They run from your love!

Dale Earnhardt Jr. Jr. everybody:

Progress at the Fed

I am a forward guidance skeptic. At heart, I'm an "expectations channel" skeptic. But, if the Fed is going to give forward guidance, having it be based on benchmarks rather than the calendar seems clearly better to me.

The idea is rather than saying, "rates at zero til 2015", to say "rates at zero til unemployment falls to X% or inflation rises to Y%".

Of course, picking X and Y is not an easy task. Bernanke might think X=7 and Y=2.5, while Krugman might be more of an X=4 and Y=10 kind of guy.

Charles Evans is given credit for pushing this path, and Janet Yellen, the Fed vice chair seems to be a recent convert.

Obama's re-election gives the Fed a lot more breathing room to experiment with these non-traditional policies, so I give Yellen political astuteness points for holding her fire until after the election.

I still don't see benchmark forward guidance as anything remotely resembling an effective medicine to cure the economy, but it is a better form of guidance than calendar guidance, even though all the caveats about time consistency, binding future Feds, and political pressure still apply equally.

 

MacGarch

Models with a persistent, time-varying error variance (i.e. GARCH) models, are mainly used in Macro to investigate whether uncertainty affects the conditional mean (i.e. GARCH-M).

However, even if we are not modeling GARCH in Mean effects, ignoring conditional heteroskedasticity, or "correcting" our coefficient standard errors for it by a White-type of correction can be problematic.

For one thing, a maximum likelihood approach can have almost infinite relative efficiency gains over OLS. Thus in a VAR context, ignoring the conditional variance-covariance process, can lead to poorly estimated coefficients and thus poorly estimated impulse responses.

For another, White (or Newey-West) standard errors are not generally appropriate in the case of a GARCH variance process.

Jim Hamilton has a great piece about these phenomena, with a couple interesting examples of how dealing with the conditional variance can change inferences about the conditional mean.

This is a situation I've seen in my own work. Here is an older piece with Mark Perry in the Journal of Finance about liquidity effects, and here is a joint piece with Haichun Ye in Economic Inquiry about the twin deficit phenomenon. In both cases modeling the conditional variance process changed inferences about the conditional mean.

Here is a recent piece by rising macro star Olivier Coibon in the AEJ: Macro which also demonstrates the importance of modeling the conditional variance process.

GARCH (or Stochastic Volatility if you prefer) in macro is still way under appreciated and under used.

Put a bird on it

LeBron links to Stephen Williamson's post about the statistical problems inherent in calculating the vague and unobservable path of "potential output", especially when using the HP filter. I recently criticized the CBO's approach.

This is a sad but general problem in modern macro. Theories are built around unobservable variables. To calculate the output gap, we need potential output, but it's not observable. In growth & development, many issues hinge on the behavior of total factor productivity (TFP), but it is also unobservable.

Modern business cycle theory has made an art form of this. In seeking to better replicate real world data, more and more driving shocks are needed. So we discover that "shocks to the mark-up" for example (or shocks to "preferences") are now an important force in business cycles. These shocks too, are unobservable and receive even less scrutiny than do potential output or TFP (they are typically not ever displayed or forced to pass an "eyeball" test of reasonableness).

Modern business cycle theory also frequently uses the HP filter to produce the business cycle data that it calibrates to or uses for estimation. This use of the HP filter is no less problematic that the use criticized by Williamson in the original linked post.

People, when you read or hear people talking about unobservables like they were data, it's good to remember that the series in question were created by someone using a model with assumptions and limitations. Ask them to show you their series, to defend its derivation and its time series properties.

The bottom line is that no one knows what potential output is or what TFP is. I certainly don't agree with Williamson and Lacker that we are currently at or near maximum output/employment, but I do agree that we have no idea exactly how far away from that point we are currently operating.

Not so fast, Noah!

Noah Smith lets his freak/scientist flag fly. Says he can't conform to tribal thought because he has to follow scientific principals.

Sounds good, and I agree with a lot of what he's saying.

But then he lets fly with this:

"RBC models say that small government is good."

YIKES!

Where to start?

Real Business Cycle models do not "speak" with one voice.

Most people who advocate for small government wouldn't know an RBC model if it bit them it the butt.

Very few people actually use RBC models in this day and age. Virtually all models now have monetary sectors and some form of monetary non-neutrality and are thus referred to more generally as DSGE (dynamic, stochastic, general equilibrium) models. RBC theory is a useful teaching tool, but I don't know anyone using it as a guide to policy.

I have never seen in any RBC or DSGE paper I've read (which easily would be 100+ papers) a statement like "thus we see small government raises welfare". Perhaps Noah is inferring his statement from the fact that some early RBC models didn't have government in them? Or that some early RBC models argued that business cycle fluctuations were optimal? I'd be very curious to see the money quotes to support Noah's statement.

If I do think to think about some type of generic RBC model, the government could easily have a large and important role as a funder of basic research leading to improved technological progress.

Plosser!

Great speech by Charles Plosser. It starts with a nice concise history of the evolution of mainstream macro  which leads into a set of suggestions for research on monetary policy.

Well worth reading in its entirety, but here is the money quote:


Fourth, and related, macroeconomists need to consider how to integrate the institutional design of central banks into our macroeconomic models. Different designs permit different degrees of discretion for a central bank. For example, responsibility for setting monetary policy is often delegated by an elected legislature to an independent central bank. However, the mandates given to central banks differ across countries. The Fed is often said to have a dual mandate; some banks have a hierarchal mandate; and others have a single mandate. Yet economists endow their New Keynesian DSGE models with strikingly uniform Taylor-type rules, always assuming complete credibility. Policy analysis might be improved by considering the institutional design of central banks and how it relates to the ability to commit and the specification of the Taylor-type rules that go into New Keynesian models. Central banks with different levels of discretion will respond differently to the same set of shocks.


 Let me offer a slightly different take on this issue. Policymakers are not Ramsey social planners. They are individuals who respond to incentives like every other actor in the economy. Those incentives are often shaped by the nature of the institutions in which they operate. Yet the models we use often ignore both the institutional environment and the rational behavior of policymakers. The models often ask policymakers to undertake actions that run counter to the incentives they face. How should economists then think about the policy advice their models offer and the outcomes they should expect? How should we think about the design of our institutions? This is not an unexplored arena, but if we are to take the policy guidance from our models seriously, we must think harder about such issues in the context of our models.

Shout it from the rooftops!

Angus impossibility theorem

Here it is:

There is no such thing as a purely micro-founded macro model that is actually useful for forecasting.

The original RBC models were, more or less, purely micro-founded models. But, they didn't track anything. They could match some unconditional moments, but couldn't replicate realistic dynamics.

People, we don't even have very good micro foundations for money! We just put it in the utility function or arbitrarily assume a "cash in advance" constraint. That's one reason why the original RBC models didn't even contain money.

Amazingly to me, Central Banks in the Western world have spent a lot of money and economist-hours trying to construct dynamic stochastic general equilibrium (DSGE) models that are actually useful for forecasting.

This effort has largely led to the de facto abandonment of micro-foundations. In the quest to make the models "work" we often either choose whatever micro-foundation that gives the best forecast regardless of micro evidence about whether or not it is accurate, or we just add ad hoc, non-micro-founded "frictions" to create more inertia. Or we just add more and more "shocks" to the model and say things like, "much of the variation in X is caused by shocks to the markup".

So macro has to live in this weird world where, to correctly evaluate policy changes and welfare, we need to use fully micro-founded models that we know do not track reality, and to track reality, we need to come perilously close to giving up on micro-foundations altogether.

No wonder we are so often in a bad mood!

Don't forget about the denominator

Perhaps encouraged by the recent drop in unemployment from 9 to 8.6, President O opined that the rate could drop to 8% by November 2012.

Given that most of the recent drop is attributable to people leaving the labor force, I guess Obama is looking for 600,000 more discouraged workers to take a hike before next November?

Magic Fed dust

"There is still a sufficiently low real interest rate that would produce recovery, but it’s a rate that’s hard to achieve."

--Paul Krugman

The accuracy of this quote depends on the definition of the word "hard" (sorry to go all Bill Clinton on you people).

Despite all the recent talk of unconventional monetary policy, the Fed really only has one bullet, manipulating bank reserves. They can shoot that bullet at the nominal interest rate, or at the inflation rate, but not at both.

Suppose the real interest rate required to "produce recovery" was -10%. There is no way the Fed can both hold the nominal rate near zero and create 10% inflation. They might be able to hit -10% fleetingly at a positive and rising nominal rate with a rapidly accelerating inflation rate, but we have seen in the 1970s that such conditions are not conducive to growth.

The Fed simply can't produce stable negative rates on financial instruments relevant for investment or financing consumer durables.

So if "hard" means "impossible to pull off in any sort of constructive way", then I agree with the quote.

I heart Benjamins!

Bennett McCallum says that we shouldn't raise inflation targets to avoid the zero bound problem because "Present institutional arrangements are not immutable. In particular, elimination of traditional currency is feasible (even arguably attractive) and would remove the ZLB constraint on policy."

Wow, thanks Ben (and all the others of your ilk).

Making currency illegal so the government can impose negative rates of return on all conceivable assets is such a dumb idea that only a highly trained economist could call it "arguably attractive".

There is little enough anonymity and privacy left in these United States of ours; let's not get rid of the last remaining shreds under the guise of "improving the performance of monetary policy".

Or, to put it another way, Big Brother is already plenty big enough!

Macro and the non-economist

After playing tennis with a non-economist friend yesterday, he asked me how can macro have two completely different schools of thought which seem to differ even on the basics. I told him that, at the op-ed level, macro had a lot of ideology and politics in it and there were more than two schools of thought!

He then asked how it could be the case that when people look at the same data, they don't arrive at the anything near the same conclusion. He said that it was irritating and frustrating to see constant disagreement by economists over macro issues

I told him two things.

First, there isn't really that much data! Since world war two we are working on what, our 10th business cycle?

Second, macro is largely a non-experimental science thus causation was a b*&#ch to figure out and counterfactuals were in short supply.

I also told him that op-ed level macro wasn't generally serious academic macro (though some of it is).

And he asked me what serious academic macro had done vis a vis predicting the meltdown.

I told him, "very little".

I then told him macro forecasters are like weatherpeople, the worse we do and the worse things get, the more they are in demand. I don't think he was too impressed.

I don't fault modern macro for not predicting the financial meltdown; to me thats a borderline silly complaint.

I do think though that op-ed level macro is often not doing the profession any favors in its quest to be viewed as a science.

My old Macro professor goes Medieval on Modern Macro

Larry Meyer:

"There’s also another tradition that began to build up in the late seventies to early eighties—the real business cycle or neoclassical models. It’s what’s taught in graduate schools. It’s the only kind of paper that can be published in journals. It is called “modern macroeconomics.”The question is, what’s it good for? Well, it’s good for getting articles published in journals. It’s a good way to apply very sophisticated computational skills. But the question is, do those models have anything to do with reality? Models are always a caricature—but is this a caricature that’s so silly that you wouldn’t want to get close to it if you were a policymaker?

My views would be considered outrageous in the academic community, but I feel very strongly about them. Those models are a diversion. They haven’t been helpful at all at understanding anything that would be relevant to a monetary policymaker or fiscal policymaker. So we’d better come back to, and begin with as our base, these classic macro-econometric models. We don’t need a revolution. We know the basic stories of optimizing behavior and consumers and businesses that are embedded in these models. We need to go back to the founding fathers, appreciate how smart they were, and build on that."

Full interview is here.

Obviously many Central Bankers disagree with Larry as the Fed and the ECB and the Central Bank of Canada are heavily invested in DSGE modeling.

Is Macroeconomics just looking under the streetlamp?

A fascinating new paper by Ricardo Caballero basically says yes:

"In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has begun to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected."

The piece is well worth reading both for its own arguments and the list of interesting "periphery" papers mentioned and cited.

Breaking down the Econ Nobel

Overall, I like the choices. Search theory and unemployment. My personal choice was Paul Romer and will be until he gets it, but this is a deserving group.

As usual, LeBron is all over this story and has done it better than I ever could.

Here are his post on Mortensen, on Pissarides, on Diamond, and his personal take on the relevance and meaning of this year's prize.

Kudos to Tyler for excellent and incredibly rapid coverage of this year's economics Nobel. Given that these guys were far from the front-runners, he must have produced all of this on the run this morning.

Markets in Everything: Mexican Century Bonds Edition

This is a pretty amazing turn of events. Mexico is selling 100 year government bonds and the expected yield is around 6%!

I admit that I am impressed with Mexico's macro management over the last 10 years, but a 6%, 100 year bond?? I don't think I'd be that bullish on Mexico.

I would suggest to our own government though that borrowing long now, rather than short is a good idea.

I got your uncertainty right here!

In the blogoscopic debate about the importance of policy uncertainty for the weak recovery, not so much attention has been directed to monetary policy uncertainty.

In a great post over at Carpe Diem, Mark Perry shows that inflation has become much less predictable in the recent past. Here's a chart from his post:

GARCH is "generalized auto-regressive conditional heteroskedasticity". I can't tell from the graph though if MP is plotting the conditional variance or the conditional standard deviation.

In addition, I have written papers with Mark and others showing that inflation uncertainty lowers output growth.

Makes you think, no?

Onions

People, VV Chari has 'em!

Check out his recent testimony at the sausage factory.

Here's the punch line:

"I would argue that the United States devotes shamefully little to economic research. For example, the NSF's budget for economics is a pitiful $27 million out of which $2.6 million goes to the worthwhile activity of supporting the Panel Study on Income Dynamics.

Twenty five million dollars for an activity that is deemed fundamentally important by the people of the United States?

Out of that 25 million dollars, my best estimate is that only about 10 per cent goes to macroeconomics. Compare $2.5 million to an overall NSF budget of $6 billion or to the federal government support of basic research of roughly $30 billion.

I should emphasize that, in my judgment, the NSF's peer review process in economics is exceptionally fair and thoughtful. Expanding resources to the NSF's economics program will surely result in much better economic research and will result in very little waste."

Wow, only 27 million "pitiful" dollars for an activity that the "people of the United States" consider to be "fundamentally important", i.e. DSGE modeling!

The horror!

People, he's basically using the crisis to argue in favor of more summer money!

If you look up onions in the dictionary, all that should be there is this:

Does the "zero bound" imply that inflation targets should be raised? Part II

A new (and recommended) NBER working paper (ungated version can be downloaded from here (it's the first entry under "working papers") by Olivier Coibion, Yuriy Gorodnichenko, and Johannes F. Wieland says no.

"We study the effects of positive steady-state inflation in New Keynesian models subject to the zero bound on interest rates. We derive the utility-based welfare loss function taking into account the effects of positive steady-state inflation and show that steady-state inflation affects welfare through three distinct channels: steady-state effects, the magnitude of the coefficients in the utility-function approximation, and the dynamics of the model. We solve for the optimal level of inflation in the model and find that, for plausible calibrations, the optimal inflation rate is low, less than two percent, even after considering a variety of extensions, including price indexation, endogenous price stickiness, capital formation, model-uncertainty, and downward nominal wage rigidities. In our models, price level targeting delivers large welfare gains and a very low optimal inflation rate consistent with price stability."

So basically, they almost agree with Uribe & Schmitt- Grohe, who argue that the optimal inflation rate is zero or negative.

Someone hasn't been paying attention

and that someone is Nobel Laureate Paul Krugman:

Spend now, while the economy remains depressed; save later, once it has recovered. How hard is that to understand?

Very hard, if the current state of political debate is any indication. All around the world, politicians seem determined to do the reverse. They’re eager to shortchange the economy when it needs help, even as they balk at dealing with long-run budget problems......So America has a long-run budget problem. Dealing with this problem will require, first and foremost, a real effort to bring health costs under control — without that, nothing will work.

Look, I clearly don't have a Nobel Prize or a gig at the Times, but I do remember the last year of history! The government put together a near 1 trillion dollar "stimulus" package and passed a comprehensive health reform bill.

That did happen, didn't it? Or am I just somehow plugged into the Matrix and missing the truth?

The government has enacted a big stimulus package, bailed out GM, extended unemployment benefits and the Fed has undertaken extraordinary expansionary measures. To me, this hardly qualifies as "eager to shortchange the economy".

A disinterested spectator could look at the evidence and easily conclude that old school macro policy didn't work rather than arrive at PK's conclusion which is apparently that it hasn't been tried!

It just seems to be an article of faith with Krugman, DeLong and others, some kind of twisted syllogism:

"Fiscal policy can always bring the economy to full employment. The economy is not at full employment, therefore fiscal policy has not been sufficiently applied."

On the long-run part of the equation, Krugman points, with apparently no sense of irony, to out of control health costs as the killer problem.

Wow. Just wow.

Krugman should be an anarchist at this point, shouldn't he?

He says we need currently need stimulus and health care cost control. Hey Paul, the government has spent most of the last year working on those two issues with apparently no results.

Paul, either your model is wrong or the government is totally incompetent (or both?)

Inflation targeters: yer doing it wrong!

Recent experience has led some people to argue that central bank inflation targets should be raised above their 2% levels in order to better accommodate the problems of monetary policy at the zero interest bound.

Not so fast, say Uribe and Schmitt-Grohe in their new NBER Working Paper, "The Optimal Rate of Inflation" (ungated version available here)

The central goal of this chapter is to investigate the extent to which the observed magnitudes of inflation targets are consistent with the optimal rate of inflation predicted by leading theories of monetary nonneutrality. We find that consistently those theories imply that the optimal rate of inflation ranges from minus the real rate of interest to numbers insignificantly above zero. Our findings suggest that the empirical regularity regarding the size of inflation targets cannot be reconciled with the optimal long-run inflation rates predicted by existing theories. In this sense, the observed inflation objectives of central banks pose a puzzle for monetary theory.

And then there's this:

Furthermore, we argue that the zero bound on nominal interest rates does not represent an impediment for setting inflation targets near or below zero.

A paper on this topic by these authors would obviously be self recommending except that I have read it and am actively recommending it.