Archive for the Category Monetary Policy

 
 

Williamson on monetary policy and interest rates

In the past, Stephen Williamson has attracted some fierce criticism for his views on the relationship between money and interest rates, specifically some posts that seemed to deny the importance of the “liquidity effect.”  Nick Rowe and others criticized Williamson for seeming to suggest that a Fed policy of lowering interest rates would actually lower the rate of inflation–via the Fisher effect. Williamson has a new post that seems to have somewhat more conventional views of the liquidity effect, but still emphasizes the longer term importance of the Fisher effect:

If the central bank experiments with random open market operations, it will observe the nominal interest rate and the inflation rate moving in opposite directions. This is the liquidity effect at work – open market purchases tend to reduce the nominal interest rate and increase the inflation rate. So, the central banker gets the idea that, if he or she wants to control inflation, then to push inflation up (down), he or she should move the nominal interest rate down (up).

But, suppose the nominal interest rate is constant at a low level for a long time, and then increases to a higher level, and stays at that higher level for a long time. All of this is perfectly anticipated. Then, there are many equilibria, all of which converge in the long run to an allocation in which the real interest rate is independent of monetary policy, and the Fisher relation holds.

Before discussing Williamson, let me point out that back in 2008-09, 99.9% of economists thought the Fed had eased policy, and that the deflation of 2009 occurred in spite of those heroic easing attempts.  That 99.9% included the older monetarists.  Only the market monetarists and the ghost of Milton Friedman insisted that money was tight and that interest rates were falling due to the income and Fisher effects.  I’d like to think that Williamson agrees with us, but of course he’d be horrified by the specifics on the MM model, indeed he wouldn’t even recognize it as a “model.”

Williamson continues:

A natural equilibrium to look at is one that starts out in the steady state that would be achieved if the central bank kept the nominal interest rate at the low value forever. Then, in my notes, I show that the equilibrium path of the real interest rate and the inflation rate look like this:

Screen Shot 2014-09-13 at 10.41.23 AM

Is that really monetary tightening?  After all, inflation rises.  Here’s the very next paragraph by Williamson:

There is no impact effect of the monetary “tightening” on the inflation rate, but the inflation rate subsequently increases over time to the steady state value – in the long run the increase in the inflation rate is equal to the increase in the nominal rate. The real interest rate increases initially, then falls, and in the long run there is no effect on the real rate – the liquidity effect disappears in the long run. But note that the inflation rate never went down.

The scare quotes around “tightening” suggest that Williamson is also skeptical of the notion that tightening has actually occurred.  Indeed inflation increased, then policy must have eased. However to his credit he recognizes that “conventional wisdom” would have viewed this as a tightening.  Nonetheless the final part of the paragraph has me concerned.  Williamson refers to the disappearance of the liquidity effect, but in the example he graphed there is no liquidity effect, as the rise in interest rates was not caused by a tightening of monetary policy.  If it had been caused by tighter money, inflation would have fallen.

So how can the graph be explained?  As far as I can tell the most likely explanation is that at the decisive moment (call it t=0) the equilibrium Wicksellian interest rate jumps much higher, and then gradually returns to a lower level over the next few years.  And the central bank moves the policy rate to keep the price level well behaved.  I suppose you might see this as being roughly the opposite of the shock that hit the developed economies in 2008, except of course it was more gradual.

Suppose there had been no change in the Wicksellian equilibrium rate, and the central bank simply increased the policy rate by 100 basis points, and kept it at the higher level.  In that case, the economy would have fallen into hyperdeflation. When you peg interest rates in an unconditional fashion, the price level becomes undefined.

Is there any other way that one could get a path like the one shown by Williamson? Could the central bank initiate this new path? Maybe, at least if you don’t assume a discontinuous change in the interest rate, followed by absolute stability.  To explain how you could get roughly this sort of path lets look at the reverse case.

Suppose the Fed had been increasing the monetary base at about 5% a year for many years, and the markets expected this to continue.  This led to roughly 5% NGDP growth.  The markets assumed the Fed was implicitly targeting NGDP growth at about 5%.  But the Fed actually also cared about headline inflation, which suddenly rose higher than desired (due to an oil shock.)  The Fed responded by holding the base constant for a period of 9 months.  (For those who don’t know, so far I’ve described events up to May 2008.)

This unexpectedly tight money turned market expectations more bearish.  As expectations for NGDP growth became more bearish, the asset markets fell and the Fed responded by cutting interest rates.  And since inflation did not immediately decline, real short term rates also fell (still the mirror image of the Williamson graph.)  BTW, we know that even 3 month T-bill yields FELL on the news of policy tightening at the December 2007 FOMC meeting.  Williamson would have approved of that market reaction!!

Normally the Fed would have realized its mistake at some point, and monetary policy would have nudged us back onto the old path.  In this case, however, market rates had fallen to zero by the time the Fed realized its mistake.  And the Fed was reluctant to do unconventional stimulus.  There was a permanent reduction in the trend rate of NGDP growth, as well as nominal interest rates. This showed up in lower than normal 30-year bond yields.  The process played out even more dramatically in Europe (and earlier in Japan.)

I do have one quibble with the Williamson post.  He seems too skeptical of the claim that the ECB recently eased policy.  But before I criticize him let me say that I find his error much more forgivable than the conventional wisdom, which views low interest rates as easy money.

Williamson points out that the ECB recently cut rates, and that if the ECB leaves rates near zero for an extended period of time, then inflation is likely to stay very low, as in Japan.  All of this is correct.  But I think he overlooks the fact that while the overall policy regime in Europe is relatively “tight”; the specific recent actions taken by the ECB most definitely were “easing.”  We know that because the euro clearly fell in the forex markets in response to that action.

I think this puzzles a lot of pundits.  It’s very possible for central banks to take relative weak actions that are by themselves expansionary, even while leaving the overall policy stance contractionary, albeit a few percent less so than before. That’s the story of the various QE programs in America.

I encourage all bloggers to never reason from a price change.  Do not draw out a path of interest rates and ask what sort of policy it is.  First ask what caused the interest rates to change—the liquidity effect, or the income/Fisher effects?

PS.  Of course I agree with most of the Williamson post, such as his criticism of “overheating” theories of inflation.

HT:  TravisV

Level vs. growth rate targeting

Here’s Lars Christensen:

In fact I am pretty sure that if somebody had told Scott in July 2009 that from now on the Fed will follow a 4% NGDP target starting at the then level of NGDP then Scott would have applauded it. He might have said that he would have preferred a 5% trend rather than a 4% trend, but overall I think Scott would have been very happy to see a 4% NGDP target as official Fed policy.

Actually I would have been very upset, as indeed I was as soon as I saw what they were doing.  I favored a policy of level targeting, which meant returning to the previous trend line.

Now of course if they had adopted a permanent policy of 4% NGDP targeting, I would have had the satisfaction of knowing that while the policy was inappropriate at the moment, in the long run it would be optimal.  Alas, they did not do that.  The recent 4% growth in NGDP is not the result of a credible policy regime, and hence won’t be maintained when there is a shock to the economy.

However I do agree with Lars that the Fed has done much better than the ECB.

HT:  TravisV.

Don’t show this St. Louis Fed article to Nick Rowe

A commenter sent me a paper from the St. Louis Fed:

This view can also be represented by the so-called “quantity theory of money,” which relates the general price level, the total goods and services produced in a given period, the total money supply and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:

MV = PQ

In this equation:

  • M stands for money.

  • V stands for the velocity of money (or the rate at which people spend money).

  • P stands for the general price level.

  • Q stands for the quantity of goods and services produced.

Oh, so that’s the quantity theory of money.  In fairness, they do mention stable velocity later on. But stable velocity is the QTM, it’s where you start the explanation.  They continue:

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues:

  • A glooming economy after the financial crisis
  • The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy).

If only the Fed had joined the ECB in raising interest rates back in 2011.  Then we would have had a much faster recovery.

What do the Germans really think?

Nicolas Goetzmann sent me the following:

The European Central Bank is doing what it can to help the flagging euro zone economy but it has basically run out of tools, German Finance Minister Wolfgang Schaeuble said on Tuesday.

“It’s no good to hold the central bank responsible for growth and jobs – it’s doing what it can but it has basically exhausted its tools, as you can see from current developments,” he told Germany’s Bundestag lower house of parliament.

“Cheap money can’t force growth either – otherwise we’d have no problems now,” he said.

I have no idea what any of this means, but I can think of at least two possible interpretations:

1.  The Germans think the ECB is stuck in a liquidity trap, and that further stimulus will not boost inflation.  Of course in that case the Germans would not object to further stimulus at the ECB.

2.  The Germans believe that further stimulus would boost inflation, but that higher inflation would not boost RGDP growth.  But in that case the “exhausted its tools” phrase is a completely misleading metaphor, as it [Update: by "it" I meant the metaphor] hints at a liquidity trap, not a vertical SRAS curve.

Anyone else have any idea as to what he means?  And shouldn’t a German finance minister be able to communicate with the public in a way that is understandable to someone with PhD in monetary economics from the University of Chicago?

Maybe it was better when they ignored us

Nicolas Goetzmann sent me the following article in the FT, by Wolfgang Munchau:

The third theory is monetarist. Some will be surprised to find that monetarists still exist, but they do under new guises, such as “market monetarists”. Milton Friedman, the godfather of monetarism, said inflation is always and everywhere a monetary phenomenon. And so, of course, would be a lack of inflation. The market monetarists argue that the central bank should target a certain measure of broad money in circulation to achieve price stability.

Yikes.  I’m still counting the number of mistakes in that paragraph.  How many can you find?

At least he didn’t call us Austrians, which is how Allan Meltzer referred to me (twice!) at the recent Mont Pelerin Society meetings.  :)

PS.  I wonder if famous pundits think this way:  ”I vaguely recall hearing something about market monetarists.  I suppose they must believe X.  I could look it up, but eh, I’m an important pundit and MMs are a bunch of nobodies, so they’ll just have to make do with my characterization. After all, I’m pretty busy right now.”