Archive for the Category Monetary Policy


Long and variable leads (a reply to Tony Yates)

Tony Yates expresses shock that someone calling himself a market monetarist could reject Milton Friedman’s famous “long and variable lags” claim about monetary policy.

I have great respect for Friedman, but when I did my research on monetary policy in the interwar years (which is the period where it is easiest to clearly identify monetary shocks) I wasn’t able to find significant lags.   The monthly WPI and industrial production indices seemed to move almost immediately and sharply after monetary shocks.  If NGDP data had been available, it would have also responded quickly.

Even worse, I found that Friedman and Schwartz had misidentified monetary shocks by focusing on the monetary aggregates, which often moved ahead of or behind the actual shock.  Thus the devaluation that occurred in April 1933 led to expectations of future money growth, and these expectations led to an immediate surge in prices and output. That’s what led me to coin the “long and variable leads” phrase.  I thought it would be obvious to people that I know that classical theories of causation don’t really allow for cause to follow effect.  Rather that it is actually expectations of future money growth that caused the near term NGDP growth surge.  I used a bit of poetic license to drive the point home.

Later I learned that Woodford and Eggertsson were doing similar research from a New Keynesian perspective.  Here’s Yates:

Sumner cites Woodford and Krugman as commenting on the potency of expectations, and uses this in support of his thesis that changing expectations changing things refutes the long and variable lags thesis.  But I am quite sure neither of them believe any such thing.  Estimated versions of Woodford’s model (for example, the original Rotemberg-Woodford model) behave just like my account above.  And Krugman is a firm believer in sticky prices, talking interchangeably between IS/LM and New Keynesian models.  Which behave just as I’ve explained above.

The only model I know where monetary policy has its entire effect instantaneously is the flexible price rational expectations monetary model.  And in this case there is no point in monetary stabilisation policy at all.  Money has no short-run effects on output.  Optimal policy in this model is to set rates at zero permanently, obeying the Friedman Rule.  If there are real frictions in this model, like financial frictions, there will still be a role for fiscal stabilisation, however.

I’m sure these mix-ups would get ironed out if MaMos stopped blogging and chucking words about, and got down to building and simulating quantitative models.  Talking of which….

Lots of problems here:

1.  Obviously I’m a believer in sticky wage/price models, and hence do not believe that monetary policy has an instantaneous effect on all prices (although it does instantly impact the prices of commodities traded in auction-style markets.)  So Yates has mischaracterized my views.

2.  When Woodford’s coauthor Gauti Eggertsson tried to apply their approach to the Great Depression, he read a great deal of my empirical work, and seemed to like it. Eggertsson’s 2008 AER paper on monetary policy expectations in 1933 cites three of my empirical studies.  That doesn’t mean he agrees with all my views, but he didn’t seem to find them ridiculous. And in 1993 I published a paper arguing that temporary currency injections would not be inflationary, 5 years before Krugman published “It’s Baaack . . .”

3.  I can’t speak for all market monetarists, but I’m extremely skeptical of the VAR modeling approach discussed by Yates.  The early attempts at VAR models produced a “price puzzle,” which meant that tight money seemed to “cause” higher inflation.  I remember thinking “Yeah, what do you expect when you use interest rates as an indicator of the stance of monetary policy.”  Yes, some of these problems have been “fixed”, but I’m not impressed by the fact that 99% of the economics profession seemed to think monetary policy was “easy” during 2008-09.

In my view economists should forget about “building and simulating quantitative models” of the macroeconomy, which are then used for policy determination. Instead we need to encourage the government to create and subsidize trading in NGDP futures markets (more precisely prediction markets) and then use 12-month forward NGDP futures prices as the indicator of the stance of policy, and even better the intermediate target of policy.  It’s a scandal that these markets have not been created and subsidized, and it’s a scandal that the famous macroeconomists out there have not loudly insisted that it needs to be done.

If and when we get out of the Stone Age and have highly liquid NGDP and RGDP futures markets, then it would be much easier to explain my views on leads and lags. In that world a change in NGDP futures prices, not a change in the fed funds rate, represents a change in monetary policy. To be more specific:

I predict that whenever the 12-month forward NGDP futures prices starts falling significantly, near term NGDP would fall at about the same time, or soon after.  For instance, if we had had a NGDP futures market in 2008, then during the second half of the year you would have seen a sharp fall in 12 month forward NGDP futures.  At roughly the same time or soon afterwards current NGDP would have been falling. In contrast, if the Fed had moved aggressively enough to prevent 12-month forward NGDP prices from falling, then near term NGDP in late 2008 would have been far more stable.  I think that’s roughly consistent with Woodford’s view, although we may differ slightly on the lag between a change in 12-month forward NGDP expectations and a change in actual NGDP.  (Nor would he necessarily accept my views on the potency of monetary policy in 2008.)

PS.  The post also speculates on my views on fiscal policy.  Just to be clear, I oppose attempts to force a balanced budget.

PPS.  Yates’s blog is entitled “Longandvariable.”  Not the specific post, the entire blog. He just needs to add “leads.”

PPPS.  Yates refers to me as a “MaMoist.”  I guess that’s better than being a Maoist, like that faction in the Greek party Syriza.  You know, the party so many on the left now seem enamored with.  The one that has a bunch of MPs that idolize history’s greatest mass murderer.

HT:  Marcus Nunes


The dog that did not bark

Tyler Cowen has a new post offering opinions on a wide range of issues.  In many cases I agree with his views.  For instance, this one:

5. We are still in the great stagnation, for the most part.  But with nominal gdp well, well above its pre-crash peak, it is not demand-based “secular stagnation.”  It just isn’t, I don’t know how else to put it.  And the liquidity trap is still irrelevant and has been since about 2009.

The reasoning used is not very persuasive.  Could you imagine him making that argument in late 1982, when NGDP was above the pre-recession peak?  But Tyler’s conclusion seems sound.

However I take issue with this claim:

4. During the upward phase of the recovery, monetary policy just doesn’t matter that much.

I can’t even imagine what a model would look like where that claim was true.  To see why it is not true, compare the post mid-2009 recoveries in the US and Europe. If monetary policy in the US and Europe did not matter very much during the recovery, then the tightening of monetary policy in mid-2011 in the eurozone ought to have had little effect.  What does it look like to you?

Screen Shot 2015-02-25 at 8.32.42 AM

I think the problem here is that the US recovery looks fairly smooth, and also disappointing, despite various actions by the Fed.  It’s tempting to conclude that Fed policy didn’t matter very much.  But all you have to do is to look across the pond and you’ll see that it mattered a great deal.

PS.  I’m not sure why the Fred’s eurozone RGDP data is not updated.  I believe there’s been a very anemic recovery in the past year.

Update:  Marcus Nunes has updated the graph.  David Beckworth also has a post, which takes a deeper look at the US/eurozone divergence.

Why Switzerland is such a great country (all’s well that ends well)

The Swiss National Bank did a very foolish thing last month.  No, it was not foolish to stop pegging their currency to the euro.  Fixed exchange rates are a bad idea. Central banks should target macro aggregates.  Instead, the mistake was in letting the Swiss franc (SF) suddenly appreciate by 15% to 18% against the dollar and euro, at a time when Switzerland was experiencing mild deflation.  There were two explanations offered, both completely bogus:

1.  They feared the euro would depreciate sharply because of QE.  Actually the EMH says it’s impossible to predict high frequency currency moves, or alternatively changes in real exchange rates, and hence the SNB was foolish to make that assumption.

2.  They feared they’d have to buy lots of foreign assets to maintain the peg, leading to a larger balance sheet.  But if it’s a small balance sheet you want then you don’t end the peg with a sharp revaluation, which just makes the SF even more attractive.  You end it by devaluing your currency, to make it less attractive.  They got things exactly backwards.

The good thing about the Swiss is that they are sensible people, and have mostly undone the damage of that foolish decision.  The first thing they did is to start trying to depreciate the Swiss franc by buying foreign assets.  Wait a minute, wasn’t that what they were (supposedly) trying to avoid doing by ending the peg? Yes, and it didn’t work.  They were right back in the same mess as in mid-2011, before the peg.

The following graph shows that the SF has fallen from rough parity with the euro after the de-pegging, to about 1.08 SF to the euro today:

Screen Shot 2015-02-23 at 5.18.21 PM

And this graph shows that the Swiss stock market, which crashed on the decision that some claimed was “inevitable” (hint, markets NEVER crash on news that is inevitable), has regained most of its losses.

Screen Shot 2015-02-23 at 5.20.17 PM
Indeed the recovery is even a bit more impressive than the recent fall in the SF. Why is that?

Obviously it’s partly because global markets have rallied with the Greece agreement. But it also reflects the recent fall in the euro against the US dollar. When the Swiss first pegged to the euro in September 2011 it traded at about $1.35 to $1.40/euro.  It was still in that range in the first half of 2014. Today the euro trades at $1.13/euro. That means the SF has actually depreciated against the dollar in recent years.  In trade-weighted terms the SF is probably up slightly, but less than the euro/SF exchange rate might suggest, and indeed far less than even a month ago.  Here is the value of the dollar in terms of SF.

Screen Shot 2015-02-23 at 5.51.19 PM

Given that the Swiss economy was doing fine a year ago at a euro/SF exchange rate about 10% lower than today and a dollar/SF exchange rate about 5% higher, it’s not surprising that stocks have recovered much of their losses, although they remain modestly below the levels of right before the float.

When the Swiss made this foolish decision I suggested that a revaluation of something like 5% might be defensible, but not the 15% to 18% revaluation that actually occurred.  I’m pleased that the Swiss National Bank has seen the light, and that Switzerland has preserved its reputation as one of the best-run economies in the world.

Now they just need to nudge the SF a bit lower, and they’ll be fine.



Noah Smith has “incredible confidence” that he understands my views

Here’s Noah Smith:

Scott Sumner expresses incredible confidence that NGDP targeting is best .  . . .  I think normal people realize that that certitude is basically never warranted.

Well I’m certainly not a normal person, but he’s got it exactly backwards. I think it very unlikely that NGDP targeting is best, and have said so on many occasions.  As far as certitude, I’m not certain of anything.  I’m not certain that I’m not dreaming right now, or that the world won’t end next week.  More seriously, my hunch is that there are other targets that are better than NGDPLT, and that for some developing countries even an inflation target might be better.  There’s also a non-trivial chance that I’m wrong about almost everything, and that Paul Krugman or Bob Murphy is much closer to the truth.

Although I believe absolute certainty is never warranted, my impression is that “most people” believe exactly the opposite. Most people are certain that free will exists, that personal identity exists, etc. Indeed I find most people to be wildly overconfident in their beliefs in all sorts of areas.  I’m an extreme skeptic, out there on the 99.9% end of the skepticism distribution.  In fairness, I probably have occasionally used the term “certain” when I meant fairly sure, but I am quite confident I’ve never even hinted that I’m certain NGDP targeting is best.  It certainly, err, almost certainly is not.

The Economist on good and bad deflation

The Economist magazine has a very good editorial discussing good and bad deflation, and worries that the world is now experiencing (at least in part) the bad type. They conclude by urging central bankers to rely on a less ambiguous indicator:

Change the target

Policymakers should be more worried than they appear to be, and their actions to avert deflation should be bolder. Governments need to boost demand by spending more on infrastructure; central banks should err on the side of looseness. (Next month the ECB will start quantitative easing—and about time too.) Now is also the moment to consider revising the monetary rule book—in particular, to switch the central bankers’ target from the inflation rate that most now favour to a goal for the level of nominal GDP, the total value of spending in an economy before adjusting for inflation. With such a target there is no need to distinguish between good and bad price shocks. And the change in rules would itself send a signal that policymakers are serious about banishing the threat of deflation.

Central bankers change course slowly, and their allegiance to inflation targets runs deep. Conservatism often serves them well. But in this case it could cost the world economy dearly.

Notice that they advocate “level” targeting, which is very important in a world where the zero bound seems to occur with increasing frequency.

HT:  Peter Spence, Frank McCormick

PS. I also recommend Edward Hugh’s post on Spanish deflation.