Archive for the Category Monetary Policy


Krugman on the limits of monetary policy

Here’s Paul Krugman, in his pessimistic mood:

You might think that it’s a fundamental insight that doubling the money supply will eventually double the price level, but what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all.

And as a result, monetary traction is far from obvious. Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously — and certainly “credibly promising to be irresponsible”, to not undo expansion in the face of future inflation, is a much harder thing to achieve than simply acting when the economy is depressed.

Just to be clear, Krugman is not saying the central bank must promise a specific future money supply on a specific date, he’s saying the expected future money supply must be large enough to produce a specific expected future inflation rate (or price level.)

There are several possible solutions to the credibility problem.  One that both Michael Woodford and I have discussed is level targeting.  Suppose the central bank always falls short of its price level or NGDP target by 1%, due to a lack of credibility.  You might argue that this describes the current situation in Japan, for instance.  If the central bank has a level target, that shortfall only has significant macroeconomic effects in the very first year.  After that the level of the target variable continues to fall 1% below target, but the growth rate of the aggregate (which is what really matters) is always on target (after the first year.)

A second solution is to adjust the monetary base as needed to peg the price of CPI futures, or NGDP futures.  That will keep expected future growth in the nominal aggregate right on target.  If that seems “to good to be true,” it’s because it exposes the fact that worry about “liquidity traps” is actually worry about something else—the size of the central bank balance sheet.  But in the long run the central bank balance sheet will be smaller with a more expansionary policy, and perhaps (as the Swiss central bank showed a few years ago) even in the short run. If the central bank balance sheet is too big for comfort when you are hitting your target for expected future inflation, or expected future NGDP growth, then raise the Price level/NGDP target path or lower the rate of interest on reserves.

In my view this is where Krugman goes off course.  He assumes that if the central bank has done a lot, and has still fallen short, it would have had to do even more to succeed—bleeding into fiscal policy. In fact, just the opposite is true.  The central banks that succeed are those (like the Reserve Bank of Australia) that do the least. That’s because faster NGDP growth leads to a much lower desired ratio of base money to GDP, and hence smaller central bank balance sheets.

Krugman continues:

Just to be clear, I have supported QE in both Britain and the US, on the grounds that (a) central bank purchases of longer-term and riskier assets may help and can’t hurt, and (b) given political paralysis in the US and the dominance of bad macroeconomic thinking in the UK, it’s all we’ve got. But the view I used to hold before 1998 — that central banks can always cause inflation if they really want to — just doesn’t hold up, theoretically or empirically.

I seem to recall that Krugman was quite pessimistic about the ability of the BOJ to succeed in producing inflation, at least a few years ago.  But when they raised their inflation target to 2%, they did succeed in moving from deflation to mild inflation (albeit still short of the 2% goal.)  The good news is that we now know that the Japanese government can sharply depreciate the yen anytime it wishes to (something else that Krugman had originally doubted.)  That means the BOJ can inflate–it’s just a matter of how committed they are to make it happen.  In a sense this is also Krugman’s view (when he’s in the more optimistic mood), and he’d undoubtedly argue that the political push from Abe helped the BOJ.  In the past Krugman seemed to think fiscal stimulus was an easier sell politically.  That may be true in a few cases, but in Japan monetary stimulus has turned out to be the easiest part of the three-part reform project.  And monetary policy doesn’t have to worry about fiscal offset, in the way that fiscal policy must worry about monetary offset.

On the other hand, my recent Econlog post on the ECB shows an almost Krugmanian level of pessimism.  I just don’t see the institutional resolve at the ECB to raise inflation up to their 1.9% target. Europe badly needs to rethink everything they are doing, from the ground up.

HT: Ken Duda

A distant echo of the big bang

Before beginning, I’d like to announce that Gabe Newell (CEO of Valve) has generously funded the next year of Hypermind’s NGDP futures market, and I hope to announce some new contracts (including the exciting 2014:4 to 2015:4 contract) in the next week or so.  I also plan to start posting daily NGDP futures prices, as soon as I can figure out how to get a link to that market.  I hope to get iPredict’s NGDP futures market fully funded by January.

The recent news has been dominated by the sharp fall in TIPS spreads.  In the US, 5-year inflation expectations are down to 1.25% and the 10-year TIPS spread is 1.68%.  Does this mean money is way too tight?  Not necessarily, but it does suggest that money was way too tight back in early 2010 and mid-2011.

Recall that I often say, “inflation doesn’t matter, only NGDP matters.” Back in early 2010 and mid-2011, CPI inflation briefly rose above 2%.  Europe also experienced above target inflation at about this time.  Many observers misinterpreted this data, believing it had implications for the proper stance of monetary policy, whereas in fact NGDP is the variable that matters.

So if NGDP was so low, why was inflation above target?  If there is anything we know about Phillips curve models it is that they are consistently unreliable.  In early 2010 and mid-2011 there was a big increase in global commodity prices, driven by fast growth in places like China. This had no bearing on US NGDP or monetary policy.  The underlying demand conditions were quite weak in both the US and Europe.  In recent months the commodity boom is unwinding, and lower headline inflation is showing up.  But this does not necessarily mean money is too tight in the US (although it quite likely is a bit too tight to hit the Fed’s dual mandate over the next 5 or 10 years.)  Instead, the recent deflation is a distinct echo of the actual NGDP “deflation” (and why is there still no word for falling NGDP!!) that occurred in the early part of this decade.  That’s when money was much too tight, but supply disruptions in the Middle East and Chinese demand temporarily inflated oil prices, helping to disguise the deflationary pressures.  Now it is showing up.

This all makes the hawks look ridiculous today.  Indeed they have not one but two big problems:

1.  The hawks fought against monetary stimulus in 2010 and 2011, arguing that we needed to focus like a laser on 2% inflation.  OK, but 5-year inflation expectations are now 1.25%, even lower in Europe.  What do the hawks say today?

2.  The hawks are uncomfortable with low interest rates, and have developed dubious ad hoc “theories” that low rates will create asset market bubbles and financial instability.  But how do we get higher rates?  The hawks ignored the wisdom of Milton Friedman (that ultra-low interest rates mean money has been tight) and the Germans got the ECB to raise rates twice in 2011. The result is exactly as Friedman would have predicted.  The US is about a year away from exiting the zero bound, whereas the eurozone is 5 or 10 years away, at best.  The German plan backfired.

Hawkishness was the superior monetary model in the 1970s, but has since degenerated into an atavistic set of urges:  No inflation!  Higher interest rates! (As if those two goals are compatible.) It’s very sad, and perhaps a blessing in disguise that Friedman is not here to seen his ideas being abandoned by the right wing of the profession.

PS.  Did I forget to mention that the misleading TIPS spreads are just one more reason why we need a Federal Reserve-funded NGDP futures market?  If the government won’t fund this nearly perfect example of a “public good,” with a benefit/cost ratio of more than 100,000 to 1, who will?  Not the Austrians.  Not the Keynesians.  Not the New Classicals.  Not the RBC economists. Only the MMs are stepping up to the plate to make it happen.

PPS.  Oh, and where are all the people who said in mid-2013 that Bernanke’s tapering comments caused much higher bond yields, proving that only QE was holding down yields?  QE ended many months ago, and rates keep falling lower and lower.  The market is financing our still large budget deficits at 2.74% on the 30-year bonds.  Is that the “liquidity effect?”  Is that “Cantillon effects?”  Don’t be silly.

Chris Rock gives new meaning to “creative destruction,” and Ezra Klein responds

I’m afraid that I don’t know much about Chris Rock.  I stopped watching TV decades ago and don’t keep up with pop culture.  Most of my readers will find this interview to be too liberal (as I do), but you can’t deny that he’s an interesting thinker, and has some provocative observations.  One of my favorites was when he compared being a rich black man in America to the Bill Murray role in Lost in Translation.

Ezra Klein also enjoyed the Rock interview, but he criticized Rock’s claim that Obama should have let the economy drop sharply in early 2009 (no bailouts or stimulus), so that the GOP would have owned the fiasco, and then later in 2009 Obama could come in and rescue the economy.  I’m going to slightly disagree with both Rock and Klein, but not quite in the way you might expect. Before doing so let me point out that Ezra Klein may well be the most talented reporter in America, and I was honored to make a recent list of “must read” bloggers he mentioned.  However even there I’d respectfully disagree.  I’m probably a bit more moderate and pragmatic that Bryan Caplan, but he’s someone liberals need to read more than me, even if they are annoyed.  He should replace me on the list.  Robin Hanson too.

Here’s Klein discussing Rock:

The big problem with this idea — which I’ve heard other liberals propose in the past — is it’s morally odious: it would have meant putting millions of Americans through harrowing pain in order to help Obama out politically. If a GM lets a team flatline the team loses a few games. If the president lets the country’s financial sector flatline millions of people’s lives are destroyed.

But the other problem with this idea is it would have be a political disaster for any president, including Obama, who tried it.

Those are fine arguments, and I mostly agree.  But consider the following historical analogy. Between July and October 1932, the economy finally began recovering.  Then a relapse occurred, partly due to Hoover’s incompetence.  In a campaign speech Hoover indicated that we were almost forced off gold early in the year, and that only his adroit leadership had saved the gold standard. Of course that made the markets doubt the future stability of the gold standard, especially with FDR leading in the race for president.

FDR was never willing to commit to staying on the gold standard, despite it being part of the Democratic platform in 1932.  Unfortunately, fixed exchange rate regimes are one area where (for better or worse) governments have to lie.  If they even hint that they might consider devaluation, markets will lose confidence in the currency and attack the peg.  FDR should have either lied and said he’d stay on gold, or announce he planned to devalue, which would have immediately forced a devaluation.  The uncertainty from October 1932 to March 1933 created a run on the dollar and then a collapse of the banking system during the long interregnum.  In the last days of the Hoover administration, the President tried to put together a bank holiday plan and asked for FDR’s cooperation (i.e. commitment to continue the policy.)  FDR would not cooperate.  This is not to exonerate Hoover; he should have done the bank holiday anyway.  He was a very incompetent president, despite being perhaps the most competent person to ever be elected president.  There must be a lesson in there somewhere for the “great man” theory of history.

Then FDR took office, and immediately saved the day with a bank holiday.  But that was not enough to spur a recovery, so 6 weeks later he devalued the dollar.  Now FDR was the hero.  Then he implemented lots of Hoover’s ideas in his New Deal–mostly bad ideas, like the cartelization of industry and artificially high wages.

FDR’s sabotage (if that’s what it was–which is of course debatable) occurred before he took office. So it’s not exactly what Rock proposed.  But given how much liberals revere FDR, I could not help thinking of this episode when reading Klein’s piece.  So in a sense I agree with Klein, and that’s why I believe FDR should have avoided ambiguity over the dollar.  Don’t do something that hurts the economy, in the hope that the later political implications will allow you to become a hero by saving it.  It’s like a three bumper shot in billiards, theoretically possible, but highly unlikely.  And that means unethical.

Now for my contrarian view.  I don’t think Obama could have sabotaged the economy, even if he had tried. Unlike FDR, he had little control over monetary policy in the short run.  If during the campaign he had promised to put a hawk in charge of the Fed, his promise would have been laughed at.  All he had was fiscal policy, and you all know about my views on monetary offset. Indeed I think an Obama attempt to sabotage the economy via austerity might have actually helped.  Here’s the argument:

1.  Depression scholar Ben Bernanke had no intention to preside over another Great Depression. While he preferred that fiscal policymakers would share the burden, he was prepared to go it alone if necessary.

2.  Some of the suggestions Bernanke gave Japan in the early 2000s (like level targeting of prices, or focusing on NGDP) would have probably been more effective than the actual monetary and fiscal stimulus combined.  Would he have pulled out a nuclear option like level targeting?  I can’t be sure, but I’d say that without fiscal stimulus there is at least a 25% chance the recovery would have been faster due to strong monetary stimulus, and perhaps a 40% chance it would have been about the same.  And yes, that means there’s a non-negligible probability that I am wrong about monetary offset, as I’ve always acknowledged.

I don’t expect this argument to change the minds of any Keynesians, and I’m not sure I’m entirely convinced myself.  But I do believe we overrate the ability of any one person, even the president, to boost the economy.  And that also means we also overrate their ability to hurt the economy.

I don’t believe that President Obama understands economics well enough to be qualified to sabotage the economy, or save it.

PS.  Check out David Henderson’s excellent piece on police brutality, and also Adam Ozimek’s great post.

Financial Times: Low rates don’t mean easy money

There are days where everything seems hopeless.  I still find that 98% of the pundits I read don’t even understand that low rates don’t mean easy money.  People still think that “austerity” is somehow determining the growth rate of NGDP.  Yesterday NPR had an especially clueless discussion of the relative performance of the US and Eurozone, which merely served to reinforce the (false) priors of their mostly affluent liberal audience.

And then once and a while there is a tiny ray of hope:

Macroeconomic measures are caught in a deadlock between the conservative instincts of Germany and the expansionary needs of everyone else. To illustrate this incoherence the Bundesbank on Friday downgraded forecasts of German growth at the same time as its president complained that money was too loose.

Monetary policy provides the best key to understanding the variegated global picture. The central banks of the US, UK and Japan all adopted easier policies and were rewarded with an upturn. Given weak wage growth and a lack of fiscal support, such stimulus ought to continue.

Europe is an unhappy exception. Despite German misgivings, low interest rates are no evidence that money is too loose: nominal GDP growth stutters along at less than 3 per cent, a clear sign that the stance is much too tight. In recent years the ECB twice made the mistake of raising rates too soon, and thereby punished Europe with a deeper recession and a worse fiscal crisis. If its president Mario Draghi cannot ease policy further, the consequences will be just as serious. 

By the way, remember those people who told us that the eurozone’s problems were all “structural,” and that NGDP growth wasn’t a problem?  That was when the PIIGS were plunging lower and Germany was growing fast.  Doesn’t that logically mean that if the PIIGS start recovering then the eurozone will grow faster?  In contrast, if a lack of NGDP growth is the problem, faster growth in the PIIGS will be offset by slower growth elsewhere.  Keep those two hypotheses in mind as you read this:

“THE world cannot afford a European lost decade,” says Jacob Lew, America’s treasury secretary. The latest European figures were uninspiring. In the third quarter the euro zone grew by just 0.6% at an annualised rate. This sluggishness was not primarily due to the countries hit hardest by the crisis—Greece’s economy grew faster than any other euro-zone country, and Spain and Ireland are recovering. Rather, it is the core countries that are exhausted—and few more so than the biggest, Germany. It grew by just 0.1% in the third quarter, after contracting by the same amount in the previous three months.

Just to be clear, Europe does have plenty of structural problems.  That’s why they are 30% poorer than the US.  But that doesn’t mean that slow NGDP growth is not also a problem.

PS.  I’ve recently been sent many papers to read and comment on.  Right now I am overwhelmed with work, but promise to get to them when the semester ends.

PPS.  The original version of the post erroneously stated that Martin Wolf wrote the article.  My mistake.

The dog still isn’t barking

I always try to find something interesting to say about the jobs report.  The obvious headline was the 321,000 new jobs, plus an upward revision in previous months totaling another 44,000.  The past three months are very strong.  Hourly wages were up a strong 0.4%, but over the past 3 months, or 12 months, we are still seeing only about 2% trend wage growth–no real breakout yet.

In my view it’s the bond market that is the most interesting—the dog that isn’t barking.  I’ve been talking about low interest rates being the “new normal” for quite some time, but I would have expected somewhat higher interest rates with this sort of strong jobs growth.  The argument that the Fed is artificially holding down bond yields no longer holds, for two reasons; QE has ended, and more importantly TIPS spreads have been falling.  They are only 1.74% on the 10 year, and 1.98% on the 30-year.  The 10 year yield of 2.26% really drives home the point that low rates are the new normal.  People at the Fed think they’ll be “normalizing” rates at about 4% a few years down the road.  That now seems like a pipe dream.  The old rules no longer apply.

A trend wage growth of 2% isn’t enough to get you 2% trend inflation, because while productivity growth has been slowing, it’s not zero.  The Fed is a long way from achieving a 2% trend rate of inflation.

What does this say about current monetary policy?  Just what I have been saying for months—we don’t know if it’s too easy or too tight until we are told the Fed’s objective–in clear, easy to verify terms.  Many of the conservatives at the Fed would prefer they simply focus like a laser on 2% inflation, and ignore unemployment.  For that group (assuming they are intellectually honest) money is clearly too tight right now.  It’s not even debatable.  For the dual mandate doves like Yellen, things are less clear.  If the goal is 3% NGDP growth long term, then money may well be too easy.  If it’s 5% trend NGDP growth, then money is too tight.  If it’s 4%, then perhaps the Fed is close to being on target.  The Fed won’t tell us what outcome they think would be desirable, in terms of a single number that is a weighted average of its dual policy goals.

Then why was I able to say money was unambiguously too tight for so many years? Because it was too tight in terms of any plausible Fed goal.  That’s no longer true.

PS.  If my comment on the hawks and doves didn’t startle you, read it again—you weren’t paying close enough attention.

PPS.  I have a new post at Econlog, on the 1921 depression.

Update:  Greg Ip has a post speculating that the Fed may engage once again in “opportunistic disinflation,” only in the opposite direction:

Two decades ago, inflation was above any reasonable definition of price stability. In contemplating how to get it lower, Fed officials came up with the moniker of “opportunistic disinflation.” The Fed would not deliberately push the economy into recession, but it would exploit the inevitable recessions and resulting output gaps that came along to nudge inflation closer to target. In 1996 then governor Laurence Meyer defined it thus:

Under this strategy, once inflation becomes modest, as today, Federal Reserve policy in the near term focuses on sustaining trend growth at full employment at the prevailing inflation rate. At this point the short-run priorities are twofold: sustaining the expansion and preventing an acceleration of inflation. This is, nevertheless, a strategy for disinflation because it takes advantage of the opportunity of inevitable recessions and potential positive supply shocks to ratchet down inflation over time.

Of course positive supply shocks are a fine time to engage in disinflation, but recessions are the worst possible time.  That didn’t stop the Fed from engaging in disinflation in the 1991, 2001, and 2009 recessions.  It’s a procyclical policy, which makes the business cycle worse.  Let’s hope they don’t use the next boom as an “opportunity” to raise inflation, and then the inevitable recession that follows as an opportunity to reduce it.