Nick Rowe’s wisdom, New Keynesianism vs. NeoFisherism, and Fed incompetence, all explained in one 7 minute bicycle video
HT: Tyler Cowen
A slightly off-center perspective on monetary problems.
HT: Tyler Cowen
Back in 2011 most experts claimed there was nothing the Japanese could do to boost NGDP. It was believed they were stuck in a liquidity trap. Then in 2012 candidate Abe announced that he would implement a more expansionary monetary policy, including a 2% inflation target. I suggested the policy would help, although they’d fall short of 2% inflation. Mark Sadowski has a post showing the path of inflation. (When Abenomics was announced in November 2012 the Nikkei was around 8700 and the yen at less than 80 to the dollar.)
Mark also generously quoted from a 2011 post of mine that I’d forgotten about.
Just to be clear, it is quite possible (likely in my view) that Japan could get another 2% of RGDP by switching to a 3% NGDP target. But it would be a one-time gain, as their labor market got less rigid. Unemployment might fall to 2% or 3%, but trend growth shouldn’t change.
In fact, RGDP growth was 2.4% in the first year of Abenomics, and has been roughly zero since. Recall that zero is the new trend growth for Japan, due to their rapidly falling working age population. Yes, I was a bit lucky, but as Napoleon once said “give me lucky generals.” (or something vaguely like that, probably in French, not English.)
Marcus Nunes has a new post that quotes from the recent FOMC meeting:
There was push back against hesitating. A number of officials argued that a rate increase could convey confidence to the world about the economic outlook and that the Fed needed to move in acknowledgment of the progress the economy had already made toward normalcy.
Yes, tighter money from the Fed is just what global markets are looking for right now, to regain confidence.
You can’t make this stuff up. While traveling I saw a story that the new President of the Dallas Fed is going to be a management professor.
PS. I have a new post at Econlog.
In the previous post I pointed out that higher interest rates are inflationary, as they raise velocity. And yet I forget that just as most people wrongly think economic growth is inflationary, most people wrongly think higher interest rates are contractionary. And they are making the exact same mistake, not holding M constant when they make their observation.
In the short run, a Fed decision to raise rates is indeed often contractionary. But that’s because they typically raise rates by cutting the money supply, which is more contractionary than the higher interest rates are expansionary.
Don’t believe me? Then how about that famous Keynesian Larry Summers, which established this proposition in a paper he did with Robert Barsky. They found that under the gold standard, higher interest rates led to booms and rising prices, and lower interest rates led to recessions and deflation. Before 1913 the Fed didn’t even exist, so movements in interest rates impacted the demand for gold, which impacted NGDP growth.
One commenter asked about the likely September increase in interest on reserves, which is supposed to be contractionary. And it will be. My claim was that a rise in market interest rates is expansionary, as this makes it more costly to hold base money (in an opportunity cost sense.) As the demand for base money falls, the price level and NGDP rise. But a rise in IOR is very different, it increases the demand for base money, which is contractionary.
The key variable here is the opportunity cost of holding base money, which is the market interest rate minus the IOR. For some insane reason on October 8, 2008 the Fed made that gap negative for the first time since 1940, and we all know what happened next.
PS. For those who can read French, here’s a new article in Atlantico where I am interviewed on the subject of China.
Monetarism can be viewed as a way of explaining changes in macroeconomic aggregates by looking at shifts in the supply and demand for money. Monetarists like to sharply distinguish between money (the medium of account) and credit (loans of the medium of account.)
Tyler Cowen recently linked to an article by Haelim Park and Patrick van Horn, which analyzes the role of the 1936-37 increase in reserve requirements. Here’s the abstract:
We analyze the impact of contractionary monetary policy through increases in reserve requirements on bank lending. We compare the lending behavior of banks that were subject to the requirement increases in 1936–37, Federal Reserve member banks, to a group of banks that were not subject to the reserve increase, Federal Reserve nonmember banks. After implementing the difference-in-difference estimators, we find that the increases in reserve requirements did not create financing constraints for member banks and lead them to reduce lending. Therefore, the actions of the Federal Reserve concerning the required reserve ratios cannot be blamed for instigating the economic downturn of 1937–38.
Let me first emphasize that I don’t have any problem with the overall article, which I haven’t even read. Elsewhere I’ve argued that the reserve requirement increases probably did not play a major role in the 1937-38 recession. But I’d like to quibble with the word “Therefore”, used in the final sentence of the abstract. The fact that the reserve requirement increases did not reduce lending in directly affected banks by more than in other banks does not imply that the reserve requirement increases were not contractionary.
Let’s review why reserve requirements matter. A higher reserve requirement may lead to more demand for bank reserves, and hence more demand for base money. An increase in [demand for] base money is, ceteris paribus, a contractionary monetary policy. It reduces prices and NGDP. Of course ceteris is often not paribus, and in many cases monetary policy actions that look contractionary do not have contractionary effects, perhaps because they are viewed as temporary, as was most likely the case in 1936-37. Or because banks held large quantities of excess reserves, and hence an increase in the reserve requirement did not increase the total demand for reserves. Or perhaps because it was expected to be offset by some other monetary action, such as a change in the base.
Even with all of the preceding caveats, I think it’s quite possible that the reserve requirement increases were at least slightly contractionary in effect. But even if they were contractionary, I’d expect roughly the same impact on bank lending for those banks that face reserve requirements, as for those that do not. To see why, imagine that reserve requirements applied to retailers, not banks. The Fed required retailers to hold cash balances equal to at least 10 days sales. Now the Fed suddenly raised the required ratio to 20 days sales. What would happen to bank lending?
To simplify the exercise let’s assume that the Fed doesn’t change the monetary base. The retailers must scramble to get the extra cash reserves from the fed funds market. That causes the fed funds rate to rise. Banks pass on the higher wholesale cost of credit with higher interest rates on loans. So bank lending declines, even though (by assumption) the reserve requirement doesn’t apply to any banks, only retailers.
Here’s another channel, more in line with monetarist thinking. The increase in the retailers’ demand for cash reserves has the effect of reducing base velocity. Because (by assumption) the base is fixed, this reduces NGDP (and perhaps RGDP.) As banks see NGDP decline, they conclude that there are fewer good loan prospects, and hence curtail lending.
Note that in both cases, the interest rate channel and the base money demand channel, the effect of higher reserve requirements on retailers is to indirectly reduce bank lending, even though the higher reserve requirements for retailers have no direct effect on banks.
The endogenous money crowd often argues that reserves don’t constrain bank lending. At the level of individual banks they are correct, although they often draw incorrect conclusions from this observation, especially at the macroeconomic level, where the overall money supply may not be endogenous. For instance, in 1936-37 the base was partly constrained by the size of the monetary gold stock. Nonetheless, it’s true that if a bank sees a good loan opportunity, it can make the loan and worry about getting reserves later, perhaps by selling off bonds, or perhaps by borrowing in the fed funds market.
The older monetarists of the 1950s-1980s may have erred in arguing that we should target M2 growth at a steady rate. But let’s not throw the baby out with the bathwater. The older monetarists had important insights on the need to focus on money, not credit. Monetary policy is about shifts in the supply and demand for base money, it’s not about bank lending. By ignoring these insights the profession badly misjudged the nature of the Global Financial Crisis, which was fundamentally due to a failure of monetary policy, not banking policy.
PS. I just returned from 10 days in Costa Rica—did I miss anything important? Last night the Miami airport was an insane madhouse, with the entire TSA/Customs/Passport control regime reaching new heights of incompetence. Four long lines and over two hours to change places, even with us literally running between torture chambers. Every day I get a bit more libertarian, as I get mugged by reality.
PPS. The original post omitted the phrase “demand for”
Here’s the abstract of a new NBER paper by Julio Garin, Robert Lester and Eric Sims:
This paper evaluates the welfare properties of nominal GDP targeting in the context of a New Keynesian model with both price and wage rigidity. In particular, we compare nominal GDP targeting to inflation and output gap targeting as well as to a conventional Taylor rule. These comparisons are made on the basis of welfare losses relative to a hypothetical equilibrium with flexible prices and wages. Output gap targeting is the most desirable of the rules under consideration, but nominal GDP targeting performs almost as well. Nominal GDP targeting is associated with smaller welfare losses than a Taylor rule and significantly outperforms inflation targeting. Relative to inflation targeting and a Taylor rule, nominal GDP targeting performs best conditional on supply shocks and when wages are sticky relative to prices. Nominal GDP targeting may outperform output gap targeting if the gap is observed with noise, and has more desirable properties related to equilibrium determinacy than does gap targeting.
I recall a paper by David Beckworth and Josh Hendrickson that made a similar point about how NGDP targeting can do better when output gaps are measured with noise.
I believe the following is the first time that “never reason from a price change” has appeared the FT:
In the words of an influential monetary thinker, “never reason from a price change”.
(False) modesty prevents me from naming the influential monetary thinker.
I will be back home (I hope) tomorrow. Lots of catching up to do.
HT: Thomas Powers, Evan Soltas, JimP