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Paul Krugman on monetary policy options

Saturos sent me some interesting PowerPoint slides by Paul Krugman:

Screen Shot 2014-04-11 at 9.37.21 AMKrugman overlooks a third option, targeting an alternative variable that is not subject to the zero lower bound.  Or perhaps he regards that as a regime change.  I can’t be sure.  But it need not involve the Fed changing its inflation/unemployment targets, so it depends how one defines ‘regime.’  I believe he regards “regime shift” as something like an increase in the inflation target to 4%.

In any case, alternative targets include foreign exchange rates, the price of actively traded commodities such as gold, and CPI/NGDP futures prices. Fisher’s Compensated Dollar plan was an adjustable gold price peg, aimed at stabilizing the price level.

In the past I’ve argued that Krugman had a sort of blind spot in this area.  For instance, he was too pessimistic about the ability of the Swiss National Bank to peg the franc at a lower level vs. the euro.  In any case, it’s interesting to compare these schemes to forward guidance. Krugman correctly points out that there is a theoretical possibility of an “expectations trap” with forward guidance.  Markets might not believe central bank promises to fully carry through with monetary stimulus, as the initial effect on expectations is all the central bank really wants and needs.

You can think of the alternatives to interest rate targeting (assets that lack a zero bound) as a way of overcoming the expectations trap. When you target a variable with no zero bound (forex, gold, NGDP futures, etc) you are forced by the market to do “enough” to make the promise credible. Hence no expectations trap. In this post Krugman correctly pointed out that the risk of an expectations trap is replaced with the risk of a central bank balance sheet that is bloated to undesirable levels. In practice, I think that’s unlikely to be a problem for any “reasonable” nominal aggregate policy goal.  And if it does become a problem the market is telling you that perhaps your inflation/NGDP target path is too low.

And we should not overlook the bright side of a bloated balance sheet.  Suppose Japan was still at the zero rate bound after pegging CPI futures at a 2% premium over the spot CPI.  That might imply a bloated BOJ balance sheet.  But that would prove beyond any doubt that the Japanese government had just spent the past 20 walking down a sidewalk covered with $100 bills (or 10,000 yen bills) without once stopping to pick one up.  Not smart, and it’s about time they raised their inflation rate target if they can do so without raising the nominal cost of funding the Japanese debt by one iota.  A free bento box.

Krugman also makes this comment:

Screen Shot 2014-04-11 at 9.51.35 AMOnce again, this is correct but slightly misleading. The distinction between the direct effect of a policy shift and the effect of a shift in the future expected path of policy is almost equally important when not at the zero bound.  Any monetarist thought experiment involving a higher money supply ALWAYS involves the implicit assumption that the increase is permanent, or at least semi-permanent.  Alternatively, when markets react very strongly to changes in the fed funs target (Jan. 2001, Sept. 2007, Dec. 2007) the market reaction almost certainly reflects changes in the expected future path of the fed funds rate, not the current setting.

I was also amused by this; from one of his PP slides:

Screen Shot 2014-04-11 at 9.56.01 AMI wondered what had been deleted from this passage, as there seemed to be missing material at the end of each line.  Here’s where Google is a miracle of the modern world—I was able to find the Wikipedia source:

On September 13, 2012, the Federal Reserve announced a third round of quantitative easing (QE3).[7] This new round of quantitative easing provided for an open-ended commitment to purchase $40 billion agency mortgage-backed securities per month until the labor market improves “substantially”. Some economists believe that Scott Sumner‘s blog[8] on nominal income targeting played a role in popularizing the “wonky, once-eccentric policy” of “unlimited QE”.[9]

Ah, that’s much better!



Reply to Frances Coppola

Here is Frances Coppola:

Scott Sumner argues thatwhen the monetary base is fixed, low interest rates are deflationary. I’ve emphasised the fixed monetary base because it is an important condition. If the monetary base is NOT fixed then the relationship between low interest rates and deflation is much less clear.

Logically, this makes sense. If the supply of base money is fixed, then falling interest rates indicate* rising demand for base money, increasing its value and therefore causing prices to fall. Aficionados of a classical gold standard will recognise this as “benign” deflation. Falling interest rates when the monetary base is fixed are an indicator of healthy growth.

I would argue the opposite.  Low interest rates are usually indicative of weak growth, as both real and nominal interest rates are procyclical.  Barsky and Summers showed that under the gold standard, when the economy slowed interest rates tended to fall.  This increased the demand for gold (the medium of account) and was deflationary.

The “good deflation” was a secular phenomenon.  It was associated with a rise in the demand for money from positive trend real GDP growth, not lower interest rates.

It’s misleading to say falling interest rates are only deflationary under a constant monetary base. They have a deflationary impact regardless of the base, it’s just that when the base is changing the deflationary impact from falling interest rates is often offset by the inflationary impact of a rising monetary base.

The Fed was not holding the monetary base fixed and allowing the interest rate to fall, which is what Sumner implies. It was actively supporting the Fed Funds rate.

The Fed Funds rate is not simply a market interest rate. At the time, it was the primary monetary policy tool, though these days – because of the presence of excess reserves in the system – it has been superseded by the interest on reserves (IOR) rate.

Interest rates fell becasue of a weakening economy, not because the Fed cut interest rates.  When the Fed announcement in December 2007 was less expansionary then expected, 3 month T-bill yields (which are market interest rates) fell on the news. Markets understand market monetarism. A few weeks later the Fed had a panicky emergency meeting and cut it’s fed funds target in an attempt to keep up with changing economic conditions.  The reduced demand for loanable funds was pushing rates lower, and because the Fed did not respond by increasing the base this led to a further slowdown in NGDP.

Sumner seems to think that the Fed should not have supported the rate by draining reserves. On he contrary, he explicitly blames the Fed’s failure to expand the monetary base at this time for the subsequent collapse of NGDP:

Between August 2007 and May 2008 there was no change in the monetary base, and yet interest rates fell sharply.  Not surprisingly NGDP growth slowed and we tipped into recession.

But the problem was inflation:

Expansionary monetary policy when inflation was already so far above target would have seemed like madness. Even since the crisis, it takes a brave central bank to hold its nerve and its expansionary policy when inflation is a long way above target, as the Bank of England has discovered.

Yes, at the time the market monetarist message would have seemed like madness—focus on NGDP growth and ignore inflation.  But we now know it is inflation targeting that is madness.  Even Bernanke now admits that actual policy was too tight during the crisis.

Nor would NGDP targeting necessarily have made much difference to Fed policy. We now know, with the benefit of hindsight, that NGDP was going to fall off a cliff in 2008. But at the time, NGDP didn’t show much sign of such a dramatic collapse:

It would have made a huge difference, because with NGDPLT monetary policy works with “long and variable leads.”  The expectation that the Fed would return to the 5% trend line in the long run would have stabilized asset markets in the short run, and Lehman might not have even failed.

Those in favour of a strict rule-based approach to monetary policy based on something like an NGDP target will no doubt be disappointed: but as I said above, an NGDP target would not necessarily have resulted in a markedly different policy stance in the crucial early part of the financial crisis.

Maybe not all that different, but then the initial part of the recession was exceedingly mild.  Most importantly NGDPLT would have created expectations of a very different policy in the latter half of 2008, which would have made the recession far milder.

PS.  The Coppola post refers to a money supply graph that I wasn’t able to find. Was it included? Another graph has a garbled horizontal axis, and another refers to potential NGDP which is a nonexistent concept.  “Potential” only has meaning for real variables.

Update:  I mistakenly linked to the wrong version of the post.  The correct version does have a money supply graph.

HT:  Travis V.


Mark Sadowski on monetary stimulus, currency depreciation, and trade balances

Before beginning, let me point out that many people seemed to misread my previous post.  I was making no claims about causality.  God knows I’m no expert in criminology!  I was making a joke about people with a certain blind spot—incentive effects.

Over at Econlog I have a post discussing Edward Hugh’s recent piece on Abenomics.  At the end I cited a comment by Mark Sadowski.  This post will be another of his excellent comments:

Off Topic.

This claim by Edward Hugh reveals he really doesn’t get it.

“But it’s worse, the monetary expansion has driven down the value of the yen but in the context of the second arrow – a double digit fiscal deficit – this drop in value is leading to a growing not a declining trade deficit. The FT’s Tokyo bureau chief, Jonathan Soble, has an enlightening recent piece on this…”

Although Japanese nominal exports have surged by 15.2% between 2012Q4 and 2013Q3, nominal imports are up by even more, or by 16.5%:

Devaluation improves a country’s trade balance only if the Marshall-Lerner condition on trade elasticities holds, and research shows that they’re not met in the majority of cases, either past or present:

That’s not to say that currency devaluation isn’t beneficial, of course it is, but the benefit flows primarily from increased domestic demand. Here is a study of the competitive devaluations of the Great Depression by Barry Eichengreen and Douglas Irwin:

The Great Depression is a particularly important historical example because then, as now, most of the advanced world was up against the zero lower bound in policy interest rates.

An examination of Figure 4 on page 48 reveals that the only countries that experienced import growth from 1928 to 1935 (the UK, Japan, Sweden and Norway) were members of the sterling block that devalued early (1931). In most of these countries net exports actually declined over the period because imports rose more than exports.

The order of recovery from the Great Depression follows the order in which they abandoned the gold standard perfectly:

But this wasn’t because of increased net exports.

The US devalued in 1933 which immediately led to a swift recovery from the Great Depression. Nominal exports doubled from 1933 to 1937. But nominal imports increased by 110.5%:

As a result net exports went from a small surplus (about 0.2% of nominal GDP) to being roughly in balance.

France was part of the Gold bloc of countries that devalued late (1936). From 1936 to 1938 nominal exports increased by 95.4% and nominal imports increased by 80.9%:

However, since imports were already substantially greater than exports, the nominal deficit actually increased by 55.4%.

Japan’s original ryōteki kin’yū kanwa (QE) was officially announced in March 2001 and concluded in March 2006. The following is a graph of the BOJ’s estimate of Japan’s real effective exchange rate which is trade weighted with respect to 16 different currencies and takes into account their relative inflation rates:

The real effective exchange rate fell from 116.25 in February 2001 to 91.09 by March 2006, when the BOJ announced the completion of QE, a decline of 21.6%.

Exports rose from 10.2% of nominal GDP in 2001Q4 to 19.3% of GDP in 2008Q3. Imports rose from 9.4% of GDP in 2001Q4 to 19.5% of GDP in 2008Q3. From 2002Q1 to 2008Q1 real (adjusted by the GDP implicit price deflator) grew at an average annual rate of 11.0%. Real imports grew at an average annual rate of 12.1%.

So there was boom in both exports and imports. But imports grew faster than exports, and net exports actually moved from surplus (0.8% of GDP) to deficit (-0.2% of GDP) between 2001Q4 and 2008Q3:

It’s very telling that today the only major currency area up against the zero lower bound in interest rates that hasn’t done QE (the Euro Area) is also the only major currency zone where the trade balance has improved substantially since 2009, going from 0.6% of GDP in 2009Q1 to 3.3% of GDP in 2013Q3:

But this has occurred in large part because nominal imports have been falling since 2012Q3 due to falling domestic demand. Nominal exports have barely changed since 2012Q3.

I’d add that Greece has done an especially good job of “improving” its trade balance.

I was skeptical until I saw the phrase “nuclear mathematician”

This was in my email box this morning:

Dear Reader,

I admit, an 18.79% annual return for the rest of your life sounds too good to be true.

You have every right to be skeptical of such claims.

I certainly was skeptical when a colleague of mine told me he had developed and back-tested a system for making such profits.

But then he divulged the entire story . . . how he discovered a secret calendar that Wall Street uses to grab 250% gains, and how he teamed up with a nuclear mathematician to perfect the calendar to pick winning trades 96% of the time.

It truly is one of those marvels that “you have to see to believe . . .”

Which is why my colleague was kind enough to put a video together revealing this secret calendar, and how anyone could use it to profit.

Back-tested?  Then count me in.

Even better, the company was strongly recommended by a famous conservative newsmagazine.

Comment of the day

Here is Britmouse:

I find it astonishing that Krugman and Wren-Lewis, having done post after post in 2012 describing how the UK does have real fiscal austerity in 2012, are suddenly happy to now argue that a relaxation of fiscal austerity in 2012 is the “reason” for GDP recovery in… erm, 2013.