Thoughts on US Prepared for Hutchins Center Conference, March 21, 2016

Richard H. Clarida Professor of Economics and International Affairs Columbia University

Global Strategic Advisor PIMCO

pg 0 QE and Nominal GDP… the Collapse (and Rebound?) of the Money Multiplier

US 1.0

0.8 yoy growth in nominal GDP 0.6 growth in balance sheet (yoy) 0.4

0.2

0.0

-0.2 % change in money multiplier -0.4 % change in money demand (inverted) -0.6

-0.8 Note that quarter by quarter the growth in nominal GDP is exactly accounted by these three factors -1.0 Dec '06 Sep '07 Jun '08 Mar '09 Dec '09 Sep '10 Jun '11 Mar '12 Dec '12 Sep '13 Jun '14 Mar '15 Dec '15

As of 31 December 2015 SOURCE: Haver Analytics

pg 1 Maturity profile of the Fed’s balance sheet through 2030

TSY, TIPS, and Agency Debt MBS 200

180

160

140

120

100 USD $bn 80

60

40

20

0 Q1 2016 Q3 2016 Q1 2017 Q3 2017 Q1 2018 Q3 2018 Q1 2019 Q3 2019 Q1 2020 Q3 2020 Q1 2021 Q3 2021 Q1 2022 Q3 2022 Q1 2023 Q3 2023 Q1 2024 Q3 2024 Q1 2025 Q3 2025 Q1 2026 Q3 2026 Q1 2027 Q3 2027 Q1 2028 Q3 2028 Q1 2029 Q3 2029 Q1 2030 Q3 2030

As of 1 January 2016 SOURCE: Bank of , PIMCO MBS “maturities” are estimated by modeling prepayments on MBS currently held on the Fed’s balance sheet.

pg 2 A ‘New Neutral’ Requires a Gradual Lift Off to a Lower Destination

The equilibrium real rate is at present well below its historical average and is anticipated to rise only gradually over time as the various headwinds that have restrained the economic recovery continue to abate. If incoming data support such a forecast, the should be normalized, but at a gradual pace.

- Chairman Janet Yellen speaking at the "The New Normal for Monetary Policy” research conference at the of , March 27, 2015

SOURCE: Federal Reserve

pg 3 Evolution of Market Pricing of Short Term Interest Rates in December 2018

December 2018 Eurodollar Interest Rate Future Contract Implied Policy Rate 7.0

6.0

5.0

4.0 Old Neutral = 4% Nominal Percent (%) Median Blue Dot

3.0

2.0

1.0

0.0 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16

As of 29 February 2016 SOURCE: Bloomberg

pg 4 Global growth converging to slowing trend trajectories

Potential output growth and its components

Advanced Economies Potential employment growth Capital growth Total factor productivity growth 2.5

2.0

1.5

Percent (%) 1.0

0.5

0.0 2001–2007 2015–2020

Emerging Market Economies Potential employment growth Capital growth Total factor productivity growth 8.0

6.0

4.0 Percent (%)

2.0

0.0 2001–2007 2015–2020

As of 15 April 2015 SOURCE: IMF World Economic Outlook

pg 5 Neutral real interest rate, in theory, a weighted average of US and foreign potential output growth (Clarida, Gali, Gertler (2002))

Only in the special case of a closed economy is neutral real interest rate a function solely of home potential output growth. In general, CGG (2002) show that:

Potential Global GDP Growth * + rrt = ρ + β 1Et{∆ yt 1}+ β 2Et{∆yt+1} Potential Home GDP growth

What happens in Beijing and Brasilia is (almost) as important as what happens in Washington to US bond yields - in the front end as well as the long end!

pg 6 US Bond Yields Reflect in Part the Value of Insurance in an Uncertain World

Curiously, heightened risk and fears of “ further disruptions – not just another financial crisis, but also geopolitical instability and pandemics – do not seem to carry much weight in current policy discussions… Though bonds are hardly a perfect hedge against such risks… even relatively minor shifts in disaster risk – say, a rise from a normal 2–3% to 3–4% – can lead to a massive decline in global real interest rates, even taking them well into negative territory. This can be the case even if expected growth is strong… ” Ken Rogoff, “The Stock Bond Disconnect,” Project Syndicate

SOURCE: Atlantic Monthly

pg 7 Total Return on a 30 Year US Treasury Bond in 2008…40%!

Price of a 4.75% 2/15/37 Treasury Bond in 2008 150

140 Ceteris paribus, a 40 percent expected return on a 30 year Treasury with a 2 percent greater probability of a crisis lowers the expected return absent the crisis by about 70 basis points! 130 Price (US $)

120

110

100

90 Jan '08 Feb '08 Mar '08 Apr '08 May '08 Jun '08 Jul '08 Aug '08 Sep '08 Oct '08 Nov '08 Dec '08

As of 1 January 2009 SOURCE: Bloomberg

pg 8 Fed likely to continue to rely on communication to keep policy rate expectations anchored…

“The Committee expects that economic conditions will evolve in a “The Committee anticipates that it will be appropriate 5y 5y break-even inflation (BEI) manner that will warrant only gradual increases in the federal to raise the target range for the federal funds rate 3.5 funds rate; the federal funds rate is likely to remain, for some when it has seen further improvement in the labor time, below levels that are expected in the longer run. market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” 3.0 FOMC Statement – 16 December 2015

QE 2 Fed Statement - 18 March 2015

2.5 QE3+4

2.0

Twist 1.5 “To support continued progress…the “This exceptionally low range for the federal funds rate will be appropriate at least

Break Even Inflation Rate (%) Committee…anticipates as long as the unemployment rate remains above 6-1/2 percent, inflation 1.0 that exceptionally low between one and two years ahead is projected to be no more than a half levels for the federal percentage point above the Committee’s 2 percent longer-run goal, and funds rate are likely to longer-term inflation expectations continue to be well anchored.” 0.5 be warranted at least through mid-2015” Fed Statement - 12 December 2012 QE 1 Fed Statement - 13 September 2012 0.0 Feb '08 Aug '08 Feb '09 Aug '09 Feb '10 Aug '10 Feb '11 Aug '11 Feb '12 Aug '12 Feb '13 Aug '13 Feb '14 Aug '14 Feb '15 Aug '15 Feb '16

As of 29 February 2016 SOURCE: Bloomberg, Federal Reserve

pg 9 As output gaps close in some major economies, and as central banks aim to run economies ‘hot’, is there upside risk to inflation that is not factored in to the consensus view?

A permanent hit to potential output? 20

19

18 9.8%

17

16 $ trn

15

14

13

12 2000 2002 2004 2006 2008 2010 2012 2014 2016

As of 25 January 2016 SOURCE: CBO, “An Update to the Budget and Economic Outlook: 2015 to 2025”

pg 10 US Price Level Since 1992…Time for a Price Level Target?

PCE Price Deflator Price level path consistent with 2 percent inflation 120

115 If the Fed were to aim for a Price Level Target, it would Fed formally adopts a 3.3% 110 want inflation of almost 3% for next 3 years to make up 2% inflation target for falling below the price level path consistent with 2 105 percent inflation objective.

Level 100

95

90

85

80

75

70 Dec '91 Dec '92 Dec '93 Dec '94 Dec '95 Dec '96 Dec '97 Dec '98 Dec '99 Dec '00 Dec '01 Dec '02 Dec '03 Dec '04 Dec '05 Dec '06 Dec '07 Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Dec '15

As of 31 December 2015 SOURCE: PIMCO, Haver Analytics

pg 11