Archive for the Category Monetary Policy


Targeting inflation and offsetting fiscal austerity are the exact same thing

Stephen Williamson has a very good post on the Canadian austerity of the 1990s. But in the comment section I think he misunderstands the concept of “fiscal offset.” First an anonymous commenter says:

Canada has offset the contractionary effects of austerity via monetary policy…

And Williamson responds:

That’s part of the point. It doesn’t look like they did. As you say, Canada has an independent monetary policy, but, post-1991 they appear to be behaving as by-the-book inflation targeters. Basically, they make an agreement with the fiscal authority about their policy rule, and then they stick to it, independent of what the fiscal authority is up to.

Sticking to your target regardless of what the fiscal authority does is exactly what fiscal offset means.  The idea is simple. A fiscal contraction would normally depress AD, causing inflation to slow.  The central bank must do enough stimulus to offset that potential decline in AD, in order to prevent inflation from falling.  If you observe the inflation rate always being on target, then the central bank is successfully offsetting any fiscal action that would have otherwise moved AD and inflation.  As an analogy, if the temperature in your house is always 22 degrees (centigrade), then the thermostat/furnace is doing an excellent job of offsetting the warm and cold fronts that move through your town.

So why do I call the post “excellent”? Start with the fact that Williamson recognizes that fiscal austerity in Canada was not contractionary.  Even better he recognizes something that all too few bloggers understand:

But it might be more appropriate to think about monetary policy in terms of the ultimate goals of the central bank.


PS.  Yes, fiscal policy has other channels besides AD, so real GDP could still change. But the AD channel is what Keynesians obsess over.

HT:  Tom Brown

When the paradoxical becomes mainstream

Market monetarist ideas often sound quite paradoxical to the uninitiated.  Back in 2008 and 2009 it was a struggle to get anyone to even pay attention.  How are we doing today?  One indication is provided in the cover story of a recent Economist magazine:

The danger is that, having used up their arsenal, governments and central banks will not have the ammunition to fight the next recession. Paradoxically, reducing that risk requires a willingness to keep policy looser for longer today.

.  .  .

When central banks face their next recession, in other words, they risk having almost no room to boost their economies by cutting interest rates. That would make the next downturn even harder to escape.

The logical answer is to get back to normal as fast as possible. The sooner interest rates rise, the sooner central banks will regain the room to cut rates again when trouble comes along. The faster debts are cut, the easier it will be for governments to borrow to ward off disaster. Logical, but wrong.

Raising rates while wages are flat and inflation is well below the central bankers’ target risks pushing economies back to the brink of deflation and precipitating the very recession they seek to avoid. When central banks have raised rates too early—as the European Central Bank did in 2011—they have done such harm that they have felt compelled to reverse course. Better to wait until wage growth is entrenched and inflation is at least back to its target level. Inflation that is a little too high is a lot less dangerous for an economy than premature rate rises are.

Here’s the technical explanation.  When the Fed tightens monetary policy, the Wicksellian interest rate falls as the market interest rate rises.  Why is that important?  Because the Fed adopts expansionary monetary policies by reducing its target rate to a level below the Wicksellian equilibrium rate.  The lower that rate, the less room central banks have to conduct “conventional” monetary policy (i.e. raising and lowering short term rates.)  So if you want the ability to cut rates below the Wicksellian equilibrium rate in the future, the best way of insuring that you can do so is by not raising them today.

Notice the Economist suggests that the ECB’s tight money policy of 2011 triggered the double-dip recession.  This is also progress.  A few years ago I recall economists claiming that modern recessions were different.  The idea was that earlier recessions were caused by the Fed raising rates to combat inflation, whereas modern recessions were caused by balance sheet issues.  This is wrong, as you can see from this graph of ECB target rates:

Screen Shot 2015-06-19 at 9.51.27 PM

The ECB raised rates in July 2008, and then twice in the spring of 2011.  In 2008 they raised rates because they were worried about high inflation.  In 2011 they raised rates because they were worried about high inflation.  Of course in both cases they made a mistake, as NGDP growth was weak.  But inflation is the ECB’s special obsession.  Now for the results.  In 2008 the tight money policy caused a mild recession to suddenly become much more severe.  This economic downturn sharply reduced the Wicksellian equilibrium rate, so that even later reductions in interest rates were not enough to make the policy expansionary in an absolute sense.  And in 2011 the tight money policy also caused a recession, and again later rate cuts were not enough to turn things around.  Only when the ECB adopted QE did monetary conditions improve (slightly.)

Before Americans feel too smug about this sorry record, recall that the Fed refused to cuts rates in the meeting after Lehman failed.  Their excuse?  Worry about high inflation.

I’ll end with a quote from Gandhi:

First they ignore you, then they ridicule you, then they fight you, and then you win.

PS.  The rate increases of 2008 and 2011 do not, by themselves, tell us anything about the stance of monetary policy.  For that you look to NGDP growth.  I simply include them for the “people of the concrete steppes”, who complain that central banks didn’t “do anything” to cause the recent recessions.  Yes they did.

PPS.  The Great Recession was triggered by a Fed decision in December 2007 to cut rates by 1/4% rather than 1/2%. Frederic Mishkin and Janet Yellen understood what a horrible mistake the Fed was making.

PPPS.  Over at Econlog I have a new post comparing fiscal policy during 1937 and 2013.

We need a commission on stabilization policy

I know, you are gagging on the title of the post.  I hate commissions too.  But there’s already a lot of discussion about a commission to re-evaluate the Fed’s goals and tactics.  And the current proposals are both too much and too little.  Too much because there are some tactical questions that the Fed itself can resolve better than any commission.  But there are also some questions that the Fed currently cannot answer, and where a commission could be very useful to the Fed. I believe the biggest issue now is what to do about stabilization policy in a world that frequently hits the zero bound during recessions. That’s not the world of the past 50 years, but I believe it’s quite likely to be the world of the next 50 years.

Although I don’t recall doing so, it’s quite possible that at some point in the past 6 years I insinuated that Paul Krugman favors fiscal policy because he likes big government.  Perhaps there’s even a grain of truth in that statement.  But there’s also one really big problem with that claim.  Consider:

1.  Paul Krugman strongly supports raising the inflation target to 4%

2.  There is only one justification for raising the inflation target to 4%; it makes it possible for the Fed to handle 100% of the responsibility for stabilization policy.

And it’s not just Krugman; lots of other liberal economists have also favored raising the inflation target to 4%.  Why do I bring this up now?  Because I can just hear commenters saying how naive I am; “liberals will never agree to a plan that eliminates the need for fiscal policy.”  Then why do so many favor 4% inflation target?  And why does Paul Krugman say fiscal policy is pointless when nominal interest rates are positive?

Now I don’t happen to favor a 4% inflation target, and I doubt that this would be the outcome of the commission.  But I do believe the commission’s output would be very useful, even if I don’t “get my way” on fiscal policy.

Both liberal and conservative economists agree on these basic facts:

1.  When trend NGDP growth rates are lower, the economy will hit the zero bound more often.  One option is to raise the inflation target.  The Paul Krugman solution.

2.  Another option is to do something like NGDPLT.  My preferred solution.

3.  Another option is to keep the Fed’s current policy framework, 2% PCE inflation, growth rate targeting, and unemployment near the natural rate.

Economists also agree that option three may require some hard choices.  These include:

a.  Pursuing QE to the limit in a liquidity trap.  Allowing the Fed to buy whatever it takes, even if they have to move beyond Treasury debt.  Telling the Fed not to worry about capital risk, the Treasury has them covered.  My second preference.

b.  Constraining the Fed to buy securities of no more than a specific amount, say 50% of GDP, to avoid excessive risk.  Other options are also possible here, such as more aggressive cuts in IOR, perhaps to negative levels.  Then just live with a slow recovery.  Similar to current policy.

c.  Same as option b, but have an implicit agreement that once the Fed hits its QE limit, fiscal stimulus will take over.  The Larry Summers solution, Krugman’s second preference.

Policy is currently hindered by the fact that the Fed doesn’t know exactly how aggressive it should be, partly because Congress is not even aware of these “hard choices.”  So we don’t have any sort of clear policy regime, rather we drift in a sort of limbo, where the Fed doesn’t really know how much others want it to do.  Or whether it would be scolded for large capital losses on its balance sheet if rates rose sharply.  Or whether Congress would support the Fed if it shifted its target higher in order to keep interest rates above zero.  The Fed knows that politicians are concerned that rates are low for savers, but doesn’t know if that concern implies they’d favor higher interest rates that are caused by higher inflation.

I don’t think this commission is politically feasible until January 2017, but at that time it just might work. I’m assuming the Dems will again win the presidency and the GOP will retain the House.  Gridlock will make fiscal policy impossible unless an agreement can be reached.  If you put sensible conservatives like Taylor, Mankiw and Hubbard on the committee, with sensible Keynesians, they are all going to understand the trade-offs I discussed above.  The GOP economists can explain to GOP politicians “look, it’s inflation or socialism, take your choice.  If we don’t have a bit more inflation then interest rates will fall to zero, and the Fed will keep expanding its balance sheet, bigger and bigger.”  Or we’d get fiscal stimulus, another option the GOP doesn’t like.  The liberal members of the commission can explain to Democrats “look, it’s better if the Fed handles stabilization policy, and fiscal resources are utilized for pressing social needs, not economic stabilization. And in any case, the GOP will never let us do the amount of fiscal stimulus we need, or they’ll insist on tax cuts that ‘starve the beast’.”

Krugman and I may not get our way.  Maybe the commission will compromise on a monetary/fiscal mix, where the Fed takes the lead, but the fiscal authorities act if the Fed ‘s balance sheet hits X% of GDP.  If I lose the battle I’ll stop objecting to fiscal stimulus.  I’ll stop claiming the multiplier is zero.  I’ll stop claiming there is monetary offset.  If that’s clearly the regime, and it’s all spelled out, then so be it. At that point I’ll argue that payroll tax changes are the best form of stimulus.

But right now there is great uncertainty about who is in charge, and what is expected of the Fed.  This stuff really needs to be clarified for the zero bound environment.  Or at least discussed.  I’ll bet the Fed would be thrilled if Congress told them exactly what their responsibilities were in terms of capital losses, instead of leaving it quite vague.

What would Congress decide in the end?  One possibility is keeping the 2% inflation target, and a continual role for fiscal policy.  That’s very possible.  Or Congress might ask the Fed to study options for preventing the zero rate bound from hamstringing monetary policy, and they might buy into a technical fix like level targeting and/or NGDP targeting. I don’t know.  But politics goes in cycles.  After so many years of gridlock, 2017 might be a good time for a compromise.  To make this happen we all have to starting talking up the idea right now—assuming anyone agrees with me.

Monetary offset and the time inconsistency problem

I recently ran across a very revealing article from April 24, 2012:

NEW YORK, April 24 (Reuters) – Federal Reserve policymakers are sounding the alarm over a “fiscal cliff” at the end of this year, when scheduled U.S. tax hikes and spending cuts could pose a big threat to the fragile economic recovery.

Along with its official mandate of watching unemployment and inflation, the U.S. central bank is keeping a close eye on a potentially debilitating political fight over how to fix the budget deficit.

If lawmakers in Washington do not get rid of the tax hikes and spending cuts due to take effect in early 2013, the country could easily careen into another recession. Any moves by Congress, however, aren’t expected until after the Nov. 6 presidential election.

The Fed is worried that individuals and companies could hunker down and curb spending, making markets antsy as the country awaits the outcome of an election that could pave the way for new tax and spending policies.

Though few expect Washington to do nothing while fiscal policies push the economy into another downturn, partisan politics could undermine the Fed’s unprecedented actions to revive the economy.

“I have been disappointed that the president and Congress are not taking action until after the election,” St. Louis Fed President James Bullard told reporters in Utah last week.

“I’m also worried that markets will react badly to the fiscal cliff at the end of this year. Markets might start to speculate about what might or might not happen … after the election,” he said.

Asked what the Fed can do, however, Bullard seemed to dismiss the possibility of resorting to new bond buying to counter the effects of political gridlock over the budget deficit and economic policy.

“It’s up to the Congress,” he said.

By the end of 2012, it was pretty clear that fiscal policy would sharply tighten in 2013. The Fed responded with QE3 and some additional forward guidance.  Bullard was so confident that these steps would offset the fiscal guidance that he forecast an acceleration of RGDP growth in 2013, to around 3% to 3.5%.  Actual RGDP growth (Q4 to Q4) turned out to be about 3.1%. So we have a nice example of monetary offset, with a happy ending.

But notice something strange at the end of the long quote; Bullard seems to be warning Congress not to expect the Fed to bail them out if the send the economy into a recession with reckless fiscal austerity.

When I was young I got a nice job offer from the New York Fed, at a salary 75% higher than my Bentley salary.  My department chair took the offer to the Dean, who responded, “Tell him I hope he likes New York.”  In the end I stayed at Bentley. (Feel free to insert dog retreating, tail between legs metaphor here.)  I learned a lesson, and indeed not once have I ever told my daughter “If I catch you smoking pot you can forget about me paying for your college education.”  My threats aren’t credible, due to the time inconsistency problem.

Matt Yglesias once wrote a post pointing out that the Fed denies that it engages in monetary offset:

A curious issue that in my opinion he and other proponents of the full monetary offset thesis haven’t fully grappled with is that Federal Reserve officials keep saying it’s not true. I heard John Williams of the San Francisco Fed say it’s not true at the Brookings event this morning. I heard Ben Bernanke say it’s not true at the American Economics Association meeting in Philadelphia earlier this month. I separately heard William Dudley of the New York Fed say it’s not true in Philadelphia. Janet Yellen has repeatedly said it’s not true. And since full monetary offset isn’t just an abstract economic thesis, it’s specifically a thesis about the actual behavior of the Federal Reserve, the fact that nobody in a position of authority at the Fed believes in it seems like a big problem worthy of a more substantive response.

You find lots of counterarguments in this post, written in response to Matt’s post. That post is my best counterargument. But I’d add this post as a footnote, as it shows how statements by Fed officials regarding their intentions may not accurately describe the Fed’s actual future policy response, but rather may reflect a desire to get Congress to do more of the heavy lifting.

That’s not to say that Matt’s completely wrong, indeed his views are actually about halfway between my view and the views of more traditional Keynesians.  Here’s the very next paragraph of the Yglesias post:

What I think clearly is true is that partial monetary offset is very real. The people who thought the tight fiscal policy of 2013 would crush the economy were wrong, and they were proven wrong precisely because of monetary offset.

That’s a reasonable argument, and if my version of monetary offset were proved wrong at some later date, Yglesias’s view would be the alternative that I’d find most plausible.  But thus far the data seem to support something close to full offset—both the 2013 case of austerity in the US, and the cross sectional study by Mark Sadowski.  Of course “further research is needed.”

PS.  Here’s a perceptive observation from the April 2012 article:

“We’re naive if we think that [fiscal cliff] doesn’t play into the Fed’s thinking about monetary policy,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets in New York.

“But the way that the Fed would want to present it is a minor consideration at best, because they don’t want to be supplementing fiscal policy,” Porcelli said.

Porcelli clearly gets it, although the term ‘supplementing’ doesn’t really capture the idea he’s trying to express.  He should have said, “offsetting.”

PPS.  I have a new post on the euro over at Econlog.

AD shocks aren’t so mysterious

Marcus Nunes pointed me to a Stephen Williamson post.

On the other hand, suppose I am an empirical macroeconomist, and I’m trying to understand the Great Recession. I have coffee with Paul Krugman, and he tells me not to worry. This looks pretty much like other recessions – just an insufficiency of demand. As an empirical macroeconomist, I may not know what Paul is talking about, as there now exist practicing macroeconomists who have never seen AD/AS, IS/LM. But, for example, Christiano, Eichenbaum, and Trabandt know AD/AS, IS/LM (at least I’m pretty sure the first two do). They’re well-known empirical macroeconomists, and they’re not coming out and saying the Great Recession is about aggregate demand deficiency. They have a model, and the model has stochastic shocks which they give names to, and none of those shocks appear to have the name “aggregate demand.” They have taken the time to write a whole paper in which they try to figure out how the shocks account for the Great Recession, and what the propagation mechanism is. Conclusion:

We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound.

Sorry, but that’s not in AD/AS, IS/LM.

So I took a look at the abstract to their paper:

We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound. We reach this conclusion looking through the lens of a New Keynesian model in which firms face moderate degrees of price rigidities and no nominal rigidities in the wage setting process. Our model does a good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the rise in the cost of working capital played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.

That sounds an awful lot like an AD paper to me.  But I’ve only read the abstract. Perhaps someone else can read the paper, and tell me why they used a NK model with liquidity traps and sticky prices, if it’s not an AD-oriented model.

Returning to the Williamson post:

Now, consider another person. This one is older than the average undergraduate – old enough to actually care about the Great Recession, and not think of this as ancient history. This person is, say, 30, and worked on Wall Street during the financial crisis. She saw a lot of stuff. Volatile financial market activity, unemployed people, large financial institutions in trouble, etc. Now she’s motivated to go back to school and take some economics so she can understand all that stuff. She takes an intro-to-macro course, learns AS/AD, and is told that the Great Recession is just like all the other recessions – AD shifts left. Given her experience in the world does this get her excited? Does this information somehow put all her practical experience into perspective? I don’t think so.

I can’t speak for her, but it would sure get me excited.  If I’d run up huge debts and then found myself unable to pay them off, I’d double down and work harder. The fact that Americans, on average, decided to take lots of vacations in late 2008 is a big puzzle.  Especially in industries that had nothing to do with subprime mortgage debt, like autos and services.  Why did so many autoworkers stop working when the mortgage crisis occurred in 2008? Why didn’t creative destruction work, with labor moving from overbuilt housing to other areas? Why did output fall in almost all industries? I’d want to take a course in macro to find out.

And suppose I was told that there are competing theories:

1.  Technological regress in autos, people forgot how to make them.

2.  An earthquake destroyed most of America’s auto-making facilities.

3.  Autoworkers were tired of working, and decided it was time for a long vacation.

4.  The government raised the minimum wage to $30/hour, making the industry uncompetitive

5.  AD fell, and Americans cut back on spending on cars.

Which of those theories, or any other you’d like to mention, might that hypothetical stock trader find plausible?  If she was really smart she might ask why a decline in spending would reduce real output.  And you’d answer that prices are sticky.  And then she’d ask why AD fell, and you’d mention the financial crisis.  And then she’d ask why the Fed didn’t offset the effect of the financial crisis on AD by easing monetary policy.  And you’d mention the zero bound, and their reluctance to pursue unconventional techniques to the max.

Hmmm, sticky prices, financial crisis, the zero bound problem, isn’t that the abstract to the paper Williamson said was not AS/AD?

I actually enjoyed reading Williamson’s post.  Lots of good observations about Krugman and Meltzer.  A nice critique of Phillips curve thinking.  But I’m far less impressed by modern modeling techniques than he is.  For me the proof is in the pudding.  If modern macro really is making progress, then we ought to hear its practitioners make useful observations during a major crisis.  Or at least make observations as astute as someone like Milton Friedman would have made in 1997:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Instead we’ve regressed, and most of what I’ve read since 2008 has been utter nonsense, starting with claims that the Fed has been conducting an “easy money” policy.  In fairness to Williamson, he and David Andolfatto are among the extremely tiny number of macroeconomists who don’t equate low interest rates with easy money.

PS.  I have a new post on Iceland over at Econlog.