Did Bill Gross get some insight from this blog? Maybe but it might (unfortunately) be outdated

The legendary Bill Gross – formerly of PIMCO and these days Janus Capital – does not believe in a hike from the Federal Reserve this year. This is what he has to say about the issue according to a Tweet from Janus Capital:

Fed really tracks Nominal GDP, which since 2012 and last 12 mos avg 3.6%. Unless it moves higher fugetabout a hike. 4th Qtr? 3.0.

I of course to a very large extent agree. In fact I have long been making exactly the argument that the Fed since the second half of 2009 effectively has been targeting 4% NGDP growth.

The first time I argued that was in the blog post The Fed’s un-announced 4% NGDP target was introduced already in July 2009 back in September last year.

I would course love the Fed to in fact target 4% NGDP growth (level targeting), but I am afraid that the Fed has been moving away from this un-announced target in recent months since Janet Yellen took over as Fed chair.

Hence, back in August in my blog post Yellen should re-read Friedman’s “The Role of Monetary Policy” and lay the Phillips curve to rest I argued that Yellen’s had caused the Fed (or rather the FOMC) to shift focus from monetary/nominal factors and towards the labour market and more specifically towards a focus on a rather old-school style Phillips curve.

Yellen’s argument essentially is that inflation is not a monetary phenomena, but rather a result of lower unemployment, which causes wage growth to accelerate, which in turn push up inflation. This is what presently – due the the “low” level of unemployment – seems to be the driving force behind Yellen’s hawkishness.

As a consequence, I am not sure that Bill Gross is right. I would love him to be right, but I am afraid that Bernanke’s de facto 4% NGDP target might not be as rock solid anymore.

Another factor that is pushing the Fed in a more-than-good hawkish direction seems to be the influence of Fed vice-chair Stanley Fischer who has the responsibility for “macroprudential” analysis at the Fed. With a focus on macropru Fischer seems to increasingly thinking the Fed should worry about bubbles and imbalances in the US economy (I by the way see no signs of bubbles – see here what I wrote back in June on the issue.)

Any monetarist would of course be deeply skeptical about the Fed’s ability to spot bubbles and even more skeptical about its ability to do anything about them. However, Fischer does not share that view and it seems to me that he is causing the Fed to become overly worried about these issues.

I am not in the business of making forecasts on this blog, but I can only say that I am less certain about the Fed’s policy rule today than I was a year ago.

A year ago I would without hesitation have said that the Fed of course was targeting 4% NGDP growth and since NGDP expectations (according to prediction markets such as Hypermind) presently are falling somewhat short of this “target” there would be no reason to believe the Fed would hike. However, with Yellen’s Phillips curve focus and Fischer’s macroprudential focus I am beginning to worry that we might be getting “off track” from the 4% NGDP.

I certainly hope I am wrong and I would very much hope that the Fed would clearly articulate that it was targeting 4% NGDP growth for the medium-term and that it will set monetary parametres to hit this target.



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Macroprudential follies and procyclical central bankers

A couple of days ago I came across an article from Bloomberg, which I think is very telling about everything which is wrong about the recent hype about macroprudential policies.

This is from Bloomberg:

When Katja Taipalus came home from school every day in the Finnish town of Jalasjaervi, she knew her working parents wouldn’t be there. Instead, her retired grandfather, who also lived in the large wooden house, played cards and other games with her. They even repaired a car.

Those discussions taught her to stay focused when she became an economist and her research hit a dead end, she says. The end result: an indicator that helps detect asset-price bubbles in equity and housing markets — as much as a year in advance.

“Asset prices have been one of the main components as financial crises have built up,” she said in the Bank of Finland’s historic teller hall in Helsinki, its walls decorated with giant tapestries. “If we think of the tools needed to allow policy makers time to react,” one of the main ones is “getting a signal as early as possible about an asset-price bubble in the making.”

Drawing up the indicator earned Taipalus her Ph.D. last year at the University of Turku, after four-and-a-half years of study alongside full-time work at the Finnish central bank. She heads the macroprudential-analysis division of the financial-stability and statistics department, running a team of seven economists and experts who work on analysis and applied research.

There you got it. The head of macroprudential analysis in Bank of Finland apparently is able to “forecast” every major turn in the US stock market the last 140 year! (See her paper on the issue here)

I don’t know anything about Ms. Taipalus’ private wealth, but if this is true she have to be a very wealthy person indeed. If you are able to build such a model you should be able to make enormous profits. But the truth is of course that you cannot really build a model that can do this. Economists, speculators and charlatans have tried to do this as long as we have had financial markets and the truth is that nobody consistently is able to beat the market.

Yes, we might find indicators and models that might historically have worked, but the point is that once these model or indicators becomes known they will breakdown as everybody would start to use them. This is the case of stock markets and it is the the case in the  baseball market (See here why Oakland A’s stopped winning).

You might think that this is Econ 101, but nowadays central bankers increasingly think they can beat the markets. This is at the core of macroprudential thinking. Central bankers will design models and indicators to spot bubbles and imbalances in the economy and use these models to counteract “excesses” in the financial sector by increasing for example capital and liquidity ratios. I personally find the theoretical and empirical foundation for this extremely flawed.

The proponents of macroprudential policies fail to understand the basic truth of Goodhart’s Law – When a measure becomes a target, it ceases to be a good measure. It is that simple.

Procyclical central bankers

Another very serious flaw in macroprudential thinking is that not only is it assumed that central bankers can beat the market, it is also assumed that central bankers are benevolent dictators who will always do the right thing when they spot a bubble. However, we all know that central bankers are far from all-knowing benevolent dictators – if they were then there would never had been any crisis at all.

I certainly did not hear many central bankers who both warned about the risk of crisis prior to 2008 and at the same time initiated policies to avoid the crisis unfolding. In fact I only remember debating numerous central bankers prior to 2008 who all consistently said that everything was just fine.

A way to illustrate central bankers abilities to beat the market and use that information to their own advantage is the management of foreign exchange reserves. If central bankers indeed are more clever than market participants then one should expect FX reserves to to yield an higher and less risky return than for example privately managed pension funds.

Unfortunately most central banks are not exactly transparent about their ability to manage FX reserves so it is hard to find any good comparison between central bankers and private sector asset mangers abilities to undertake asset allocation. But as far as I can see there is absolutely no evidence that central bank asset managers consistently beat private sector asset managers.

I have found a quite interesting IMF study – Procyclicality in Central Bank Reserve Management: Evidence from the Crisis – by Jukka Pihlman and Han van der Hoorn from 2010, which should give serious doubt about central bankers abilities in terms of spotting bubbles. Just take a look at the abstract:

A decade-long diversification of official reserves into riskier investments came to an abrupt end at the beginning of the global financial crisis, when many central bank reserve managers started to withdraw their deposits from the banking sector in an apparent flight to quality and safety. We estimate that reserve managers pulled around US$500 billion of deposits and other investments from the banking sector. Although clearly not the main cause, this procyclical investment behavior is likely to have contributed to the funding problems of the banking sector, which required offsetting measures by other central banks such as the Federal Reserve and Eurosystem central banks. The behavior highlights a potential conflict between the reserve management and financial stability mandates of central banks. This paper analyzes reserve managers’ actions during the crisis and draws some lessons for strategic asset allocation of reserves going forward.

Concluding, central banks during booms tend to take on more risk – they overweight risky assets – while they during busts tend to reduce risk – underweight risky assets. Hence, central banks consistently act in a procyclical fashion.

This is of course is not only bad in terms of ensuring the highest and most stable return at the lowest possible risk, but it also adds to the swings in the economy as the central bank will add liquidity to the financial system during booms and redraw liquidity during crashes.

As the authors of the IMF study states:

When the crisis hit (in 2008), many central banks withdrew these investments, in some cases rather abruptly, in ways very similar to commercial asset managers. Traditionally very conservative investors, with a low appetite for risk, the crisis response of reserve managers was perhaps unsurprising—and from an individual reserve manager’s perspective even rational—yet the withdrawal of central bank investments also put further pressure on the banking sector when other sources of funding dried up simultaneously and spreads exploded. In some countries, the withdrawal was unavoidable, as reserves were urgently needed for intervention or to finance domestic support measures during the crisis. In most countries, though, reserves were not used, or the amount used was much smaller than the withdrawal of investments from the banking sector. In each case, and certainly in aggregate, reserve managers acted very procyclically, and may well have been in conflict with the more prominent financial stability objectives of the central bank. Through such behavior, reserve managers may have contributed, albeit unintentionally, to the funding problems in some banks, and have forced an even stronger policy response by the authorities in countries issuing a reserve currency.

The authors also quotes a yearly survey of Reserve Management Trends (RMT) from Central Banking Publications. This is from RMT in 2007 – one year ahead of the crisis:

“The trend for central banks to invest in riskier assets in the search for yield has continued…Many respondents gave what they saw as the reason for the continuation of this trend. In particular, several emphasised the low-yield environment.”

So it might be that the head of macroprudential analysis at the Bank of Finland can forecast all stock market busts one-year in advantage, but apparently her colleagues in most central banks of the world did not have access to her models. Too bad…

So I remain skeptical about the usefulness of macroprudential policies – in fact I believe that an over-reliance on such policies could lead to an increase in the volatility and fragility of the global financial system rather than the opposite.

The Danger of an All-Powerful central bank – against macroprudential policies

I have often disagreed with the views of University of Chicago Professor John Cochrane over the paste five years. However, his latest oped in the Wall Street Journal is spot on.

In the oped Cochrane questions the rational for the increasingly common view that central banks should pursue “macroprudential” policies to reduce the risks in the financial sector.

This is Cochrane:

Interest rates make the headlines, but the Federal Reserve’s most important role is going to be the gargantuan systemic financial regulator. The really big question is whether and how the Fed will pursue a “macroprudential” policy. This is the emerging notion that central banks should intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability.

For example, the Fed is urged to spot developing “bubbles,” “speculative excesses” and “overheated” markets, and then stop them—as Fed Governor Sarah Bloom Raskin explained in a speech last month, by “restraining financial institutions from excessively extending credit.” How? “Some of the significant regulatory tools for addressing asset bubbles—both those in widespread use and those on the frontier of regulatory thought—are capital regulation, liquidity regulation, regulation of margins and haircuts in securities funding transactions, and restrictions on credit underwriting.” 

This is not traditional regulation—stable, predictable rules that financial institutions live by to reduce the chance and severity of financial crises. It is active, discretionary micromanagement of the whole financial system. A firm’s managers may follow all the rules but still be told how to conduct their business, whenever the Fed thinks the firm’s customers are contributing to booms or busts the Fed disapproves of.
I completely agree with Cochrane.

Macroprudential policies might very well develop into ad hoc and completely discretionary policies rather than a rule based monetary and financial policy regime. That is certainly not the direction we would like to see monetary policy move.

Cochrane continues:

Macroprudential policy explicitly mixes the Fed’s macroeconomic and financial stability roles. Interest-rate policy will be used to manipulate a broad array of asset prices, and financial regulation will be used to stimulate or cool the economy.

I think this is an extremely important point to make. The purpose of monetary policy is to provide nominal stability – either in the form of an inflation target, a price level target or an NGDP target and fundamentally the central bank basically only have one instrument to hit that – increasing or decreasing the money base. It is the Tinbergen rule – one policy instrument, one policy target. It is Econ101.

If the central bank starts to take into account macroprudential “targets” then it would have to put aside other targets. A good example of this kind of “mixed message” in monetary policy has been the conduct of monetary policy in Sweden in the last couple of years where the Riksbank increasingly has focused on macroprudential indicators – for example property prices and household debt – in the conduct of monetary policy.

The result has been that Swedish monetary policy has been tighter than it otherwise would have been if the Riksbank had only focused on it’s official inflation target. The result has likely been that Swedish unemployment is higher than it would have been if the Riksbank consistently pursued its official inflation target and there is very little – if any – evidence that the Riksbank’s policy has increased financial stability in Sweden.

In fact in a recent paper former Riksbank deputy governor Lars E. O. Svensson shows “that a higher policy rate leads to a higher debt ratio, not a lower one. This result may be surprising to some, at least at the Riksbank, which has apparently made a sign error in its assumptions. The result is actually quite easy to understand once one carefully considers how debt, GDP and inflation are affected by a higher policy rate.”

I think Svensson’s paper quite clearly shows the dangers of having macroprudential policy dominating monetary policy making.

Central banks have a lousy track-record on detecting “bubbles”

Back to Cochrane:

It’s easy enough to point out that central banks don’t have a great track record of diagnosing what they later considered “bubbles” and “systemic” risks. The Fed didn’t act on the tech bubble of the 1990s or the real-estate bubble of the last decade. European bank regulators didn’t notice that sovereign debts might pose a problem. Also, during the housing boom, regulators pressured banks to lend in depressed areas and to less creditworthy customers. That didn’t pan out so well.

Yes, markets are often wrong, but there is very little (no) evidence that central bankers are better at diagnosing “bubbles” and “systemic” risks. Hence, it is not a question whether markets are good or bad at forecasting bubbles. The question is whether regulators better than market participants in spotting bubbles?

It is also correct that moral hazard problems might mean that private investors will ignore or downplay risks and that is an argument for certain regulations of the financial sector. However, my own personal experience is that regulators often are extremely reluctant to utilize their regulatory powers when it is “obvious” that there is a bubble of some kind.

In 2006 I co-authored a paper forecasting a major macroeconomic and financial crisis in Iceland and in a number of papers in 2007 I made similar warnings about the risks to the Baltic economies. Unfortunately the warnings turned out to be correct. The “crash” predictions were essentially based on macroprudential analysis and in that sense one can of course say that this shows the effectiveness of macroprudential analysis. Macroprudential analysis have long also indicated that something could go badly wrong in India – however, the Reserve Bank of India has done little if anything to act to avoid these risks neither has the Indian government.

Even though I thought it was quite obvious that both the Icelandic and the Baltic economies were heading for a major crash the local regulators in both Iceland and the Baltic States were extremely hostile towards these warnings and they completely failed to act before it was too late. In fact the regulators in more than one case acted as “cheerleaders of the boom” rather than defenders of financial and macroeconomic stability. This of course added to the feeling among investors that nothing could go wrong.

Hence, even if macroprudential analysis can in fact diagnose “bubbles” and systemic risks it is in no way given that that will lead regulators to take the right actions (never forget the Iron Law of Public Choice). The Icelandic crash is sad testimony to that. So is the Baltic crisis.

Cochrane’s policy advice  

Cochrane has good policy advice:

First lesson: Humility. Fine-tuning a poorly understood system goes quickly awry. The science of “bubble” management is, so far, imaginary.

Consider the idea that low interest rates spark asset-price “bubbles.” Standard economics denies this connection; the level of interest rates and risk premiums are separate phenomena. Historically, risk premiums have been high in recessions, when interest rates have been low.

…Second lesson: Follow rules. Monetary policy works a lot better when it is transparent, predictable and keeps to well-established traditions and limitations, than if the Fed shoots from the hip following the passions of the day. The economy does not react mechanically to policy but feeds on expectations and moral hazards. The Fed sneezed that bond buying might not last forever and markets swooned. As it comes to examine every market and targets every single asset price, the Fed can induce wild instability as markets guess the next anti-bubble decree.

Third lesson: Limited power is the price of political independence. Once the Fed manipulates prices and credit flows throughout the financial system, it will be whipsawed by interest groups and their representatives.

Hear, hear…Cochrane is right – central banks need to return to rule based monetary policies. Macroprudential policies on the other hand might risk moving us away from rule based policies and towards a regime where central bankers become firefighters.

PS I am not arguing that macroprudential analysis cannot be useful. It can be a good tool for market participants and (non-central bank) regulators, but monetary policy should focus on ensuring nominal stability. Nothing else.

PPS If central bankers really need a good macroprudential indicators then the best indicator might be to look at the growth and level of nominal GDP.

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