Archive for the Category Monetary Policy


A time for nuance

Macroeconomics is really complicated.  I would consider myself a supply and demand-sider, a rational expectations and efficient markets guy, and a market monetarist.

So it’s not surprising that I am often misunderstood, just as more famous bloggers like Paul Krugman are often misunderstood.  When things are far out of whack, as in 2009, it’s much easier to be understood.  You simply need to pound the “monetary stimulus” theme with a sledgehammer.  No nuance required.  As the economy gets closer and closer to the natural rate of unemployment (and we are only about 6 months away), the issues get more and more complicated. Here are some things I find that I need to continually address in comment sections:

1.  Real shocks matter, even when demand is a problem.  If someone with cancer gets stabbed by a mugger on the way to the hospital, they have multiple problems.  Which problem is worse?  Well the stab wound is more acute, but the cancer is a bigger problem in the long run.  A demand shortfall may be more acute, but like a stab wound is more easily treated than structural problems. When an economy has severe structural flaws, a policy of monetary stimulus will not fix the country’s problems.  It will just fix one of them, leaving the more severe problems in place.

2.  Contrary to the recent claim of the New York Times, the definition of a recession is not 2 consecutive quarters of falling RGDP.  The US had a recession in 2001, but we did not have two consecutive quarters of falling RGDP, whereas Japan may have recently seen two consecutive quarters of falling RGDP, but is not in recession.  Economists look at many factors before determining whether a recession has occurred.  Recessions are periods where output falls well below trend.  It matters a lot whether the trend rate of RGDP growth is 7% (China) or zero percent (Japan.)

3.  Monetary offset works by adjusting the long run expected rate of growth in nominal aggregates (such as inflation or NGDP) to offset the effect of fiscal actions.  It is not capable of smoothing out high frequency fluctuations due to real shocks.  A sudden change in government spending, sales tax rates, or a natural disaster, will affect RGDP in the near term, even if monetary policy is offsetting any effects on NGDP 12 or 24 months out in the future.

4.  A failure to achieve RGDP growth and a failure to achieve NGDP growth are logically distinct events.  Don’t confuse them. Many economists use the wrong data when evaluating policy success. If you are making the Keynesian argument that monetary stimulus is incapable of boosting AD, you use NGDP data.  If you are making the Real Business Cycle (RBC) argument that monetary stimulus will not boost output you use RGDP data.  Many Keynesians seem to be oblivious to the distinction between a change in aggregate demand and a changed in the aggregate quantity demanded (caused by a supply shock.) For instance, the April 1 sales tax increase sharply depressed Japanese RGDP in Q2, leaving NGDP almost unchanged.  Keynesians don’t seem to realize that when they complain about slow RGDP growth in a country with high inflaiton (like Britain a few years back) they are making a RBC argument, which tends to discredit the Keynesian model.  There are lots of ways that policy can “fail.”  If you don’t know the right data to cite to make your point, no serious economist will pay attention to your arguments.

Furthermore, the EMH says the efficacy of policy is evaluated at the point it is announced (if a surprise) not after the fact.  There is no “wait and see to ascertain whether Abenomics worked.”  It was obvious from the get go that it would “work” in a limited sense, but fail to achieve the announced goals.  And it has.  If Japan wants to boost trend RGDP growth, then they need to adopt supply-side reforms.  Printing money doesn’t solve that problem, especially in a country with 3.6% unemployment.

5.  Rational expectations theory says that monetary policy cannot be evaluated in isolation, but rather must be considered in the context of a clearly spelled out policy regime.  Admittedly, when things are clearly far off course, (as in 2009) you can assume monetary policy is too tight under any plausible policy regime.  But not today.  For instance, I could easily construct plausible arguments for money being either too easy or too tight:

a.  Too tight:  Because we are likely to hit the zero bound in the next recession, policy should be more expansionary, to promote a trend rate of NGDP growth high enough to keep us away form the zero bound.

b.  Too easy.  NGDP growth is likely to average a bit over 3% over the next few decades, given the Fed’s inflation target.  In recent years it has run a bit over 4% per year.  If it keeps that up it will later have to be offset with sub-3% NGDP growth, perhaps leading to recession.  Inflation should be low during booms and high during recessions.  Yet Janet Yellen seems to be determined to raise inflation up to 2%, probably getting there near the peak of the business cycle.

Which do I believe?  Neither.  I don’t know what’s optimal until I’m told what sort of objective the Fed has in the long run.  Tell me their long run NGDP target, and I’ll tell you whether money is too easy or too tight today.

It’s much better to live in a place like Switzerland where the problems are complex and the solutions are unclear, rather than North Korea where the problems are simple and the solutions are straightforward.

Were market monetarists wrong about Japan?

If there has been any blogger more accurate than me in their claims about Japan in recent years, please send me all his/her relevant posts, so I can can give him/her some praise.

Just to review:

1.  I predicted the BOJ would be able to depreciate the yen, if it choose to do so.  I’ve been proved right again and again.  Paul Krugman had doubts.

2.  I predicted monetary stimulus would boost inflation, but that they’d fail to hit their 2% target (excluding taxes).  I was right.  Krugman’s been all over the map, hostile to fiscal stimulus in the late 1990s, then too pessimistic about the possibilities for monetary policy before Abe, then (perhaps) too optimistic.  And now?  I can’t tell.

3.  I predicted the monetary stimulus would boost growth, but that growth would remain low as the working age population is falling fast.  I was proved right. (Krugman agrees it boosted growth.)

4.  I predicted a growth surge before the April 1 tax increase and a growth slump afterwards.  I was right.  BTW, this has nothing to do with “monetary offset.”  And Japan is not in a “recession.”

I mention this in response to a recent post by Paul Krugman, who has totally forgotten about the outcome of his earlier 2013 “test” of market monetarism, and started claiming that monetary offset doesn’t hold:

The bad growth news shows, pretty clearly, that the consumption tax hike was a big mistake. It also shows, by the way, how weak the market monetarist argument — which is that fiscal policy doesn’t matter, because central banks can always achieve the nominal GDP they want — really is; do you seriously want to contend that Kuroda likes what he sees, that he isn’t trying as hard as he can to boost Japan out of deflation?”

This is Krugman being Krugman—making it seem like his opponents are making idiotic claims.

BTW, Kuroda is engaged in monetary offset (the yen has recently fallen from 109 to 118), just as market monetarists would expect, and no, he is not doing all he can.  For instance, he could do MORE, and in all likelihood will do MORE when he discovers that he needs to do MORE to hit his target.

Perhaps some day Krugman can explain to us how events that we predicted accurately somehow disprove the market monetarist view.  Does he believe that market monetarists claimed that Japanese consumers would be indifferent between buying a car on March 31 and April 1st, after the tax rise?   It sounds like an April Fools Day joke.

The real problem with the sales tax increase is that the money is being used to finance additional government spending.  A few years back the Keynesians told us that taxes didn’t matter very much, it was all about spending.  Well Japan is ramping up its government spending.  Now Keynesians seem to have suddenly discovered that it’s taxes that matter, not spending.

PS.  Just three weeks ago Krugman did a post showing that inflation expectations in Japan have risen to almost 2%.  I doubt that, but let’s say Krugman’s right.  If inflation expectations have risen to close to 2%, then how could the tax increase have had a major impact on the prospects for growth going forward?  Is Krugman making an Art Laffer-style supply-side argument that tax increases reduce growth without reducing inflation? Is he now an inflation optimist and a growth pessimist for Japan?  Where’s the model?  When conservatives used to make that argument he would ridicule it.  BTW, I’m a moderate on this question—call me a supply and demand-sider.

HT:  Michael Darda

Wrong question, wrong answer

John Cochrane has a new piece in the WSJ, criticizing the widespread concern over deflation risks, especially in Europe. I have mixed feelings about this whole enterprise.  I’ve repeatedly argued that inflation doesn’t matter, and that economists should just stop talking about inflation (and deflation.)  But they obviously won’t stop, and hence I guess I can’t blame Cochrane for responding to the often incoherent discussion. He lists 4 reasons to be skeptical about deflation fears:

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

He’s right about point 4, there’s very little risk of a deflationary spiral.  And of course he’s right about the insanity of borrowing money to try to overcome deflation. Point 2 is a lousy metaphor, which doesn’t capture the logic of higher inflation as a way of avoiding a liquidity trap.  If Cochrane insists on shoe metaphors, here’s the right one:

Suppose you occasionally have to go out and shovel snow when it’s 40 below.  You should have one set of shoes that is 2 sizes too large, so that you can wear 4 pairs of socks with it.

Points one and three are examples how conservatives (except for the great Milton Friedman) have an unfortunately tendency to minimize the impact of demand shocks.  It’s true that inflation itself doesn’t matter, and that almost all Phillips Curve models perform really poorly.  But that’s a side issue.  When economists worry about deflation they are actually worried about falling NGDP, they just don’t realize it.  Obvious lower prices, ceteris paribus, are perfectly fine.  But when NGDP growth comes in 10% or 20% lower than workers or borrowers expected when they signed labor and debt contracts, then you have big problems.  Conservatives tend to have a blind spot for that problem (except for Milton Friedman, obviously.)

PS.  I hereby issue “loud cries to unstick wages.

PPS.  Notice to my international readers.  Keep in mind that 40 below zero fahrenheit is equivalent to 40 below zero centigrade.  

HT:  Ramesh Ponnuru

Please respond to our arguments

Saturos sent me a IEA paper on monetary policy , by Pascal Salin.  There’s a section discussing market monetarism:

Let us assume that, because of excessive taxation and regulation, there is a real rate of growth of -2 per cent in a country. If, because of monetary growth of 3 per cent, there is a 5 per cent inflation rate, the growth rate of nominal GDP will be 3 per cent. If the target for nominal GDP is equal to 5 per cent, monetary authorities will increase the rate of growth of the quantity of money in order to reach the target. This will lead to inflation of 7 per cent. Once again, we cannot solve a problem without knowing its causes. If the low rate of real growth is due to non-monetary factors, one cannot change it just by manipulating monetary instruments.

It is impossible to reach two targets of economic policy with only one instrument (monetary policy) and the NGDP measure combines together two variables which tend to be affected by different types of policy (monetary policy and policies that affect the real economy).

These things make me want to pull my hair out.  We are told that bad policies that reduce trend RGDP growth to minus 2% will result in 7% inflation under NGDP targeting?  With absolutely no boost to RGDP? That’s the claim?  My response is “hell yes” that’s exactly why we need NGDP targeting!  If you target inflation in that scenario then RGDP growth would be well below minus 2%, and you’ll have mass unemployment.  Indeed the (supposedly awful) outcome he describes is exactly why we need MM.

It doesn’t bother me when someone disagrees with market monetarist ideas.  But tell us why! When it’s clear they’ve never read any of our proposals, and are not responding to any of our claims, then there can be no meaningful debate.  I looked at the references at the end of the paper to try to figure out which market monetarist papers he had read.  The references contained a total of three items.  A 1968 paper by Milton Friedman, and 2 papers by the author himself.  That’s it. No wonder he seemed completely unaware of the logic behind market monetarism.

The second paragraph is even worse.  No, NGDP is not two variables, it’s a single variable.  It’s not even debatable.  His logic would imply that inflation is also two variables, as it can be partitioned into goods price inflation and services price inflation.  In any case, even if for some strange reason you were able to convince me that NGDP were two variables, the standard argument that one monetary policy tool can’t hit two variables would have no relevance.  A single monetary policy tool can obviously hit any nominal composite of two variables that represents a weighted average boiled down to a single number.

BTW, here are some odd points about the article:

1.  He seems Austrian, but ignores the fact that Hayek favored NGDP targeting.

2.  He has nice things to say about money supply targeting, and rejects the claim that velocity is quite unstable.  Yes it seems that way (he argues), but just wait until we stabilize the money supply–then velocity will be much more stable.  OK, so he likes money supply targeting and thinks it would lead to stable V.  And if it was as successful as he anticipates then we would end up with . . .

. . . we’d end up with that awful NGDP targeting!

Did the monetary policy environment change in 2011?

Lots of people have pointed me to an article on the zero bound by Eric Swanson:

According to traditional macroeconomic thinking, once monetary policy hits the zero lower bound, there is nothing more the Committee can do to stimulate the economy – monetary policy is essentially ‘stuck at zero’. A corollary of this observation is that fiscal policy becomes more powerful than in normal times because any stimulus from fiscal policy on output or inflation will not be partially offset by monetary policymakers raising interest rates to keep inflation in check. In other words, monetary policy will not act to ‘crowd out’ fiscal policy because interest rates will remain stuck at zero as long as the economy is weak (see, e.g., Mankiw 2013, Chap. 12).

The role of monetary expectations

More recent research, however, has emphasised how monetary policy expectations can alter this reasoning. Reifschneider and Williams (2000) and Eggertsson and Woodford (2003) show that, if the Federal Committee can credibly commit to future values of the federal funds rate, then it has the power to largely work around the zero lower bound constraint. As these authors point out, the economy depends not just on the current level of the federal funds rate (a one-day interest rate), but rather on the entire path of the expected future federal funds rate over the next several years. Put differently, businesses and households typically look at interest rates with maturities out to several years when making investment and financing decisions. Even if the current federal funds rate is stuck at zero, the Committee could continue to push longer-term interest rates lower by promising to keep the federal funds rate low for an extended period of time. In this way, the Committee could continue to stimulate the economy even when the current federal funds rate is constrained by the zero lower bound.

This line of reasoning suggests that monetary policy has probably not been as constrained by the zero lower bound as the traditional way of thinking would imply.  Figure 1 plots the federal funds rate along with the one-, two-, five-, and ten-year Treasury yields. Although the funds rate (solid black line) is essentially zero from December 2008 onward, even the one-year Treasury yield averages close to 0.5% throughout 2009 and 2010, and fluctuates noticeably as the outlook for the economy and monetary policy rose and fell over this period. The two-year Treasury yield is even higher and more volatile. Thus, Figure 1 suggests that monetary policy might not have been very constrained by the zero lower bound until at least mid-2011.

I certainly agree with the primary claim of this article–monetary policy was not very constrained by the zero bound in 2009-10.  But it’s disappointing to see someone call the wacky liquidity trap view “traditional macroeconomic thinking.” Perhaps it could be called traditional old Keynesian thinking, but it was certainly a discredited model by the 1980s, if not earlier.

I’m also a bit uncomfortable with focusing on mid-2011, when 1 and 2-year T-bond yields fell close to zero.  There is nothing special about that date, because there is nothing special about 1 and 2 year T-bonds.  Three-month yields were close to zero throughout 2009 and 2010, and 5-year yields have been well above zero since 2011.  Nothing of importance changed in 2011.  The Fed always has the ability to adopt monetary stimulus if it chooses to do so, as interest rates are not an important part of the monetary policy transmission mechanism.  Of course the Fed ended QE1 and QE2 and QE3 because each time they (wrongly) thought the economy didn’t need any more stimulus.

The paper uses a rather indirect method of trying to ascertain whether monetary policy is constrained.  Swanson looks at whether longer-term bond yields are impacted by economic news. But why not look at whether longer-term bond yields are impacted by monetary news?  And why pick a highly ambiguous indicator like interest rates? Why not look at whether forex prices and stock prices and TIPS spreads are impacted by monetary news?

Nonetheless, I’m pleased that a distinguished economist like Eric Swanson has concluded that monetary policy was much less constrained than many pundits assumed.  At the end of the article, Swanson notes that this implies that crowding out continued to apply after 2008, thus weakening the impact of the ARRA stimulus program.  But crowding out assumes a constant money supply, which is obviously unrealistic.  In fact, “crowding out” depends almost entirely on the degree of monetary offset. I’d like to see the profession stop talking about the crowding out of aggregate demand and move on to the real issue; how do central banks respond to fiscal initiatives?