pg 0

Thoughts on US Monetary Policy Prepared for Hutchins Center Conference, March 21,

2016

Richard H. Clarida Professor of Economics and International Affairs

Columbia University

Global Strategic Advisor

PIMCO

pg 1

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

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

US

growth in balance sheet (yoy)

% change in money multiplier

% change in money demand (inverted)

yoy growth in nominal GDP

Note that quarter by quarter the growth in nominal GDP is exactly accounted by these three factors

As of 31 December 2015 SOURCE: Haver Analytics

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

pg 2

0

20

40

60

80

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120

140

160

180

200

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

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2024

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2024

Q1

2025

Q3

2025

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2026

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2026

Q1

2027

Q3

2027

Q1

2028

Q3

2028

Q1

2029

Q3

2029

Q1

2030

Q3

2030

USD

$bn

TSY, TIPS, and Agency Debt MBS

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

Maturity profile of the Fed’s balance sheet through 2030

pg 3

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

SOURCE: Federal Reserve

The equilibrium real federal funds 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 federal funds rate should be normalized, but at a gradual pace.

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

pg 4

0.0

1.0

2.0

3.0

4.0

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6.0

7.0

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

Perc

ent (

%)

December 2018 Eurodollar Interest Rate Future Contract Implied Policy Rate

Old Neutral = 4% Nominal Median Blue Dot

As of 29 February 2016 SOURCE: Bloomberg

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

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0.0

0.5

1.0

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2.0

2.5

2001–2007 2015–2020

Perc

ent (

%)

Advanced Economies Potential employment growth Capital growth Total factor productivity growth

0.0

2.0

4.0

6.0

8.0

2001–2007 2015–2020

Perc

ent (

%)

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

As of 15 April 2015 SOURCE: IMF World Economic Outlook

Potential output growth and its components

Global growth converging to slowing trend trajectories

pg 6

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

}{}{ *1211 ++ ∆+∆+= ttttt yEyErr ββρ

Potential Home GDP growth

Potential Global GDP Growth

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:

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 7

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 8

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

90

100

110

120

130

140

150

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

Pric

e (U

S $)

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

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!

As of 1 January 2009 SOURCE: Bloomberg

pg 9

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

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

Brea

k Ev

en In

flatio

n Ra

te (

%)

5y 5y break-even inflation (BEI)

QE 1

QE 2

Twist

QE3+4

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

“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected in the longer run. FOMC Statement – 16 December 2015

“The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” Fed Statement - 18 March 2015

“This exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.” Fed Statement - 12 December 2012

“To support continued progress…the Committee…anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015” Fed Statement - 13 September 2012

As of 29 February 2016 SOURCE: Bloomberg, Federal Reserve

pg 10

12

13

14

15

16

17

18

19

20

2000 2002 2004 2006 2008 2010 2012 2014 2016

$ tr

n

A permanent hit to potential output?

9.8%

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?

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

pg 11

3.3%

70

75

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85

90

95

100

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110

115

120

Dec

'91

Dec

'92

Dec

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Dec

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Dec

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Dec

'00

Dec

'01

Dec

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Dec

'15

Leve

l

PCE Price DeflatorPrice level path consistent with 2 percent inflation

Fed formally adopts a 2% inflation target

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

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

As of 31 December 2015 SOURCE: PIMCO, Haver Analytics