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The Covid-19 pandemic has dramatically illustrated the importance of good data in informing government policy, and led to important innovations in the way data is collected, analysed and disseminated.
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The 10-year treasury yield reached an historic low this week, crossing the 1% barrier. For many observers, this was a troubling development that confirms the U.S. economy is being sucked into the mire of secular stagnation. For others, it was an unsurprising outcome given the long-run trajectory of interest rates and the ongoing safe asset shortage problem. Both views have some merit. The decline of the 10-year treasury yield does create problems for the U.S. economy, but it has been happening for some time. There is nothing magical about crossing the 1% barrier, though it does brings closer the day of reckoning for the Fed's operating framework.
The decline of the 10-year treasury yield, if sustained, means the entire yield curve may soon run into its effective lower bound. This will render useless much of the Fed's toolbox. Fortunately, there is a fix for the Fed's operating framework that makes it robust to any interest rate environment. This fix, ironically, ties the Fed more closely to fiscal policy while making it more Monetarist in practice.
This post outlines the proposed fix, but first motivates it by explaining how the decline in the 10-year treasury yield creates problems for the U.S. economy.
Why The 10-Year Treasury Yield Decline Matters
The are three reasons why the fall in the 10-year treasury yield matters. First, it implies there is an excess demand for safe assets. These are securities that are expected to maintain their value in a financial crisis and, as a result, are highly liquid. The biggest sources of safe assets are government bonds from advanced economies, especially U.S. Treasuries. The global demand for them has far outstripped their supply and this has led to the global safe asset shortage problem. The 10-year treasury yield falling below 1% is the latest manifestation of this phenomenon.
The safe asset shortage is problematic because it amounts to a broad money demand shock that slows down aggregate demand growth. One solution is for safe asset prices (interest rates) to adjust up (down) to the point that safe asset demand is satiated. The effective lower bound (ELB) on interest rates prevents this adjustment from happening and causes investors to search for safe assets elsewhere in the world. Other economies, as a result, are also affected by the safe asset shortage problem and experience lower aggregate demand growth.1
The demand for safe assets, as noted above, is closely tied to the demand for liquidity. This can be seen in the figure below which shows that the use of money assets (i.e. money velocity) closely tracks the 10-year treasury yield. Over the past decade, this has meant the public's desired money holdings have increased as the 10-year treasury yield has fallen. All else equal, this implies slower growth in aggregate spending.
Below is a chart from an upcoming policy brief of mine that illustrates this point from a global perspective. It shows the average 10-year government bond yield between 2009 and 2019 plotted against the average growth rate of domestic demand over the same period. The government bond yield can be viewed as the safe asset interest rate in these advanced economies. The figure reveals a strong positive relationship between the safe asset yield and the domestic demand growth rate.
One has to be careful interpreting the causality here, but I do further analysis in the policy brief and find shocks to the bond yields do influence domestic demand growth. The safe asset shortage, therefore, appears to be a drag on global aggregate demand growth. The first reason, then, why the decline in the 10-year treasury yield matters is that it portends weaker aggregate demand growth.
The second reason the decline matters is that it leads to a flattening of the yield curve. Financial firms that fund short term and invest long term rely heavily on a positive slopping yield curve to make this business model work. A flattening yield curve undermines it and may lead to less financial intermediation. This is one reason an inverted yield helps predict recessions. In this case, however, the effect may be longer lasting than the business cycle as the decline in treasury yields appears to be on a sustained path.
The third reason the decline matters is that it impairs the Fed's current tool box. The Fed's target interest rate is now down to a 1-1.25% range, a small margin for a central bank that normally cuts around 5% during a recession. The Fed could turn to large scale asset purchases once it hits the ELB, but with the 10-year treasury now near 1%, there is not much space here either. Consequently, the Fed's toolbox is shrinking and soon could be rendered useless.
Now the Fed can add to its toolbox and indeed the Fed is exploring new tools--such as negative interest rates and yield curve control--under its big review of monetary policy. Even these tools, however, are limited since the declining 10-year treasury yield is compressing the yield curve.
The Fed's current toolbox, in short, is premised on a positive interest rate world that is slowing fading. The Fed, therefore, may soon face a day of reckoning for its current operating framework. That possibility and what the Fed could do in response is considered next.
Revamping the Fed's Operating Framework
The Fed's operating framework--defined here as the instruments, tools, and targets the Fed uses in its conduct of monetary policy--has been geared toward a positive interest rate environment. This framework has been increasingly strained by the downward march of interest rates. The 10-year treasury yield dropping below 1% underscores this challenge.
The Fed needs, consequently, an operating framework that is robust to any interest rate environment and one that is capable of stabilizing aggregate demand growth. I have proposed a fix to the Fed's operating system that addresses these challenges in a forthcoming journal article. Here I want to briefly outline that proposal. It has three parts: (1) the Fed adopts a dual reaction function, (2) the Fed adopts a NGDP level target, and (3) the Fed is empowered with a standing fiscal facility for use at the ZLB. The three parts are explained below.
Part I: A Dual Reaction Function. To make the Fed's operating framework robust to both positive and negative interest rate environments, I call for a two-rule approach to monetary policy. Specifically, the Fed would follow a version of the Taylor rule when interest rate are above zero percent and follow the McCallum rule when interest rate are at zero percent or below. The former rule uses an interest rate as the instrument of monetary policy while the latter rule uses the monetary base as the instrument. Consequently, the Fed would have effective instruments to use no matter what happens to interest rates.
Part II: A NGDP Level Target. A level target provides powerful forward guidance since it forces the central bank to make up for past misses in its target. For reasons laid out here, I prefer a nominal NGDP level target (NGDPLT) and specifically, one that targets the forecast. This combined with the first feature implies the following dual reaction function system for the Fed:
Here, in is the neutral interest rate, the NGDPGap is the percent difference between the forecasted level of NGDP and the NGDPLT for the period of t to t+h, Δb is the growth rate of the monetary base, Δx* is the target NGDP growth rate, and Δv is the expected growth rate in the velocity of the monetary base for the period of t to t+h.
Part III: A Standing Fiscal Facility. The final part of the proposal establishes a standing fiscal facility for the Federal Reserve to use when implementing the McCallum rule. That is, when the Fed starts adjusting the the growth of the monetary base according to the McCallum rule, it will do so by sending money directly to the public. My proposal, then, incorporates 'helicopter drops' into the Fed's toolkit in rule-like manner.
I provide more details in the paper, but here are the advantages of this proposed operating framework. First, it keeps countercyclical macroeconomic policy at the Federal Reserve. This provides continuity with the existing division of labor between the U.S. Treasury Department and the Federal Reserve. Second, it enables the Fed to provide meaningful countercyclical monetary policy no matter what happens to interest rates. Third, it provides credible forward guidance since it combines a NGDPLT with helicopter drops. Finally, since this operating framework would require the Fed to be much more intentional about the rules it follows, it would make the Fed more rules-based and predictable.
This proposal would require approval from Congress. Given the Fed's shrinking toolbox and the ongoing expectation that it deliver countercyclical policy, this may not be as big an ask as some imagine. Moreover, it could easily be seen as return to a more Monetarist Federal Reserve since it would be relying more explicitly on the monetary base to implement monetary policy.
Conclusion Some commentators have speculated that the corona virus might be a shock that forces us out of our complacency and spawns many unintended innovations. To the extent this shock leads to ongoing declines in the treasury yields and exhausts the Fed current toolbox, it might also lead to innovations in U.S. monetary policy. Here's hoping it does along the lines suggested above.
1 The safe asset shortge can also become self-perpetuating and lead to what Caballero et al (2017) call a 'safety trap'. This problem emerges when the excess demand for safe assets pushes down safe asset yields to the effective lower bound (ELB) on interest rates. If the excess demand for safe assets is not satiated at that point (i.e. the equilibrium real safe asset interest rate is below the ELB), then aggregate demand will contract and push down inflation. Via the Fisher relationship, the lower inflation will drive up the real safe asset interest rate and increase the spread between it and the equilibrium real safe asset interest rate. As a result, aggregated demand will further contract and the cycle will repeat. This is the safety trap.
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The 26th UN Climate Change Conference, COP26, will take place in Glasgow in November. Can it succeed? What does 'success' actually mean in the context of the climate crisis?
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We will measure and track the multiple dimensions of equity in the internal and external workings of UK development organisations to influence meaningful change in their policies, practices, and partnerships.
The Equity Index is a UK social enterprise advocating for greater equity across the international development sector. We will measure and track the multiple dimensions of equity in the internal and external workings of UK development organisations to influence meaningful change in their policies, practices, and partnerships. This includes racial and gender equity, equity in knowledge production, in funding, in collaborations and more. We are an anti-racist and feminist organisation that supports the broader decolonising development and Shift the Power movements.
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Brexit has shaken British politics and raised important questions about how our democracy functions.
Philip Rycroft, who was the lead civil servant on constitutional issues within the UK Government from 2012 to 2019, will examine how much Brexit has stressed the democratic process. He will look at trust in the institutions of the state and the state of democratic representation across the UK. He will ask what this means for the future of our democratic institutions and for the future of the United Kingdom itself.
About the speaker
Philip Rycroft worked in the Department for Exiting the European Union (DExEU) between March 2017 and March 2019, from October 2017 as Permanent Secretary. He was responsible for leading the department in all its work on the Government's preparations for Brexit. From June 2015 to March 2019 he was head of the UK Governance Group in the Cabinet Office, with responsibility for advising ministers on all aspects of the constitution and devolution. From May 2012 to May 2015, he was the Director General in the Office of the Deputy Prime Minister, Nick Clegg.
Through his career, Philip worked in a variety roles, in the civil service in Scotland and London, in the European Commission and in business. He is now an academic and independent consultant.
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If victors write history, and Bashar al-Assad is consolidating his grip on Syria after nearly a decade of civil war, is there any hope of justice for victims of state-sponsored abuse in Syria?
Russia and China have blocked efforts to set up an international tribunal for Syria, so Syrians in exile have been searching for ways to use national laws, and the principle of universal jurisidiction to pursue accountability.
Last year Germany arrested two Syrian men and charged them with committing crimes against humanity. When they go on trial this year, it will be the world's first prosecution for state-backed torture in Syria. Activists have also filed cases in Norway, Sweden and Austria, and international groups are stockpiling evidence in the hope of future court cases.
But with the top members of Assad's government safely ensconced in Damascus, how much impact can these cases have?
About the speaker:
Emma Graham-Harrison is senior international affairs correspondent for the Guardian and Observer. She has covered conflicts, political crises, energy and the environment in more than 40 countries across five continents, and was based in China, Afghanistan and Spain for over a decade, before returning to London to take up her current roving role. She graduated from Oxford with a first class degree in Chinese Studies, and speaks Mandarin and Spanish. Awards include Foreign Reporter of the Year at the 2017 British Press Awards; her investigative work on the Cambridge Analytica investigations was also recognised at the British Press Awards and by the London Press Club.
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Greenhouse gas monitoring – and increasingly climate policy monitoring, meaning the continuous tracking of policies with indicators – has existed since the early 1990s – and is thus a long-standing practice. For a long time, most people thought it to be a very technical exercise of low politics, but our new work demonstrates that this […] The post Guiding Europe Towards Faster and Deeper Decarbonisation: An Enhanced Role for Policy Monitoring? appeared first on Environmental Europe?.
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by Taro Nishikawa This article is based on research presented at the UACES Graduate Forum Research Conference 2021 (17-18 June, online) After the European Community (EC) launched the Common Commercial Policy (CCP) in 1970, the question of who influences EC/EU positions in international trade negotiations became an important scholarly research topic. On the one hand, greater control […] The post Vertical Interplay between the European Commission and Member States in EU Trade Policy appeared first on Crossroads Europe.
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The 28 EU Commissioners met today to decide the fate of the EU's Nature Directives (the 1979 Birds Directive and 1992 Habitats Directive). Would these two directives, the cornerstone of EU biodiversity legislation, be deemed 'fit for purpose' or would they be revised and potentially weakened? After years of internal debates within the European Commission, […] The post Nature Directives 'Fit for Purpose': a turning point for EU policy dismantling? appeared first on Environmental Europe?.
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As one previous post on this blog detailed, the current political turmoil in Northern Ireland was sparked by a subsidy for renewable energy production. Though it is tempting to blame political carelessness, the ongoing RHI scandal prompts a broader reflection about renewable energy policy instruments. Incentives akin to the RHI are relatively common in renewable […] The post The politics of (bad) policy design: French solar panels and Northern Irish boilers appeared first on Environmental Europe?.
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The words the future of conflict triggers shiny images of technology overtaking the battlefield and an extreme revolution in military affairs. But how real is the hype about the disruption to defence and what will this mean for the soldier on the ground? In this panel we bring together three experts to consider the real face of the future of conflict. Flt. Lt. Dr James Kuht, RAF Doctor and Founder of the Reimagining Defence podcast, Lt. Col Al Brown, Chief of the Staff General Scholar and Visiting Fellow at Pembroke College, Oxford and Graham Fairclough, former Chief of Staff for the UK's Chief of Defence Intelligence in London and currently Chief of Staff for Rebellion Defence to share their experiences and vision for harnessing the exponential growth in technologies for defence, its potential uses and misuses, and the implications for the battlefield.
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[…] the temporary response to the economic fallout caused by the pandemic: truly, it represents a Hamiltonian moment for the EU. Some 80% of the resources will be channelled through the Recovery and Resilience Facility with […]
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A week after the Paris Agreement entered into force, the United States have elected Donald J. Trump as their 45th President – a man who famously described climate change as "created by and for the Chinese in order to make U.S. manufacturing non-competitive." His stance on climate change, his strong support for coal and pledge […] The post Donald Trump v. The Environment: learning from past attempts to dismantle environmental policy appeared first on Environmental Europe?.