history of 3% real growth for the U.S. economy, the last five years are sufficient to allow them to assert that those longstanding trends are now a thing of the past. So just as CBO dismissed worries about excessive options income, the ineluctable arrival of recessions and a myriad of other things as they promised a $5 trillion boon, they now dismiss the prospects for any meaningful recovery and project a dismal backdrop as far as the eye can see.

In 2001 I was adamant that the vision of eternal bliss was bound to be very wrong. Indeed, forecasting that eternal perfection was unlikely was about the easiest pronouncement I ever made. In current circumstances, I cannot say I KNOW CBO’s pessimism on growth is unfounded. The point, however, is that the pessimism they champion on the deficit and debt outlook, is almost certainly unfounded. And that, of course, is because the debt explosion is almost entirely a product of the mismatch they have with dismal growth and normal real interest rates.

The CBO effort is therefore captive to a much more insidious computation. Again, for emphasis, the forecast embraces a traditional rise for interest rates, notwithstanding no climb for economic growth. I guess the charitable thing to say is that, having no evidence that things should be different for interest rates, they impose a ‘more of the same’ interest rate forecast—a move to a 1990s invented Taylor Rule neutrality. And lo and behold we are in a debt service crisis.

But the crisis disappears if interest rates reconcile themselves with the rotten real economy outcome. Likewise the crisis evaporates if real growth returns to a more traditional trajectory. My own tastes lean toward the second notion. An Irish colleague of mine at Johns Hopkins thinks the pessimism on the economy is justified. We like to think our different biases reflect stereo-typical differences between American and Gallic sympathies. But we completely agree on the point of this essay. Deficit and debt possibilities are much less threatening if we demand coordinated opinions about interest rates and real economy trajectories.

Read more/comment
September 23, 2013

Saint Louis Fed Research Assistant Positions By Jonathan Wright

Please see the attached recruiting notice.

FRB-STL RA Recruting Flyer

Read more/comment
September 23, 2013

NY Fed Research Assistant Positions By Jonathan Wright

Graduating seniors (especially those minoring in Financial Economics) might be interested in working as a research analyst at the NY Fed. Please see the attached for more info.
NY Fed Research Analyst Brochure
NY Fed Research Analyst Job Description
NY Fed Research Analyst Poster

Read more/comment
September 19, 2013

The Euro Crisis: Four Hard Truths By admin

German voters go to the polls on Sunday to determine the future leadership of their country – and perhaps the future of the Eurozone, as well.

With the continent’s largest economy, and the political clout to match, Germany is a central player in the Euro crisis.

Odds are good that Chancellor Angela Merkel, who has been criticized for pushing crisis-stricken governments to drastically curb their spending, will be reelected. However, her Christian Democratic party may have to form a coalition with parties whose fiscal stance is less hawkish.

Economists Robert Barbera, Olivier Jeanne, and Jonathan Wright and political scientist Nicolas Jabko recently outlined the challenges still facing the common currency. Speaking at a forum with graduate students at the Johns Hopkins Department of Economics, the scholars pointed out four hard truths the new German leadership – and all of Europe’s politicians – will have to confront to get Europe back on track. David Dagan, a graduate student in political science, wrote this summary of their discussion.

1) This crisis was not caused by government debt

The Euro crisis was touched off by the profligate fiscal policies of the Greek government, but focusing on this triggering event in isolation can be misleading. The majority of the debt that ended up going sour in Europe was privately held: Spain and Ireland, in particular, fell victim to housing bubbles in the American mould. What’s more, much of the problematic Spanish and Irish debt was originally issued by German banks, Barbera and Wright noted.

As in the U.S., the tailspin in the private credit markets posed a mortal threat to European banks, who had to be bailed out by their governments. It was these bailouts that then created giant public-sector liabilities.

“It’s only in Greece that it really was fundamentally a pure government fiscal problem, and yet the narrative of ‘Where the Eurozone crisis comes from’ seems to fit the Greek story and no other story,” Wright said.

2) Austerity was a political choice – and not just in Germany

Merkel has taken a lot of heat for her insistence that countries deeply slash government spending in exchange for aid packages. Berlin’s emphasis on austerity is often explained in almost psychological terms, as the product of the myopic economic views of German elites – particularly, a morbid fear of inflation.

Not so fast, Jabko said. Austerity won the day largely because it was a politically savvy choice. The austerity prescription grew directly out of the narrative that the Eurozone crisis had been the product of irresponsible government spending. And that narrative was useful to politicians of all stripes.

In Germany, this story allowed politicians to evade questions about how Berlin had contributed to the crisis. Otherwise, there could be uncomfortable questions about the lending practices of German bankers in southern Europe. Similiarly, it might be noted that Germany had spurred the southern-Europe bubble by dragging down Eurozone interest rates in the early 2000s, when its economy was hurting.

But don’t just blame the Germans, Jabko said. Many observers say that Germany forced austerity on its struggling EU partners – but that is not the whole story. The same narrative of profligate spending was adopted by many opposition politicians in the crisis-stricken countries, too. This move allowed them to score political points against ruling parties and ultimately to take over the levers of power. Once in government, these politicians brought the story to its logical conclusion by imposing austerity, and they were often able to evade responsibility for these painful policies by blaming incumbent governments as well as foreign creditors.

3) Either German workers do better, or southern workers do worse

Jeanne explained that the Euro’s financial crisis is rooted in a deep structural problem: Germany makes things more cheaply than southern Europe. The Germans hold that advantage for two reasons: first, they are more productive per labor-unit than most countries, and second, labor and business have cooperated to hold wages down over the last decade.

The imbalance in production costs leads directly to an imbalance in the terms of trade: southern European countries buy much more from Germany than they sell back to Germany. And such a trade imbalance is always accompanied by an increase in foreign indebtedness. In other words, the debt plaguing southern Europe is a logical result of underlying imbalances in the real economy.

For these imbalances to be corrected, the costs of production between Germany and its neighbors must even out. And there are two ways to make that happen: lower wages in southern Europe, or raise wages in Germany. Put simply, either German workers get paid more, or southern workers get paid less.

Of course, higher wages are not all good news for the Germans. They would produce higher inflation, which hurts savers – and Germany is a nation of savers. A recent paper estimates that Germany would need to experience an inflation rate of 4 percent annually for five years, coupled with zero inflation elsewhere for the same period, to close the gap with its neighbors.

4) A breakup leaves Germany on the hook, too

But before Germans refuse to swallow that bitter pill, they should consider something else. As Wright explained, the architecture of the European banking system leaves them extremely vulnerable in the worst-case scenario of a disorderly breakup of the Eurozone. At the moment, capital is flowing into Germany like beer at Octoberfest. The reason is that bank deposit insurance does not insure against the risk of currency breakup. If Spain leaves the Euro, then Spanish bank deposits will still be insured, but the payment will be in devalued pesetas.

The mechanics of these deposit transfers matter profoundly, however. In a single currency area, the deposits are transferred by the Bundesbank – Germany’s central bank – making a loan of equal value to the Spanish central bank. And that’s not good news for the Germans. Because the same risk that motivated the original depositors to shift their assets – the prospect of a Spanish exit from the Euro resulting in a devaluation of debt – now resides with the Bundesbank.

Read more/comment
July 31, 2013

Real GDP Revisions: A Better 2012, Front Loaded By rbarbera

The Q2:2013 rise for real GDP, 1.7%, was better than expected and much better than feared. The two big misses, relative to expectations, were a contribution from inventory investment and only a modest drag from government spending. Raw data on stockpiling suggested a big drag from inventory investment. Not so. In addition, the drag from government was considerably smaller than expected—sequester notwithstanding.

More interesting, I think, was the revision to back years. The two quarter average for real GDP growth, Q4:2011-Q1:2012, was previously estimated to be 3%.  Recall that during this period we now see a boomlet in payroll jobs gains—the average monthly increase is 226,000. According to this morning’s revisions, those hefty job gains now are associated with a much more substantial 4.3% annualized real GDP growth rate.

The full year growth rate for 2012 now stands at 2.8%, substantially higher than the 2.2% pace initially estimated. As it turns out the jump for both Q4:2011 and Q1:2012 real GDP overwhelms the effects of mild downward revisions for later quarters (see below):

2011:Q4 2012:Q1 2012:Q2 2012:Q3 2012:Q4 2013:Q1 2013:Q2 Year 2011 Year 2012
Original 4.1 2.0 1.3 3.1 0.4 1.8 1.0 1.8 2.2
Revised 4.9 3.7 1.2 2.8 0.1 1.1 1.7 1.8 2.8
Difference 0.8 1.7 -0.1 -0.3 -0.3 -0.7 0.7 0.0 0.6

And going forward? ADP’s tally of July job growth, at 200,000, was impressive. Whatever the effects of sequester, they should be history by this year’s fourth quarter. An economy growing at near 3%, the revised full year 2012 figure, still makes sense to me.

Read more/comment