This is good advice from Stephen H. Penman. As he sees it, there are five steps in the fundamental analysis of a company:
1) Knowing the business
2) Analyzing information
3) Developing forecasts
4) Converting the forecast to a valuation
5) The investment decision: Trading on the valuation
Here's the part I find really interesting:
"An analyst can specialize in any one of these steps or a combination of them. The analyst needs to get a sense of where in the process his comparative advantage lies, where he can get an edge on his competition. When buying advice from an analyst, the investor needs to know just what the analyst's particular skill is."
Buffett's concept of a "circle of competence" only addresses Penman's point (1), but of course it is virtually impossible to be expert in points 2-5 if you fall short on (1).
Friday, February 28, 2014
What is deflation, really?
What is deflation? This
seems like a fairly simple question at first blush - negative growth of some
price index, possibly allied with some arbitrary decision on how many quarters
of data we need to judge a trend. But that's just a technical description of
how to measure deflation, which is frankly, pretty boring.
Mario Draghi has offered another definition of deflation. “We don’t have any evidence of people postponing their expenditure plans with a view to buying the same thing at lower prices, in other words we don’t see what is defined to be deflation,” Draghi said after a Group of 20 meeting in Sydney.
I'm surprised more people didn't respond to Draghi's claim. Firstly, that's a symptom of deflation, so not particularly useful as a definition per se. Second, this is a symptom/definition/cause that you see in textbooks, but I find it incredibly hard to believe. Japan is obviously the most recent example of deflation, so I hope some Japanese friends can comment on this, but it seems that purchases need to be highly time-elastic (i.e. people need to be very willing and able to postpone consumption) for this to be valid.
I think we get at the "deflation" issue better if we look at what the word means in regular English. Deflation is the condition of being deflated, either physically, or figuratively. To deflate in the latter sense is "to depress or reduce (a person or a person's ego, hopes, spirits etc.); puncture; dash, as in "Her rebuff thoroughly deflated me." Deflation is essentially a crisis of confidence. Workers are scared to ask for higher wages. Businesses are afraid to ask for higher prices. No-one believes they have pricing power any more. And so the crisis of confidence feeds on itself as a deflationary mindset takes hold.
It seems unusual to me that confidence is seen as an important feature of booms and busts, but less of deflation and inflation. Perhaps that's because we couch it in monetary jargon like "monetary velocity". I don't dispute Friedman's dictum that inflation is always and everywhere a monetary phenomenon, but it seems to me that sustained deflation can only occur with a dwindling of confidence. It's not the shuddering, jarring collapse of confidence we see in busts. Instead, it's a slow draining of confidence and the subtle yet pernicious readjustment of expectations.
Wolfgang Munchau reports that Germany's federal statistics office said last week that real wage (i.e. after inflation) fell in 2013, which, as he notes, is shocking. I've seen many friends - again, experienced professionals graduating from a well-regarded programme - who have adjusted their expectations down from expecting full-time offers to seeing internships as the only way to convince employers of their worth. It's a reflection of the power differential between them and employers. Some of those employers, meanwhile, are no doubt facing fee pressure from investors. And so the daisy chain of ebbing confidence continues. I'm not Richard Fisher - I know that's anecdotal and has specific problems related to the finance industry. But it's worth considering, and I'm sure you can think of other examples in European labour markets where the insider-outsider problem has only been reinforced by this crisis.
I've gone on and on about deflation, but the worst thing is that deflation is itself just a symptom of insufficiently low nominal GDP or aggregate demand. So, as we (hopefully) criticise the ECB for low CPI inflation verging on deflation, let's keep the bigger picture in mind: ad hoc attempts to increase inflation will likely fail if they do not raise nominal GDP in a sustained fashion. After all, one of the lessons we've learned from high inflation (especially hyperinflation) is that the cycle cannot be broken with stop-and-go policies. What's required is a firm commitment to a sustained regime change. The same, we will probably see, is true of deflation.
Mario Draghi has offered another definition of deflation. “We don’t have any evidence of people postponing their expenditure plans with a view to buying the same thing at lower prices, in other words we don’t see what is defined to be deflation,” Draghi said after a Group of 20 meeting in Sydney.
I'm surprised more people didn't respond to Draghi's claim. Firstly, that's a symptom of deflation, so not particularly useful as a definition per se. Second, this is a symptom/definition/cause that you see in textbooks, but I find it incredibly hard to believe. Japan is obviously the most recent example of deflation, so I hope some Japanese friends can comment on this, but it seems that purchases need to be highly time-elastic (i.e. people need to be very willing and able to postpone consumption) for this to be valid.
I think we get at the "deflation" issue better if we look at what the word means in regular English. Deflation is the condition of being deflated, either physically, or figuratively. To deflate in the latter sense is "to depress or reduce (a person or a person's ego, hopes, spirits etc.); puncture; dash, as in "Her rebuff thoroughly deflated me." Deflation is essentially a crisis of confidence. Workers are scared to ask for higher wages. Businesses are afraid to ask for higher prices. No-one believes they have pricing power any more. And so the crisis of confidence feeds on itself as a deflationary mindset takes hold.
It seems unusual to me that confidence is seen as an important feature of booms and busts, but less of deflation and inflation. Perhaps that's because we couch it in monetary jargon like "monetary velocity". I don't dispute Friedman's dictum that inflation is always and everywhere a monetary phenomenon, but it seems to me that sustained deflation can only occur with a dwindling of confidence. It's not the shuddering, jarring collapse of confidence we see in busts. Instead, it's a slow draining of confidence and the subtle yet pernicious readjustment of expectations.
Wolfgang Munchau reports that Germany's federal statistics office said last week that real wage (i.e. after inflation) fell in 2013, which, as he notes, is shocking. I've seen many friends - again, experienced professionals graduating from a well-regarded programme - who have adjusted their expectations down from expecting full-time offers to seeing internships as the only way to convince employers of their worth. It's a reflection of the power differential between them and employers. Some of those employers, meanwhile, are no doubt facing fee pressure from investors. And so the daisy chain of ebbing confidence continues. I'm not Richard Fisher - I know that's anecdotal and has specific problems related to the finance industry. But it's worth considering, and I'm sure you can think of other examples in European labour markets where the insider-outsider problem has only been reinforced by this crisis.
I've gone on and on about deflation, but the worst thing is that deflation is itself just a symptom of insufficiently low nominal GDP or aggregate demand. So, as we (hopefully) criticise the ECB for low CPI inflation verging on deflation, let's keep the bigger picture in mind: ad hoc attempts to increase inflation will likely fail if they do not raise nominal GDP in a sustained fashion. After all, one of the lessons we've learned from high inflation (especially hyperinflation) is that the cycle cannot be broken with stop-and-go policies. What's required is a firm commitment to a sustained regime change. The same, we will probably see, is true of deflation.
Thursday, February 27, 2014
The Plano Real, and a Different Sort of Model
As Rio de Janeiro prepares for Carnival 2014, I thought it would be an appropriate time to recount an interesting episode in Brazilian politics (and footnote in Brazilian monetary history), which I discovered from reading the memoirs of Fernando Henrique Cardoso (FHC), former Brazilian president and finance minister.
In 1994, FHC was cajoling legislators to accept his Plano Real (Real Plan). The introduction of the Real, a new currency, was intended to end hyperinflation, which was over 3,000 percent (annualized) by 1994. I'll write a longer post at some point on the plan, which had some very unusual features. But for the sake of this post, I'll just point out that this plan was unpopular because it unsettled entrenched political interests and was not deemed likely to succeed, even by the IMF. Against the odds, FHC seemed to be winning support for the plan, which eventually passed, but not before it was almost derailed by political scandal.
According to FHC, the 1994 Carnival was particularly spectacular, perhaps to compensate for a year of political and economic turmoil. President Itamar Franco, who was a supporter of FHC's controversial plan, decided to be the first Brazilian president to watch Carnival from Sambodrome in Rio. No-one is quite sure how, but a buxom 27 year-old model named Lilian Ramos managed to wend her way up to the special presidential balcony where Franco was sitting. She proceeded to climb on his lap, which appeared harmless enough at first, but every time she clapped her hands, her short T-shirt rose higher and higher, eventually revealing that she wasn't wearing anything below. At all. This, of course, was manna from heaven for the photographers below.
The next day, domestic and foreign newspapers launched into the story with full force. Franco was divorced, but the foreign attention annoyed the Brazilian public and military, who were sick of Brazil being made out to to be a banana republic, as well as the Catholic Church, who demanded that Franco be more supportive of family values. Some legislators threatened to impeach Franco, and FHC was apparently approached by a member of the military who enquired where FHC's loyalties would lie if impeachment occurred.
How exactly Ramos found herself on the balcony with Franco is a matter of some speculation. FHC argues that the moment was politically motivated and engineered in an attempt to embarrass Franco, and derail the Real Plan, a theory he says is corroborated by the fact that Ramos later announced plans to run for political office. That, of course, will probably never be known, but it is highly doubtful that a politically sensitive and ambitious agenda like the Real Plan could have been implemented if the country had been forced into further turmoil. Given the importance of this plan in ending hyperinflation and setting the stage for reform and growth in Brazil, it's fortunate that the scandal passed, so we can relegate the incident to an amusing footnote in Brazilian political and economic history. I'll leave you with this comic gem (non-Portuguese speakers, relax, you can use Google Translate). I imagine this was a fairly family-friendly version of some of the comics going round at the time:
In 1994, FHC was cajoling legislators to accept his Plano Real (Real Plan). The introduction of the Real, a new currency, was intended to end hyperinflation, which was over 3,000 percent (annualized) by 1994. I'll write a longer post at some point on the plan, which had some very unusual features. But for the sake of this post, I'll just point out that this plan was unpopular because it unsettled entrenched political interests and was not deemed likely to succeed, even by the IMF. Against the odds, FHC seemed to be winning support for the plan, which eventually passed, but not before it was almost derailed by political scandal.
According to FHC, the 1994 Carnival was particularly spectacular, perhaps to compensate for a year of political and economic turmoil. President Itamar Franco, who was a supporter of FHC's controversial plan, decided to be the first Brazilian president to watch Carnival from Sambodrome in Rio. No-one is quite sure how, but a buxom 27 year-old model named Lilian Ramos managed to wend her way up to the special presidential balcony where Franco was sitting. She proceeded to climb on his lap, which appeared harmless enough at first, but every time she clapped her hands, her short T-shirt rose higher and higher, eventually revealing that she wasn't wearing anything below. At all. This, of course, was manna from heaven for the photographers below.
The next day, domestic and foreign newspapers launched into the story with full force. Franco was divorced, but the foreign attention annoyed the Brazilian public and military, who were sick of Brazil being made out to to be a banana republic, as well as the Catholic Church, who demanded that Franco be more supportive of family values. Some legislators threatened to impeach Franco, and FHC was apparently approached by a member of the military who enquired where FHC's loyalties would lie if impeachment occurred.
How exactly Ramos found herself on the balcony with Franco is a matter of some speculation. FHC argues that the moment was politically motivated and engineered in an attempt to embarrass Franco, and derail the Real Plan, a theory he says is corroborated by the fact that Ramos later announced plans to run for political office. That, of course, will probably never be known, but it is highly doubtful that a politically sensitive and ambitious agenda like the Real Plan could have been implemented if the country had been forced into further turmoil. Given the importance of this plan in ending hyperinflation and setting the stage for reform and growth in Brazil, it's fortunate that the scandal passed, so we can relegate the incident to an amusing footnote in Brazilian political and economic history. I'll leave you with this comic gem (non-Portuguese speakers, relax, you can use Google Translate). I imagine this was a fairly family-friendly version of some of the comics going round at the time:
Wednesday, February 26, 2014
Let A Thousand Blogs Bloom (or Sumner's Hydra)
I was both pleased and flattered to see my post on Rick Mishkin draw a response from Scott Sumner. For a relatively new blogger, this was the equivalent of having Michael Jordan comment on a sign I was waving in the crowd. Personal satisfaction aside, however, it was an opportunity to reflect on the history of market monetarism as an idea. The essence of my post on Mishkin was to show that his textbook (literally) ideas on monetary policy could have mitigated some of the effects of the Great Recession. Of course, Mishkin was hardly the only proponent of such ideas. Early on, Sumner joked that his gravestone should read: "Devoted his life to blogging on Hetzelian ideas". But here's the funny thing: I've read quite a bit of Hetzel, and while I understand his ideas, they didn't make as much on an impact as the work of Sumner and others. I commented tonight that I enjoyed Marcus Nunes and Benjamin Cole's book on market monetarism more than I enjoyed Hetzel's book on the 2008 recession. To some, that's probably an act of intellectual heresy (or inferiority). I can just hear it now: "Seriously, dude? You liked the Lord of the Rings movies more than the book? Wow." I think what this really shows is that any idea needs different expositors. Like the movies, blogs have a certain immediacy, and are an excellent introduction to a more complex medium. Some people respond to the written word. Some people respond to the spoken word (listen to Sumner's early expositions on market monetarism, and compare them to later, more refined versions where he deftly anticipates many of the criticisms). Some people respond to pictures (one of the undoubted strengths of Nunes and Beckworth's blogs). Some of us needed The Money Illusion to understand why Cassel and Hawtrey were worth reading.
It's interesting to trace the genealogy of the movement. Sumner encouraged Marcus Nunes to start his own blog. Nunes allowed Lars Christensen to do a guest post on "market monetarism", thereby giving a name to an idea that only seemed inchoate because it had not yet been appropriately named. The efforts of all these bloggers (and others like David Beckworth, David Glasner and Nick Rowe - sorry, I'm not sure how or if they fit in this family tree) eventually pushed me to write to explore things I didn't (and still don't) understand fully. I'm fairly sure that young, talented bloggers like Evan Soltas and Yichuan Wang got their starts from being mentioned by Sumner. Again, this dispelled the idea that market monetarism was an arcane idea that belonged to the select few. Besides the generational span, there is a diversity of nationalities (Brazilians, Danes & Singaporeans, to name a few!) and areas of focus (academic economists to market practitioners) represented. The last is important because these ideas can be tested every day in markets. People don't talk about reflexivity because Soros is a great philosopher. They talk about it because he's a billionaire, and because he thinks it works. What the blogosphere needs to continue to do is convince people that this is a worthwhile idea because it works.
The analogy that stands out to me is how the value investing credo has spread. Benjamin Graham basically created the concept. His Graham-Newman partnership spawned Buffett, Ruane and Schloss. You'd have to be completely ignorant not to know the influence that generation has had on today's fund management industry. Or, to take a modern day version, Julian Robertson's Tiger Management gave birth to Tiger Cubs, grand-cubs, and hangers-on who are happy to claim any lineage at all.
I say that last bit with complete self-awareness. I don't for a second imagine that the quality of posts or originality of ideas here merit the influence that Sumner has had (nor do I intend to focus primarily on monetary policy). Equally, I'm sure Buffett would be horrified at the simplistic version of value investing you sometimes see espoused on Internet fora. But value investing as a discipline has proceeded beyond Graham's relatively simple quantitative measures of value. That's why it's fascinating to see the Hydra in action. Monetary policy is still seen as something that only the high priests of the FOMC and ECB can call on. It would be dangerous if monetary policy became subject to populism, but it equally should not be something that ordinary citizens shrug their shoulders at, particularly at a time when major central banks consistently fail their institutional mandates, or when money mischief is being wrought on the people of Venezuela & Argentina.
But don't get me wrong - I'm optimistic. It's a slow process, but the battle of ideas is being won, one retweet at a time. So, as Sumner himself might say, let a thousand blogs bloom.
It's interesting to trace the genealogy of the movement. Sumner encouraged Marcus Nunes to start his own blog. Nunes allowed Lars Christensen to do a guest post on "market monetarism", thereby giving a name to an idea that only seemed inchoate because it had not yet been appropriately named. The efforts of all these bloggers (and others like David Beckworth, David Glasner and Nick Rowe - sorry, I'm not sure how or if they fit in this family tree) eventually pushed me to write to explore things I didn't (and still don't) understand fully. I'm fairly sure that young, talented bloggers like Evan Soltas and Yichuan Wang got their starts from being mentioned by Sumner. Again, this dispelled the idea that market monetarism was an arcane idea that belonged to the select few. Besides the generational span, there is a diversity of nationalities (Brazilians, Danes & Singaporeans, to name a few!) and areas of focus (academic economists to market practitioners) represented. The last is important because these ideas can be tested every day in markets. People don't talk about reflexivity because Soros is a great philosopher. They talk about it because he's a billionaire, and because he thinks it works. What the blogosphere needs to continue to do is convince people that this is a worthwhile idea because it works.
The analogy that stands out to me is how the value investing credo has spread. Benjamin Graham basically created the concept. His Graham-Newman partnership spawned Buffett, Ruane and Schloss. You'd have to be completely ignorant not to know the influence that generation has had on today's fund management industry. Or, to take a modern day version, Julian Robertson's Tiger Management gave birth to Tiger Cubs, grand-cubs, and hangers-on who are happy to claim any lineage at all.
I say that last bit with complete self-awareness. I don't for a second imagine that the quality of posts or originality of ideas here merit the influence that Sumner has had (nor do I intend to focus primarily on monetary policy). Equally, I'm sure Buffett would be horrified at the simplistic version of value investing you sometimes see espoused on Internet fora. But value investing as a discipline has proceeded beyond Graham's relatively simple quantitative measures of value. That's why it's fascinating to see the Hydra in action. Monetary policy is still seen as something that only the high priests of the FOMC and ECB can call on. It would be dangerous if monetary policy became subject to populism, but it equally should not be something that ordinary citizens shrug their shoulders at, particularly at a time when major central banks consistently fail their institutional mandates, or when money mischief is being wrought on the people of Venezuela & Argentina.
But don't get me wrong - I'm optimistic. It's a slow process, but the battle of ideas is being won, one retweet at a time. So, as Sumner himself might say, let a thousand blogs bloom.
Tuesday, February 25, 2014
The Lucky and the Skillful, The Contrarian and the Reckless
A few days ago, I wrote a post entitled "The Sociology of Quant Investing - Is There A Moneyball for PMs?", as I pondered the luck vs. skill debate. Today, there's an excellent article from aiCIO which tries to answer that question. Naturally, this sentence caught my eye: "Stan Altshuller intends to be the Billy Beane of hedge funds." Having read the description of Altshuller's process, I salute his intention, but I don't really understand how or if the process works. Presumably he doesn't want to share proprietary details. Kenneth French, appears to be skeptical of a quantitative approach: “Either before or after the fact, it’s an extremely difficult statistical problem." "If you insist on hiring an active manager,” he says, “at least get someone cheap.”
This makes excellent sense. Unfortunately, manager selection (or asset allocation) doesn't always appear to be sensible. There are two main reasons for this. First, the clear difficulty of quantifying manager skills leads some to lean on reputation. Better, as Keynes says, to fail conventionally than to succeed unconventionally. Second, asset allocation, for some, takes on the form of conspicuous consumption, i.e. the spending of money on and the acquiring of luxury goods and services to publicly display economic power. If you invested in Paulson pre-2008, not only did you make a lot of money, you probably got a frisson of excitement from sharing that fact at a bar (or a cocktail party - I guess Paulson investors don't go to bars the way I do.)
What's needed is a theory of deviance in investing. To succeed spectacularly, one must be unconventional, and therefore be deviant. The folks at aiCIO seem to agree: "According to
Martijn Cremers, a finance professor at the University of Notre Dame, a measurement of active share—the portion of a portfolio that’s unique from the benchmark—can help further differentiate competence from chance. “Active share ignores returns completely,” Cremers says. “It only looks at holdings and can serve as a complementary measure to tracking error volatility.” The concept derives from the basic premise that a fund can only outperform a benchmark if it’s different, and quantifies the proportion of the portfolio skill that is actually applied and contributes to said outperformance."
Of course, just because deviance is a prerequisite for success does not mean that all deviants will succeed. Some ideas are stupid for a reason, and some mavericks will blow their funds up. It seems to me that the tools for separating the lucky from the skillful, and the contrarian from the reckless, still have a long way to go.
This makes excellent sense. Unfortunately, manager selection (or asset allocation) doesn't always appear to be sensible. There are two main reasons for this. First, the clear difficulty of quantifying manager skills leads some to lean on reputation. Better, as Keynes says, to fail conventionally than to succeed unconventionally. Second, asset allocation, for some, takes on the form of conspicuous consumption, i.e. the spending of money on and the acquiring of luxury goods and services to publicly display economic power. If you invested in Paulson pre-2008, not only did you make a lot of money, you probably got a frisson of excitement from sharing that fact at a bar (or a cocktail party - I guess Paulson investors don't go to bars the way I do.)
What's needed is a theory of deviance in investing. To succeed spectacularly, one must be unconventional, and therefore be deviant. The folks at aiCIO seem to agree: "According to
Martijn Cremers, a finance professor at the University of Notre Dame, a measurement of active share—the portion of a portfolio that’s unique from the benchmark—can help further differentiate competence from chance. “Active share ignores returns completely,” Cremers says. “It only looks at holdings and can serve as a complementary measure to tracking error volatility.” The concept derives from the basic premise that a fund can only outperform a benchmark if it’s different, and quantifies the proportion of the portfolio skill that is actually applied and contributes to said outperformance."
Of course, just because deviance is a prerequisite for success does not mean that all deviants will succeed. Some ideas are stupid for a reason, and some mavericks will blow their funds up. It seems to me that the tools for separating the lucky from the skillful, and the contrarian from the reckless, still have a long way to go.
Sunday, February 23, 2014
What Would Mishkin Have Done?
I promised myself I wouldn't get sucked into the black hole of the 2008 Fed transcripts, but that has proven an impossible promise to keep. In my previous post, I speculated that Rick Mishkin's departure from the Fed considerably weakened it at a critical time. I also said this was nothing more than an amusing parlour game. That was wrong - amusing, yes, unimportant, no. I don't know Mishkin, though I'm aware his reputation took a bit of a beating thanks to the Inside Job. But when I was trying to learn more about monetary policy four years ago, it struck me that Scott Sumner kept saying, "This isn't unorthodox. You get this from Mishkin's textbook, which is the best-selling book on the subject." So I read Mishkin's book. It is thus of incredible importance and interest what the textbook writer himself was saying as we entered the teeth of the crisis. It's too much trouble to go through all of the transcripts - I'll leave that to Binyamin Applebaum and team - but here are some crucial points from Mishkin's last meeting on Aug 5 2008. Mishkin's actual words from the transcripts are in italics.
1) Focus on core inflation, not headline. Also, anecdotal evidence should really, really be taken with a pinch of salt. This should be obvious to experienced policymakers, but going through the psychological barrier of $100 oil (not to mention $13 natural gas) had clearly rattled some. Richard Fisher was pushing his inside knowledge from CEOs as evidence of inflation expectations becoming untethered. Mishkin responded:
Monetary policy does not control...relative price shifts. Although there are some problems in terms of core, the effect has actually been quite limited given the incredible rise in energy prices. While it’s important to think about headline in the long run, the information from core is very useful in terms of thinking about policy because it tells you whether this is spilling over into underlying inflation.
One of my concerns about going to anecdotal information and why I think we need to use an analytic framework in thinking about what is really driving the inflation process is that we do need to focus on the longer-run because that’s what monetary policy can control. I get a bit nervous about these anecdotal concerns, which I think can tell us something about headline. Then we have to ask what they tell us about the longer-run context but not put too much weight on them. That’s one reason that I think some of the analytic frameworks that we’ve developed here are very useful for thinking about these things.
I think that this is very important—it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can’t control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps.
I'll note that Mishkin himself was not immune to the importance of oil prices, worrying that it would actually lead to long-term inflation expectations changing:
Let’s hope and pray—let’s all get around in a circle and hold hands—that oil prices fall, which will also help us not get boxed in.
2) Inflation was less of a concern than macro stability.
When you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture.
3) The federal funds rate does not indicate the stance of monetary policy. Instead, look to all asset prices.
Let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me.
1) Focus on core inflation, not headline. Also, anecdotal evidence should really, really be taken with a pinch of salt. This should be obvious to experienced policymakers, but going through the psychological barrier of $100 oil (not to mention $13 natural gas) had clearly rattled some. Richard Fisher was pushing his inside knowledge from CEOs as evidence of inflation expectations becoming untethered. Mishkin responded:
Monetary policy does not control...relative price shifts. Although there are some problems in terms of core, the effect has actually been quite limited given the incredible rise in energy prices. While it’s important to think about headline in the long run, the information from core is very useful in terms of thinking about policy because it tells you whether this is spilling over into underlying inflation.
I
am very skeptical of consumer surveys because, exactly what behavioral
economics tells us, there is framing. If headline inflation is high, short-term
inflation expectations go up, which should happen, but long-term inflation
expectations also go up. When headline goes down, then they will come down.
One of my concerns about going to anecdotal information and why I think we need to use an analytic framework in thinking about what is really driving the inflation process is that we do need to focus on the longer-run because that’s what monetary policy can control. I get a bit nervous about these anecdotal concerns, which I think can tell us something about headline. Then we have to ask what they tell us about the longer-run context but not put too much weight on them. That’s one reason that I think some of the analytic frameworks that we’ve developed here are very useful for thinking about these things.
I think that this is very important—it is why I stressed the issue of the analytic framework for thinking about the inflation process and what monetary policy can do. We can’t control relative prices, but we can do something about long-run inflation expectations and expectations about future output gaps.
I'll note that Mishkin himself was not immune to the importance of oil prices, worrying that it would actually lead to long-term inflation expectations changing:
Let’s hope and pray—let’s all get around in a circle and hold hands—that oil prices fall, which will also help us not get boxed in.
2) Inflation was less of a concern than macro stability.
When you have very big downside risks to economic activity, you want to deal with inflation expectations when they actually indicate that there is some problem. And I just do not see that at this juncture.
3) The federal funds rate does not indicate the stance of monetary policy. Instead, look to all asset prices.
Let me talk about the issue of focusing too much on the federal funds rate as indicating the stance of monetary policy. This is something that’s very dear to my heart. I have a chapter in my textbook that deals with this whole issue and talks about the very deep mistakes that have been made in monetary policy because of exactly that focus on the short-term interest rate as indicating the stance of monetary policy. In particular, when you think about the stance of monetary policy, you should look at all asset prices, which means look at all interest rates. All asset prices have a very important effect on aggregate demand. Also you should look at credit market conditions because some things are actually not reflected in market prices but are still very important. If you don’t do that, you can make horrendous mistakes. The Great Depression is a classic example of when they made two mistakes in looking at the policy interest rate. One is that they didn’t understand the difference between real and nominal interest rates. That mistake I’m not worried about here. People fully understand that. But it is an example when nominal rates went down, but only on default-free Treasury securities; in fact, they skyrocketed on other ones. The stance of monetary policy was incredibly tight during the Great Depression, and we had a disaster. The Japanese made the same mistake, and I just very much hope that this Committee does not make this mistake because I have to tell you that the situation is scary to me.
4) The Great Depression and Japan were appropriate parallels to be thinking about in Aug 2008. See the quotes in part (3) as well as the now famous one below:
Remember that in the Great Depression, when—I can’t use the expression because it would be in the transcripts, but you know what I’m thinking—something hit the fan, [laughter] it actually occurred close to a year after the initial negative shock.
So there you have it. Mishkin knew what he was talking about, and I think it's pretty clear that his departure was a loss. Whether he would have been able to influence the entire group is subject to (even more speculative) debate. But if there's one lesson here, it's that orthodox, textbook monetary policy should and could have prevented 2008 from being as bad as it was. I just hope someone in Europe has a copy of Mishkin's book.
Saturday, February 22, 2014
Some Comments on the Fed Transcripts
Joao Marcus Nunes has provided a wonderful reading of the Fed transcripts, replete with his customary graphs that tell a thousand words. Please read the linked post. I find it impossible to deny his charge that the Fed was overly focused on inflation.
I just want to make a few additional points, which he may not agree with:
1) The oil price shock in Greenspan's time is an excellent point that I did not know about. Rather than an oil price shock, the 2008 Fed was responding (incorrectly) to the threat of an oil price shock to inflation expectations. I think crossing the $100/bbl barrier for WTI crude (and the concomitant China demand story) had a serious psychological effect on policymakers. Thankfully, Bernanke did not make that mistake again when the Arab Spring occurred. His critics (see next point) suggested that QE was leading to inflation, but he held firm. Again, I can't prove it, but I think we should be grateful for the development of shale resources in the US. Not only was there the promise of future oil production, but there was a HUGE difference in natural gas prices in '08 and '11 (crossed $13/mmBtu in '08 but sub $5 in early '11).
2) I said that we shouldn't abuse the transcripts to play "gotcha" with those who got it wrong, or said things that were slightly wrong. However, I do want to say something about Richard Fisher. Not only was he completely wrong in 2008, he refuses to hold his hands up and admit the mistakes, and continues to peddle the same line. He says some quite sensible things on TBTF regulation, but his record on monetary policy is frankly dreadful. It is actually quite scary that so many people still hold him up as a monetary expert.
3) Joao Marcus is absolutely right that the level of inflation expectations was lower than in the Greenspan era, and it therefore seems strange that Bernanke reacted by "leaning" against inflation. That said, I think we have to realize that (in human fashion), they were paying attention to the change, rather than the absolute level. As his graph shows, the Fed could conceivably have been concerned about the run-up from sub 2%. This does not absolve them of the mistake, but it's a charitable interpretation of the complex issue they were dealing with.
4) People often play the "what if" game, which is nothing but a pleasant parlour game. In the monetary history I've read, the biggest "what if" is how Benjamin Strong would have responded to the onset of the Great Depression. Many argue that he would not have allowed the monetary tightening that worsened the downturn. Totally unprovable but fun to think about it. So here's my little addition to the game (probably premature since I haven't read all the transcripts yet). I think Rick Mishkin's departure from the FOMC weakened the Board of Governors at a crucial time. He submitted his resignation on May 28, his departure was effective on Aug 31, and 15 days later, the Lehman bankruptcy occurred. This is important because he was one of the members who was incredibly concerned about a severe recession, and was calling it a financial crisis by mid-March. Mishkin's reputation has taken a bit of a battering thanks to the Inside Job, but there's no doubt that he had a lot of foresight as to what was developing. Would he have been able to convince Bernanke to focus on the brewing storm? We'll never know.
I just want to make a few additional points, which he may not agree with:
1) The oil price shock in Greenspan's time is an excellent point that I did not know about. Rather than an oil price shock, the 2008 Fed was responding (incorrectly) to the threat of an oil price shock to inflation expectations. I think crossing the $100/bbl barrier for WTI crude (and the concomitant China demand story) had a serious psychological effect on policymakers. Thankfully, Bernanke did not make that mistake again when the Arab Spring occurred. His critics (see next point) suggested that QE was leading to inflation, but he held firm. Again, I can't prove it, but I think we should be grateful for the development of shale resources in the US. Not only was there the promise of future oil production, but there was a HUGE difference in natural gas prices in '08 and '11 (crossed $13/mmBtu in '08 but sub $5 in early '11).
2) I said that we shouldn't abuse the transcripts to play "gotcha" with those who got it wrong, or said things that were slightly wrong. However, I do want to say something about Richard Fisher. Not only was he completely wrong in 2008, he refuses to hold his hands up and admit the mistakes, and continues to peddle the same line. He says some quite sensible things on TBTF regulation, but his record on monetary policy is frankly dreadful. It is actually quite scary that so many people still hold him up as a monetary expert.
3) Joao Marcus is absolutely right that the level of inflation expectations was lower than in the Greenspan era, and it therefore seems strange that Bernanke reacted by "leaning" against inflation. That said, I think we have to realize that (in human fashion), they were paying attention to the change, rather than the absolute level. As his graph shows, the Fed could conceivably have been concerned about the run-up from sub 2%. This does not absolve them of the mistake, but it's a charitable interpretation of the complex issue they were dealing with.
4) People often play the "what if" game, which is nothing but a pleasant parlour game. In the monetary history I've read, the biggest "what if" is how Benjamin Strong would have responded to the onset of the Great Depression. Many argue that he would not have allowed the monetary tightening that worsened the downturn. Totally unprovable but fun to think about it. So here's my little addition to the game (probably premature since I haven't read all the transcripts yet). I think Rick Mishkin's departure from the FOMC weakened the Board of Governors at a crucial time. He submitted his resignation on May 28, his departure was effective on Aug 31, and 15 days later, the Lehman bankruptcy occurred. This is important because he was one of the members who was incredibly concerned about a severe recession, and was calling it a financial crisis by mid-March. Mishkin's reputation has taken a bit of a battering thanks to the Inside Job, but there's no doubt that he had a lot of foresight as to what was developing. Would he have been able to convince Bernanke to focus on the brewing storm? We'll never know.
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