Macroeconomists sure like models.  When they see a new and interesting stylized fact, they instantly want to create a model to explain it.  Indeed they like their models so much that they sometimes forget to carefully check whether the stylized fact is, well, a fact.  Consider the following from a new paper by James Bullard, President of the St. Louis Fed.

They suggested that the combination of an active Taylor-type rule and a zero bound on nominal interest rates necessarily creates a new long-run outcome for the economy. This new long-run outcome can involve deflation and a very low level of nominal interest rates. Worse, there is presently an important economy that appears to be stuck in exactly this situation: Japan.

That’s a pretty bold assertion.  Is Japan really stuck in a deflationary trap?  I read on, looking for the evidence.  Unfortunately, I couldn’t find any.  There was a graph showing that Japan had experienced some very mild inflation, but I was under the impression that the Bank of Japan was an ultra-conservative bank, and liked mild deflation.  Indeed I thought that was pretty widely understood.  I guess not.

Is there any way to tell if I’m right?  Fortunately, the paper provides the answer a few pages later:

But for the nominal interest rate, most of the Japanese observations are clustered between 0 and 50 basis points. The policy rate cannot be lowered below zero, and there is no reason to increase the policy rate since–well, inflation is already “too low.””This logic seems to have kept Japan locked into the low nominal interest rate steady state. Benhabib, et al., sometimes call this the “unintended” steady state.

Hmmm.  Inflation is “too low.”  Japan is in an “unintended steady state.”  And how would we know?  The answer is simple, and is provided in the quotation.  The Bank of Japan would never raise interest rates during a period when inflation is “too low,” that would make no sense.  I agree.  The problem is that the BOJ did raise interest rates during the 2000s, indeed more than once.   So although Western economists consider Japanese inflation to be “too low,” it is quite apparent that the BOJ feels differently. 

Of course there are many other reasons why we know that Japan is not stuck in any sort of deflationary gap.  They let the yen appreciate strongly during the midst of the great deflationary crisis of 2008-09.  They dramatically reduced the monetary base in 2006 to prevent inflation.  Indeed almost every time the Japanese inflation rate approaches zero, from below, the BOJ seems to do something contractionary. 

But why bother with facts when we have these beautiful models?  Macroeconomists must have created a 100 models to explain how and why Japan became trapped in deflation.  It’s a pity that it never happened, as they are quite clever models.

I shouldn’t have been so sarcastic, as the Bullard paper is no worse than any other in this respect.  And in other respects it is far better than most.  Let me finish up on a positive note, by quoting Bullard’s concluding paragraphs:

When the European sovereign debt crisis rattled global financial markets during the spring of 2010, it was a negative shock to the global economy, and the private sector perception was certainly that this would delay the date of U.S. policy rate normalization. One might think that is a more inflationary policy, but TIPS-based measures of inflation expectations over five and ten years fell about 50 basis points. 

Promising to remain at zero for a long time is a double-edged sword. The policy is consistent with the idea that inflation and inflation expectations should rise in response to the promise, and that this will eventually lead the economy back toward the targeted equilibrium of Figure 1. But the policy is also consistent with the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.

To avoid this outcome for the U.S., policymakers can react differently to negative shocks going forward. Under current policy in the U.S., the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of
Treasury securities.

Exactly!  Promising zero rates as far as the eye can see is like promising failure for as far as the eye can see, because zero rates occur in depressed economies.   QE is much better.  And even better yet, supplement it with a price level or NGDP target.  (Good to know that monetarism is not completely dead at the St. Louis Fed.)

PS.  You might think I was quibbling about some rather small increases in nominal interest rates in Japan.  How do I explain the fact that Japan has experienced mild deflation “despite” low interest rates?  Easy, you’d expect mild deflation to cause very low interest rates, a point Milton Friedman made many years ago.  Interest rates are behaving exactly as you’d expect if they were targeting mild deflation (low, but occasional nudges upward to prevent outbreaks of inflation) and not at all as you’d expect if they were stuck in a deflationary trap (interest rates stuck at zero, and never raised.)

HT:  Benjamin Cole

One of the great frustrations of discussing monetary policy is that most people buy into the notion that when the Fed is “doing something” we should see changes in short term rates and/or the money supply.  In fact, it is expectations of future policy that drive AD. 

There are several problems with trying to find links between movements in the money supply, and changes in the economy.  First, the Fed is not usually trying to conduct natural experiments.  They are trying to stabilize the economy.  Thus they will often move the money supply in response to changes in money demand.  Markets understand this, and hence often don’t react much to changes in the money supply.

Even worse, an exogenous change in the money supply, even when not done in response to changes in the demand for money, may have little impact if expected to be temporary.  If we put these two facts together, then policy will only affect AD when it is not responding to money demand fluctuations, and is not expected to be temporary.  But how can the markets know this?  After all, the Fed rarely announces “we are setting out on a plan to create the Great Contraction, or the Great Inflation.”  Instead, markets gradually become aware of the fact that monetary policy is drifting off course.  And it is at precisely this moment, when markets understand that the change in the money supply is no fluke, that we observe market reactions.  Of course changes on the broader economy are closely correlated with those market reactions.

Here’s an example.  Suppose in the 1960s the Fed ran an easier than normal monetary policy.  At first inflation would only rise a bit.  Why bid up houses to twice their normal level, if you expected the Fed to soon return to its longstanding practice of low inflation.  Then gradually, little by little, people realize that monetary policy is changing in a fundamental way.  This time was different.  There may be signals, such as the breakdown of Bretton Woods, but even those changes may be partly endogenous.  In any case, once the policy is recognized as permanent, the prices of assets such as commodities and real estate will start to rise faster.  Stocks are more complicated, rising with the price level, but falling with higher rates of inflation (due to the inflation tax effect.)

This delayed reaction led many monetarists (and non-monetarists) to assume that there were “long and variable lags” between changes in monetary policy and aggregate demand.  In fact, the lags are extremely short.  The problem was that monetary shocks were misidentified, assumed to begin when the money supply changed; whereas they actually begin from the moment the money supply increase was viewed as permanent.  Thus some people argue that the bloated level of bank reserves is a sort of time bomb, waiting to explode into higher prices with a long lag.  Instead, markets don’t expect the Fed to ever allow the bomb to explode, they expect the Fed to eventually pull the reserves out of circulation, or else pay higher rates of interest to encourage banks to hold on to the reserves.  And if it does explode into high inflation, the “cause” won’t be the current rise in the base, but rather the later decision not to do something about it—the something the market now expects the Fed to do. Even the great Milton Friedman missed this insight.

How can I so arrogantly assert that the economics profession is wrong about long and variable lags?  Because there are other types of monetary policy that have an immediate effect on the future expected money supply.  And these alternative policies also immediately affect asset prices and AD.  Indeed, according to the EMH, the standard view would only make sense if there were long lags between asset prices (which are surely impacted right away) and the broader level of AD.  But if that were true then business cycles should be forecastable; which they are not.  Hence the “variable lag” cop-out. 

Fortunately, there are other ways of doing monetary policy, techniques that can immediately influence the future expected money supply.  The one I most often talk about is the 1933 decision to raise the price of gold.  This immediately raised the future expected price level (via PPP) the future expected money supply (price-specie-flow), future expected NGDP, and thus the current level of AD.  I like to think of higher levels of future expected NGDP as being what Keynes meant in his frequent references to “confidence” in the General Theory.  Keynes had great intuition, but wasn’t able to effectively work that intuition into abstract models of nominal shocks.  

Of course we don’t need to go back to the gold standard, any currency devaluation will work just as well—assuming the devaluation is an exogenous monetary policy shock, and not the fall in the real exchange rate due to an economic crisis.  (The 2002 Argentine devaluation saw a bit of both.  NGDP started rising immediately, but RGDP was temporarily depressed by economic turmoil.)   But why are currency devaluations so powerful?  The reason is that they tend to be highly credible.  When a country is operating under a fixed exchange rate regime, it loses enormous credibility and reputation by devaluing.  Therefore they often hold off until the bitter end.  Once they take that painful step, there would be no reason for the policy to be reversed.  Thus when a large devaluation occurs, it is generally the case that the future expected exchange rate (i.e. the forward rate) falls by about the same amount.  This immediately raises the future expected price level, and hence current AD.  The lags are very short. 

In some cases the effect is even more certain.  When a country’s nominal interest rate is near zero, the rate cannot fall further.  The interest parity theorem shows that if you do a major devaluation, the exchange rate cannot be expected to appreciate back to the old level unless nominal interest rates fall significantly.  But that can’t happen at zero nominal rates, and is why people like Lars Svensson argued that depreciation of the Japanese yen was a “foolproof” way out of their liquidity trap.  

The US can’t really use the exchange rate as a policy tool, it is too controversial.  But there is a price it can use, CPI or NGDP futures.  If the Fed sets a higher explicit nominal target, the effect is almost identical to currency devaluation—AD is affected immediately.  When I debated Jim Hamilton last year, I recall he was skeptical of my assertion that NGDP targeting would have prevented the economy from falling off the cliff in late 2008.  I think he was relying on the long and variable lags concept.  That would have been a good argument if my proposed policy tool was money supply expansion or a lower fed funds target.  Those changes might have had little effect on future expected policy, and hence future expected NGDP.  But an explicit NGDP target would be different.  As with currency devaluation, it would immediately change the future expected path of NGDP, and hence prop up current NGDP as well.  The Fed may try something new in the next few months.  It will either work right away (observable in the market reactions) or not at all.

We have two languages for discussing monetary policy.  The fed funds rate/money supply language is full of mysterious long and variable lags, and makes intelligent conversation almost impossible.  Literally any outcome can be assumed, depending on your assumptions about the future stance of policy.  (On the other hand, the alleged perfect substitutability between cash and T-bills is nearly irrelevant.)    If we shift monetary policy talk to prices, we can immediately pin things down.  It could be the price of gold, a basket of commodities, a foreign exchange rate, the overall price level, or NGDP.  What’s important is that this sort of discussion almost always has implications for future policy as well, and that’s what we need to know to pin down the current stance of policy.  Intertemporal arbitrage connects current and future prices.  Unfortunately, as we saw in the New York Times story I just posted on, almost all M-policy talk continues to refer to near-term levels of short term rates and the monetary base.  Which means we are still talking gibberish.

Between 1929 and 1933, and again between 1937-40, the wholesale price level trended steadily downward.  Since 1994 the Japanese economy has experienced a deflation rate of roughly 1% a year in the GDP deflator.  What do all three of these famous deflations have in common?  During most of the time banks held unusually large quantities of reserves, far above normal levels.  High levels of reserves (often excess reserves) is one of the most characteristic stylized facts of prolonged deflation. 

Here is Philly Fed Bank President Charles Plosser, quoted in the New York Times:

“I think the fear of deflation in and of itself is probably overblown, from my perspective,” Charles I. Plosser, president of the Philadelphia Fed, said last week in an interview. He said that inflation expectations were “well anchored” and noted that $1 trillion in bank reserves was sitting at the Fed. “It’s hard to imagine with that much money sitting around, you would have a prolonged period of deflation,” he said.

On a more positive note, here’s St. Louis President Bullard moving in our direction:

Fed Member’s Deflation Warning Hints at Policy Shift

By SEWELL CHAN

WASHINGTON — A subtle but significant shift appears to be occurring within the Federal Reserve over the course of monetary policy amid increasing signs that the economic recovery is weakening.

James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the American economy was at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”

On Thursday, James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed’s current policies were putting the American economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”

The warning by Mr. Bullard, who is a voting member of the Fed committee that determines interest rates, comes days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed, though it had no immediate plans to do so.

Mr. Bullard had been viewed as a centrist and associated with the camp that sees inflation, the Fed’s traditional enemy, as a greater threat than deflation.

But with inflation now very low, about half of the Fed’s unofficial target of 2 percent, and with the European debt crisis having roiled the markets, even self-described inflation hawks like Mr. Bullard have gotten worried that growth has slowed so much that the economy is at risk of a dangerous cycle of falling prices and wages.

Among those seen as already sympathetic to the view that the damage from long-term unemployment and the threat of deflation are among the greatest challenges facing the economy, are three other Fed bank presidents: Eric S. Rosengren of Boston, Janet L. Yellen of San Francisco and William C. Dudley of New York.

As the Fed’s board of governors shifts, the doves are getting more attention.

President Obama has nominated Ms. Yellen to be vice chairwoman of the Fed. The Senate Banking Committee voted 17 to 6 on Wednesday to confirm her, though the top Republican on the panel, Senator Richard C. Shelby of Alabama, voted no, saying he believed Ms. Yellen had an “inflationary bias.”

Mr. Obama’s two other nominees, Peter A. Diamond and Sarah Bloom Raskin, who like Ms. Yellen are on track to be confirmed by the Senate, have also expressed serious concerns about unemployment.

.   .   .

“This is very significant,” Laurence H. Meyer, a former Fed governor, said of Mr. Bullard’s new position. “He has been one of the most hawkish members, but he is now calling for the Fed to ease aggressively. There seems to be no question he wants to do it sooner rather than later, and relatively forcefully.”

As you know, I have been emphasizing the very low TIPS spreads on 5 year bonds, currently about 1.4%.  Inflation hawks often reply that these spreads are not reliable.   But former inflation hawk Bullard seems persuaded:

Mr. Bullard said that inflation expectations had fallen from about 2 percent earlier this year to about 1.4 percent now, as judged by one measure, five-year Treasury inflation-protected securities.

The outcome could be an “unintended steady state” like Japan’s slow-growth economy. “The U.S. is closer to a Japan-style outcome today than at any time in recent history,” he wrote.

Along with changing the “extended period” language and resuming asset purchases, the Fed could lower the interest it pays on excess reserves — the reserves the banks hold with the Fed in excess of what they are required to — from its current rate of 0.25 percent.

Lowering interest on reserves?  Where’d that crazy idea come from?  But I still get frustrated by this sort of reasoning:

Richard W. Fisher, president of the Dallas Fed, said in an interview this week: “Reasonable people can argue that there’s a risk of deflation, but we haven’t seen it in the numbers yet.”

These two regional bank presidents [i.e. including Plosser], along with Thomas M. Hoenig of the Kansas City Fed, are associated with the hawkish camp within the Fed whose focus is continued vigilance on inflation.

If stable prices are the goal, and not 2% inflation, then why did the Fed run 2-3 % inflation for decades, only deciding to go for zero during the worst financial crisis in American history?  Oh, I forget, opportunistic disinflation.  (aka: “Having cancer is a good opportunity to lose some weight.”)

HT:  Marc Stern and David Glasner

The first best solution for our unemployment problem is easier money.  The second best solution is not extended unemployment benefits, however, it is job subsidies:

The average duration of unemployment continues to break records, after all, and studies have shown that the longer people are out of work, the less employable they become.

“I never, ever, ever thought I’d end up in an art gallery,” said Tremaine Edwards, 35, a former computer technician who had been unemployed for two years before he was hired in May by Gallery Guichard, a private gallery in Chicago. Mr. Guichard now earns $10 an hour, financed by the government, through the Put Illinois to Work program, to maintain the company’s Web site, curate exhibits and run gallery events.

He has also become the gallery’s star salesman, selling five paintings during the most recent gallery opening despite no background in fine arts or sales.

“I feel like if I knew I could have done this 15 years ago, I would have,” he said, grateful for the opportunity to escape cubicle life. “As long as I keep selling like this, I think I’ll be fine, no matter what happens with Put Illinois to Work.”

Proponents of these national job subsidies, initially financed with $5 billion of stimulus money, say it is better to pay people for working in real jobs than to pay them jobless benefits for staying idle.

Placing workers in the private sector is also more promising than giving them make-work government jobs, they say, because market forces can be harnessed to figure out where people like Mr. Edwards should invest their skills for the long run.

I don’t know anything about the effectiveness of this particular job subsidy, but there are definitely some subsidy ideas that would be preferable to unemployment insurance extensions.  One such idea is lower payroll taxes.

The WSJ discussed a recent paper by Benjamin Friedman and Kenneth Kuttner, which supports two of the major themes of this blog:

New research on monetary policy is reinforcing the idea that when it comes to the Federal Reserve, watching what officials say is as much or maybe even more important than watching what they do.

A new paper published by the National Bureau of Economic Research, written by economists Benjamin Friedman and Kenneth Kuttner, sought to get to the heart of how monetary policy actually brings about changes in the economy. The economists note the world’s major central banks, most notably the Fed, can bring about changes in interest rates almost entirely by stating that they want a shift in the cost of borrowing.

This is one point I keep emphasizing, monetary policy is most effective when the central bank signals future policy intentions; movements in the fed funds rate only matter to the extent that they signal future policy intentions.  This means that when the central bank appears to be “doing nothing” it actually might be quite active.  The old Keynesian economics of the liquidity trap, which implicitly underlies all arguments for fiscal stimulus, is predicated on the assumption that a sort of singularity is reached when nominal rates hit zero.  They can’t be lowered, and political pressure makes increases unlikely during periods of high unemployment.  So (the argument goes) fiscal policy multipliers can be calculated under the assumption of “other things equal,” i.e. no monetary policy sterilization.  But that’s not how things work in the real world.  As soon as a massive fiscal stimulus is passed, and conservatives start worrying about inflation, then central banks start chattering about exit strategies.  This chatter is monetary tightening, just as surely as a rise in the fed funds rate.  We are always in the classical world, there is no Keynesian world.

“There is little if any observable relationship between the interest rates that most central banks are setting and the quantities of reserves that they are supplying,” the paper said. Studies of central banking action “consistently show no relationship between movements in policy interest rates and the supply of reserves” in the U.S., the euro zone and Japan, it added.

Instead, the change in rates across the yield curve, driven by a central bank shift in a very short-term rate few actually can access, is tied to what the institution has told financial markets.

“The announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation,” the economists wrote. When it comes to the U.S. central bank, “on many occasions, moving the federal funds rate appears to have required no, or almost no, central bank transactions at all”–the market did the Fed’s work for it, the paper stated.

Woodford and Eggertsson are best known for the view that what really matters is not the current setting of policy instruments, but rather changes in the expected future stance of policy.  And in my own small way I reached that conclusion independently during my research on the Great Depression.  The Friedman and Kuttner paper provides support for the idea that Fed signals drive monetary policy much more than current changes in policy tools.  Of course eventually those policy levers must adjust, but that adjustment may occur over long periods of time.

The paper doesn’t assert that markets for bank reserves are steady, noting that “since 2000 the amount by which reserves have changed on days of policy-induced movements in the federal funds rate has become noticeably larger on average.”

But the trading is just noise: “In a significant fraction of cases–one-third to one-fourth of all movements in the target federal funds rate–the change in reserves has been in the wrong direction,” calling into question the central bank influence in the process.

The paper gives some hope to policy makers who believe that resolute talk about keeping inflation in check, along with preparation for future action, will keep prices contained in a time of historically high bank reserves.

It should be no surprise that reserves often move in the “wrong” direction.  Changes in overnight fed funds rates are not driving the economy, they are reflecting economic conditions.  Here is a simple example.  Suppose the economy booms and lots more transactions are occurring.  The boom will raise rates, and the level of reserves will also rise to reflect the higher level of transactions (assuming the Fed is inflation targeting.)  The whole process is driven by the Fed’s inflation targets; once those are set then the money supply and interest rates are both endogenous.  But there is a great danger in this kind of thinking:

Fed officials have argued managing market expectations is the key. If the Fed appears to remain a credible guardian of price stability, then inflation should remain in check. While that may seem like a rather ephemeral bulwark against an inflation surge, the paper says it’s this very notion of expectations and communications that drives policy in the best of times too.

Here’s real problem.  The Fed’s inflation targeting signals are far too vague.  Taken literally, sudden price stability would be a disaster.  If the Fed suddenly reduced inflation from the recent 2.5% norm to zero, then unemployment would rise sharply.  (Come to think of it, they just did that!)  Of course people will say; “By price stability the Fed implicitly means 2% inflation.”  Fine, but that requires a symmetric response to changes in inflation in either direction.  The WSJ writer clearly seems to think only excessively high inflation is a potential problem, not excessively low inflation.  And the Fed behaves as if they suffer from the exact same confusion as the WSJ writer.  The Fed is ever-vigilant against above normal inflation, but doesn’t seem vigilant against below normal inflation.  And that doesn’t even address the fact that their “dual mandate” implies they should actually be even extra vigilant against excessively low inflation.

Yes, Fed signals drive AD and NGDP.  But we need clear signals, signals that are consistent with the Fed’s policy goals.  And what are the Fed’s policy goals . . .

HT:  Tyler Cowen