Archive for the Category Monetary Policy


Will it matter when the Fed has “traction?”

People have made all sorts of arguments against “monetary offset,” but there’s only one that actually makes much sense.  The argument is that the Fed does not like doing “unconventional policies” like QE, because they feel “uncomfortable” with a large balance sheet.  (Put aside the fact that QE is perfectly conventional monetary policy–open market operations—and that there is no reason at all to feel uncomfortable with a large balance sheet.  The Fed is effectively part of the Federal government.)

Nonetheless, there is a sort of plausibility to the theory; Fed officials will occasionally say they would cut interest rates further if they could.  But what is the implication of this theory?  It seems to me that this theory implies that Fed policy should become much more aggressive when the Fed is no longer hamstrung by the zero bound.  When they can stimulate without adding to the balance sheet.  But this raises an interesting paradox—the Fed is conventionally viewed as being “stimulative” when they cut rates.  Thus the Fed should want to cut rates as soon as they can do so, which means right after they raise them!

Of course I’m half-kidding.  More realistically the implication is that once the Fed stops doing the “uncomfortable” QE, there will be a long period of zero rates before they raise them.  And perhaps there will be, but right now the Fed suggests it will be raising interest rates in less than a year.

Here’s a graph from a Marcus Nunes post:

Screen Shot 2014-10-30 at 6.15.21 PMNGDP had been rising at about 5% per year in the 17 years before the recession, and it’s been rising about 4% per year in the “recovery.”  Because wages and prices are flexible in the long run, the real economy has been recovering despite the lack of any demand stimulus.  We have fallen from 10% to 5.9% unemployment.  But most people think the economy is still in the doldrums, and needs more stimulus.  President Obama just instructed the Department of Labor to increase unemployment compensation benefits (without any authorization from Congress of course–why do you think would Congress be involved in spending decisions?) This was done because unemployment is at emergency levels, requiring extra-legal remedies.

Fortunately the Fed is no longer doing the “uncomfortable” QE policy, which adds to the balance sheet.  So if you believe the fiscal policy advocates, the Fed should be raring to go with stimulus. How do they do that?  By promising to hold rates near zero for a really long time, or until the labor market is really strong.  But instead, they are suggesting that they will probably raise interest rates soon.  There will be no attempt to get back to the old trend line; the new one seems just fine.

Let’s consider an analogy.  A bicycle rider has a “policy” of maintaining a steady speed of 15 miles per hour.  Then he hits a long patch of ice, and slows to 10 miles per hour, perhaps due to a lack of traction, perhaps because he decided to go slower.  How can we tell the reason?  How about this, let’s put a strong headwind in his face, and see if the speed slows even more.  But now he petals harder and keeps maintaining the 10 miles per hour speed.  That suggests it’s not a lack of traction. But the pessimists insist it must be a lack of traction, why else would he have slowed right when he hit the ice?  Then the bicycle final comes to the end of the ice.  The lack of traction proponents expect him to suddenly speed up, exhilarated by the sudden traction of rubber on asphalt.  Oddly, however, the bike keeps plodding along at 10 miles an hour.  Nothing seems to have changed even though the ice patch is long past.

[In case it's not clear, the headwinds were the 2013 austerity, and the end of the asphalt was the end of the liquidity trap.]

Here’s my claim.  The Fed promise to raise rates soon is not the sort of statement you’d expect from a central bank that for the past 5 years had been frustrated by an inability to cut rates.  (Nor is their other behavior consistent—such as the on and off QE.)  Rather it’s the behavior of a central bank that has resigned itself to pedaling along at a slower speed.  Ten miles per hour is the new normal.

I don’t want to sound dogmatic here.  Obviously monetary offset is not “true” in the sense that Newton’s laws of mechanics are true; the concept only applies in certain times and places.  Oh wait, that’s true of Newton’s laws too .  .  .

Opponents of monetary offset face two big problems.  In theory, the central bank should target some sort of nominal aggregate, and offset changes in demand shocks caused by fiscal stimulus. And in practice it seems like they do, as we saw in 2013, even at the zero bound.  So if monetary offset is not precisely true, surely it should be the default baseline assumption.  Instead, as far as I can tell 90% of economists have never even considered the idea.

PS. Totally off topic, I love this sentence from an article on why a million dollars no longer makes you rich:

Although it sounds like a lot of cash, $1 million of today’s money is only worth $42,011.33 of 1914 dollars, which is less than today’s median household income.

Someone should collect all these amusing claims in the media.  They could have added that today’s median income of $42,011 is only equal to $1764 in 1914 dollars, roughly equal to the per capita GDP (PPP) of Haiti.  I guess I was wrong, the American middle class really is struggling.

The problem with procyclical inflation

Here’s Charles Evans in the WSJ:

“We’ve averaged well under that 2% mark for the past six-and-a-half years,” Mr. Evans said. “With a symmetric inflation target, one could imagine moderately above-target inflation for a limited time as simply the flip side of our recent inflation experience–and hardly an event that would impose great costs on the economy.”

There’s no doubt in my mind that a policy of letting inflation run a bit above target during the next boom will not cause great hardship during the next boom

But a policy of running inflation below target when unemployment is high and above target when it is low makes the business cycle much worse, and does impose great hardship.  Some conclusions:

1.  A procyclical inflation policy violates the dual mandate.

2.  NGDP targeting would lead to countercyclical inflation (a good thing).  As Nick Rowe likes to say, you want to make it so that the public’s stupid belief that inflation is bad . . . is true.  Good supply-side policies would become anti-inflation policies.

3.  Discussions of “what should the Fed do now?” are meaningless and incoherent, unless embedded in a clearly specified long run policy regime, as are discussions of whether QE “increases inequality.”

Charles Evans is actually one of the best people at the Fed.  Then there is the other Charles:

Federal Reserve Bank of Philadelphia President Charles Plosser said Friday that inflation levels that have fallen persistently short of where the central bank wants them to be are not a significant issue to him right now.

It’s true that inflation levels are “a little bit low” relative to the Fed’s desire to have price pressures hit 2%, Mr. Plosser said at an appearance in New York. But, “for the most part, I’m not too concerned about that,” he said.

What he doesn’t say is that the reason the Fed has failed is partly due to the fact that he’s consistently been pressuring them to be more contractionary, even as they were already far too contractionary to hit their dual mandate. So Plosser’s telling us that the Fed is not doing its job, partly due to his consistently bad advice, but he doesn’t much care.

Fortunately, market monetarist ideas are gradually seeping into the media.  A few days ago we saw this at the Financial Times, now it’s Bloomberg’s turn:

Based on the gap between yields of government notes and TIPS, traders have scaled back estimates for average inflation through 2019 by a half-percentage point since June to 1.52 percent, Fed data compiled by Bloomberg show.

.  .  .

With the Fed’s preferred measure averaging 0.34 percentage point less than CPI in that span, traders are signaling prices based on that gauge may rise as little as 1.18 percent. Through August, the personal consumption expenditures deflator has fallen short of the Fed’s 2 percent goal for 28 straight months.

Fed officials “need to be paying attention to that because there’s a collective wisdom element to the TIPS market,” Mitchell Stapley, the chief investment officer for Cincinnati-based ClearArc Capital, which manages $7 billion, said in an Oct. 8 telephone interview.

Did QE worsen inequality? That’s not even a question

When people ask whether QE worsened inequality they think they are asking a coherent question. But that merely shows how poorly most people understand monetary economics.

Let’s ask a different question:  Did Obama’s appointment of Ben Bernanke increase inequality? Any sensible listener would ask: “Compared to what?”  After all, most models are roughly linear, at least for very small changes (I’m rusty at math, so tell me if that is wrong.)  In other words, whatever impact monetary policy has on inequality, the impact of picking Bernanke over a more dovish alternative (Romer) would have been the opposite of Obama picking Bernanke over a more hawkish alternative (Summers.)   I can’t imagine anyone being able to make sense of the question “did Bernanke increase inequality” without knowing the counterfactual Fed chair.  And of course the same is true for Fed policies, is the counterfactual more or less contractionary than the actual policy?

Now some people will say; “the obvious implication is that the counterfactual was no QE, and that this was a more contractionary alternative.”  This is very likely how people think about it, but of course that assumption is wrong.  My preferred policy would have been far more expansionary, and hence would have involved far less QE.  Let’s break this down into 2 questions:

Does monetary stimulus increase inequality?

Does delivering monetary stimulus via QE affect inequality more than some other method?

I’ll take the second question first.  Suppose Bernanke did not do QE, but rather some equally effective stimulus method.  Perhaps slightly raising the inflation target, or going to level targeting. Would that make any difference for inequality?  I hope it’s obvious that it would not.  The mechanics of QE are totally uninteresting.  You are just swapping one Federal government interest bearing liability (reserves) for another federal government interest bearing liability (T-bonds.)  Any “Cantillon effects” are trivial.  I hope I don’t have to explain to people that this “money” did not “go into the stock market”:

a.  The money went into bank reserves, or currency.

b.  Money never goes into markets; there is no giant safe on Wall Street storing all the money invested in stocks.  Money goes through markets.  You buy, someone else sells.

If there were no QE, but equally fast NGDP growth produced by a higher inflation target, stocks would have done equally well.  Indeed stocks responded more strongly to forward guidance than QE3 in late 2012.

So now we can rephrase the QE question: “Did Bernanke’s monetary policy since 2009 worsen inequality?”  Now it’s much easier to see that we need a counterfactual.  You might prefer to describe that policy as 1.5% inflation, or perhaps 4% NGDP growth (my choice.)  Either way it’s a fairly contractionary policy.  And it’s no longer “obvious” what the counterfactual is, would it be 3% or 5% NGDP growth?  In my view 5% growth would have helped the unemployed and the rich more than the middle class with stable jobs (say teachers.)  So that has mixed effects on inequality, indeed so ambiguous that it’s probably not worth even thinking about, as the effect would be trivial compared to the net gain to America from a stronger economy.

If you think the alternative to QE was a more contractionary policy, say 3% NGDP growth, then it would hurt the rich and poor more than the middle class.  In order to favor that policy you’d have to hate the rich so much that you be willing to impoverish millions of poor people to screw the rich. But even someone who hates the rich as much as Paul Krugman favors QE.

Sorry, but “does QE increase inequality?” is a really, truly moronic question.  I apologize for wasting your time.

PS.  Here’s Buttonwood at the Economist:

This is at the heart of the matter. Even if the Fed does not increase rates next year, it will surely take a big economic shock to make it resume QE. The markets have relied on the central banks for so long, like a small child holding his dad’s hand when learning to ride the bike. It is time to let go of the hand now, but there will be a few bumps and bruises along the way.

This is truly a horrible metaphor, and helps explain how the developed world got so far off course. Taken literally, the counterfactual to “using monetary policy” is barter. Obviously that’s not what people mean when they say it’s time to stop using monetary policy.  Buttonwood probably means that we are propping up the economy with an excessively expansionary monetary policy.  But of course that’s confusing the tools (fed funds targets, the monetary base, etc.) with the actual policy itself (1.5% inflation, 4% NGDP growth, etc.)

By 2007 almost no serious economist in America believed that money was “easy” in the early 1930s, despite ultra-low interest rates and massive QE.  And now almost all serious economists believe monetary policy has been “easy” in recent years precisely because of ultra-low rates and massive QE.  This fact is appalling.  The intellectual decline in mainstream macroeconomics since 2007 is stunning–nothing like this regression has happened since the early 1970s, or perhaps the late 1930s.  And this time the worst mistakes are being made by those on the right.

By the way, the right metaphor is not training wheels, but rather which way do you want to steer the bicycle?  No serious pundit is advocating walking.

Ben Southwood finds lots of evidence for (market) monetarism

Ben Southwood of the Adam Smith Institute has several recent blog posts that are well worth reading.

When the Bank moves its key policy rate, commentators talk about it hiking or cutting interest rates; on top of this, we’ve seen extremely low effective interest rates in the marketplace; together this makes it reasonable to believe that the central bank is the cause of these low effective rates.

There are lots of reasons to doubt this claim. In a previous post I pointed out that the spreads between Bank Rate and market rates seem to be narrow and fairly consistent—until they’re not. I made the case that markets set rates in an open economy. And I arguedthat lowering Bank Rate or buying up assets with quantitative easing (QE) may well boost market rates because they raise the expected path of demand, the expected amount of profit opportunities in the future, and thus investment.

Since then I came across an elegant and compelling explanation of exactly why this is. In a 1998 paper, Tore Ellingsen and Ulf Söderström show that this is because some monetary policy changes are purely expected and ‘endogenous’ responses to economic events, whereas some monetary policy changes are unexpected ‘exogenous’ changes to the central bank’s overall policy framework (like raising or lowering the inflation rate that markets believe they really want).

When changes are expected, market rates keep a tight spread around policy rates; when changes are a surprise, cutting Bank Rate actually results in higher interest rates in the marketplace.

The post has some nice graphs showing this distinction.  He has another post citing no less that 4 papers with monetarist-friendly findings.  Here’s one example:

In “QE and the bank lending channel in the United Kingdom”, BoE economists Nick Butt, Rohan Churm, Michael McMahon, Arpad Morotz and Jochen Schanz tackle the popular creditist view that movements in lending drive overall activity, and that quantitative easing works by stimulating lending, and find “no evidence to suggest that quantitative easing (QE) operated via a traditional bank lending channel”. Instead, their evidence is consistent with the monetarist view, that “QE boosted aggregate demand and inflation via portfolio rebalancing channels.”

They find this result by looking at the difference between banks that dealt directly with the Bank of England when it was buying gilts (UK government bonds) with new money in its QE programme. If the creditist view held, these banks would be more able to expand their lending with the extra deposits created when the BoE hands over new money for gilts.

And a post exposing the silliness of internet Austrian commenters, who seem to think that anyone who is not an Austrian is a Keynesian.

Ben’s colleague Sam Bowman (also at the ASI) has a good post explaining NGDP targeting.

Meanwhile, the only head of a major central bank ever to say good things about NGDP targeting now presides over an economy that is creating jobs at a rate no one could have imagined 18 months ago.

Tyler Cowen on exports

Tyler Cowen has a wonderful new post pointing out that all countries can increase their exports at the same time, and this may boost global output.  I’m going to try to make it even wonderfuler (is that a German word?)

[Update: When I say "exports" I mean "exports", not "exports minus imports" (a category no one should pay any attention to.)]

Let’s avoid reasoning from an export change, and ask why exports might increase:

1.  Supply-side reforms that boost the efficiency of the export sector, perhaps by removing tax/regulatory barriers.

2.  Monetary stimulus aimed at currency depreciation.

3.  More government saving, which depreciates the real exchange rate.

My claim is that if these things are done on a global scale, the first two are expansionary in net terms, and the third is neutral.

Supply-side reforms boost output under either an inflation target, or a dual mandate.  If you want to use the Keynesian model, these reforms boost the Wicksellian equilibrium interest rate, which makes NGDP grow faster, even at the zero bound.

For years I’ve been pointing out that a (mild) international currency war would be great.  All currencies can depreciate at the same time, against goods and services. We know that monetary stimulus in the US makes European stocks go up, and vice versa.  But it isn’t just market monetarists; Keynesians like Barry Eichengreen have also noted that a currency war would be expansionary, as it was in the 1930s. These first two points are probably what Tyler had in his mind when he criticized the mercantilist mindset.

As far as government saving (fiscal austerity), I’d say it’s a net wash, for monetary offset reasons.

PS.  Roughly 100% of the time when people blame virtue in one country (Germany, China, Japan, etc.) for problems in the global economy, they are working with a flawed model.  Classical economics (Hume’s Of the Jealousy of Trade) was supposed to be about overcoming that xenophobia.  We still have work to do.

PPS,  I once published a paper claiming that IS-LM was essentially a gold standard model.  Here’s Tyler:

It sometimes feels like the IS-LM users have a mercantilist gold standard model, where the commodity base money can only be shuffled around in zero-sum fashion and not much more can happen in a positive direction.